Linde plc (LIN) Earnings Call Transcript & Summary

Good morning, everybody. This is Bob Koort, Head of the U.S. equity research effort on the chemical space here at Goldman. And on the line, I've got my teammate, Dylan Campbell, who helps me covering Linde. Before we get started, I have to make a quick disclosure statement. We're required to make certain disclosures on public appearances about Goldman's relationships with the companies we discuss, disclosures relate to investment banking relationships, compensation received, 1% or more ownership. Prepared to read aloud disclosures for any issuer upon request. However, these disclosures are available in our most recent reports available to U.S. clients on our firm portals. Disclosures and updates to those disclosures are also available by ticker on the firm's public website. Very excited to start off today with Linde. We've got Juan Pelaez who runs the IR department; and we've got Matt White, Executive VP and CFO. As usual, for this conference, we're going to direct a question-and-answer session, but you, as clients, on the web portal have the opportunity to ask your own questions. We'll prioritize and put those ahead of our own. But if you're too bashful, we certainly can fill the time with our own questions. So with that, why don't we get started? Matt, if you don't mind, obviously, the Linde-Praxair merger really changed the landscape of the industrial gas [ section ]. I was wondering if you could just talk about the merits of that combination and how the integration is going here, a year plus into it.

Sure. And first, Bob, I'd like to thank you for having us. And also I'd like to thank you all online here attending virtually. So to your question, I would say both the merger itself and the integration process have been progressing better on virtually every front than what we had originally expected. And I think if you go back in time to when we had the merger date and look at the key benefits we had defined and sort of look at where we are now, roughly a year and almost a half later, first, we had laid out the cost savings. And it was $900 million of annualized cost savings and $200 million of annualized CapEx savings that we would achieve over a 2 to 3-year period. Right now, we're ahead of both. And I think that is supported by the financial results that we've been able to demonstrate over the last 5 quarters. In fact, if you look at the last 5 quarters, our operating margins have expanded 300 basis points from our end of year 2018 which was the baseline prior to the merger. From 2018 to 2019, our EPS grew 19% or 23% when you exclude the effects of currency translation. And every single segment had strong margin improvement. In addition to those costs and CapEx savings, we had stated that we were going to get additional capital structure synergies. We didn't give a number, but we said that we plan to get those incremental above these other stated synergies. And also we were going to have a very balanced and thoughtful capital allocation policy that would not only grow the business but also return a lot of value to shareholders. Again, when you look back, 2018 to 2019, we delivered on a lot of those capital structure benefits. Our tax and interest alone year-over-year added $0.34 of EPS in that time frame. We laid out a very clear and concise capital allocation policy. And last year, we had $2.5 billion of share repurchases and that excludes the over $3 billion of repurchases we did for the squeeze-out related to the merger. And in the last 5 quarters, we increased the dividend 17%. And finally, the overarching theme was that we were going to get the best of both, the combination of Linde AG technology and engineering portfolio with the Praxair operational excellence model, and really, the longer range that would lead to stronger sales synergies. And we're starting just to bring together thousands and tens of thousands of people with their know-how experience. We've got an unrivaled technology and engineering portfolio and global reach on all of our applications and services. So this has led to what we have today, which is almost a $10 billion project backlog, industry-leading with all top tier customers. So I think we're just scratching the surface on this area, but this is something that's going to improve every year. So overall, I'd say we had a pretty good start but this is something that we will continue to improve on every year.

And Matt, you guys have a very good history of cost control and managing the cost structure. Can you talk about how much more you can do beyond that $900 million? I think annually, you guys have pulled 3%, 4% out of your cost structure. That was the target. Maybe talk about how that's shifted, if at all, in the combined entity?

