Air Products and Chemicals, Inc. (APD) Earnings Call Transcript & Summary

Good morning. Thank you for joining us. It's Laurence Alexander with the Jefferies Chemicals team. You had been to date, and now we're going to chat with Simon Moore from Air Products. I think for most of you, he needs no introduction. But Simon, how about we just sort of jump straight in, unless you had some opening remarks? If you just wanted to make -- to frame the lay of the land in the discussions you've been having since the earnings call?

Well, let me just say thank you. We appreciate the opportunity to participate in the conference. Certainly, a little bit of a different style than we're all used to, but I think very efficient. So thank you to Laurence and the rest of the Jefferies team for setting this up. And thanks to the investors who have dialed into this new format. So happy to jump into whatever questions you have, Laurence.

Right. Okay. Then let's start with a question around addressable markets and business model. We've seen -- a few years ago, the common debate was the lack of growth opportunities on the horizon for industrial gases. Now you have gasification, you have hydrogen, you have refinery upgrades for the IMO 2020, and then the next IMO generation after that. How do you look at the decision -- or how do you look at the need to vertically integrate? Or I think what some investors are looking at is vertically integrating into methanol production and ammonia production, given the scale of the products for the kind of what people view as the conventional industrial gas model.

Yes. Well, great questions. So let me take a couple of areas there. I mean I think to be honest with you, we would agree with you. And Seifi said this a few times. If you look at the most traditional part of the industrial gas business model, ultimately, in the long run, that's going to be driven by industrial production or manufacturing. So whatever you think that's going to be in the long run, certainly not the environment we're in right now, that's kind of what that business is going to grow at. So to be honest with you, we were excited about the opportunity to create kind of some new growth markets. And for a few years now, we've been talking about gasification as one of those growth opportunities. We've certainly talked about carbon capture as one of those growth opportunities. And we have talked for a while, and certainly, we've been talking a lot in the last month or so about the hydrogen probability market. So I think we -- just to be clear, we like our base business. We're going to continue to support it. It creates value. It's going to grow, but it's going to grow at a fairly modest rate. And these new growth opportunities, we're very, very excited about. Let me just talk specifically about your question. And really, as I'm sure everybody saw, we announced a relationship with Haldor Topsoe to support this idea of bringing methanol and ammonia production into these projects where it makes sense. Let me be really clear about something. Air Products is not getting into the methanol and ammonia business. But let me give you an example of the Indonesia project, right? That's gasification, syngas cleanup, ASU and methanol production. So we have a customer and supplier there, where we can go to them and say, look, you've got coal and you want methanol. We can do the whole thing for you now. We can be a one-stop shop. If you're comfortable outsourcing the ASU, the gasifier, the syngas cleanup, go one more step, outsource the methanol, your life is a lot simpler. We still do this under the on-site business model, so we're not taking methanol price risk. And this creates a lot of value from a project execution standpoint. We've got a single team who's executing a single project at the site that now includes methanol rather than the customer doing one part, and we're doing another part. So I would say the strategy was around being able to offer kind of this one-stop shop, in this case, to a customer. And then if I go on, and I know we'll talk a little bit more about the carbon-free hydrogen project, but specifically there, again, we're not getting in the ammonia business. We're going to use ammonia as a carrier to take hydrogen from NEOM in Saudi Arabia to the markets where it needs to be for the transportation fuels. So we're going to produce ammonia, absolutely, but it's really a transport mechanism. So as you said it's around, where does production of, example, methanol and ammonia, makes sense in some of these projects that we're already doing? And how does it create value for the customer?

And so one question. The way that question then comes back to me as often people say, well, is there a -- what if there -- you end up with a problem with a downstream customer who's taking the ammonia or the methanol, would you then just effectively have to turn down the asset? Or could you sell into the merchant market while they fix their operations? And so maybe if you could answer that with respect to kind of the traditional take-or-pay protections that you build into the on-site contracts.

Great. Well, the interesting thing is in the NEOM project, we know who the offtaker of the ammonia is, it's their products, right? So we understand that. So good question. Let's talk about the Indonesia project then. So we are looking forward to have the same type of on-site contract we have with all of our other contracts, where we have a committed fixed payment from the customer that is due to us regardless of what happens. Now of course, that fixed payment escalates to cover inflation. So that's the on-site business model. That's what we're looking for. Now if we had a certain situation where the customer had a problem and methanol could still be produced, we'd figure out what the thing that makes sense in that case would be. But the key is we still have that same on-site business model protection we've always had.

