Praxair (PX) has increased its dividend for 22 consecutive years and offers one of the highest quality cash flow streams an investor can find. With the stock down over 20% in 2015 and offering a 2.8% yield, it might be time for investors to consider taking a nibble in this blue chip dividend growth stock.

Praxair – Business Overview

PX was founded in 1907 and is one of the largest producers of industrial gases (e.g. oxygen, hydrogen, argon, helium, nitrogen, carbon dioxide) in the world. Customers use PX’s gases in their operations and manufacturing processes and receive the gases via pipeline, truckload, or in packaged containers.

PX operates a very capital intensive business that is well diversified by gas distribution method, geography, and end market (healthcare, petroleum refining, computer-chip manufacturing, beverage carbonation, fiber-optics, steel making, aerospace, chemicals and water treatment).

The majority of PX’s business is conducted through long-term contracts which provide stability in cash flow and the ability to pass through changes in energy and feedstock costs to customers.

From a gas distribution standpoint, on-site plants account for 29% of sales (supplied directly via pipeline), merchant is 34% (tanker trucks deliver to customer storage containers), packaged gas is 29% (supplied in high pressure metal containers), and other delivery methods are 8% of total revenue.

The company is very diversified by end market: manufacturing 24% of sales, metals 17%, energy 13%, chemicals 10%, healthcare 8%, electronics 8%, food & beverage 8%, aerospace 3%, other 9%.

By geography, PX generates 54% of its sales in North America, 12% in Europe, 14% in Asia, 14% in South America, and 6% in other countries.

Praxair – Business Analysis

Despite PX’s sensitivity to economic activity, we believe the company has a strong economic moat for several reasons.

The industrial gas business is extremely capital intensive. Large manufacturing plants take around three years to construct, costly pipelines and a large fleet of delivery equipment must be assembled, and everything needs to comply with technical regulations. However, funding these needs is only the beginning of the challenges faced by new entrants.

The price customers pay for industrial gas is not high, and gas typically accounts for just a small portion of their overall manufacturing costs. However, the cost to transport the gas to the customer is often substantial – gases often need to be stored at a certain pressure and temperature, significantly limiting how far they can be transported at a competitive price. PX has stated that its distribution radius is no more than a couple hundred miles from its manufacturing plant.

Trying to battle an incumbent on price alone is a losing battle when they have greater network density and lower costs of production than you. If they felt threatened, they could temporarily reduce their prices to squeeze out higher cost producers that are threatening a particular region.

Furthermore, PX has strong customer relationships and many long-term, take-or-pay contracts that make its markets all the more difficult to break into. A meaningful amount of its gas is also shipped directly to customers via pipeline, creating high switching costs. Each local market is typically dominated by the company with the densest distribution network because they operate more efficiently.

For these reasons, many of PX’s customers are highly dependent on it for their industrial gas needs, which are generally mission-critical to their operations and manufacturing processes. Since there are few viable competitive alternatives and the cost of industrial gas is such a small proportion of customers” total costs, PX typically enjoys strong pricing power.

While PX is facing several meaningful macro headwinds at the moment, the company was able to improve its operating margin to an all-time high last quarter because of higher pricing and strong cost controls. The company also announced it would raise prices by up to 20% for North American customers earlier this year. Few companies have such pricing power.

The industrial gas industry is also very slow-changing. The production methods used to create industrial gases haven’t changed much over time, and customers’ applications of gases have gradually expanded. There really aren’t any meaningful substitutes for these products, and the localized nature of each market ensures a generally healthy competitive environment.

While market players do consumer significant amounts of natural gas and electricity in their manufacturing process, they also have a unique raw material cost benefit. Many industrial gases are produced by air separation – literally using air from the atmosphere and cleaning, purifying, processing, and separating it into useful gases. It’s hard to find a cheaper input cost than air!

Altogether, PX’s substantial economies of scale, dense distribution networks, long-term supply contracts, and strong pricing power result in good returns on invested capital, predictable cash flows, and consistent long-term growth opportunities.

Of the major gas players (ARG, APD, Air Liquide, Linde), PX has the highest operating margin, return on capital, and cash flow margin. PX’s financial leadership seems to suggest that the company has been one of the most disciplined capital allocators and/or dominates some of the most attractive regions. This durable business isn’t going away anytime soon.

Praxair – Key Risks

While PX’s business model has many strengths and defensive qualities, it is sensitive to economic activity. When GDP growth slows and commodity prices fall, fewer metals need to be manufactured, demand for chemicals drops, gas and oil refining activity slows, and more.

PX’s stock price is down over 20% in 2015 for many of these reasons. Upstream energy markets are weakening (13% of sales), Brazil (18% in 2011, closer to 9% today) is in a recession, China (6%) continues slowing down, and the strong dollar is hurting sales and earnings growth (over 50% of sales are outside the U.S.).

As long-term dividend growth investors, we would normally be licking our chops after seeing these transitory headwinds, which should ultimately reverse and lead to brighter times for PX.

However, we fear that some of these headwinds could persist for a very long time and potentially cause larger risks in the next year or two. While we wouldn’t expect any sort of dramatic fallout like the one that rippled through the master limited partnerships sector, some of the defensive characteristics of PX’s business model could be increasingly challenged.

For example, if commodity prices remain low and continue pressuring demand for steel, some customers could be unprofitable. If their production volumes drop below the minimum level in their take-or-pay contracts with PX and they don’t have the cash flow to pay, what happens?

After years of rapid buildouts, many of these manufacturing, energy, and chemical markets could be oversupplied for several years in countries such as China and Brazil. How safe is the cash flow from some of these customers as they grapple with capacity rationalization? We also wonder if PX’s backlog could start to contract if things get really bad, creating more fears around the stock, or if it will experience delays when it starts to ramp up some of its major new projects in the next 1-2 years (these are from major investments made during 2011 through 2014).

Furthermore, fewer new growth opportunities in developing countries could lead to higher competition and lower returns for the remaining pool of projects that do exist. If the battle for market share intensifies between incumbents, future returns on capital could contract

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