Sure. And I think to your point, when you look at part of what I mentioned on the operational excellence culture in Praxair, that was something that had a very rigorous monthly model. We had very structured reviews to get at the productivity with all of the business units around the world. And probably equally important, we had a matching incentive scheme. And the purpose of that incentive scheme was to align management and, as far down the organization as we could, the incentives with our owners. And what that did was really drive an ownership behavior or an ownership mentality across the organization. So Linde Plc had adopted that operating model, adopted that incentive scheme. And with that, we not only are ahead, as I mentioned, of our $900 million synergies. In fact, we're pulling some forward today, but we continue to find other opportunities. And some of it is situational based. We're in an environment today where you are seeing volumes in certain parts of the regions declining. And what we're able to do is better align our cost structure around what we're seeing in the environment. In fact, it creates a bit more of a burning platform, brings the culture even more together with a common goal. And we're seeing even greater opportunities and more accelerated opportunities. And the nice thing is, is when things do recover, and they will, we just don't need to bring these costs back. So this is something that should be a positive for us going forward. But we're going to continue to leverage technology, digital tools, and really just the overall organizational knowledge. And I have a high degree of confidence that we're not only going to have some pretty strong productivity and synergies in these first few years post-merger, but this is something that's going to continue every year and beyond.

Watching the chemical space, a lot of deals we see there's a synergy count, and then there's some sales synergy aspiration that goes beyond the cost synergies. Can you talk about what might be available there? Are there sale synergies? Have you seen any yet? What do you see on the horizon there?

Definitely, there are sale synergies. It's a number we didn't publicly give, but we stated that we will get them. And the reason we didn't publicly give it is you know sometimes sales will be subject to what's going on in the environment, in the market, the customers. But we are fully confident that we're going to see value and benefit in that front. And internally, we do have metrics and we have a pretty intense focus. Clearly, it's going to be utilizing the technology I mentioned, the engineering technology platform. We have a lot of applications that we're able to leverage today, simple ones like dry reforming, some of our electrolysis technology. These are ones that are particularly, I'd say, in more demand but among many others. Another example, we have product line platforms for what's called small on-site. These are kind of the workhorses in a lot of the small on-site area primarily for nitrogen and oxygen. And by combining this product platform across both companies, we really filled in any holes that might have existed in either legacy company. In addition, you've got very strong regional presence and density where you can back that up. So the combination of that has given us dozens more wins in those areas, in those small on-sites that we normally would not have achieved as individual legacy companies. And another area that's going to be I think the biggest opportunity going forward, especially with the sales synergies combining, is just what you're seeing in hydrogen and decarbonization around the world. I mean we are really best positioned between our portfolio, our capabilities, our density, asset network to be able to support this initiative. We've got a lot of success stories already in the world with our electrolysis units, our hydrogen mobility units, our clean hydrogen. And this is in a lot of the leading regions in the world. With Korea, China, we've made many announcements and wins in places like that, Scandinavia, Germany and many others. In fact, we're able with our full-scale technology, we can bring a customer from a pilot phase all the way to full green hydrogen. And it's through a combination of our capabilities, including our ITM joint venture, which really gives us a pretty exciting electrolysis step-up in terms of what we can offer. And in the next 5 to 10 years, we're going to invest over $1 billion in clean energy. And we already have a detailed list that exceeds this number. So we have a high degree of confidence we're not only going to deliver this goal, but we'll likely exceed it. So when I think about this merger on the long range, really, it's going to be the sales synergy, the technology of integrating all this talent, all this capability, that will be the most valuable synergy in the long run on this merger.

And can you just give a little deeper explanation of this electrolysis and hydrogen opportunity?

Sure. So as you know, electrolysis today, it's not as competitive as more traditional ways to make hydrogen and primarily 2 reasons: Number one is scaling and number two is just the ability to get the renewable power source. However, what we're able to do is find relationships with customers where we can scale them up. So we can bring them a hydrogen solution today at 99-plus percent reliability. And we can start them on stacking of these electrolysis units so they can essentially get hydrogen through an electrolysis, right, basically, splitting water. And then as you migrate and as you evolve, we can work to get renewable power sources to connect to that. Obviously, renewable power is very distributed, but we are one of the largest power buyers in the world. And our model is such that it supports a very strong base for any power producer. Not only are we a steady stable base that can help make these power investments get a good return. But also we could turn off at any point. We can be able to put power back to the grid because we have storage capabilities. So it'll be a combination of making investments supporting renewable power, building the technology and stacking our electrolysis units. Every year, they continue to get more powerful where we can stack and give more energy at a smaller footprint, and then obviously have the whole network of hydrogen to keep them backed up and supported so our customers have the reliability they need. So it's something that is a bit of an evolution. But when you think about it, you look today what's happening with the economies, you've got governments that, obviously, for long periods of time, and rightly so, have been concerned about the environment, concerned about the planet. And now they're in a position where they're putting trillions of dollars into the economy in light of what's going on with COVID. On top of that, most economies are looking at double-digit unemployment. And we're already seeing in places like Europe where they can combine these efforts and of the money they're putting in and retraining the workforce, accelerating clean energy, accelerating clean hydrogen. So I do think you may see an acceleration of this. You may see a very large investment on this through government action. And what that could do is really accelerate this process. So we're pretty excited about that, and that's something that we think will be -- Steve mentioned on the call before, this is going to be a multibillion-dollar business for us in the future, for Linde alone. And so I think we're going to talk more about this in the future. But it's something that I think can be a very, very strong growth platform for us.

