Linde plc (LIN) Earnings Call Transcript & Summary

Good day, and thank you for standing by. Welcome to the Linde plc Teleconference. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to Mr. Juan Pelaez, Head of Investor Relations. Please go ahead, sir.

Thanks, Amara. Good morning, everyone, and thank you for attending today's call. I am Juan Pelaez, Head of Investor Relations, and I'm joined this morning by Matt White, Chief Financial Officer. Today's presentation materials are available on our website at linde.com in the Investors section. Please read the forward-looking statement disclosure on Page 2 of the slides and note that it applies to all statements made during this teleconference. Let me now turn over the call to Matt.

Thanks, Juan. Good morning, everyone. As stewards of shareholder capital, we have an obligation to act in the best interest of our owners, including prudent oversight of factors which could negatively affect the stock price. Over the last 2 years, we've observed increased valuation barriers from regulatory caps associated with our European listing. While these caps are not new, the Linde dual listing structure and relative performance is uncommon. And this has provided us a unique perspective on these challenges. The purpose of today's presentation is to explain the negative impact from these barriers, describe the actions taken by management and provide a recommendation. Given how these matters directly affect shareholders, we felt this forum was the most appropriate communication method. So let's start on Slide 3. And with a summary of our stock structure. Linde is currently listed on 2 different exchanges, the New York Stock Exchange in the U.S. and the Frankfurt Stock Exchange in Germany. Note, these are full listings. So unlike depository receipts, we must comply with all local laws and regulations of each exchange. The stock trades in 2 different currencies is overseen by 2 different exchange regulators, must follow 2 different GAAP reporting requirements and is a member of different index pools. Almost 3/4 of all volume trades through New York, but this is for a single homogeneous share pool. So in theory, any share can be redeemed in either exchange. While some companies have dual European listings or depository receipts in foreign exchanges, there are very few with full U.S. and European listings. And Linde's overall structure is unique. With this backdrop, it may be helpful to explain some of the differences between U.S. and European stock markets, which you can find on Slide 4. The table at the top lists certain attributes of major European and U.S. indices, from which I'd like to highlight a few key points. First, several European indices have market capitalization based limits. These caps define the maximum percent any one company can represent in a particular index. If a company exceeds this limit, it must be sold during the rebalancing period, which I'll discuss on the next slide. The caps are all defined locally and range from a low of 10% in Germany to a high of 20% in Switzerland, including none in the U.K. Second, actively managed mutual funds that follow the European regulatory framework known as UCITS are subject to a separate cap which defines how much of a single stock they can own in one fund. Most large European mutual funds choose to adhere to use it. Since it enables much lower compliance costs across a larger pool of potential European clients. UCITS-compliant funds must follow what is called a 5/10/40 rule, which essentially means no one company stock can comprise more than 10% of any mutual fund. Therefore, most active mutual funds in Europe also have a cap of 10%, which firms often set lower to ensure UCITS compliance. This rule is part of a broader European regulation overseen by the EC. So it's unrelated to the local index caps set by each country. The existence of 2 different unrelated caps can create valuation challenges since stocks can be sold for technical reasons unrelated to performance or fundamentals. Furthermore, smaller local index funds coupled with the broader UCITS limitations create additional complexity on portfolio ratings and ability to generate alpha for European fund managers. You can see how some smaller indices contain certain members with significantly higher relative weighting. This combination not only creates technical selling pressure but also arbitrage opportunities, which can harm stop valuation. So while the overarching concept of regulatory-driven portfolio diversification seems beneficial to the investor, it can negatively impact fund returns in small exchange pools with disproportionate member weighting and performance. You'll note that the U.S. has none of these limitations, mostly due to the much larger size and breadth, which enables more natural diversification with unrestricted trading. In fact, you can see how the P/E multiples vary based on index size and restrictions with larger, less restricted indices having higher valuations than smaller, more restricted ones. And while these structures apply to all stocks, Linde has been one of the most capped stocks in Europe, which I'll speak to more on Slide 5. Upon exceeding the cap, Linde stock is negatively impacted by forced selling during the index rebalancing process. Rebalancing occurs when index managers trade stocks to meet the published requirements and thus avoid tracking error. In the DAX index, of which Linde is a member, the rebalancing occurs once a quarter over a 3-week period. So essentially 12 weeks per year. At the start of each quarterly rebalance window, the index provider will communicate the appropriate weighting, after which each fund has 3 weeks to rebalance their portfolio. Meaning buying and selling stock to align with the requirements. The table represents 12 quarters of rebalance periods for the Linde German stock since the merger. Within each quarterly box, the lower left number represents the Linde stock weighting at the time of the rebalance measurement date, with any number under 10% denoted as a green box and conversely, numbers of 10% or greater denoted in a red box. The arrow within the box provides the Linde relative stock performance versus the DAX index during this 3-week period. Any