Undervalued Dividend Growth Stock Of The Week: Air Products & Chemicals (APD)

I’m going to make a bold statement.

Becoming a successful and wealthy investor has never been easier.

It’s never been easier to access business information.

It’s never been cheaper to invest in businesses.

And I’d argue we’ve never had so many high-quality companies to select from and invest in.

Businesses are objectively larger than ever.

After all, we’ve only recently seen companies cross over the $1 trillion market cap for the first time.

But I think it’s clear that businesses are also better than ever.

Just take a look at the Dividend Champions, Contenders, and Challengers list to see what I mean.

That list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

We’re not far away from 1,000 companies that are so good at routinely increasing their profits, they’re able to routinely pay out ever-larger cash dividends to shareholders.

I was able to recognize in 2010 just how good modern-day investors have it.

And I took advantage of this, starting the process of building the FIRE Fund.

That’s my real-money portfolio.

It’s chock full of the high-quality dividend growth stocks you’ll find on the aforementioned CCC list.

These businesses are so great, so profitable, and so adept at rewarding shareholders, they’ve given me financial freedom.

This portfolio produces enough five-figure passive dividend income for me to live off of.

I live off of this dividend income at a rather young age.

In fact, I was able to retire in my early 30s.

How?

I provide the answers in my Early Retirement Blueprint.

As you might imagine, investing in great businesses (via high-quality dividend growth stocks) has been a pillar of my success.

But that’s not all.

Valuation at the time of investment is always crucial.

Price only tells you what you pay. It’s value that tells you what you actually get for your money.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Taking advantage of the unprecedented advantages of modern-day investing by buying high-quality dividend growth stocks when they’re undervalued puts you on the path toward extraordinary wealth and passive income.

To be fair, judging value requires a valuation system to already be in place.

But don’t fret.

In Lesson 11: Valuation, which is part of an overarching series of “lessons” on the dividend growth investing strategy, fellow contributor Dave Van Knapp discusses valuation and lays out a simple-to-follow valuation system.

This system can be easily applied toward just about any dividend growth stock you’ll find.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Air Products & Chemicals, Inc. (APD)

Air Products & Chemicals, Inc. (APD) is a major global producer and supplier of industrial gases. They’re the largest supplier of hydrogen and helium in the world.

Founded in 1940, Air Products & Chemicals is now a $55 billion (by market cap) industrial gases juggernaut that employs over 20,000 people.

The company’s FY 2021 sales were reported through four Industrial Gases business segments organized by geography: Americas, 40%; Asia, 28%; EMEA, 24%; and Global, 5%. Corporate and other accounted for the remaining 3%.

Air Products & Chemicals has a terrific business model.

Industrial gases are critical input for the manufacturing processes of many different end products ranging from electronics to vehicles.

Because of the critical nature of these industrial gases, and because constant, reliable access to these gases is a must, a manufacturer will set up a long-term contract with a dependable provider of these gases.

Complex infrastructure is then installed at a manufacturing site to ensure reliability, which makes it costly and difficult to switch providers later.

If all of that weren’t already great reasons to own a slice of the business, Air Products & Chemicals is part of a global oligopoly – three major companies in this space occupy the vast majority of the global market share.

Air Products & Chemicals combines necessary input with long-term contracts fortified by complex infrastructure within the favorable confines of a global oligopoly.

This company basically cannot lose over the long run.

It’s hard to imagine any future world, decades down the road, in which they’re not producing substantially more revenue and profit… and paying out a much larger dividend.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As things stand, the company has increased its dividend for 40 consecutive years.

They easily qualify for their status as an esteemed Dividend Aristocrat.

The 10-year dividend growth rate is 10.1%.

I’m always more than happy to see a double-digit long-term dividend growth rate.

And you’re pairing that growth with a starting yield of 2.7%.

This yield handily beats the market, and it’s also 50 basis points higher than its own five-year average.

The payout ratio is 62.9%, based on midpoint guidance for this fiscal year’s adjusted EPS. That’s slightly elevated but not worrisome. It basically sets them up to grow the dividend roughly in line with the business.

I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or higher) dividend growth rate.

This yield is on the lower end of that range, but the high dividend growth rate makes up for it.

Great dividend metrics.

Revenue and Earnings Growth

As great as these metrics are, though, they’re mostly looking backward.

However, investors must risk today’s capital for the potential rewards of tomorrow.

Therefore, I’ll now build out a forward-looking growth trajectory for the business, which will later be instrumental when the time comes to estimate the stock’s intrinsic value.

I’ll first show you what this company has done over the last decade in terms of its top-line and bottom-line growth.

And I’ll then reveal a professional prognostication for near-term profit growth.

Amalgamating the proven past with a future forecast in this way should allow us to make some reasonable determination about where the business might be going from here.

Air Products & Chemicals advanced its revenue from $9.6 billion in FY 2012 to $10.3 billion in FY 2021.

That’s a compound annual growth rate of 0.8%.

You’d be forgiven for being disappointed in this number.

However, the limited top-line growth over the last decade is by design.

The company made a decision to purposely make the business smaller and more efficient through their “Five-Point Plan”.

This plan focused operations on industrial gases by jettisoning non-core businesses.

Executing this plan led to spinning off the electronics material division in 2016, and they then sold the performance materials division in 2017 for $3.8 billion in cash.

I must say, it’s worked out pretty well.

Earnings per share grew from $5.44 to $9.43 over this 10-year period, which is a CAGR of 6.3%.

