Industrial Gas Majors Proceed with Caution

29 April 2002 00:00  [Source: ICB Americas]

As a modest global economic recovery unfolds, the industrial gas sector is expected to improve after unexciting performance in 2001. The consensus among both US and European chemical analysts is that the sector will improve on its 2001 earnings performance, driven largely by price increases and continued financial discipline rather than growing volume.

Upside in 2002
Analysts are generally favorable about the sector's prospects for 2002 as they see a recovery unfold and market fundamentals improve. "Industry positives remain intact for the global industrial gas sector and for both Air Products and Praxair," says Banc of America Securities analyst Mark R. Gulley. "Prices have remained firm throughout the worst industrial recession in a decade while operating rates are 75 to 80 percent," he says. "Pricing has not yet caught up to higher power rates. Power rates and merchant prices tracked each other through 1997. But power rates climbed 10 percent per year 1998 to 2001 while prices were essentially flat through 2000."

Merrill Lynch analyst Donald D. Carson says the demand weakness in industrial gases is ending and earnings improvement will continue because of pricing strategies. "We expect demand for industrial gases to bottom in the first quarter. All the major industrial gas producers remain focused on improving merchant prices back to reinvestment levels, which we estimate could occur within one year in North America," he says.

Analysts look to a similar earnings improvement among the European players. Merrill Lynch analyst Robyn Coombs says the industrial gas sector, like the chemical sector in general, will continue to seek earnings improvement in 2002 through cash flow and cost control. "Many players, especially the industrial gas companies, are focusing on renewed efforts to generate more cash via enhanced capital expenditures discipline and better working capital management," says Ms. Coombs.

Analysts' relatively positive view of the sector's outlook has been mirrored by improved stock performance. Of the five leading players--Air Liquide SA, The BOC Group, Linde AG, Praxair Inc. and Air Products and Chemicals Inc., three companies' stock prices actually reached a 52-week high in the first quarter of 2002. In US dollars and based on the share price of its primary exchange, Linde reached an all time high of $50.49, Praxair of $61.11 and Air Products and Chemicals of $51.65. Conversely, Air Liquide actually reached a 52-week low in late January at $130.375. Both Praxair's and Air Products' share price appreciated nearly 35 percent from the end of the first quarter this year as compared to last year. Linde's share price appreciated 23 percent year-over-year, ranking it third in the group of five. This performance was followed by BOC, whose stock appreciated 13 percent. Air Liquide was the only company whose stock did not appreciate in double digits year-over-year at the end of the March quarter. Its share price increased 7 percent.

Despite improvement in stock valuations, some analysts are more cautious about recovery. Timothy Gerdeman, managing director and US specialty chemicals analyst at Lehman Brothers, is restrained about the tangible effect of the economic recovery of the specialty chemical sector in general and industrial gases in particular. "We are cautiously optimistic that US specialty chemical producers are now exiting this cycle's trough, although the timing and magnitude of a material, sustainable recovery by the second half of 2002 is uncertain at best. Hence, conservatism is warranted," he says.

Commenting on February sales data from the US leading producers Praxair and Air Products and Chemicals, Mr. Gerdeman notes, "We are encouraged by Praxair's comment regarding North America demand beginning to pick up across selected industrial markets." He moderates that assessment with caution based on Praxair's comments from mid-March. "As Praxair reinforced at our Lehman-sponsored investor luncheon on March 11 in New York, 'the industrial economic recovery is likely to occur in fits and starts, rather than in a straight upward sloping line,'" Mr. Gerdeman observes.

On the positive side, analysts say the leading players have sound business models, which include capital discipline and investment in niche areas, and they will report better financial results as overall economic conditions improve. Among the most important elements are "investing in less capital-intensive growth areas, such as electronics and home care; focusing more sharply on services and technology licensing; selectively investing in capital-intensive but high growth areas, such as hydrogen, in which barriers to entry remain high; aggressively raising prices to reverse decade-long deflationary trends; and leveraging the current infrastructure to better exploit the industry's combination of global customers and regional strengths, particularly distributing networks," says David Begleiter, chemical industry analyst. "We believe these actions are already resulting in higher-growth, high return business models at both Air Products and Praxair," he says.