And with respect to the ammonia, the distribution channel, there's a perception that comes up pretty frequently around that this is a build a fleet and then hope the demand is there. And then there's a second question that comes up around, there's going to be an adoption curve, but there's also an industry learning curve and deflation. I think the Hydrogen Council talks about 60%, 70% reduction in distribution costs over the next 20 years. So how do you sort of build that distribution network out and avoid the risk of having stranded assets that are not competitive?

Sure. Good question. And let's face it. There's -- everybody's got a forecast for the demand and the price of hydrogen. Let's talk about a couple of things. So first of all, maybe just for a second, why are we going to produce this hydrogen in NEOM in Saudi Arabia? And I think the key to recognize here is it's a low-cost of [ production. It's the way ] it boils down to. The sun and the wind, very strong, if you will, and very consistent in this location. So when you're producing carbon-free hydrogen, you've got to start with renewable power, and you optimize your renewable power, the more sun you have, the more wind you have, the better utilization you get out of your assets. So we very much believe that producing in that location and then using ammonia to transport is going to allow us to deliver hydrogen to the vehicle out of the dispensing station at a very, very long-term competitive cost. We are confident that this will be a very viable asset for the long term. The other thing that I think is worth just chatting about a little bit is some basic economics, Laurence, and I know you understand this. So maybe if you'd allow me to kind of go through this for a little while. Everybody wants to talk about dollars per kg. I think, first of all, there's some confusion out there if we were to still be talking about selling hydrogen to a steel mill, a single location in very large quantities right next to the plant, that's one thing. That looks a lot like the hydrogen business today. But if we're talking about hydrogen dispensed and delivered to a vehicle, that's a very fundamentally different concept. And just some very simple math. If you take a look at gasoline or diesel at $3 or $4 a gallon, that's equivalent, on a [ dollar basis ], to hydrogen at roughly $10 per kilogram. And it depends a little bit on the efficiency of the vehicle. So our view is if you can deliver hydrogen to the vehicle at $10, $11, $12 a kg, you're roughly competitive with where gasoline and diesel is today -- before we begin to talk about the value the world is going to put on carbon-free hydrogen. So when we look at those things, we feel very good about the assets in the long term. Obviously, we're going to be working to optimize the system. We think the physical distribution of the ammonia, to be honest with you, that's a well-trodden path, right? Ammonia is distributed around the world today. The fact it's carbon-free ammonia is sort of interesting, but the ships and the trucks don't know that. And then in terms of building the stations themselves, we're going to be looking to optimize the dissociator, but the compression of the dispensers, that's something we do today. So I guess, to boil it down is we think this project creates very long-term competitive supply of hydrogen into this exciting market.

So how do -- since these are all very different contract structures and very different time frames, and then you have your historical merchant business with much smaller -- the ASUs are much smaller scale projects, how do you prioritize? And how do you avoid -- I mean we've often had companies talk about how they get sucked into the largest projects, always wins when it's the same return on capital as small projects. And so there's a natural tendency to evolve into a business with more and more -- sorry, fewer and fewer large bets until one goes wrong. And then the -- and so we've seen that with a few companies, that cultural evolution. How is Air Products safeguarding against that?

Yes. It's a great question. And I mean if I could just even say it a different way, who's paying attention to the base business while you're working on these big fancy projects, right, to be blunt about it. And the answer is, we've got people who absolutely, every day, are working on keeping our customers supplied, optimizing our plants, optimizing our distribution and safety, went out of his way on the most recent earnings call and even beyond the one prior to that, to thank those teams who have worked very hard in a difficult situation to make that happen. So how do we keep that team focused? First of all, looking to inspire the team at Air Products. Seifi also went out of his way to make it clear that we are committed to our people and our team during this very difficult situation. We're not looking to lay people off. We're not looking to cut salaries. So we're looking to kind of earn the commitment from the people through that methodology. Our fundamental recognition or reward structure, as Seifi said, we still have our annual bonus program based on the EBITDA performance of the business units. So there's many people around who are not involved in these big large projects but to the extent that they can deliver on optimizing the cost of production of distribution, quite frankly, pricing in the merchant business. Those are areas that they can deliver EBITDA that's very helpful to the company's results, and to be blunt, is also helpful for their annual bonus. So I think the way that we've got this position is very, very effective. We've got a number of people who are laser-focused on developing these large projects, different kind of people who are laser-focused on executing these big projects, you got to build them well. But from a number standpoint, there's an awful lot of people at Air Products who are not directly involved in these big projects, and they are the ones that continue to deliver on the base business. And our -- and the way we think about it is, to some degree, we earn the right to do the big projects by continuing to deliver on our base business results. And that's how I think we are very capable of doing both of these going forward.