upward pointing green arrow means Linde outperformed the index, whereas a downward red arrow means Linde underperformed the index. In 11 out of 12 quarters, there is a positive correlation. In other words, when Linde was above the cap, it underperformed. And when it was below, it outperformed. The only period that did not correlate was Q4 of 2021. Shortly after the DAX index changed from 30 to 40 members, essentially providing Linde temporary cap cushion since the overall size of the index increased. As I mentioned, Linde has been one of the most capped stocks in Europe, averaging almost 2/3 of each year above the limit since 2020. Therefore, this technical selling pressure has been persistent. In addition, Linde is an active buyer in both the U.S. and German exchanges through the share repurchase program. This provides us a unique perspective on trading patterns, which support these findings. And they've been further validated from extensive conversations with several large investment firms, including existing shareholders. Our analysis and research led to the conclusion that the Linde stock valuation is being negatively impacted by regulatory caps. The next logical question of what have we done about it, can be found on Slide 6. Our management team first noticed this issue in 2020. And has been working diligently to identify an appropriate remedy. However, given the multiple parties involved and regulatory framework, this was not something that could be easily changed. Deutsche Borse, as the owner of the DAX identified this issue some time ago and has made multiple attempts to fix it. First, they reformed the DAX Index in late 2021 by expanding the membership from 30 to 40 companies, increasing total market capitalization and thus, providing more room for the cap. Unfortunately, it only took Linde approximately 3 months to once again exceed the limit. In addition, Deutsche Borse proposed to raise the DAX cap from 10% to 15% in the second quarter of this year, but abandoned that effort from negative investor feedback, primarily due to investor concerns around the UCITS 5/10/40 rules. Within Linde, we've had various discussions with key stakeholders, even modified our own share repurchase program around this limitation, but none were successful. Despite significant efforts over the last year, we believe broader reforms across Europe would be needed to resolve this issue. In light of this, management initiated a project to determine the benefits and drawbacks of our current stock listing structure, which you can find on Slide 7. Almost a year ago, we formed a project team with internal and external experts to evaluate the pros and cons of a dual listing structure. We assessed risk, cost and benefits across several key functions that are directly or indirectly affected by the dual listing. This was a comprehensive effort that took several months, with the results reviewed by executive management and the Board of Directors. It was a thorough and balanced analysis that led to the conclusions highlighted on Slide 8. Overall, we believe that one stock listing in the United States is in the best interest of Linde's shareholders. There are 3 main drivers to this conclusion. First, we believe there is a long-term valuation upside through removal of technical barriers in addition to a more diverse and higher valued index pool. Extensive research and stock repurchase experience have identified negative effects from being listed on 2 different stock exchanges. Second, simplifying down to only 1 publicly traded exchange will lower costs and complexity, which will create more value for our owners. Linde is one of the very few companies in the world that files full U.S. GAAP and IFRS reports for public listing, which is expensive, complex and exposes us to significantly more regulations and risk. By reducing to only one exchange, Linde can undertake additional productivity initiatives that are not possible under the current structure. Finally, by eliminating the second listing, we can reduce the perceived exposure to a single country. Linde is a global company with operations in almost 100 countries, of which each represents a single-digit or less percentage except for the U.S. Despite this fact, Linde stock often trades with the sentiment in Germany, especially prior to the U.S. market opened. We've identified this through daily trading observations and detailed investor discussions. Achieving these improvements would require delisting from the Frankfurt Exchange, which is discussed further on Slide 9. There are a few different ways we could have chosen to accomplish this goal, such as a tender offer or reorganization. But we determined that an Irish domestic scheme of arrangement and merger provides the lowest risk, lowest cost and least disruptive method. Equally important, this approach requires 75% shareholder approval. We believe a vote on this matter would be the most appropriate course of action since shareholders are directly impacted. We've included in the appendix a preliminary time line of key milestones. We anticipate the entire process should take approximately 4 months with the voting period estimated to conclude in February 2023. In summary, Linde has a unique and complicated listing structure that creates incremental cost and risk to the organization, while negatively affecting the value of the stock from European technical limitations. To address this concern, we conducted an in-depth review and determined that delisting from the Frankfurt Exchange would be in the best overall interests of shareholders. The recommended method to delist was chosen for reduced complexity, lower cost and to allow shareholders to decide through a vote. And while there is potential for short-term stock flowback, we believe it's more than offset by long-term valuation upside. It's important to note our structure was appropriate at the time of the merger since it helped create significant value for our owners. Looking back, we would have done it the same way. However, when combining the current limitations with our expectation of strong future performance, we believe now is the time to communicate this issue and let shareholders decide the path forward. I'll now turn the call over to Q&A.