Interesting. I want to touch on business trends, but one last integration question. Can you give us an update on how your noncore asset disposals have fared to date and what's left to go?

Sure. And I'll kind of split it into 2 buckets. So first, there's what was the mandated regulatory divestments for the merger. And that's substantially complete. We have one very, very small immaterial asset left in Asia. It's on our books as a disc ops, and that'll be done here in a few months. So for all intents and purposes, we're done on that front. But separately, we're continuing to enhance the portfolio. And when the merger date happened, about a year or so ago, we were fortunate enough that there were no, I'll call it, significant underperforming assets of any size. We had some small ones, and we immediately addressed them. Some we had to shut down. Others, we were able to sell. But what we're looking at today is we still have in our portfolio some noncore assets, and we also have some underperforming gas assets in certain regions. So we've done a pretty detailed portfolio analysis last year. We are actively working to both improve them and see what strategic options exist. And you've probably seen publicly, there have been a few announcements we've had of some divestitures. In fact, most recently here a month or so ago, we had divested an LNG business in Scandinavia. That was just not something that we were the best owner for. So the progress continues. In light of this environment, the buyer pool might be a little bit more slower today. It may be a little more hesitant today. But that being said, we're still going to continue to improve these businesses, and we'll still evaluate the options that exist. But irrespective, our business quality will improve every year. I'm confident of that.

This is Dylan Campbell on Bob's team. I guess shifting here to current business trends, last week during earnings, you offered a few different scenarios for covering kind of what that implies for your business. One, assuming second level -- second quarter levels persist, essentially through the end of the year and then another that assumes that volumes come off before the third quarter but are still down year-over-year relative to 2019. Can you talk a little bit about the defensive nature of your business and how one, that's providing a good barrier for some of the risks we're seeing in the volumes, and then also how you preserve the upside once the macro does improve and kind of how that offsets and you kind of contribute -- or contribute to the growth opportunity?

