In this episode of Industry Focus: Energy, host Nick Sciple is joined by Motley Fool senior analyst John Rotonti to break down the industrial gas industry and the case for investing in industrial gas giant (and Dividend Aristocrat), Linde (NYSE:LIN).
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This video was recorded on June 28, 2021.
Nick Sciple: This episode of Industry Focus was recorded on June 28th, 2021. Some things may have changed between then and when you're hearing this episode. Welcome to Industry Focus, I'm Nick Sciple. This week, Motley Fool Senior Analyst John Rotonti returns to the show to take a look at the industrial gas industry, focusing on one of its most dominant players. John, welcome back to the show.
John Rotonti: Thanks, Nick. Always love being on the show. I was just thinking back before I came on, I think this is the fourth episode we've done on your Industrial podcast and I've loved it all. It's one of my favorite things I do at The Motley Fool.
Sciple: Well, I'm excited to have you back on. We've got another exciting sector to talk about. In the past, we talked about water heaters, so we talked about water, now let's talk about gas. I mentioned we are going to talk about Linde later, but first off I just want to give an introduction into the industrial gas market. For folks who may not be familiar with this, what is it? What do they do? Why does this matter? Why is it important in the world?
Rotonti: Linde is the largest industrial gas company in the world. It generates about $28 billion in sales, has a market cap of $148 billion. It does have net debt of $11.6 billion, so its enterprise value is about $160 billion. But its balance sheet is very strong, which we can get into. Basically at a high level, these industrial gas companies produce a variety of industrial gases using cryogenic air separation and other technologies. Then it sells these gases or these molecules to clients in different industries around the world. It does operate in a global oligopoly, with the three largest players being Linde, Air Liquide and Air Products and Chemicals. Combined, those three players have roughly 80% global market share, and Linde has roughly a third of that. There is another market outside of the big three because some customers have their own industrial gas plants. Over time, Nick, that could provide a slight growth opportunity, because Linde does occasionally acquire some of these plants that its customers are decommissioning or deconsolidating. But there you have it, it is a global oligopoly. The three largest players have 80% global market share, and Linde is the largest. I'll say the primary gases sold are oxygen, which is used in healthcare facilities, both hospital and home care. People need oxygen. Steel mills also use oxygen to heat the blast furnaces. So oxygen is a big one. Hydrogen that is used for ultra low sulfur diesel. It's used to make electronics, it's used for jet fuel, for rockets. Nitrogen is used to make semiconductors, it's used for food freezing. Argon is a big industrial gas used in welding. Then, CO2 used in beverages for the bubbles in the beverage and in food freezing. So those are the five big gases.
The last thing I'll say about the industry is that industrial gases, and one of the things that attracts me to the industry, Nick, is that they are an essential product for global growth and industrial production. I just went through some of the industries they sell into, including electronics and semiconductors. They are an essential product, but they only account for a very small percentage of their customers' total expenses or their customers' total budget. Usually, only 1-3% of their customers' total budget. Like I said, these gases are sold into everything from steel mills to hospitals, to semiconductor fabrication facilities.
Sciple: These things are difficult to do. What's the process of making these gases? You've mentioned cryogenics. This is complicated chemistry going on here.
Rotonti: It is complicated chemistry. It's a highly capital intensive business. Cryogenic air separation is the way that they produce their atmospheric gases. Basically cryogenic air separation is when you chill down, you freeze these atmospheric gases down to a point where you can separate the primary components of that atmospheric gas. Those primary components are oxygen, nitrogen, and argon. You separate those primary components to where they can be stored and then shipped and delivered to the customers. Process gases, non-atmospheric gases like hydrogen and carbon dioxide, are basically manufactured using a variety of other methods. But there is real chemistry, real technology happening here on a molecular level. These are molecules.
Sciple: You mentioned this industry, essential products, global oligopoly, why does Linde stand out to you among that oligopoly as the company of interest to you? I don't think we gave a ticker earlier. LIN is the ticker if you're looking up the ticker in the U.S.