"The key issue going forward, in our view, is whether companies can maintain their newfound capital discipline," says Mr. Begleiter. "With all the gas companies stating their adherence to more capital discipline and, more importantly, investors holding management's feet to the fire, we are optimistic the industry will continue to improve. Our estimate for returns on capital reaching 10.4 percent by 2003 reflects the continuation of a disciplined capital environment," notes the analyst.

ABN Amro estimates the industrial gas sector's aggregate capital expenditures will be $2.8 billion, nearly 12 percent of sales in 2001, a decline of 33 percent from peak levels. The firm projects that capital expenditures will increase 6 percent in 2002 and 9 percent in 2003, with the majority of the spending occurring at Air Liquide and BOC, as spending in Air Products and Praxair remains relatively flat.

Cost savings are only one driver toward lower capital expenditures, observes Mr. Gulley, who also points to changing market dynamics, which include falling investment rates for the sector's merchant gas businesses. "The majors in the US have satisfied volume growth by conversion to on-site supply. As a result, growth in the US merchant capacity has slowed. The second-tier players that were expanding faster than the market-AGA and Messer-have been acquired. Plus, capacity is better utilized," says Mr. Gulley. "Product swaps and joint production facilities allow for better capacity utilization, delaying the need for individual company capacity expansion," he adds. A recent example is the formation of new entity between Linde and BOC, Linde BOC Processing LLC, for which the companies will cooperate in industrial gas production for process plants.

What's Hot, What's Not
Analysts also point to new demand drivers for the industrial gas sector. Schroder SalomonSmithBarney analyst Andrew Benson says hydrogen and health care, particularly in Europe, offer the greatest growth potential for the sector as global oxygen demand will remain relatively flat. The analyst also projects slowing demand for specialty gases and ultra-pure carrier gases used in the electronics industry this year, but cautions that Asia will continue to be a source of overcapacity.

"The industrial gas market has changed. The growth in the second half of the 1990s was driven by environmental legislation and technology change, which led to strong demand for oxygen by the steel, glass and chemical industries. The electronics industry was also a strong source of growth with specialty gases and ultra-pure carrier gases the main products. Asia was also a source of growth and most markets generally have now well surpassed the demand levels of 1997," says Mr. Benson.

Within the traditional bulk gas markets, growth in tonnage markets will continue to be the key driver, according to Mr. Benson, but there will be limited growth in metals and environmental applications.

Instead, Mr. Benson emphasizes the two H's, hydrogen and health care, as the catalysts for volume growth. "The key drivers are hydrogen and health care, largely home care. The outsourcing trend for hydrogen is just emerging in Europe, but it is already well established in the US. Home care provisions are immature in Europe versus the US; consumption is currently about 50 percent of the US level per person. We believe that these two end markets will generate about 60 percent of incremental growth over the next five years," concludes Mr. Benson. Within the hydrogen market in Europe, Schroder SalomonSmithBarney is expecting annual growth of 20 percent over the next five years and growth of 15 percent in European home care and medical gases.

For electronics, which had been a bright spot, Ms. Coombs remains, as do other analysts, cautiously optimistic. "Anecdotal evidence of electronics picking up [comes] from Air Products, who had just returned from Asia, from Rohm and Haas in electronic materials, whose first quarter sales were up 3 to 4 percent versus the fourth quarter, and from RPM, who supplies coatings and building products, [and] from Intel, who just rescheduled a new plant in Ireland that has been on hold. Seems so far that the recovery is more in consumer electronics rather than industrial/electronics infrastructure," says Ms. Coombs. Also in the first quarter of 2002, Intel Corp shipped its first 0.13 micron chips produced on 300 millimeter wafers. The chips were produced at the company's Hillsboro, Ore., facility.