[Operator Instructions] We'll take our first question from David Begleiter with Deutsche Bank.

Matt, could you quantify the savings or the productivity savings you expect to realize from the delisting?

The first thing I'll say is this, by no means, is driven by savings. The savings are not or any way a driver why we want to do this. I will say that our expectation would be somewhere in the single-digit millions of dollars and the vast majority of that would relate to outside service costs, like outside legal fees, outside independent auditors, filing costs. But what I will add to that is the complexity aspect is quite important that we undertake. As you can imagine and as I mentioned in the prepared remarks, today, we have to simultaneously comply with all standards every day. And when we look forward, we're seeing them diverge more, frankly. A perfect example would be, for example, the ESG standards you're seeing between Europe and the U.S., both are going on independent paths. And under this current framework, we would be required to comply with both simultaneously despite them diverging. And so what that would do is not only create more complexity for the organization, but more future costs as well. So it's not just the cost we have today but also what we'd incur going forward. That's how I would think about that.

Very great. And just on buybacks, any benefits to your buyback activities from being listed only in New York?

I would not say that. I mean we have -- obviously, to your point, we do have the ability to go in both markets today. We have not seen a time where we've maxed in both markets simultaneously today. I think our -- we have ample capacity now, as you know, of almost $6 billion, but I feel pretty comfortable that even with the volume traded would probably shift to the U.S., and that would give us more capacity if the shareholders did approve this.

We'll take our next question from Nicola Tang with BNP Paribas.

The first would be, it sounds like you guys have done a lot of work around the potential impact here. So I just first wanted to ask about whether you had an estimate for potential selling pressure firstly from European index-related funds, and then secondly, from investors for the European-only mandates? And given you require the 75% shareholder approval, I was wondering what the investor feedback has been so far since you announced it? That would be the first one.