Sure. Maybe first, I'll just start describing a little for those on the call that may not be as familiar with the scenarios that you had referred to that we laid out. Clearly, in this environment, nobody knows what will happen, what's going to happen. I'll start with that. And also I think the word recovery has a lot of different meanings to a lot of different people, and that word is being thrown around. But we felt it was important to first define what we are framing as a recovery. And our view of a recovery is a stable recession. So we said when we recover, -- we'll actually recover into a recession. And we define a recession as volumes are down low to mid-single digits, so roughly 4% to 5% year-over-year from 2019, that would be a recovery scenario. So within that, we had 2 different trajectories of a recovery. And we're not stating that we believe either one more than the other, we're just trying to give a framework that investors can put their own views in, stress test, do their own analysis and then come to their own conclusions. And so scenario one basically assume that the recovery would occur in early Q3, so say, late July. And then after that time point in late July, you'd be in a recession of 4%, 5% down from 2019. In that scenario, our EPS, excluding currency, would grow mid- to high single digits from 2019 levels. The second scenario was clearly more bearish. That assumed that the recovery would not occur until mid- to late Q4. Essentially, the lockdown conditions of Q2 would persist pretty much until late November. And then at that point in late November, you would start coming out into a recession. Even in that scenario, we view the same EPS x currency to be roughly flat to slightly down from 2019 level. In all scenarios, Q2 we view would be the weakest quarter. And then it's just a function of what type of recovery trajectory there is. And within this, obviously, with those numbers, I think it's a testament to our defensiveness. And with our defensiveness, we had laid some numbers out last week that 65% of our sales are defensive either through being in a resilient market or having fixed payment structure. And the resilient market portion, which is about roughly half of that 65%, a little over half, it's the health care, food and beverage and electronics markets. Right now, you can imagine health care and a good portion of our food markets are actually growing in this environment. They're more based on demographics, so they're not going to be cyclical to either consumer or industrial trends or fads. So those continue to grind higher thick and thin in most environments. And in this environment, several of those markets are actually growing even faster. Electronics, some people may be surprised, we call that resilient, but our industry is a little different. I think some people think of electronics is changing technologies and some volatility there. But really, the vast majority of what we do in the electronics space is we provide ultra high-purity nitrogen to remove contaminants. And these, as you can imagine, are needed to have a clean environment. So the smaller, the faster, the more powerful electronic components or devices or chips, the more nitrogen you need. So really, we're not subject to technology changes. We're just interested that there's any form of technology progression. So that's another area that we see more resilient just given the trends we've seen over the last couple of decades. So those, as I said, are about 1/3 of our business and continue to grow well. And then the fixed payments, it's a combination of both our on-site fixed payments and our packaged gas rentals. Rental payments are just what they pay on the cylinders every month. And through the 2009 global recession, the commodity contraction in 2015, our rent was paid throughout. We see strong resilience in the rental payments through thick and thin. And so that's something that also gives us a very high degree of defensiveness. So the combination of that plus pricing ability in our industry, most of our contracts price to inflation either automatically or through other mechanisms to recover costs that may be inflating through charges or surcharges. So the combination of these, coupled with, to your point, our ability to act on these costs in these environments. The packaged gases, and to a lesser extent, merchant, we're able to quickly align those cost structures in downturn environments. And while those volumes may react the most to economic downturn, they also react the best on the recovery. And the key is not needing to add those costs back. And really, what happens is we may consolidate certain fill plants, certain retail branches. We can be more efficient in how we use technology for back office admin. And as we get into a recovery period, we realize we just don't need those costs. We've demonstrated this, and you can go back to some of the results of my knowledge of the predecessor company, Praxair, and you see very strong high-margin recovery in the kind of '10, '11 period, 2010, 2011; in the 2016, '17 period. And this is something that there is a very strong leverage on the recovery. So it's a combination of the defensive in the downturn, but a nice strong leverage in the rebound. And this is something that I think fits very well for our model today.

Yes. I guess the follow-up on that. I mean when we look at kind of volume, I mean, it's fairly impressive, your ability to still grow EPS even in a down volume environment. When we look at volume growth, again, let's say, we're looking at volume growth in 2021 and 2022, what type of incrementals would you expect on that volume growth?

Well, maybe I'll talk -- we can talk just a little bit about quarter -- the quarter sequential and talk to that extent. So we had said last week on our call that the Q1 to Q2 sequential EPS for this year could drop 10% to 15%. And we said Q2, we expect it to be the worst quarter of the year. We also had said that April results which had come out at that point were noticeably better than what we had anticipated. So the 15%, the low end of that range really would assume April repeats every month of quarter 2. We're already seeing some recovery. So if anything improves between May and June, that would be upside, probably put us closer to the better end of that range or more. But within that EPS outlook, you're probably looking at between package and merchant volumes falling mid-teens, kind of sequential in that range. So from that perspective, we're able to mitigate the gross contribution, variable contribution loss of that volume. And then when it recovers, you get it back more at a gross or variable contribution. So if we can continue to do that, and we have a strong track record of doing that over the last several decades, I think this is something that continues to create value for us. So those are the kind of numbers you would expect in this environment of the reductions. But we're obviously keeping an eye on it. We track daily volumes. And this is something we'll give more color on in the second quarter when we come out with our results then.

Matt, it's Bob again. You guys obviously run a bunch of plants inside customer plants. Your customers don't really carry your inventory of your gases in those plants, so they're fairly good real-time proxies for what's going on. What have you seen in China who's restarted sooner? Maybe how does that look differently or inform you on what's going to happen in Europe and then ultimately, the U.S., which that seems sort of like the cascading order of how this pandemic has gone through the economies? What have we learned so far?

