Value Expectations submits:
Air Products & Chemicals ( APD ) offered an unsolicited bid to acquire smaller peer, Airgas ( ARG ), for $7 billion, including $1.9 billion in assumed debt, or $60 per share. ARG was trading at $43.53 before the news and shares jumped 40% to $60.96, higher than APD's $60 bid. ARG management previously turned down two offers, but is evaluating this offer and suggested that shareholders wait until their analysis is complete. Meanwhile, investors expect that APD will have to raise its bid in order to get ARG shareholders to act in their own interest.
APD management stated five reasons why acquiring ARG to create the largest industrial gas company in North America makes strategic sense. Here is a summary of APD's logic with a little commentary:
1. Better growth opportunities as a combined company. While it is true that APD has been suffering from lackluster sales, adding ARG will certainly create an immediate boost to sales. However, Airgas has been suffering the same plight as its bigger competitor recently; sales declines amid a very long recession. Although Airgas has been more successful in growing its top line over the past 5 years, the company has performed better mostly due to acquisitions. Nevertheless, ARG has been able to grow same-store sales 4% points faster on average (5 years) than APD. So either APD will have to continue acquiring more companies after the ARG purchase is closed, or learn something from ARG's management about leveraging its product line, distribution capability and customer relationships if this rationale were to come true.
2. Synergies of $250 million by the second year after the acquisition. We caution that anticipated synergies do not always play out as planned. However, with overlapping businesses, it seems that APD would be able to cut administrative and distribution costs just by eliminating some redundancies.
3. Leverage ARG's domestic sales infrastructure and use its products to penetrate international markets. Understanding how ARG has been successful in growing its top line faster than APD may help here. Also, APD's greater footprint in international geographies (54% of sales come from outside the U.S.) could provide expansion opportunities for ARG's products and services, whose international sales are a minor part of its overall business. Less than 2% of Airgas products are sold outside the U.S.
4. Economies of scale. APD does have higher margins selling much of the same industrial gases that ARG sells. However, APD has not had an acquisition of this caliber in all of its history, so management does not have a track record of integrating such a large company into its operations.
5. International expansion and focus on acquisitions for growth, given cash flow generation and access to capital. APD is less leveraged than ARG, however, after the acquisition APD will have to assume billions of dollars worth of debt. Its ability to make additional acquisitions may be limited.
Airgas management does not seem convinced that APD can effectively translate all of these points into increased shareholder value. We believe that ARG is worth $53 per share, so obviously an offer of $60 is great for its shareholders. The following charts show that ARG was undervalued before APD's bid. Using a 5-Year Median, solving for imbedded sales growth for ARG at the $43.53 share price shows that sales have to grow about 5% long term to be fairly valued. We think ARG, on a stand-alone basis, can achieve higher sales growth than 5% per year.
Now, looking at Air Products & Chemicals gives a much different story. We think APD shares were overvalued before it made a bid for ARG. Using a 5-Year Median, we can see that APD would have to grow its sales almost 26% long-term in order to justify the stock price of $73.69 (closing price on February 4, 2010).
The imbedded 26% long-term sales growth mentioned above is a pretty lofty hurdle to overcome. Adding ARG sales to its operations would give APD 50% sales growth and could provide an additional 2% growth to the high-single digit-to-low double-digit sales growth in current consensus estimates. Add the synergies that will help grow its bottom line and you certainly have a more compelling story than business as usual for APD. Still, you have to wonder where the value creation will come from, since ARG has the better Economic Margin track record.
Also, APD would have to increase its debt, since it only has less than $500 million in liquid cash to finance the acquisition. While the cash flow from ARG's operations may cover the additional interest that APD would have to pay, one has to be troubled with management's statement of looking to grow via more acquisitions - especially since it has a mixed track record in this area. The company's largest acquisition to-date was for $539 million in 2007. The acquisition was financed with debt, and it continued to increase debt levels in subsequent years, while earnings and cash flows were essentially flat-to-down by double digits. (To be fair, the global recession may have had a lot to do with this lackluster performance over the past year). There are certainly a lot of assumptions - or if we may say it, uncertainties - surrounding this multi-billion dollar acquisition attempt.
On that note, there are a few issues that come up when looking at the market's take on a few other acquisitions that have hit the news wire. First, CF Industries' ( CF ) attempt to acquire Terra Industries ( TRA ) went sour and TRA's stock price decline to reflect the premium that its shareholders were no longer going to receive. Second, we talked about Kraft Foods' ( KFT ) attempt at purchasing Cadbury Plc ( CBY ) and why we don't think that the marriage should take place. On this attempted purchase, our conclusion is similar to our KFT & CBY article.
While the market seems to think that APD will have to raise its bid, ARG shareholders can decide whether to wait until the premium is increased even further or to accept the $60 now. We think that ARG shareholders should take the money, and not worry about management's unwillingness to sell to its bigger competitor. While ARG's stock crossed the $62 per share market in mid-2008, and management believes that they can perform well enough when the economy improves for its stock to go above $60 again, the time value of money should be what drives investors today. For APD shareholders, this acquisition has too many unproven risks and they should vote down the proposed acquisition. It seems to us that APD management is spouting a whole lot of hot air-gas.
See also A Closer Look at Simon's Offer and General Growth's Response on seekingalpha.com