When chemical gases producer Air Products and Chemicals (APD 0.13%) reported its earnings last week, and warned investors that its Q2 profits will probably come up short of analyst estimates (at $2.15 per share, rather than $2.25), you might have expected investors to spook and sell off the stock.
In fact, the opposite happened. Despite the earnings "warning," Air Products stock gained 2.8% after earnings, and has mostly held onto those gains in the days since.
The reason: Air Products' Q1 earnings were just that good.
Image source: Getty Images.
A good 2019, and a good start to 2020
Air Products is coming off a strong fiscal year 2019, in which profits grew 10% (according to data from S&P Global Market Intelligence), but Air Products' stock price responded with an even greater 47% rise in value. So as you might expect, expectations were high for Air Products coming into Q1 earnings last week.
Analysts predicted the company would report earnings of $2.08 per diluted share, an astounding 32.5% increase year over year. And yet, not only did Air Products deliver every penny of that projection, it threw in a few extra pennies besides, reporting $2.14 per share in profit and scoring an "earnings beat."
Although sales grew only a bare 1% year over year to $2.3 billion, Air Products expanded the profit margin it earns on that revenue dramatically -- up from 16% to 21.7%, net. As a result, the company's profits soared 36% year over year.
What about the rest of the year?
CEO Seifi Ghasemi called the first-quarter results "strong," but despite the company earning more than expected in Q1, he hesitated to raise guidance for the rest of the year. Instead, Air Products guided investors to continue expecting Q2 earnings of between $2.10 and $2.20. (This was an "adjusted" projection, but Air Products' pro forma numbers tend to approximate its actual GAAP results closely enough that I think we can trust the adjusted numbers being very close to the company's "real" numbers.)
Farther out, Air Products is sticking with full-year adjusted guidance for between $9.35 and $9.60 per share in profit, up 14% to 17% in comparison with 2019 -- again, not adjusting the guidance upwards by the amount of the Q1 beat.
What it means to investors
Based on the reaction we've seen in Air Products' share price so far, it seems investors are fine with this. But should they be? After all, if the rest of the year still looked as strong to Air Products management as it did when the company issued its previous guidance last quarter, then logically management would take the $0.06 in "extra" profit earned in Q1 and add it onto the guidance for all of fiscal 2020. The fact that they did not do this could mean management is simply being conservative -- or it could mean the rest of the year might not go as well as Q1 did.
That could be concerning, given that even if everything goes as planned Air Products' profits will grow at most 17% this year -- a bit slow to justify the 25.7-times-earnings valuation of the stock, assuming it hits the top of its guidance range this year. (And based on trailing results, Air Products currently sells for an even pricier 29 P/E ratio!)
Adding to investor concerns, Air Products noted that fiscal 2020 capital spending will run between $4 billion and $4.5 billion, which is more than the company spent in 2017 and 2018 combined. Even at the $4 billion level, this means the company will be deeply free cash flow negative this year -- probably at least $1 billion in the red. This would be the first time that has happened to Air Products this millennium.
Granted, earnings aren't the only reason investors invest in Air Products. A certified Dividend Aristocrat, Air Products has raised its quarterly dividend for 37 consecutive years. This year was no exception, with management hiking the quarterly dividend 15.5% to $1.34 per share. At today's share price of $243 and change, that works out to a 2.2% dividend yield -- above the average yield of around 1.9% on the S&P 500.
That doesn't change the fact that Air Products looks overpriced at 29 times earnings today, but Air Products' steady record of paying dividends in good times and bad may help explain why investors are willing to forgive the company a bit of weak guidance this year.