Starting with China. Our Chinese business, they actually -- our team there did a great job, responded very well. Our on-sites ran throughout. And remember, part of that is we have very high-quality Tier 1 on-site customers. So they ran throughout really no hiccups there. We obviously practiced safety standards. We had all the PP&E, we had certain protocols to be able to keep our customers running that needed to continue to run. But in China, the merchant business declined fairly significantly, but on a very short period of time. You saw volumes drop anywhere from 50%, 60% over a short period and quickly rebounded, and they're back to levels just slightly below what our normal rates would have been at this time of the year. So it was a fairly rapid recovery. We had said in the call that in our quarter 1 results, we had about a $0.05 EPS impact total from COVID, of which, around half or maybe a little less than half related to China specifically. And really, that's a pretty minimal impact in the grand scheme of things. It was really like a more of an extension of the Chinese New Year with even a little bit further volume decline, but then they've come back quite well. Now obviously, China is a different form of government, a different structure on how they address this versus how other countries are doing it. Every country is doing it a little different in terms of how they're managing through this. So I don't know how much China will be as a good indicator of other countries. But clearly, what we saw there was pretty rapid recovery. As far as Europe, we are seeing things start to come back. And like we said, in April, things didn't drop as much as we expected. So I think the baseline of activity was still better than we thought. And things are starting to reopen here. Even in the U.S., obviously, it's very different state to state. So a lot of the industrial assets in the South ran better than, say, anything in certain parts of the coasts where you might have had more of a lockdown effect. So I think you'll see it more regional, but we're expecting that things are going to continue to probably improve here through the second quarter, and it's just a function of what levels we get to by the end of the quarter.

Could we transition a little bit to balance sheet capital allocation strategy? As you mentioned, you guys have bought back some stock. I think you said $2.5 billion of discretionary repurchases, $3 billion of the squeeze-out. How do you think about managing the balance sheet, buying back stock, maybe taking advantage of your balance sheet in terms of capital priorities? Just give us an overall summary of how you're approaching that in light of current conditions.

Yes. And I'd say our capital allocation policy is very simple, easy to understand, and it does not change. It does not change in the good times or the bad times, and it's not changing today. So really what that policy is, it starts with what capital structure do you want. That's the first question of it. And for us, it's A rating under S&P and an A2 credit rating with Moody's. That is something that we are committed to. That will not change. It's something that's important, we believe, commercially for our industry, given the long-term nature of what we do. And it also gives us very, very low-cost access to capital. In fact, recently, we did a bond here a few days ago. And we're able to get record low coupons for us. So I think from that end, that's something that will not change. And then in addition to that, we are committed to growing the dividend every year. It's an obligation for the company. We've grown it for 27 years straight, and we are not going to stop. So those are 2 kind of baseline requirements. And once we have those in place, our next priority is to invest in the business. And that can be any kind of investment. It could be an investment for a capital project, an acquisition, decaps, other growth. It doesn't matter. We treat them all the same, and we should. These are uses of capital, and whether it's an acquisition versus a project, we shouldn't change our criteria. It's a risk-reward view. And actually, calculating the return is the easy part. These are DCFs we evaluated on IRRs, unlevered after tax. And in most cases, you have fixed fees, you have contractual revenues or you have synergies that are very clear. So really, where we spend the majority of our time, and we have a very structured monthly investment committee process, is evaluating risk. And that really is the most important. You're looking 10- to 20-year kind of relationships, and you really need to understand the risk that you're entering into because even -- as you all know, in the investment community, you talk about a 12% return. You talk about a 20% return, it doesn't mean much unless you understand the risks that's attached to those. And it's no different for us. In fact, return on capital is the single most important metric in this industry. It's part of our long-term incentive and how we're measured for 3-year return on capital growth. So this is a very, very important part, we believe, of adding value to this company. And then whatever cash is left over after our dividends, after all of our investments, we use it to buy back stock. And last year, 2019, we had just under $1 billion left over, and that's after everything, free cash flow less dividends. So this is something that is a very stable, very simple capital allocation policy, and it's not something we're going to change or modify in any environment because it's a long-term view.

