I have been somewhat obsessed with trying to figure out the real tenor of the economy during this earnings season. Specialty chemical companies like Albemarle (NYSE:ALB) have been strong, coal companies like Peabody (NYSE:BTU) have been reasonably positive and industrials like Dover (NYSE:DOV) have had pretty solid guidance. In fact, the only major notes of caution have been from steel companies like Nucor (NYSE:NUE).
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Industrial gas provider Praxair (NYSE:PX) goes solidly in the camp of "good news for the economic recovery". Although industrial gas companies sign customers to long-term contracts and do not tend to be quite as cyclical as you might immediately think, the volume growth that this company is seeing is nevertheless a pretty strong testament to growing economic activity around the world.
The Quarter That Was
Praxair reported that revenue rose 18% in the second quarter, fueled in large part by a 12% jump in volumes and a 4% boost from foreign currency. The company's North American business (roughly half of the total) saw volume growth of 12%, led by traditional major end-users like the chemicals, energy, and metals industries. European growth was a surprising 12%, South American growth was also 12%, and Asian growth was 26%.
Profitability was not quite as impressive, though. Gross profit margin actually slipped more than 100 basis points from the year-ago quarter, and that seems to be a product of the company's take-or-pay business and higher power costs. Overall operating margins did improve, though, and the company saw better than 22% growth in operating income. (Learn more about Operating Margins, see Analyzing Operating Margins)
The Road Ahead
I really did not hear anything from management during the conference call that pointed to any real pockets of weakness in the economic recovery. In fact, they did at one point refer to a "dramatic" recovery over the past six months. So although they did acknowledge some slowing in China (mostly due to the country's effort to cool down the property sector), there really seems to be no reason to think that the recovery is going off the tracks.
Looking at the longer term, industrial gasses are a pretty good place to be. The industry is basically dominated by Praxair, Airgas (NYSE:ARG), Air Products (NYSE:APD), Linde and Air Liquide. That gives the industry quite a bit of pricing stability and allows for solid returns on capital throughout economic cycles. That is not to say, though, that the industry does not benefit from economic expansions. Just because the leading suppliers prefer to sign long-term deals, does not mean that they refuse short-term business and economic recoveries certainly bring upswings in volume.
The Bottom Line
Praxair's stock frustrates me. Everything on a macro level points to ongoing success and earnings momentum for the company. The fundamental valuation ratios do not seem out of line, even though the stock has had a good run.
A discounted cash flow analysis, however, presents a valuation wall. To arrive at a target price that suggests Praxair is undervalued, you have to assume a pretty incredible level of revenue growth and/or free cash flow margin. A mature industry like industrial gas is just not going to allow for an enormous expansion in margins like that, nor that level of growth for the long term.
Consequently, be careful about this stock. Everything is working with right with the company and momentum-oriented investors could find plenty to like with the stock. The risk, though, is that whenever you just ignore what cash flow tells you, you risk investing in hot air.
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