And given the size of the opportunities, does Air Products need to build out a larger, permanent engineering team?

Well, I think the answer is yes. And I think the answer is we have been doing that. And you don't see all of the announcements of people we've hired, but we have been incredibly pleased with the quality and quantity of people who want to come to Air Products. I mean, to be blunt, I have an engineering degree, but I'm not an engineer. But if you -- if your role in the world is to want to build big interesting projects, I got to believe from the standpoint across the chemical materials space, Air Products is a great place to be right now. So we have got a lot of great people that we brought into the team. Dr. Samir Serhan has joined us and leads this organization as well as other organizations and has brought a number of very, very talented people in. So our expectation is that we are going to -- we have built out our engineering resources. We've built some new engineering centers in different places around the world. It's from both a process design engineering as well as execution. And our belief is we'll continue to have the opportunities to build these big projects going forward.

So can we talk a little bit about the culture? I just remember we're -- like 10, 15 years ago, there was a rolling debate about when the company was presenting about the engineering business about shrinking the footprint because of the cyclicality that are brought into the business, because you never wanted to fire the engineers during the downturn. Is there a permanent talent pool, so to speak? And feels as if this is one more example of a -- of the cultural shift at Air Products that has been happening in the last few years. So can you talk a little bit about that cultural shift? Where are we? And how much -- where do you see areas of further change or development or evolution where management is already there, but the rest of the firm needs to be pulled in that direction?

That's a great question. I mean culture is a very interesting thing to talk about, right? Everybody knows it when they see it, it's hard to describe it. As you know, I've been at Air Products quite a long time, been in the IR role now for 10 years, and it's been incredible for me to watch, observe and hopefully participate in the change of the culture of Air Products. But I think Seifi would be the first to say he's proud of the evolution that he has led us through that we have done, but he is not satisfied with where we are today. And I think if there's an area fundamentally that we've got to keep focused on and get better at is moving with speed. Not moving recklessly, but moving with speed. Some would say, "Boy, you're moving very, very quickly. Look at what you did around this carbon-free hydrogen project." Okay, but there's a lot of other exciting opportunities out there. And why couldn't we have done that project even earlier than we did. And I don't know that there's an opportunity just to continue to push that, to continue to make necessary [ work ]. We still have some unnecessary work in our organization. And it ties it all up, and that's people who should be working on other things and will allow us to move more quickly. I think from a business-focused strategy standpoint, from a cultural standpoint, we have that. We understand what we are. We're an industrial gas company with some tremendous growth opportunities. We're going to stay focused on safety and we always have been. I think we are building self-confidence is one of the areas of culture that safety focus is on. But again, I think speed is -- we're an awful lot quicker than we used to be, but not as quick as we're going to be in the future, in my mind.

And so I guess, another area where there's been a pivot in strategy is the -- with the merchant pricing, the value over volume. There are several different ways that, that gets interpreted or implemented. One is to price to the point of substitution. One is a -- when companies have a view of a kind of new equilibrium they're trying to reach. And then they sort of move back to just pricing line with inflation. And sometimes it's sort of not as aggressive than that, it's just a matter of pricing to inflation to the customers' inflation rate rather than the inflation in your own costs and taking advantage of your efficiency in spread. Can you help us think about where this is going? I mean this is a very different trajectories in the medium term in the 5-, 7-year horizon.

Great question, right? It's a very common question about pricing. And obviously, as we often say is we're really not in a position to make comments about the industry or the future or what might happen. I think one of the things that Seifi has said is he's brought from the top-down and continue through the organization a strong focus on pricing, making sure that we're getting value for the products we're delivering. Fundamentally for our merchant products, they are absolutely critical to our customers' operation. You mentioned substitutability. That's really not a factor in a lot of our merchant products. So they're very, very important to our customers and a reliable supply is critical and yet a small part of the cost back from customers' applications. So I think what Seifi has said is, look, a few years ago, he really kind of got the team focused on pricing. We expect to maintain that focus going forward. But exactly how that will play out, to be determined.

Is there -- just process-wise, is there a fundamental shift that's happened in terms of how the value proposition is defined? Like are you throwing extra ingredients into the box? Like I remember like when the crop companies used to talk about yield and then they started talking about resilience from the pages of drought from the past. Then they added another consideration. Is it something as simple as that? Or is it more granular and case by case?