This is Dylan again. I guess switching to kind of industry pricing following the merger, I mean, conditions have been fairly supportive of continued price gains for Linde and a lot of your peers. You sounded pretty confident in your ability to continue to capture price through 2020 for the rest of the year as well. Can you provide a couple of examples of areas where you continue to capture price, considering the pretty depressed environment for, I imagine, a lot of your customers?

Well, it start -- Q1, where we just reported, we had 2% pricing globally year-over-year, and that was across all regions. And realize we had price actions already in place, and there will be some new ones throughout. But the most important thing to realize in our industry is pricing really tends to track with inflation and weighted inflation across some of our contracts automatically. We'll pass that through. And realize, we also have mechanisms to pass-through excess costs that we have to incur to supply. There are many regions of the world where we need incremental PP&E. We need certain extra costs to be able to bring the critical gases to our customers, and they incur excess costs for us. And so while these are really surcharging or passing through additional costs, they almost have an effect like price because these costs are in our run rate, sometimes for months or even a couple of quarters. But really, I would say aside from that, pricing is really -- it's a focus, it's a mentality, it's a culture. For us, we have to focus on the details. We have very rigorous reviews every month on this. We're going to evaluate what is the local inflation in that country, what's happening in the cost inflation for energy or logistics, capital, labor costs. So our management team has pretty quickly realized with our incentive structure that having a robust pricing management process really is going to be a very important part of that equation. So I'm very confident that we have the right focus. We have the right operating rhythm and metrics that we're going to ensure that we properly capture inflation in the cost of our services to be able to price them appropriately in the market.

Matt, maybe just to conclude here, we've got a minute or 2 left, but about 6 weeks ago, we came and upgraded Linde, and we had thought maybe people are missing a few things and not really giving you guys enough credit for some of the opportunity. In your seat, from your view, what is it that you think the financial markets miss or under-appreciate about the story?

Yes. Right now, I'd say that there are several things that are being underappreciated in the stock, especially on the equity side of Linde. And if I were to think about it, I'd try to think about it in 3 basic buckets. I think first, it's just that we're an incredibly defensive investment, really, in any environment, including today. As I mentioned, 65% of our sales are defensive by nature, and they have shown our success in the 2008, '09 global recession, the commodity correction in 2014 and '15, and so far, through first quarter here, you've seen very little effect on our business. We've got almost a $10 billion backlog. That is the highest quality and largest in the industry. I wouldn't trade it with anyone. We've got a significant productivity and cost efficiencies in our model, not just from the merger, as I mentioned, the $900 million that we're ahead of, but going forward. And our financial results have continued to show that, and they will going forward. Double digit earnings, double digit cash, we grew our operating cash flow 26% last year -- or this last quarter, and margin expansion. The second thing is just we have an incredibly strong balance sheet and cash-generating profile. And I think investors are appreciating this general concept for most companies today, but I think we're being underappreciated on it. As I mentioned here, Tuesday, we just issued a 7- and 12-year bond. These are the lowest coupons ever in industrial gas space at this tenor. We have a very strong commitment and ability that we're going to keep raising the dividend, and we're going to allocate this excess cash and capital not just to investing and growing the business, which we have a lot of prospects, but also for shareholder-friendly actions. And the last -- third point is the growth opportunities. We have a very good growth profile looking ahead. Aside of the backlog, aside from the pricing opportunities and the resilient markets I've mentioned, which are performing well in this environment, we've got secular growth driver related to clean hydrogen. It's something that we are best positioned given our size, scope, capabilities, asset, network, and this alone is going to be a multibillion-dollar opportunity for our company. And when there is a recovery, we will get positive leverage, as I mentioned. This is something that we're going to get a nice rebound on that back end. We're not banking on it. We don't need it, but it's something that often gives us significant incremental growth at attractive margins. And in a call later this year, we're going to elaborate on a lot of these items and lay them out more clearly. But I think we've proven over the last several decades through several crises that we're able to have the right rhythm, the right approach and the right management style to manage through these and not only manage well during them, but come out stronger. So I would just say that we're going to continue to surprise people by our overperformance. And I expect that this under-appreciation or under-valuation is going to get corrected in the next few quarters here.

We're both rooting for that. Matt, Juan, unfortunately, that's the end of our time. Really appreciate it, and you guys stay safe. Have a great day.

Yes. Thank you. You too. Stay safe.