Following the institutional investors can be a useful strategy for retail investors.
Institutional investors are so big, they move the market. This is a form of “bottom feeding” investing, where retail investors can lurk in the shadows of “whales” (institutional investors) and get fat on the leftovers. The same principle can be used by following “sharks” (activists).
The likes of activist investors, including big names such as Carl Icahn and Bill Ackman, have been reforming companies for decades now. And for those investors who followed Icahn into Chesapeake Energy Corporation (NYSE:CHK) or Netflix, Inc. (NASDAQ:NFLX), they were handsomely rewarded. These sharks take meaningful stakes in companies and then push for management shakeups, restructurings, spinoffs, operational improvements, etc.
Has the market lost faith in Ackman that quickly? Granted, the media has had a field day over the J.C. Penney Company, Inc. (NYSE:JCP) debacle, not to mention the virtual implosion of his Herbalife Ltd. (NYSE:HLF) short. However, Ackman is coming off one of his biggest wins with Canadian Pacific Railway Limited (USA) (NYSE:CP), which also happens to be in the industrials sector. His Pershing Square hedge fund managed to make 2.5 times its money in just around two years at Canadian Pacific.
While Ackman emphasized the need for operational reform and efficiency improvement at Canadian Pacific, the campaign at Air Products could prove to be a bit different. Ackman hasn’t laid out his exact plans, but he has called Air Products’ business “simple, predictable, and free-cash-flow-generative, and enjoys high barriers to entry, high customer switching costs and substantial pricing power.”
All characteristics of a great investment, but the valuation alone does not appear to be a viable investment thesis. Air Products trades at a price-to-earnings (P/E) ratio of 23.2, in line with its peer Airgas’ 24.3 and Praxair’s 21.7.
As well, Air Products has grossly underperformed its peers over the past decade, with its stock up only 118%, compared with Airgas’ 477% return and Praxair’s 275%. This is, in part, because the company continues to underperform in terms of its return on invested capital (ROIC) and return on equity (ROE). Air Products has an ROIC of 7.6% and ROE of 15.3%. Compare this to Praxair’s ROIC of 11.3% and ROE of 29%, and Airgas’ ROIC of 8.3% and ROE of 19.4%.
Air Product’s dividend is already the highest among the three major gas companies, paying a 2.7% yield, compared with Praxair’s 2% and Airgas’ 1.8%. The payout ratio is 60%, leaving little room for a dividend increase.
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| Copyright © Air Products and Chemicals, Inc. | ||
| Ackman has called Air Products’ business “simple, predictable, and free-cash-flow-generative, and enjoys high barriers to entry, high customer switching costs and substantial pricing power.” |
So what does Ackman see as the real catalyst?
One of the big opportunities lies in Air Products’ balance sheet. The company has a debt-to-equity ratio that’s nearly half of Airgas’ and Praxair’s, and its leverage ratio is at least 80% of either peer.
With this less levered balance sheet, Ackman could push the company to recapitalize and make share repurchases or pay a special dividend. Ackman could also push the company to make acquisitions.
Air Products made a play for Airgas in 2010, but eventually abandoned its efforts. Ackman could push for a marriage of the two, which would allow Air Products to better compete with Praxair. Praxair has a market cap that’s 50% greater than Air Products and nearly five times that of Airgas. But together, Air Products and Airgas’ revenues would surpass Praxair’s by 30%.
Assuming that Ackman “does his thing,” whether it be optimizing operational efficiencies or leveraging the balance sheet, the plan is to bring Air Products’ returns more in line with peers. Assuming Ackman gets Air Products’ ROE up to 20% with share repurchases and modest operational improvements, the stock could easily see $145 over the next 12 months.
Risks to consider: As with any activist investment, there is the risk that the activist announces plans for increasing shareholder value, the stock moves up quickly in a short time period, but plans fail to materialize and the stock tumbles. Air Products also has a poison pill in place that prevents Ackman from buying more than 10% of the company without having board approval.
Action to take –> When activists get involved in a company, the stock tends to see an initial run, but they also tend to outperform the broader market over the following years. Investors haven’t seen the initial pop in Air Products stock, but once Ackman lays out his plans, the stock could move higher.
P.S. Air Products is one of those companies that are fundamental to broad economic success. It reminds us a lot of what we call “forever” stocks. “Forever” stocks can be bought, forgotten about and held — forever. To learn more about these stocks — including some of their names and ticker symbols — click here.
– Marshall Hargrave