SalomonSmithBarney analyst Gil Yang also says the semiconductor sector is improving, albeit modestly. "Despite the worldwide slowdown in the semiconductor industry, we believe there are still ample growth opportunities for electronics chemicals," he says. "As the industry continues to 'miniaturize,' through shrinking line widths, and new technology such as copper becomes more prevalent, we believe opportunities exist for electronics chemicals suppliers. Sufficient yields of high-density, advanced semiconductors cannot be achieved without the use of electronics chemicals," notes Mr. Yang.

Longer term, as the sophistication of semiconductor chips manufacturing improves, so will the use of specialty gases. "As more and more semiconductor chips move toward leading-edge manufacturing, the use of specialty gases is expected to increase. Gases used in the etching process should benefit from this trend while the growth of atmospheric gases should be closer to the production of integrated circuits," says Mr. Yang.

The largest volumes of gases used in semiconductor processes are for the protection of wafers from atmospheric exposure during the manufacturing process and to carry or dilute other gases. Nitrogen is used most in terms of volume, followed by hydrogen, oxygen, helium, and argon. The gases used in semiconductor manufacturing are not categorized as specialty gases in the traditional sense, but these gases require high levels of purity, rendering them highly specialized. Gases are also used in the semiconductor manufacturing process as dopants, dry etchants and in chemical vapor deposition (CVD). During the CVD process, controlled chemical reactions are used to deposit functional layers of semiconductor, dielectric, or conductor materials. Silane, dichlorosilane, trichlorosilane, silicontetrachloride, disilane, tetraethylorthosilicate, silicon tetrafluoride, methylsilane, germane, ammonia, nitrous oxide and tungsten hexafluoride are some of the gases used in CVD processing.

Unlike the overall industrial gas market, which is dominated by the five major companies, the global specialty gases market is open to more competition. "Several companies that purify and repackage gases from the original manufacturer dominate the specialty gas business for semiconductor manufacturing in the US. However, no single company produces all of its own gases. Air Products and Chemicals, Praxair, BOC Edwards, Nippon Sanso (Matheson), and L'Air Liquide are the major suppliers of specialty gases for the semiconductor industry. In addition to Air Products and BOC, major suppliers of gases for the semiconductor industry in Western Europe are AGA Gas, Alphagaz (a division of L'Air Liquide), Linde, and Messer Griesheim GmbH. Companies that supply gases for the Japanese semiconductor market include Air Liquide Japan, AirWater Inc., Iwatani Industrial Gases Corp., Kanto Denka Kogyo Company, Koatsu Gas Kogyo Company, Ltd., Mitsui Chemicals, Nippon Sanso Corp., Osaka Sanso Kogyo Ltd., Showa Denko K.K., and Taiyo Toyo Sanso Company Ltd.," comments Mr. Yang..

Major PlayersShow Restraint
In terms of acquisitions, the five major players were modestly active during the first quarter of 2002 (charts, below and on page FR8). BOC announced the largest acquisition for its nongas vacuum business, Seiko Instruments' turbo molecular pumps business, at roughly $80 million, which is part of its plan to position itself in semiconductor manufacturing. Also, earlier this month, BOC announced a joint venture with Sinopec Yangzi Petrochemical Corp. The new entity, Nanjing BOC-YPC Gases Company, will supply industrial gases in Nanjing, China, which will include supply to BASF-YPC Company Ltd., the BASF/Sinopec joint venture that is building an integrated petrochemical complex in China. The BOC-YPC venture includes a $100 million investment by BOC to purchase three and to construct one air separation unit by 2004. The facility will be able to produce 2,600 tons of gaseous oxygen and 2,000 tons of gaseous nitrogen and liquid product to the local merchant market. The investment marks BOC's largest investment in China. Also, BOC made a $16 million acquisition for a 36.5 percent stake in Nissan Industrial Oxygen.