Rotonti: That's right, Nick, it is ticker LIN. This is a company, because you mentioned the ticker, I should have also mentioned, Linde was founded in 1870 something, maybe 1878,1879, off the top of my head. It merged with Praxair, which we will get into that merger in a second. Praxair was founded in 1907. So these are 100+ year-old businesses still to this day just as relevant, if not more relevant than ever, powering our economy like never before. Here's how that works. The business model: there are three distribution modes. First, Linde will build an on-site plant with a direct pipeline to the customer. What I mean by on-site is literally on the same ground or directly next to a customer's site, they build one of these air separation plants. On top of that customer's plant Linde will add a liquifier to liquefy these gas down and then they will sell that liquid version of the gas to merchants within a two hundred mile radius. First distribution mode is the on-site plant directly piped into the customer through a pipeline. Then they also built a liquefier. The second distribution mode is to sell to merchants. Basically, you take the gas from that on-site facility, liquify it and put it in a tanker truck that you see on the road, bringing that tanker truck of merchant gas delivered to the customer. That liquefied gas is stored in a Linde owned storage tank on the customer's facility that Linde leases to the customer.
Then the third distribution mode is they put that liquid gas into smaller metal cylinders. That's their packaged industrial gases. On-site you have a merchant and then you have packaged. Linde has all three. The reason I like Linde is it is further along in having all three distribution modes as far as my research can tell. Air Liquide is doing all three, but as far as I can tell a couple to several years behind Linde in doing this network density model. The other major player, Air Products & Chemicals, is just at this point focusing on on-site at this point. I feel like Linde has a more diversified business model. The other thing I like about the industry as a whole Nick is the customer terms, the pricing dynamics. Basically, these on-site plants, Nick, are 10-20 year take-or-pay contracts. Super long term contracts, take-or-pay. They have minimum requirements that also have cost pass-throughs written into the contract. Linde's biggest costs are natural gas and power and electricity. If those go up, Linde passes those higher natural gas and higher electricity costs onto its customers that were written into the contract. That's the on-site business 10-20 year contracts. For the merchant business those are five to seven year contracts, or let's say three to seven year contracts. The package, the smaller cylinders, those are two to five year contracts, but these are all long-term contracts. The merchant and the package have historically increased prices year-in and year-out, about 2% per year. Important to note, Nick, the on-site business has long-term 10-20 year take-or-pay contracts with annual cost pass-throughs written into the contract and the merchant and packaged businesses have pricing power equal to about 2% annually per year.
Sciple: Yes, so maybe it's helpful to give us some examples here. You've got the on-site business. You set up an airplane and you hook up a pipeline to say an oil refinery or something like that.
Sciple: Or you're going to use where you're going to take this, you're going to use a steady amount of this product every single day. You can't turn this plant off. The merchant business, think about maybe your local restaurant that needs to use the carbon dioxide or what have you in their processes or what have you. You have a tank outside of the back of the restaurant, that's where they put the product. Then lastly, the package business is like someone who needs at-home oxygen and they get an oxygen tank delivered on a regular basis to their house. Maybe that goes from Linde to a supplier before it gets to that customer. But these are the folks who are using this business model. This big industrial customer, hooked right up into my veins, smaller industrial customer, you need a tank on your facility and then an individual user, you've got this smaller individual cylinder tank like you might see folks who use these personal oxygen. All these customers have different needs and different requirements and you can satisfy all of them from those same facilities. You can make some of those deliveries. You can take the stuff that you're piping into one of these bigger on-site facilities and instead, hook that up to a truck and that truck goes out to distribute some of the same places. You use the same resources for multiple distribution modes. Have I said it the right way?
Rotonti: It's exactly right. For a lot of small restaurants I think they're going to use packaged CO2 in the cylinders, but you're exactly right. Massive plants have the on-site literally on their grounds or right over the fence, it's called over the fence CapEx literally a pipeline directly next store piping in. They don't use all of the gas. The extra gas that the anchor customer does not use is liquefied and transported to other customers within a 200 mile radius. This is a really other important part of the business model, Nick. These gases are difficult and expensive to ship. These industrial gas companies build these 200 mile radius moats literally all over the world. These are geographic moats because it is so difficult and expensive to shift this stuff. What happens is, Nick, this is also really important. Something I think the market actually may be missing about Linde and that I want to highlight is that we talked about the pricing power. The reason Linde has pricing power Nick is because they're selling an essential product, as we said. Yet account for a very small percentage of their customers' overall budget, as we said. But the third part of this is customers need reliable access to these gases. Think about if a hospital doesn't have access to oxygen or a steel mill doesn't have access to oxygen or semiconductors facility doesn't have access to nitrogen. People die or production shuts down. These are essential products.