Yes. I would say -- I'm going to connect it back to the previous question you asked. It's really about culture. I mean I was a commercial person in Air Products for a long time, and we had a strong commercial culture, but it was one of don't lose the customer. And look, we're not looking to lose customers, right? We'd like to keep all of the customers we have. But to be willing to have a self-confidence that we're going to raise prices, and pricing is not an absolute science. There's an art and a science to it. And sometimes, you don't get it just right. Sometimes, you raise the price it's a little bit too much, and the customer makes a different choice. That's not a great thing, but you can't shoot the salesperson when that happens. You got to learn from that, you got to maybe adjust. So I think that there's a self-confidence that we can raise prices. And if occasionally, we lose a piece of business, we're not going to fire that sales person. I think the other thing that goes back to, another element we've talked about, which is the locally empowered teams. You cannot run pricing in the merchant business, in the industrial gas business from a central location. You can create the culture, you can inspire, you can create the self-confidence, but the tactical decision-making depends on the local supply-demand balance. So making clear that, that's in the hands of the local team and go back to something we talked about at the beginning of the conversation, the team has got an annual EBITDA target and success in pricing is a great way to meet or exceed their target and reward the whole team. So I think when you combine the self-confidence, the willingness to lose business necessary with the empowered local team, I think that's actually the step change that's allowed the pricing success that we've enjoyed.

And I think it was on the last call that Seifi mentioned that even while retaining your A-rated balance sheet, there was about $40 billion of medium-term CapEx that you had a line of sight on. What -- besides just access to the capital markets, what would be the constraints for carrying that kind of project backlog over, I don't know, 7, 8, 10 years? I mean what's -- I mean it's just -- is that a staffing? Is there a -- are there other structural elements within the firm that need to be flexed out or built out?

Sure. Well, let me just, if I could, for a second connect some numbers there because there's a lot of different numbers floating around, right? So let's just talk a little bit about what we've laid out. A few years ago, we said, okay, we've got a plan at that time to spend about $15 billion for a 5-year window through '22. [ That ] time, you might remember, that plan was met with some skepticism. There's no growth in the industrial gas business. There's no way you can deploy that much capital productively. And obviously, we've actually reached that goal kind of halfway through this 5-year window. So as you know, and everybody knows, we do this quarterly kind of running tally of our capital deployment, how much have we spent, how much have we committed and how much [ are billable ]. But we've [indiscernible] based on this 5-year window and based on trailing 12 months EBITDA. So the numbers that we show, roughly $18 billion over this time frame, in actuality, that number's going to grow significantly because the EBITDA is going to grow as we bring these projects on. So I want to make sure we take a second here and ground people on the fact that we're not constrained by $18 billion. The other point is, the time frames are getting a little bit mismatched. So for example, with this somewhat arbitrary 5-year FY '18 to '22 window for the availability, but a lot of the spending for the recent projects goes beyond that. So as Seifi said on the call, we're going to reset this at some point in the near future. So there's plenty of capital capacity available. As Seifi and Scott articulate on a very regular basis, it's important for us to maintain our A/A2 rating. So that's a "constraint". We have productive discussions with the rating agencies about, okay, what exactly does that mean from a leverage standpoint? But we think that there's a lot more than this $18 billion of capital available to deploy while maintaining the A rating. So that's kind of, if you want, the supply side, how much money do you have. Obviously, back to some of your earlier points, you have to have the good highway return opportunities. We feel even better today, I think, than we did a year ago or 2 or 3 years ago as some of these longer-term growth potentials have come forth a little bit earlier. Seifi said on the call that maybe the hydrogen for mobility market has come to us a little bit even earlier than we would have anticipated. And we still see gasification and carbon capture opportunities. So you got to have the capital. You got to have the opportunities. And then, of course, back here, we talked a little bit about engineering, you've got to have the capacity to execute these projects. They're large. They're complicated. We're very proud of our ability to do that. As I said, we've been investing in increasing our engineering resources and making sure that we are going to be able to execute the projects consistent with the opportunities and the capital availability. So I think that we're going to be able to deploy a lot more than the $18 billion, and we'll make sure that we can execute those as well.

And so a frequent question that's come up, and even today, somebody just sent one in along these lines, is the return on capital over the next couple of years. Would the firm be able to keep a ROIC flat even as these new big projects are being brought on? Or are we going to be in for a 3- to 5-year period of declining return on capital, even with all the tailwinds that you have from the merchant pricing and volume leverage on that side?

