Over the past year, the shares of Air Products and Chemicals Inc. (NYSE:APD) are up about 49%, and I thought I’d look in on the company to see if it still makes sense to buy at these levels. It does not. I’ll go through my reasoning for avoiding the shares by looking at the financial history here and by looking at the stock as a thing distinct from the actual business. The risk to my “avoid this stock at this price” thesis is the insider buying activity we’ve seen, and I’ll go through that also. I’ll also talk about my favourite option trade here, because, just because the shares are expensive at this level, it’s possible to make some money by agreeing to pay a reasonable price for them.
When looking at Air Products and Chemicals’ financial history, it becomes apparent that this is a growth company. In particular, over the past five years, revenue has grown at a CAGR of ~2.6%, and net income has grown at a much faster pace (6.5%). On the back of this, management has grown the dividends per share at a CAGR of about 7.4% since 2015. These dividend payments have grown every year for the past five years, totaling just over $4 billion that management has returned to shareholders since 2015. On the other hand, investors have been subject to dilution, as management has sold about $475 million of stock since 2015. Of course, I would prefer to see this dilution slowed somewhat.
In terms of the balance sheet, I’m generally very comfortable with the capital structure here for a few reasons. First, this company is one of the few that have actually reduced their leverage over the past five years, with total debt falling at a very impressive CAGR of ~10.4%. Although most (66%) of debt is due in 2024 or earlier, the company has an enormous cash hoard on hand that represents ~73% of total debt. Finally, the weighted average interest rate on short-term debt is only ~3.7%, which I consider to be quite reasonable. All of this leads me to conclude that there’s little risk in the balance sheet here. So, in sum, I’d say there’s little to be worried about regarding the financials from this business. If the shares are reasonably priced, I think this would be a great buy.
Source: Company filings
The problem is that the shares aren’t actually reasonably priced, and that’s why I can’t recommend them. One of the things I find so interesting about investing is the fact that an objectively great company can be a terrible investment, and a struggling company has the potential to be a great investment. The reason for this is that, if there’s too much optimism embedded in price, the shares are likely to eventually drop, as excessive optimism will inevitably be dashed in my view. For that reason, I insist on only buying companies that aren’t excessively priced. I judge the level of optimism in a few ways, ranging from the simple to the more complex. I first compare the ratio of price to some measure of economic value, like earnings, free cash flow etc. In particular, I want to find stocks that are trading at multiples below both their own history and the overall market averages. The following is a graph of Air Products’ PE multiple over time, and I think it is safe to say that the shares are trading near the high-end of their historical range.
In addition, I try to unpack what the market must be assuming about the long-term forecast for the business. To do this, I turn to the work done by Professor Stephen Penman in his book “Accounting for Value.” In this piece, Penman walks investors through how they can use price itself as a source of information. The approach involves using the magic of high school algebra and a standard finance formula to isolate the “g” (growth) variable to work out what the market must be thinking about long-term growth. At the moment, it seems that the market assumes that Air Products and Chemicals will be growing at a perpetual rate of ~7.5%. In my view, this is excessively optimistic and is another reason to avoid the shares at these levels.
Although I’ve concluded that the shares are overpriced at these levels, I need to point out that there’s a risk to my thesis. Namely, people who know much more about this business than I ever will are putting significant capital to work in the company near these levels. I’ve said many times that not all investors are created equal. Some people have a knack for this because of a combination of skill and emotional makeup. Some people are superior investors because they have teams of analysts at their disposal. Some are politicians like the great Nancy Pelosi, who operate under a completely separate set of laws. (60 Minutes’ Blows The Lid Off Congressional Insider Trading). Some people are particularly good at making trades in a given company because they work at the company. In my view, when we outsiders are made aware of the investment moves of these insiders, we should at least take notice. With that in mind, I would point out that, this past July, Chairman and CEO Seifi Ghasemi purchased 20,000 shares for a little over $4.5 million. In my view, when people who know this business best put their own capital to work in it, it’s unwise to bet against them, given the informational advantage they hold.
Options As Alternative
I find myself on the horns of a dilemma with this company. On the one hand, it’s a very profitable growth company, with a strong history of growing dividends. In addition, at least one investor who knows the business better than Wall Street ever will has put over $4 million of his own money to work in the company. On the other hand, the shares are expensive in my estimation, and I hold the view that the more an investor pays for a stream of future cash flows, the lower will be his subsequent returns. I think options offer an alternative to choosing to either sit on the sidelines of plug my nose and simply buy.
I consider the short put trade in this circumstance to be ideal because it creates a win-win trade in my view. If the shares remain expensive, the put seller wins by simply pocketing the premium. If the shares drop in price, the investor may be obliged to buy, but will do so at a price that represents a great long-term value.
At the moment, the June puts with a strike price of $190 are my preferred options. These are currently bid-asked between $180 and $205, and if an investor simply takes the bid here and is subsequently exercised, they will do so at a net price ~20% below the current level. Holding all else equal, that would result in a PE multiple of just under 20 times and a dividend yield of ~2.5%. I think paying $190 for these shares has a much better chance of producing a great long-term return, so in my view, this is a very compelling trade.
There’s obviously much to like about this company. The business is growing nicely, and management rewards shareholders with ever-increasing dividend payments. In addition, the nature of the business is such that there’s reason to assume that dividend increases will continue for years. In addition, an insider who knows this business best has just put a significant amount of capital to work. The problem is that the shares are expensive relative to the overall market and to their own history. For that reason, I can’t recommend simply buying. That said, I think it is possible to make some money here by selling the June $190 puts. If the shares remain buoyant, the investor simply pockets the premia. If the shares fall, the investor may be obliged to buy, but will do so at what I consider to be a great price. I can’t recommend the shares at the moment, but I strongly recommend selling put options on this great company.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I will be selling the puts described in this article.