Their customers see them as a utility, they want reliability. Just as they see their water or their light as a utility, they see Linde as utility. If Linde already or if any of these players already have a plant in that 200 mile radius. Linde is more likely to get a second plant in that 200 mile radius because their customers want backup capacity. They want that reliability that you would get from a utility company. The fact that these customers want reliability, Linde is more likely to get a second or a third plant within that 200 mile radius and the same for the other players that are using this network density business model of multiple modes of distribution. There is very little competition within these 200 mile radiuses. You build these modes within this 200 mile radius where you have basically all of the business from the on-site customers and other merchants within that radius. It's a really, really strong, reliable, predictable business model. A lot of people talk about recurring revenue, one of the most recurring sources of revenue out there. Rightly so, people talk about software with recurring revenue because of the subscription models.
But one of the greatest sources of recurring revenue is when you have Linde build a plant on your grounds and connect to your facility direct pipeline or you have a Linde storage tanker truck on your facility that Linde is leasing to you. This is a really predictable, high recurring business model. About 25-30% of their revenues come from these 10-20 year take-or-pay contracts. But about another 30% of their revenues come from defensive industries like healthcare, electronics and technology, food and beverage. 60%-ish of their revenue, I would describe as highly predictable or recurring in nature.
Sciple: We talked about before we hopped on the show John. It really feel like the pipeline companies, the oil and gas pipeline companies except with none of or much less of the environmental concerns that actually if you want to get into some of the SG stuff going on with Linde, actually trying to help solve some of these problems when it comes to emissions and gas storage and things like that. But when you look at the take-or-pay contracts, steady increase, all those things, its infrastructure essentially, but infrastructure, without some of the negative implications you have of other pipeline infrastructure.
Rotonti: Totally, Nick, I like that analogy and [laughs] especially because Linde builds pipelines directly giving access to their on-site customers. You mentioned the take-or-pay contracts, we mentioned the annual price escalators, 2% pricing power. I do want to highlight just because you mentioned it. I didn't know if we're going to go here honestly, but the SG story is, I think, underappreciated too. Linde has been on the Dow Jones Sustainability World Index for 18 consecutive years, something that no other chemical company can say. It's also on Ethisphere's list of the world's most ethical companies for 2021. It has set a goal to have 30% female employees by 2030. It's on pace to beat that. It's developing and commercializing carbon capture technologies that capture CO2 emissions, and then repurpose those emissions for food-freezing, for dry ice, for carbonated beverages, for water treatment. Then perhaps most exciting of all, is that it has this opportunity to sell hydrogen as a green fuel alternative into various industries. Nick, you know about hydrogen better than me because you follow transportation so closely, but they can sell hydrogen as a green fuel to fuel-cell EV manufacturers, to other energy companies, to renewable power producers. I think that the hydrogen business in particular and their carbon capture business gives them a degree of optionality, Nick.
Sciple: Yeah. I'm not an expert on the hydrogen business by any means, but I would say that the folks that are experts in industrial gases are probably positioned to benefit if that becomes something that's needed at a pretty wide scale because they've been doing it for a long time. The hydrogen business has actually been around for a long time. It's not at this huge scale that it might be in a world with fuel sales. There's some healthy skepticism about whether that world materializes. But it's out there. I think that the carbon capture stuff most certainly is coming. It's something that we're going to see lots of investment dollars flow toward where I think these folks can be big beneficiaries.
Rotonti: Linde has the technology. They're investing in that R&D. They generate enormous cash flows. Nick, for such a capital intensive business if you just pop into CapIQ your free time or whenever, this is a mid to high-teens free cash flow margin business according to CapIQ. It's honestly the economics of this business. We talked about why, because of the long term contracts. Because of the reliability of the revenue. Because of the pricing power. The economics of this business are really strong.
Sciple: I wanted to get into that, John, and just through resiliency and all that serves a quote. I pull it from the 2020 CEO, his letter to shareholders. It says, "Excluding the effects of currency earnings per share," this is in 2020, "Grew 13% while sales were down 2%. Gross operating cash flow grew 21% and we returned $4.4 billion to our shareholders between dividends and share repurchases, return on capital. The single most important metric for a capital intensive business grew 180 basis points to 13.4%. Based on our ability to expand free cash flow during the most challenging economic conditions we increased our dividend by another 10%, representing the 28th consecutive year of dividend increases. These results are a testament to our ability to outperform in any macroeconomic environment. What can you say about the resiliency of the company in the past year? Is this an unbreakable business? Sales were down 2% in all those good numbers. The dividends up another 10%. This is probably the biggest disruption we're going to see in the economy in decades and this company just kept on checking.
