There are not many businesses whose primary raw material is, literally, as free as air. Although there are important industrial gases that are not distilled out of air by refrigeration, most of the principal industrial gases are. They are virtually omnipresent in manufacturing, used for:
- isolation: protecting reactive items from oxidation and fire suppression
- refrigeration and flash freezing: use as coolants
- combustion: acetylene for welding, cutting, brazing, and soldering
- oxidation: enriching combustion atmospheres; also in chemical processes and bleaching
- propellants and purgation: chemically neutral media for aerosols and cleaning pipes
They have important nonindustrial applications in healthcare, water treatment, diving, greenhouses, and beverage carbonation. Exotic gases such as arsine and silane are used for a variety of purposes in the semiconductor industry that do not fall into any of the categories mentioned.
Praxair (NYSE: PX) is the Western Hemisphere's largest gas supplier. The refining, petrochemical, and steel industries are major users: Typically Praxair enters into long-term take-or-pay contracts with them, and builds plants on site. These usually supply other consumers, too ("merchant" sales), typically with bulk deliveries by road or rail tanker. Some merchant customers (including Praxair units) fill cylinders ("packaged" sales) for use in medical, welding, diving, carbonation, and other applications. On-site, merchant, and packaged sales accounted for 29%, 34%, and 29% of Praxair's nine-month gas revenue, respectively.
Praxair earned 41% of its nine-month revenue in the U.S., 13% elsewhere in North America, 14% each in Asia and South America (of which, 11 percentage points from Brazil), and 12% in Europe; the remainder came from surface technologies, itself a minor multinational. The U.S. gas business is more profitable than other regions and surface technology.
Given the international spread of its activities, dollar strength has been a drag on Praxair's 2015 revenue. In the first nine months of 2015, forex subtracted 9.5% from year-over-year revenue growth, Brazil being especially painful. However, industrial gases, being bulky, are essentially a local business. Other than, perhaps, in gases for the semiconductor industry, which are high-value, low-volume items, Praxair is not an exporter, so currencies only generate translation losses. Nine-month revenue declined 11.9%: Prices were a bit firmer, but volume declines more than offset them. Declining demand from oil and gas drillers and a decline in sales to Western Hemisphere manufacturers (not further specified) are to blame. This should be corrected with the price increases -- some of them quite significant -- that Praxair announced on Dec. 16.
Disregarding restructuring charges, pre-tax income declined 10.2% year over year, reflecting savings across the board, but especially on cost of sales. The latter reflects lower energy costs (most industrial gases are produced through refrigeration or with super-heated steam; these and compression are energy-intensive). Ex-restructuring, pre-tax margin rose 1.9 percentage points.
Praxair has enormous operating leverage. Its most important raw material is free. It has relatively few other variable costs: Its manufacturing is quite capital-intensive, full-year revenue per employee will come in above $400,000, equity is 25.2% of its balance sheet total and inventories only 2.9%. For most of its customers, what Praxair supplies them is both crucial and a relatively small, variable part of their costs. Consequently, despite a low-inflation environment in which many companies are under considerable pressure, Praxair can expect to push through the price increases it has announced. The company exports very little, so a recovery of top-line growth does not depend on the dollar weakening -- only on it ceasing to strengthen.
What all this means, especially when energy costs are low, is that just about all of any incremental revenue that Praxair is able to capture drops directly to its bottom line, creating few associated costs along the way. Since the company is exposed to virtually every industry, minor economic recovery, just about anywhere in the world, will increase its income. Praxair provides an ideal hedge against the risk that investors' pessimism turns out to be mistaken.
Meanwhile, the company is clearly able to find cost savings, and its restructuring expenditure in 2015 will benefit 2016 earnings. Opportunities for capital investment are plentiful, as are relatively small, immediately earnings-accretive acquisitions. Praxair has not succumbed to the temptation to increase its borrowings in order to repurchase shares: It has a buyback program, but net repurchases have reduced average shares outstanding only 2.7% over the last year. The company has a long history of increasing dividends and its shares currently yield 2.8%.
There are relatively few hedges that pay you to hold them, and that also have an opportunity to be good investments even if the risk against which they hedge does not materialize. At 17.3 to 17.6 times Praxair's full-year 2015 earnings guidance, the shares are not expensive: They are trading just 1% above their 52-week low. If a recovery of world economic growth does unexpectedly materialize, Praxair is strongly leveraged to it. If it does not, it is probably better positioned than most industrial equities to provide acceptable returns to investors.