It’s important to point out that most of this growth started to reveal itself after FY 2016, which is when net margin started to increase dramatically.

The company is simply doing much more today with what is effectively the same sales base from 10 years ago.

This isn’t a function of big buybacks, either – the float is actually up slightly compared to a decade ago.

Also, it’s worth pointing out that the company’s GAAP EPS can be lumpy. In my view, the company’s true earnings power is better than this mid-single-digit bottom-line growth rate would imply.

It can be instructive to instead look at adjusted EPS in this case.

Indeed, the company’s guidance for adjusted EPS for this fiscal year, at the midpoint, is calling for 14% YOY growth.

Looking forward, CFRA believes that Air Products & Chemicals will compound its EPS at an annual rate of 15% over the next three years.

CFRA’s forecast for EPS growth would be more than twice as high as what Air Products & Chemicals has delivered over the last decade.

Is this crazy?

I don’t think so.

Keep in mind, most of the last decade’s EPS growth came about after the transformation.

An acceleration in growth is playing out here.

Moreover, again, I believe that the GAAP EPS number often doesn’t fully communicate what this business is capable of doing.

The business is structured to succeed based on providing high-value but low-cost gasification. Long-term contracts get locked in when huge projects begin. And this is all occurring within the favorable structure that is a global oligopoly.

This is an extremely powerful and compelling setup.

And there’s no shortage of work here.

CFRA highlights this: “We think APD has a solid backlog of growth projects, with a focus on expanding the scope of syngas supply agreements, acquiring air separation units, and winning agreements in large industrial gas projects.”

They’re not exaggerating.

The company’s total backlog is over $18 billion.

In addition, new growth avenues that didn’t even exist 10 years ago are now opening up for the company, which further supports the growth acceleration thesis.

CFRA adds color to this point: “APD is well positioned to capitalize on gasification related to carbon capture and hydrogen mobility, which are long-term secular tailwinds.”

There’s also the green hydrogen story.

The company’s $5 billion partnership with Saudi Arabia’s ACWA Power and NEOM on the world’s largest green hydrogen plant in Saudi Arabia is a prime example of this.

We’re basically taking what was already a very good business 10 years ago, improving it through renewed focus on its core strengths, and then adding on new growth vectors.

This is very exciting.

If Air Products & Chemicals is able to grow its EPS at a rate that’s even close to what CFRA is projecting, the dividend should be able to rise at least at a high-single-digit rate over the foreseeable future.

When you’re already getting a 2.7% yield to start off with, I find that to be rather appetizing.

Financial Position

Moving over to the balance sheet, the company has a great financial position.

The long-term debt/equity ratio is 0.5. The interest coverage ratio is over 18.

Profitability is strong and improving, especially in the margin department.

Over the last five years, the firm has averaged annual net margin of 21.5% and annual return on equity of 18.6%.

Adding some perspective to the margin expansion story I touched on earlier, the company was routinely printing single-digit annual net margin prior to FY 2017.

There’s almost nothing to dislike here about this high-quality Dividend Aristocrat.

And the business is protected by durable competitive advantages that include global economies of scale, high barriers to entry, heavy switching costs, a global oligopoly, and long-term contracts with fixed infrastructure.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

Demand for industrial gases correlate with manufacturing activity. Any large-scale economic downturn would impact the business.

Air Products & Chemicals is involved in a variety of major energy projects around the world. Continued evolution in the global energy complex adds risk to part of the business.

Input costs can be volatile.

More than half of the company’s sales come from outside the Americas, which adds currency and geopolitical risks.

These risks should be considered, but I find them to be quite acceptable when weighed against the quality of the business.

And with the stock down more than 20% from its 52-week high, the valuation makes it particularly compelling right now…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 24.4.

This compares favorably to its own five-year average of 29.1.

The sales multiple of 4.8 is also off of its own five-year average of 5.4.

And the yield, as noted earlier, is significantly higher than its own recent historical average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 8%.

I’ll admit that this is as high as I’ll go when modeling in a long-term dividend growth rate.

But I think this business deserves it.

Their long-term dividend growth rate is well over this level, and the near-term forecast for EPS growth is nearly twice as high as this.

I’m not saying they’ll blow the doors off with growth, and the days of double-digit dividend growth might be limited, but I fail to see why the business can’t grow the dividend at a high-single-digit rate over the long run.

For reference, the most recent dividend increase, which was announced earlier this year, came in at exactly 8%.

The DDM analysis gives me a fair value of $349.92.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I see my valuation model as being very fair, yet the stock still comes out looking extremely undervalued.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates APD as a 4-star stock, with a fair value estimate of $317.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates APD as a 5-star “STRONG BUY”, with a 12-month target price of $324.00.

I came out on the high end, but we’re all in agreement that the stock looks to be worth much more than it’s currently being priced at. Averaging the three numbers out gives us a final valuation of $330.31, which would indicate the stock is possibly 34% undervalued.

Bottom line: Air Products & Chemicals, Inc. (APD) is a high-quality Dividend Aristocrat with great fundamentals that operates within the friendly confines of a global oligopoly. Their industrial gases are cheap but critical input that force favorable long-term contracts. With a market-beating yield, double-digit long-term dividend growth, a reasonable payout ratio, 40 consecutive years of dividend increases, and the potential that shares are 34% undervalued, long-term dividend growth investors ought to seriously consider this name right now.

— Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from D&I: How safe is APD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 95. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, APD’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.