Sure. Good question. Of course, somebody else gets into the mathematics of how these numbers are all calculated, right? So let's talk about, first of all, the top line, right, or the top line of that equation. We expect profits to grow. No surprise there, right? We're going to bring the projects on stream. They are profitable projects that are going to improve. We'll see what happens with merchant pricing, but we certainly expect the profits to grow. And then if we talk about for when we do our ROCE calculation. Actually, now that we've actually borrowed some of the money and we have that cash on the balance sheet, that's actually a drag on the ROCE. And you saw that for [ over the ] quarters as we average that in on a 5-quarter average basis. So to some degree, we have this sort of idle cash. There's a bit of a drag on the ROCE. But that's really just kind of mechanically how the mathematics work. That capital will get deployed, and that capital will be one of the things that contributes to the EBITDA going [indiscernible]. So we're very confident that the projects are going to carry greater than this 10% IRR. And over the long run, I think that we're absolutely expecting the ROCE to improve.

And I think to that point, do you expect, over time, the average return on capital of your on-sites to be drifting higher because the current vintage of projects is higher return than the 2000 to 2015 vintage? And you had a few fairly low return kind of [ chunky ] projects in there. So should we see sort of an upward drift over the next cycle?

Well, I think there's no doubt about it. Since Seifi has been aboard, he's been crystal clear from day 1, and he's just looking for demanding a minimum 10% IRR on our projects. And I think the other thing that's pointed out, and Scott talks about this on a regular basis, is we can all run a spreadsheet and back sell to a return that we're looking for, right? We all know how to do that. But the projects that we're doing, quite frankly, are much, much more in the on-site space. So they really don't have the assumptions around certain ancillary products or merchant products. So I think we are demanding a higher return and the chances of getting that return are much, much higher than they used to be. So I think since Seifi has come on, again, it's not just a minimum 10% IRR that we're looking for. There's a higher quality of projects. We're going to continue going forward. And I'll again reiterate the same word, minimum. Some people here, "Oh, you're doing all these projects at 10%." you've never heard Seifi say that. He's always said minimum, and he has acknowledged in the last couple of projects that those exceed that 10% commitment as well.

I guess a question came in on the Saudi Arabian project that when it's looked at in terms of the cost of carbon avoidance, it looks to be about an $800 price per carbon. I don't know, I might have done the math myself. I don't know if you're familiar with that kind of framework. But just -- is that sort of the way you look at it? Or are there other parts to the project that are not part of the disclosed economics that help explain sort of the -- I think this is similar to, on the last earnings call, there was that question about the power intensity of the project.

Sure. So when we go back to and look at it -- and so look, the actual avoided CO2 emissions, first of all, could be calculated in a few different ways. What we look at on this project is, can we deliver carbon-free hydrogen at the pump to the vehicle at a cost which we think is going to be attractive to the market. And I know that seems very simplistic, but that's what we're focused on. So as we look at, again, as we kind of talk through this math, we think that $10, $11, $12 per kilogram is competitive on a dollars per mile basis to gasoline and diesel. And then to layer on top of that, clearly, the world is going to have an appetite or a demand or a need or a premium for carbon-free hydrogen. That's what we're focused on. We didn't just sit down on this project and say, okay, what's the price of CO2 today in a certain region? This is a way to do that. Our observation is the world is very, very focused on carbon-free hydrogen as a transportation fuel, and that's how we think about the project.

And then the last question that came in is, can you just talk to your utilization rates in the merchant business from the perspective of how much volume leverage do you have before you need to start doing new growth CapEx in that side of the business?

Yes. And I'm glad you asked. I mean, so look, the utilization rates -- first of all, prior to this downturn, they weren't at the 80%, 90% levels. There was already [ capacity prior ] and obviously, that's been [ exacerbated from ] here. I believe we'll see that volume come. Hopefully, the world will get back to from an industrial production manufacturing standpoint. But I think very importantly in there, we are -- again, we're committed to the merchant business. We're going to invest in the merchant business where needed. And you can see there's a couple of modest-sized projects in our backlog where we are adding capacity. So even if overall utilization rates in a region are at a certain level, 70%, 75%, there can still be pockets where we need additional capacity, and it makes sense to do that. But again, it's a very local market. We obviously talk about the utilization rates on a regional basis, which are making very local decisions. So as you said earlier, right, we're excited about the large projects, but we got teams of people who are very focused on where do we need to add capacity in the merchant business, and we're happy to support those investments as needed.

Okay, great. I think that brings us to the half hour. So thank you very, very much for the discussion today, and good to see you. And if anybody has any questions, please feel free to reach out to either of us.

All right. Well, thank you very much, Laurence, and the rest of the team. Everybody stay safe, and we'll talk to everybody soon. Thank you. Bye.

Take care.