Nicola, it was a little hard to hear, but I think you were asking about flowback and maybe some investor feedback that we might have gotten to date. So I'll try to address those questions. If not, let me know differently. So starting with flowback. Clearly, that was an area we spent a lot of time and focus on. As you saw from the presentation slides, capital markets was one of the key areas of focus. And within that, flowback and potential future premium were 2 very, very important areas we spend a lot of time on internally and with outside experts. So when looking at the flowback, I think you need to start with how many shares do you estimate are traded between the 2 exchanges. And as a lot of you know, the European filing requirements are not quite as rigid as the U.S. So there's not an exact answer, plus it's moving every day. But we've done significant research and effort with investor outreach, confirmation directly with investors through surveillance organizations and other ancillary filings that we've come to the conclusion that the split, I'll say, between the Frankfurt and the New York ownership is fairly similar to what the volume split is today. So roughly 3 quarters, 1 quarter. It may move up or down, but that's what we've seen in our evidence in our work. So then when you start with that 25%, I'll call it roughly number that we deem in Frankfurt today, I would analyze the potential flowback into 3 types of investors, which would be retail, institutional, active and then institutional index. So starting with retail. The way this merger is structured and if approved by shareholders, it will be seamless to the shareholder. It will be a one-for-one exchange immediately. I want to emphasize nothing is changing in the organization. So this is not a taxable event for shareholders. I think it's important to say that. There is potentially 1 very minor caveat, and it relates to Germany only for institutional investors that may have more than 1% or 5 million shares in a single fund. We don't believe that's going to trip anyone, but that is the only potential event. And that will be more disclosed in our proxy. But other than that, this is nontaxable, and we don't expect it to be taxable for our current share base. So from that perspective, the retail shareholder can own through their brokerage firm in either exchange. It will be seamless for them. It will be nontaxable. And although the currency today, they may own in Europe is euros and it would be dollars if this proposal is approved, realize that as a dollar functional company, the dividends are all paid in dollars today. They're just converted to euros when they arrive. And our stock must always equilibrate between the currency differentials to avoid arbitrage anyways. So given all that, we don't anticipate much flowback. We estimate the European retail to be somewhere in the neighborhood of low single-digit to mid-single-digit percent of that roughly pool there when you look at what's available in the Frankfurt. The next category I would look at as institutional index. We estimate their ownership right now to be mid- to high single-digit percent related to Europe, that is. When we look at that one, we clearly expect flowback there. As you know, the index rules are set very rigidly in terms of what they are able to own. For example, for the DAX index, you must be listed on the Frankfurt Exchange. So given that, the flowback would be obvious, and we would expect that. But to add just some information around that, some of you may recall that last year, in 2021, Linde was actually deleted from the FTSE Russell Index ironically due to some confusion about our structure. But upon that deletion, which occurred in the second quarter, we had roughly low to mid-single-digit percent of flowback that occurred. But we were able to manage that with our buyback and the stock was able to recover. So we have experienced that at least that level during 2021. Then the balance would be the institutional active. And this is one that's really going to be, as you all know, a mandate-by-mandate conversation. Now what I want to stress in this is Linde will be identical if this proposal is approved. Our corporate structure is the same. We will still be Irish. We will still have U.K. tax. Our revenues, our organization, the Board, it is all identical. In fact, if the merger does happen, our legal structure will be identical. That's why this is called a reconstitution under Irish law because substantially nothing has changed. So given that, I would only envision mandates that are exclusively aligned with your index, that could be in question. But obviously, over the next 3 months, we will work with those investors to understand that. And in my mind, worst case, if we are excluded from a potential active fund due to our exchange position, it may open us up to another fund that we currently are not eligible for. And those are things we will need to explore. So taking in balance, that's how we envision the flowback. I will add that, overall, we still see that flowback short term. We do see longer-term benefits. And we will be active with our buyback program, which right now is in a self-imposed 1 month 10b5-1, which we do because of earnings, but that will open up again Monday for us to be active again. As far as investor feedback right now, we haven't -- we've gotten some, but this is what we expect to do over the next 3 months to really sit, listen, understand their views. Clearly, we will also take that opportunity to educate on some of these factors that we've discussed. And therefore, we will be able to incorporate that more as we hear it. But up until now, from what we've heard from investors, as you can imagine, it's a spread depending upon what their mandates are today.

Sounds great. And that was my first question. And the second one, hopefully, you can hear me a bit better now. I was just curious to understand a little bit more the comments you make about U.S. stocks tending to trade at a premium to Europeans. You've obviously highlighted the kind of caps here around indices. And I would agree with you -- with that kind of conclusion, but it's true that you already trade at a premium to your closest direct European peers. So can you talk a little bit about the analysis that you've done and perhaps like the wider U.S. peer pool so just to understand a bit better?

