We closed this position on April 15, 2013. A copy of the associated Position Update report is here.
Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.
Praxair Inc. (PX) is in the Danger Zone this week. This conglomerate has run out of ways to fuel profitable growth. The company is turning to acquisitions to try to maintain top line and EPS growth, but that growth is diluting shareholder value.
PX spent $294 million on acquisitions of several small packaged gas distributors in 2011, including American Gas Group and Texas Welders Supply Company. The company had an almost identical outlay in acquisition spending for 2012.
This acquisition spending does not appear to be aiding growth in the way management hoped, as PX saw after-tax profit (NOPAT) increase by a paltry 2.6% in 2012. This small growth fell far short of the increase in invested capital in 2012, leading to a decline in return on invested capital (ROIC) to 10%. Another example of the high-low fallacy masking overpayment for cash flows with rising EPS.
This track record should temper investors’ enthusiasm over Praxair’s recently announced acquisition of NuCO2, a provider of beverage carbonation solutions, for $1.1 billion from Aurora Capital Group.
While larger in scale than PX’s past acquisitions, it looks to have a similar effect of slightly increasing earnings while dragging down on ROIC. NuCO2 is expected to generate an EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) of $115 in 2013. If one assumes NuCO2 will have a similar ratio of NOPAT to EBITDA to PX (about 50%), those earnings should translate to about $57 million in after-tax profit next year. Since ROIC equals invested capital divided by NOPAT, those profits would translate to a 5.2% return on invested capital, well below PX’s current ROIC and weighted-average cost of capital (WACC) of 6.3%.
Praxair has offered all the usual platitudes about how synergy will allow NuCO2 to generate more revenue in the future than it did on its own. Executive vice president Eduardo Menezes said of the deal, “We plan to continue to grow the business in the United States, enhance distribution efficiency utilizing Praxair’s competencies in logistics, and extend NuCO2’s offerings to customers in other regions of the world.”
That all sounds nice, but I’m skeptical as to how much PX can generate profits from expanding NuCO2’s product around the world as that business is increasingly commoditized. To create shareholder value, PX has to grow economic earnings, not revenue or EPS.
The lack of economic earnings growth is not enough to put a company in the Danger Zone. The bigger issue it PX’s high valuation. Investors needs to beware Wall Street’s proclivity to hype stocks that do lots of acquisitions that are accretive to bankers but not shareholders.
At ~$112.67/share, PX’s current valuation implies 7% growth in NOPAT compounded annually for the next 11 years. Those expectations set the bar awfully high for a large conglomerate operating in increasingly commoditized businesses. I expect the company will disappoint.
PX may be a good company, but it is a dangerous investment.
I also recommend avoiding the following ETFs and mutual funds because of their large allocation to PX and Neutral or worse rating.
- ING Corporate Leaders Trust Fund (LEXCX) – 9% allocation to PX – Neutral Rating
- iShares Dow Jones U.S. Basic Materials Index (IYM) – 7% allocation to PX – Neutral Rating
- ProShares Ultra Basic Materials (UYM) – 7% allocation to PX – Neutral Rating
- Materials Select Sector SPDR (XLB) – 7% allocation to PX – Neutral Rating
- Vanguard World Funds: Vanguard Materials Index Fund (VMIAX) – 5% allocation to PX – Dangerous Rating
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.