In other moves, Air Products and Chemicals announced the acquisition of the Mexican business (Tijuana, Queretaro and Celaya) of Messer Griesheim in December. Terms were not disclosed, but 2000 sales of the three operations were estimated at $16 million. Praxair acquired Alpine Medical LLC, a firm specializing in respiratory and home care with annual sales of roughly $25 million. Air Liquide and Linde did not announce any major acquisitions in the first quarter. However, Linde and BOC did announce an alliance to form a new entity, Linde BOC Process Plants, that combines the resources of Linde's Tulsa, Okla., facility with BOC's Murray Hill, N.J., facility for air gases and synthesis gas. The agreement includes a 30 percent participation of BOC in the Linde Engineering US operation at Tulsa, Okla. Air Liquide was the only one in the big five to announce a major capital expansion in the first quarter, a new $40 million hydrogen plant for a refinery at Esso at Port-Jerome in Gravenchon, France.

Looking forward, analysts think the major industrial gas players will continue the strategy of targeted acquisitions and limited capital expenditures.

Air Liquide
For Air Liquid, JPMorgan analyst Colin Isaac believes any acquisitions will be small and will not substantially increase the company's financial leverage position. "Although the company has mentioned the possibility of acquisitions, and despite the fact that these would represent a possible risk to Air Liquide's credit rating (AA), we do not expect the company to be active in this respect. Smaller acquisitions in health care, home care and services are a stated strategic goal for Air Liquide, but we believe that they are unlikely to be significant," says Mr. Isaac.

Air Liquide recently lowered its annual EPS (earning per share) growth prospects from 15 percent to 10 percent, although Merrill Lynch's Ms. Coombs notes these growth targets are "still healthy for an industrial company." Merrill Lynch has not changed its anticipated EPS growth target of 8 percent for 2002, but believes that the mid-term prospects in Air Liquide's core segments will be off from the prior year. "Mid-term growth is now 7 to 9 percent versus 12 to 13 percent before; we expect slower services growth due to less IT spending and less energy deals due to power deregulation. A slight downgrade is expected in industrial customers' sales growth from 4 to 5 percent per annum to 3 to 5 percent per annum. Health care is now at 10 to 15 percent versus 14 to 15 percent per annum. Electronics is still at 15 to 20 percent per annum. The global slowdown is hurting," says Ms. Coombs.

BOC
Analysts point to improving fundamentals for BOC. "BOC is benefiting from re-invigorating, for example cost-cutting, disposals, more efficient plant builds and new IT systems," says Ms. Coombs. "This should enable BOC to catch up to its peers, although historically it has lagged behind. BOC has more exposure to growth areas than its peers. For example, it is strong in electronics and is number one in Asia," she says. She notes BOC's finances are improving and predicts that those pre-acquisitions should be slightly cash generative for the foreseeable future.

Schroder SalomonSmithBarney's Mr. Benson agrees. "The gases activities have defensive earnings. This will protect margins over the medium term. Importantly, BOC has radically improved the performance and capabilities of the gases division over the past few years," he says. "BOC has been actively developing its services franchises. We believe these e-businesses will also contribute to the growth of the gases division." In the short term, the gases activities are likely to perform less well in 2002 than they did in 2000. The analyst believes the gases division's performance will improve as the electronics segments improve, which is expected in 2003. "Overall, however, the track record of the gases division-compound growth of 6.5 percent for 15 years with only year of falling profits-is not a bad one, especially in today's business climate," says Mr. Benson.

Linde
Analysts are generally bullish on Linde as well. "Linde has two key assets: its health care franchise, which includes the pharmaceutical inhaled nitric oxide (Inomax), and hydrogen technology," says Schroder Salomon-SmithBarney's Mr. Benson. The analyst says sales of Inomax could reach $300 million by 2006 on higher global sales and new indications, such as heart surgery and chronic indications. He says by 2010, the sales potential could be $800 million.

In hydrogen, Mr. Benson says Linde has the potential to capture at least 40 percent of the increased demand in the European market. The global demand for hydrogen is expected to grow at 10 percent per year, with 20 percent of that demand occurring within industrial gas outsourcing. The largest customer is expected to continue to be the petroleum refining industry.

A key issue for Linde will also be possible changes to its top management. Linde chairman Hans Meinhart and CEO Gerhard Full are expected to retire in the next 18 months, adding to the changing of the guard that has occurred at Air Products and Praxair. As of press time, speculation within the industry is that Aldo Belloni will succeed Mr. Full as CEO. Mr. Belloni is now head of tonnage, contracting and engineering activities in the US for Linde, and he was instrumental in developing the relationship between BOC and Linde in their recent alliance.

