Deep Dive - Linde Plc
An investment for all seasons
Executive summary
Say hello to Jonathan, the oldest living land animal. Guess what, it’s a tortoise that’s been around for 192 years! Here’s the prove of our strategy’s longevity 😃
Now, speaking of one of our favorite Compounding Tortoises of all time: Linde Plc. It was the result of the diligently planned merger between Linde AG and Praxair which created a well-balanced industrial gases mogul with an extended reach into healthcare, petrochemicals, food & beverage, and energy. Their separate activities did not show any overlap with Praxair's end markets being located mainly in North and South America versus Linde AG's dominance in EMEA and APAC.
When a mature business can grow its sales at a clip of 3-4% per annum at constant currency, share repurchases and economies of scale will likely translate into 6-9% annual EPS and subsequent dividend growth. Indeed, Praxair managed to post a CAGR of 6.6% in its recurring FCF/share over FY 2005 - FY 2017, whilst a doubling dividend payout ratio led to a 12% annual dividend/share growth. But Linde Plc (LIN) has managed to clearly outpace that historical track record. Exhibit I shows the Praxair financials.
Exhibit I
By improving SG&A, supply chain, and asset utilization, management of the newly formed Linde aimed for an industry-leading return on capital. And to say the least, it has exceeded those expectations.
Whereas Praxair was achieving a ROIC (excluding goodwill and intangibles) of around 12% over the period FY2005 - FY2017, Linde Plc churned out a record 25.4% in FY23 (based on the rolling NOPAT and adjusted invested capital numbers). This achievement, thanks largely to improved underlying profitability and a better ROI for growth/project investments, makes it a best-in-class industrial. Exhibit II represents Praxair’s free cash flow and ROIC trends prior to the merger.
Exhibit II
As we summarize the investment case for LIN, our expected NOPAT/share drivers are:
1% to 2% annual base volume revenue growth, strengthened by a positive mix effect (APAC and Americas becoming a larger part of the pie);
3% annual pricing attribution;
1% to 2% from margin expansion (driven by productivity gains, increased network density through base CAPEX and D&A leverage);
3% annual project backlog accretion to EPS;
2% to 3% annual share repurchases to deploy all of its excess cash flows
The above elements translate into 10% to 13% annual NOPAT/share growth.
The clean energy opportunity will eventually become another growth kicker, depending on how many identifiable opportunities will be translated into tangible investment decisions that meet LIN’s stringent criteria and backlog requirements.
Given the persistent inflationary pressures, geopolitical events and new emerging trends in the semiconductor space (electronics account for 9% of sales), LIN is well positioned to remain an investment for all seasons. We believe that its management team will continue to do what they do best: delivering industry-leading Return on Capital, operating margin and cash flow performance.
We would go even further and say that LIN's business model benefits from increased volatility as economic shocks have recently widened the performance gap with its competitors. LIN’s underlying capital intensity is much lower than what most people realize, as evidenced by its clear project backlog criteria, small incremental investments and strong presence in packaged gases.
Business model
Simply put, LIN produces (almost entirely in-house), distributes, and sells industrial gases to a variety of sectors such as healthcare, food & beverage, energy, mining, etc. By serving many industries with an essential commodity/service end market, the multinational is less prone to economic shocks and roughly 65% of its end markets are labeled as "defensive."
Whenever there’s economic uncertainty, LIN’s management team has reminded investors of its multi-decade resilience, or better: multi-century. The expression ‘what goes around, comes around’ springs to mind with the merger of Praxair and Linde AG sharing roots that date back to World War I as they so notably do. Following the War, Linde assets were confiscated and sold to Union Carbide in 1919, which included the rights to use the Linde name in the US. From 1963, the industrial gases arm of Union Carbide was known as ‘the Linde division’. When Union Carbide decided to spin-off that gases division in 1992, Praxair was formed. And so it happened that both companies re-joined forces.
Exhibit III
Basically, LIN's applications are part of our everyday life. In FY21, nearly one third of total sales came from its purely defensive healthcare and food markets. In all of the major geographies where LIN has a leading/meaningful presence, it sees attractive long-term growth opportunities in each of its key end markets.
In addition to end market diversification, LIN has a wide geographic footprint, with the bulk of total EBIT stemming from the Americas and EMEA, which made up a combined 74% of total EBIT in FY23. Most notably, the relative contribution by region has remained essentially flat over the past years but with different driving forces behind each geography’s growth.
Besides being at the forefront of the accelerated European energy transition due to the war in Ukraine and a worldwide shift toward clean energy, Linde also played a key role in providing hospitals with essential medical oxygen during the worst days of the COVID-19 pandemic.
Distribution modes
Looking at the distribution mode through which LIN operates, packaged/cylindered comes out on top with 35% of total sales. The type of distribution depends on what quantity the customer requires and what gases can be produced or transported.
Exhibit IV
Large customers that need permanent supply because of their relatively constant demand pattern will enter so-called total requirement contracts with terms ranging between 10 and 20 years. Also, there is a minimum required purchase agreement coupled with price escalation provisions. Unsurprisingly, this part of Linde's business is considered the most capital-intensive, as it has to construct gas-on-site facilities on or near the customer's production site. However, once the product plant has been constructed, these kinds of contracts will offer multi-decade cash flow visibility. Because of the fixed payment contracts, lower on-site volumes will have a bigger impact on sales than profit.
Exhibit V
For merchant deliveries, supply agreements typically vary between three and seven years, with specific types of gas such as argon and hydrogen being transported from Linde's plant at the customer's site. Customers that require small volumes will opt for packaged gas (cylindered), which can be picked up at one of Linde's packaging facilities or ordered via its retail stores. Growing the “packaged gases” segment doesn’t require much CAPEX. Exhibit VI highlights the distribution mode split per geographic segment.
Exhibit VI
Aside from producing and distributing industrial gases, which it is well recognized for, Linde Plc has an engineering segment that encompasses the design and manufacturing of air separation and other gas equipment tailored exclusively to Linde and its end customers, including third-party orders. Typically, engineering generates a mid-teens percent operating profit margin and the business enjoys a late-cycle benefit.