Okay. So to your point, when we look at the potential, I'll call it, negative impact that we see on the stock valuation, there are the 3 pieces. There are the caps which is clear, it's being restricted. The data is very evident and how the numbers are clear. There is the sentiment, which we've mentioned. And then there is the potential for a multiple expansion, as you stated. Now we specifically have not given a range because, as you know, that is something that is not that easy to calculate, but we've done a lot of research on this. And what I would start with is, as you saw the slide we presented on the market cap differences, you see the clear multiple differences. I mean that we know. Then if we take a step down into the industrial gas industry itself, it is a homogeneous industry. Now if we talk premerger, there were 4 major players that were all publicly listed. You had 2 sole U.S. listed players, and you had 1 French and 1 German listed player. There was a persistent and consistent valuation difference between those. And I'll use EV to EBITDA, which, as you know, is a more common valuation metric for this industry. So on EV to EBITDA, there was a 1 to 3 multiple premium to the 2 U.S.-listed companies over the European companies during -- I went back a 12-year period from 2007 to 2018. In fact, many of the analysts on this call have written reports about this over the last few decades. So this is in a homogeneous industry, where we all essentially do the same thing, but there is that valuation difference. Then if we take a further step deeper and analyze this, we looked at Linde over essentially 12 plus 4, almost 16-year roughly period. And what we looked at was Linde's EV to EBITDA premium multiple over the S&P 500 Index. And we compare that to the U.S. competitor, and we did it on a before and after merger. So there were essentially 2 time periods. We took 2007 to 2018 Q3, which is the merger, and then Q4 2018 to essentially last week prior to this announcement. And what we looked at was the EV to EBITDA LTM, so the last 12-month trailing premium to the S&P 500. And this is all publicly available data. So you can all do this yourselves in your own analysis. And what we found, it was quite interesting. So if we start with the S&P 500, the S&P 500 versus the DAX, we'll start with that analysis. From 2007 to third quarter of '18, had about a 1.7 turn premium to the DAX. Linde, during that time period in the U.S. predecessor company had just under 2, about a 1.8 premium to the S&P 500. So the S&P 500 at 1.7 to the DAX, and the predecessor Linde company in the U.S. had a 1.8 premium to the S&P 500. The U.S. competitor had about 0.5 premium to the S&P 500. And this is average essentially quarterly and daily is even more significant difference. Yet post merger, what happened? The S&P 500 premium to the DAX increased to 4.5. So it went from 1.7 to 4.5. Now there are a lot of reasons one can give the tech expansion in the S&P 500 of which DAX was [ laid ] on, the 2020 COVID impact, which could have been more severe to Europe. Obviously, the current 2022 energy crisis, but nonetheless, that is with the S&P 500 premium had increased to the DAX during that time period. The U.S. competitors' premium to the S&P 500 held, essentially a half turn, half turn before our merger during that entire 12 period and half turn after. However, Linde's declined. We went from almost 2 premium down to a half premium, almost to 1.5 turn. Now one reason could say, well, fundamental performance, right? The performance of the company resulted in that. Yet when we compare our performance to that U.S. competitor, it was significantly better post-merger, significantly across every metric we've looked at fundamentally. EPS, more than 2x the growth rate, operating cash flow almost 1.5x ROC. So it was not fundamentals. And what was driving it. And this is the challenge we have. Now it just so happens that's about a 1.5 to 2 turn difference, the industry for years demonstrated a 1 to 3 turn difference. And so this is kind of the evidence we come across and add into it the sentiment trading, add into it the constraints. There are days where the value of our company is more a function of the 39 of the members of the index than our company. And so this creates challenges in the valuation, and this is the evidence we've come across. I mean you have to remember, I'm a shareholder, too. And I would argue my exposure to this is greater than most, given the Linde equity exposure I have relative. And for me, it's compelling. It's very clear. And I've also been looking at this and working on this for 2 years. And as management, we have an obligation to bring this forth and ultimately, let our shareholders decide. So that's -- that's the data we've come with. I strongly recommend you do the analysis yourselves as well and see what answers you come up with.

And we'll take our next question from John McNulty with BMO Capital Markets.

Thank you certainly on the thorough analysis of it all. So just one quick one. You've got a balance sheet that looks to be somewhat underleveraged. You're going to throw off, it looks like a decent load of cash next year. I guess how aggressive would you be in terms of a buyback? And would you consider an ASR, say in the first quarter to kind of clean up some of the sloppiness that might happen as you get some of the index funds unloading and that type of thing. How should we be thinking about that?

John, I think we have plenty of capacity without having to announce an ASR or undertake an ASR. We have, as you know, about $6 billion of authority, plenty of room and capacity and access to liquidity. So we have the ability to navigate and manage this, which we will. Tomorrow, obviously, when we report our results, we'll talk further about the numbers and where we finished, which you'll get more color on. But we feel quite confident in our ability to manage that, and we will continue to manage that.