Rotonti: Nick, I love that you bring that up. I actually think you're underplaying that when you say the biggest disruption we're going to see in decades. We saw for the first time in recent memory, a global economic shutdown in order to stop the spread of the COVID virus. A global economic shutdown. During that, as you said, this company's sales barely shrink because of its ability as an exceptional operator. Steve Angel is as good as they come, he's CEO. He is as good as they come, in my opinion, he's the first ballot Hall of Famer if such reward existed for CEOs because of their exceptional operating ability, because of the contract terms that they have, Nick. We've talked about it several times already on the show, the contract terms, these long term contracts with escalators built in, they generate highly resilient cash flows. You mentioned the dividend for 28 consecutive years, that makes some of the dividend aristocrats. They have a 1.5% dividend yield. Nick, to put this in the respective, they grew their dividend 10% in 2020 during a global economic shutdown, another one of my favorite businesses, when Disney suspended their dividend.
When blue-chip companies were suspending or cutting their dividend Linde went on like it was nothing, growing their dividend 10%. You mentioned the 13% return on invested capital, that's now 14.5% as of the last 12 months. The reason they are able to do this is because not all CapEx is credit equal to the bank. What this company, like I said, they have these contractually secured growth, businesses that generate mid-teens returns on invested capital and the way you get to mid-teens is the on site business building a plant on a customer site that is a double digit after tax unlevered IRR. It's highly capital intensive. Let's say that's a 10% or 11% return on invested capital business. Then you add on merchants and package the cylinder business. Those are much more asset light. They're not as capital intensive and the merchant and the package business has the 2% annual pricing power year in and year out. Those are much higher ROIC businesses. You bring that up to a corporate level, mid-teens ROIC business. Now Nick, also, this is a growing business so let's actually model out organic revenue growth here on your show. Let's start with global GDP. I estimate that's going to be 3% going forward. Then on top of that, Linde's backlog has historically added another 1-3% annually.
Then, on top of that, Linde historically has increased prices 2%. Finally, I think I'm being conservative. I'm going to add only 1% from secular growth drivers such as healthcare, semiconductors and then possibly green energy, like we talked about. Three% from global GDP plus 1-3% from backlog plus 2% pricing power plus 1% from secular growth drivers. I think this company can conservatively grow revenue organically, 7-9% on average annually over time. You add in slight margin improvement because this is a fixed asset business model. As they flow more sales volume through that fixed asset base, there will be some operating leverage. Like I said, they are excellent operators so efficiency improvements as well, you add in slight margin improvement and buybacks. I think this is easily a company that can grow earnings per share at least 10% over the long term.
Sciple: In a business like this where the runway you've already got this business has been around for 100 plus years, probably going to be around 100+ years into the future. 10% revenue growth in a vacuum maybe doesn't get a lot of people excited. When you look at a lot of the SaaS companies that are growing +30%, what have you, 10% revenue growth for 50 years is a crazy big number. That's a perspective you have to have for a company like this.
Rotonti: Yeah. I mentioned 7-9% organic revenue growth and then at least 10% earnings-per-share growth, but you're exactly right next. Something that I talk about on Twitter quite often is a long duration growth company. They may be moderately growers. They may not be the fastest growers but if they can do it over decades, at a mid-teens return on invested capital and continue to compound that dividend per share year in and year out for the next 28 years I think you'll have a solid long term investment opportunity. Not to mention, Nick, this balance sheet, if you're just scanning, like screening for companies with net debt you see that it has $11 or $12 billion, I don't know what it is, net debt. At first glance you may have for this company, no, Nick, this is honestly an under levered balance sheet. It's debt-to-capital ratio is only 25%. Its interest coverage, which is operating income or EBIT, divided by interest expense, is 18. That's the highest interest coverage in at least a decade, according to CapIQ. It has an A credit rating from both S&P Global and Moody's. It has an attractive credit rating from new contracts, and that's their second highest possible score.