Mr. Benson projects an 11 percent increase in EPS within the next five years for Linde and says profit growth will largely be driven by Inomax, but also the restructuring benefits from its 1999 AGA acquisition. He says the company's other subsidiaries, namely Hoek Loos and Pan Gas, will continue to drive benefits from the continuation integration of industrial gases and engineering divisions.

Praxair
Wall Street remains bullish on the potential of Praxair's CoJet gas injection technology for steel mills. The company is now targeting CoJet for the basic oxygen furnace sector after having commercialized the technology to the electric arc furnace market. At a recent Merrill Lynch chemicals conference, Praxiar CEO Dennis Reilley indicated that the company is in negotiations with 14 integrated steel producers, representing nearly 30 percent of global capacity. The company is anticipating at least one new license this year.

"We estimate that CoJet could easily generate over $1.00 EPS benefit to Praxair within the next few years," says Merrill Lynch's Mr. Carson, who believes that the company could achieve two to three licenses by the end of 2002. Praxair has 45 CoJet licenses in the electric arc furnace industry with the addition of three licenses in the fourth quarter of 2001. The most significant of these licenses was its first in Asia as Asia represents one third of global steel production. In addition, the Brazilian integrated steel producer, Usiminas, awarded Praxair a 10-year contract in October, and the system was installed earlier this year.

Praxair's Mr. Reilley has indicated that the company acted too quickly in commercializing the CoJet technology to the electric arc furnace industry and was satisfied with obtaining one-year contracts. The recent multiyear contract with Usiminas indicates how the company is trying to negotiate longer-term deals.

One of the reasons Mr. Carson and other Wall Street analysts are so optimistic about the potential of CoJet relates to the company's historical track record of gaining a 50 percent market share in six years for another technology used in the stainless steel industry, oxygen-decarburization. Merrill Lynch's $1.00 EPS benefit from CoJet is based on gaining 25 percent market penetration.

Praxair also expects to gain additional price increases in the North America bulk gases in 2002, where less than 25 percent of its merchant contracts turn over each year. Because of this, less than half of these contracts include the 5 percent year-over-year price increases of 2000 and 2001. Merrill Lynch projects that Praxair's merchant operating rate in North America will approach 80 percent in the second quarter from a low of 77 percent in the fourth quarter 2001. Praxair has indicated it will begin to commercialize an oxygen-enrichment technology by the aluminum industry by late this year.

While long term prospects are good, for the near term some analysts are cautiously optimistic. "Consistent with remarks made by executive vice president, Robert Gadomski, Praxair indicates that demand for industrial gases has bottomed, but is not yet showing signs of a material recovery," says Mr. Carson.

SalomonSmithBarney's Mr. Yang remains bullish on Praxair, particularly because of its strong cash flow. "Currently, return on capital is 12 percent and is now looking to rise to 15 to 16 percent. The company also continues to generate good cash flow, which we forecast at $338 million in 2002, and which will likely be used for acquisitions in electronics or home care oxygen and also to pay down debt," says Mr. Yang. "In the gas industry, volumes appear to have bottomed. The company expects 2 percent underlying price increases in 2002, excluding surcharges," says Mr. Yang

Air Products
For Air Products and Chemicals, gases accounted for 69 percent of its 2001 sales and nearly 19 percent of its operating margin. Atmospheric gases are the largest product by volume with a total of $1.5 billion or 38 percent of sales. It has the leading position as a supplier of both bulk and specialty gases to the electronics industry, with a 29 percent share versus Air Liquide's 22 percent. This includes a number one position in nitrogen trifluoride, the chamber cleaning agent of choice for the semiconductor industry.

Air Products is also the world's largest merchant supplier of hydrogen/ carbon monoxide/synthesis (Hyco) gases with a 50 percent market share, twice its nearest competitor. Hyco is expected to grow 10 percent over the next five years driven by demand for cleaner, low-sulfur content fuels, according to ABN Amro.

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