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Analysis: Air Products feels the heat from Ackman's Pershing Square

By Ernest Scheyder and Svea Herbst-Bayliss

NEW YORK (Reuters) - In June 2011, Air Products and Chemicals Inc Chief Executive John McGlade unveiled an ambitious plan to achieve $15 billion in annual sales by 2015, with a 20 percent operating margin.

Dubbed the "15 by 2015" initiative, the program was designed to boost lagging returns at the industrial gas giant, helping it better compete with its three main global rivals: Praxair Inc , Linde AG and Air Liquide SA .

"I can assure you as an organization we are absolutely committed to delivering on these goals," McGlade, CEO since 2007, told analysts and investors in the packed room.

More than two years later, annual sales at Air Products have yet to breach $10 billion and the company's operating margin hovers near 15 percent, much lower than its competitors.

That underperformance caught the attention of William Ackman's Pershing Square Capital Management, which spent $2.2 billion beginning June 1 to amass a nearly 10 percent stake.

The investment may have set the stage for an approaching showdown between management and the hedge fund, known for its successful shakeup of Canadian Pacific Railway Ltd last year.

Shares of Air Products have jumped 14 percent since Pershing began building its stake, part of a bet by Wall Street that the hedge fund heat will prompt the 63-year old company to bring its performance up to par with peers and further boost the stock.

"There's no question that Air Products could do a better job in execution and performance," said David Begleiter, an analyst with Deutsche Bank. "It's a source of frustration for shareholders."

That's why even after the recent stock jump, money managers and analysts feel Air Products shares are still a good investment. Six analysts advise buying the stock; at least 16 advise holding; only two analysts advise selling the stock.

The hope is that Ackman can replicate his wildly successful turnaround strategy for Canadian Pacific at Air Products by focusing on efficiency.

Air Products has a reputation for top-down bureaucracy with long, meandering office meetings. Employees across the globe often seek approval from the company's headquarters in Allentown, Pennsylvania, for tasks.

Praxair, by contrast, has wasted little opportunity to mention the independence it gives regional business leaders to make sales decisions.

Praxair CEO Steve Angel, in a seeming ding at Air Products, last week bragged to investors that his leadership team reflected a "high-performance culture."

"For years, Air Products hasn't been a good steward of capital," said Mark Gulley, an analyst with BGC Financial. "Now it's catching up with them."

The clock is ticking. If neither Air Products management or Pershing Square can agree on changes, the hedge fund has until October 25 to submit at least four nominees for the board of directors to be considered at a 2014 shareholder meeting.

Ackman, as well as Paul Hilal, a Pershing Square partner and Canadian Pacific board member, are likely candidates for the Air Products board, analysts said.

NOT MEASURING UP TO PEERS

Air Products, together with its three peers that dominate the global industrial gas market, break down air to form oxygen, nitrogen and other components used in construction, health care, oil refining and scores of other industries.

The quartet tends to focus on gas plants -- building a hydrogen plant at a refinery, for instance -- and merchant gas delivery of tanker trucks to customer sites.

While geographies and customers do differ, the business strategies are fairly similar. Profits rise by strategically locating plants near key customers, sharply allocating cash and becoming more efficient, analysts say.

Praxair tends to be the company analysts most often contrast with Air Products, as Linde and Air Liquide are European.

As of December 2012, the end of Praxair's calendar year and the end of Air Products's fiscal first quarter, Air Products had a 14.5 percent operating margin, badly trailing rival Praxair's 22 percent.

Since 2008, Praxair has increased prices every year, with the exception of 2010. In that time, Air Products has increased prices only three years, and it cut prices in 2010.

By focusing on volume growth rather than pricing, Air Products has harmed profit, analysts said.

Wall Street has noticed: In the five years before June 1, when Ackman began amassing his $2.2 billion stake, Air Products shares gained 13 percent, underperforming a 30 percent gain in Praxair shares and a 33 percent gain in the S&P 500.

Still, the problems center on execution, not so much structural problems in Air Products' business, analysts said.

"The (2015) targets are still achievable goals," said James Sheehan, a SunTrust Robinson Humphrey analyst. "That's where I think Ackman will put management's feet to the fire and demand a schedule" to achieve them.

Pershing Square and Air Products declined to comment for this article.

To be sure, Air Products has had to contend with uncertain demand for its products, especially in Europe, where it relies more than Praxair for sales. The company also focuses on other areas besides industrial gas, including LNG heat exchangers and specialty chemicals for electronics companies.

It's that divergent focus that analysts say may be hurting Air Products. Were Ackman to advise Air Products to sell certain businesses, he is likely to advise divesting all but core industrial gas properties, some analysts expect.

Air Products spent $48.5 million as part of an unsuccessful attempt in 2010 and 2011 to buy smaller rival Airgas Inc , most of it on legal fees. Airgas sells small canisters of oxygen, argon and other gases to thousands of hospitals, contractors and party shops across North America, an intimate customer relationship that Air Products wanted badly.

Ironically, Air Products has instituted a poison pill defense against Ackman or another would-be acquirer, the same strategy Airgas used to defend itself against Air Products in 2011. A poison pill is meant to give a board of directors time to find alternatives to any proposed takeover bid and explain to shareholders why a hostile bid is inadequate.

It remains unclear if Ackman will use his large stake to push for McGlade's ouster as Air Products CEO. Ackman pushed for CEO exits at JCPenney , Canadian Pacific, Procter & Gamble and several other companies in which he has invested in the past.

"It really depends on whether the current management is open to making the changes Ackman wants made," said Sheehan, the SunTrust Robinson Humphrey analyst. "If he sees them as an obstacle to change, he may very well try to displace the current management."

(Reporting by Ernest Scheyder and Svea Herbst-Bayliss; Editing by Edward Tobin and Andrew Hay)

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