As of March 31st, 2021, 77% of their debt is in the form of long-term fixed rate corporate debt. This is not bank debt, not variable debt. 77% is a long term fixed rate, and Nick, it's cost of debt is so low. Listen to this, in August 2020, Linde issued 10-year bonds with a 1.1% interest rate, and they issued 30-year bonds with a 2% interest rate. But Linde issued 10-year bonds with a 1.1% interest rate. On that very same day, Google parent company, Alphabet, also issued 10-year bonds at the exact same 1.1%. This is an extremely strong balance sheet company, and honestly, Nick, given the utility-like nature of this business, the stable recurring cash flows that we talked about, I think there's room to make the balance sheet slightly more efficient, by increasing that invested capital turnover, which would drive returns on invested capital even higher.
Sciple: Right. With the cost of debt at 1% and a double-digit return on invested capital, as a shareholder, you would like them to level up. If they can find efficient projects that return those historical types of returns, that will be fantastic.
Rotonti: You're exactly right. You are talking about something called the economic spread, or the spread between the company's return on invested capital and its cost of capital, and Linde's is quite large.
Sciple: That's an understatement. Yeah. We've said lots of really positive things about the company, John. Any risks to highlight for folks?
Rotonti: Linde's growth is somewhat tied to global GDP, and that was the base at which I built my revenue ladder also toward global GDP. If we see a sustained downturn in the economy, Linde's sales will fall, but I think that's the biggest risk on the horizon. It's going to be short-term in nature. Linde will survive, like I said, this company was founded in 1870. It will come out of it probably stronger, Nick, because of its strong cash flows, maybe it can make some smart investments or acquisitions at the bottom of the market at distressed prices. But for investors, if they don't like to see a stock price fall, in the short-term, I think that's the biggest risk. That we see some sort of sustained global economic recession, and that would affect, probably the stock prices short-term. That's the biggest risk that I see right now. I see Linde as a company that's un-Amazonable, if you will. This is a wide moat, I think, highly resilient, fairly predictable business.
Sciple: Oligopoly business just grew earnings double-digits, as we mentioned during the pandemic when we had this wide-scale economics shutdown. The nature of the contracts is such that folks have to meet minimum requirements even if there is an economic downturn, so you have a floor to your downside on a lot of these deals. Is a really, really resilient business. If you need an industrial allocation, or you need a part of your portfolio that you just feel comfortable about, or you are looking for income without growing the dividend 10% in this past year. I think it's a great potential holding. John, any last thoughts on Linde before we hit the road?
Rotonti: Nick, I'll say two quick ones. One is Steve Angel and his team. They understand the drivers of intrinsic value growth. One proof point for that is, their pay is based on return on invested capital over a three-year period. Long-term focused, return on invested capital, that's how they are incentivized. The last thing I'll say, as Fools, if you were going to go do a screen for this, you're going to go look at it's financials, you'll see that it's gross margins, 44%, are at pre-merger levels. They merged with Praxair in 2018. EBIT margins on a GAAP, generally accepted accounting principle basis, are down from 22% to 16%. This is strictly because of an accounting regulation thing, which has nothing to do with their true earnings power. Basically, what happened was, when they merged with Praxair, purchase price accounting or PPA, forced them to write up Praxair's assets on the day of the merger, on October 31st, 2018. This is a one for one merger, Nick. No cash exchanged hands. One-for-one merger. Because of this, they are forced to write up the value of Praxair's assets on the day of the merger. Because of that asset write-up, depreciation jumped hugely. Off the top of my head, I think it was from $1 billion a year to $4 billion a year. Depreciation, Nick, as you know, and as our members know, is an expense on the income statement. It's a track on the income statement. EBIT margins on a GAAP basis, are down to 15-16%. It's a meaningless number. It's strictly accounting, so on an adjusted basis, EBIT margins are back to their pre-merger level.
Last thing I'll say is, if Praxair's and Linde's stock price were the same on October 31st, 2018, on the day of the merger, then no write-up would've had to happen. Linde would not have had to write-up Praxair's assets. That depreciation would not have jumped, and the GAAP EBIT margin would not have fallen as it did. If you're just looking at that, understand what is driving that, and on an adjusted basis, Linde is highly, highly profitable.
Sciple: Excellent, John. Thanks for joining me on the show. As always, can't wait to have you on again next time.
Rotonti: Nick, thanks. Love being on the show. Can't wait for next time.
Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show. For John Rotonti, I'm Nick Sciple. Thanks for listening and Fool on.