The Breaker Times

Business: Air Products and Chemicals is an industrial gases company. It’s focused on serving energy, environmental and emerging markets. Its base business provides essential industrial gases, related equipment and applications expertise to customers in dozens of industries, including refining, chemicals, metals, electronics, manufacturing and food. Air Products also develops, engineers, builds, owns and operates clean hydrogen projects supporting the transition to low- and zero-carbon energy in the heavy-duty transportation and industrial sectors. In addition, it provides turbomachinery, membrane systems and cryogenic containers globally. Air Products has operations in approximately 50 countries.

Stock Market Value: $73.83B ($332.10 per share)

Percentage Ownership: n/a

Average Cost: n/a

Activist Commentary: D.E. Shaw is a large multi-strategy fund that is not historically known for activism. The firm isn’t an activist investor, but it uses activism as an opportunistic tool in situations where it thinks it may be useful. D.E. Shaw seeks out solid businesses in good industries, and if the firm identifies underperformance that is within management’s control, it will take an active role. The investor places a premium on private, constructive engagement with management. As a result, it often comes to an agreement with the company before its position is even public.

D.E. Shaw has reached out to Air Products’ board. The firm proposed that the company take various steps to enhance shareholder value, including improving capital allocation, refreshing the board and restructuring executive compensation.

Air Products provides industrial gases and related equipment in end-markets such as refining, chemicals, metals, electronics, manufacturing and food. The company’s industrial gas business is extremely stable and low risk, functionally a risk-free, inflation-protected, senior secured bond when the business is kept pure. The nature of the business is that the company enters into long-term 15- to 20-year “take or pay” contracts with customers that have very high renewal rates exceeding 95%. The business is basically immune to economic cycles, contracts are inflation-protected, and the oligopolistic industry has huge barriers to entry. These long-term contracts functionally guarantee an unlevered double-digit return before Air Products even needs to put a dollar into the ground. When unadulterated and committed purely to its core business, this is a fantastically stable and well-valued enterprise.

However, while the company was focused on its own operations, it missed out on a wave of consolidation in the industry. In 2016, Air Liquide finalized its purchase of Airgas. In 2018, Linde and Praxair completed a merger of equals. Before Air Products knew it, the company was the odd man standing, and it was standing all alone. CEO Seifi Ghasemi’s expansion solution, having missed out on combinations with pure-play peers, has been to pursue non-core business expansion. Departing from its longstanding strategy in the traditional industrial gas business model that generates dependable capital returns, the company has moved up along the risk curve towards more speculative investments without locked-in revenue through several clean hydrogen project investments. Across five investments — the most notable of which being the Air Products’ NEOM Saudi Arabia green hydrogen project and its Louisiana blue hydrogen project — the company expects to spend nearly $12 billion of capex. When initially planned, Air Products did not have offtake agreements — agreements with buyers to purchase its future offerings — for four of the five projects (only 6% of capacity had offtake agreements). Today, over 80% of project capacity remains uncontracted.

This is a perfect example of “di-worsification.” Investors appreciate companies like Air Products for their low-risk and highly stable cash-flowing operations. Regardless of the efficacy of these non-core businesses, the typical risk-averse investors that have been historically attracted to companies like Air Products are going to flee when the risk profile changes. Moreover, investors with a larger appetite for risk who might be attracted to businesses like NEOM or the Louisiana project, are less likely to invest in it when it is diluted by a low-risk, stable business like Air Products’ core industrial gas businesses. Further, matters are not helped by the fact that peers Linde and Air Liquide have been able to execute on hydrogen projects with secured offtake agreements in place pre-construction and have focused on partnerships in line with its low-risk traditional business model.

As a result of its investment in these speculative projects, Air Products’ capex as a percent of sales has more than doubled over the past five years and is roughly four-times higher than its peer average. The company’s free cash flow conversion has turned negative whereas peers are averaging 92% since 2016. Further, its return on capital employed is moving inversely compared to peers. While management thinks that being a first mover in green and blue hydrogen and moving up the risk curve should be rewarded with a higher multiple and stock price, investors clearly disagree. Air Products has underperformed its peers and relevant benchmarks over functionally every relevant time frame in the past ten years and is trading at a 20% discount.

Now, D.E. Shaw has taken an approximate $1 billion stake in Air Products and has taken its engagement public after initially reaching out to the company over a month ago and presenting its value-enhancing plan to management on Oct. 2. D.E. Shaw will typically go public with a campaign after a resolution has been reached with the company, but the firm has encountered some resistance to engagement here. It put forward a seven-point plan to improve value at the company, focused on a revised capital allocation framework and corporate governance. Beginning with capital allocation, D.E. Shaw is urging the company to de-risk its existing large project commitments by signing offtake agreements at reasonable return hurdles, as their peers have been able to do. In addition, in light of Air Products finalizing another large hydrogen project in Texas without existing offtake agreements in place, the firm demands that the company commit to tying future capital investment to offtake agreement milestones. Furthermore, D.E. Shaw wants the company to limit annual capex to $2 billion to $2.5 billion beyond 2026, with a specific target of capex to not exceed the mid-teens as a percent of Air Products’ revenue. The firm also argues that the company should immediately repurchase its discounted shares up to its three-times target net leverage ratio in fiscal year 2025 and direct future excess free cash toward additional repurchases.

The second part of D.E. Shaw’s campaign pertains to corporate governance, in particular, succession planning for CEO Seifi Ghasemi. At about 80 years old, he has been serving in the role for a decade. Ghasemi was given a five-year extension in 2020 and it was renewed in 2023 on an evergreen basis. There appears to be no formal succession plan in place, only vague commitments to a search for an experienced former CEO of a public company. Air Products’ COO Samir Serhan officially left the company at the end of September, removing a quality internal candidate. There are questions about what viable candidate would want to join the company if Ghasemi essentially has an indefinite contract. Not to mention, his compensation over the past five years of $87 million is far greater than both the company’s peer average ($78.5 million) and S&P 500 average ($67.2 million), despite underperforming both. D.E. Shaw is demanding that the company communicate a clear, credible, and transparent CEO succession plan. It wants the company to refresh the board with highly qualified independent directors, and to restructure executive compensation to improve alignment with strategy and performance (i.e. the introduction of return on equity/return on capital employed metrics for the long-term incentive plan as peers have). The firm is also calling for the formation of one or more ad hoc board committees to oversee these initiatives.

D.E. Shaw is a large multi-strategy fund that is increasingly embracing activism as a tool to create shareholder value and has an experienced team that has had success in its activist engagements. Since the beginning of 2022, it has commenced six activist campaigns, settling for board seats in five (L3Harris Technologies, Corpay, Fidelity National Information Services, FedEx and Verisk Analytics) and successfully opposing a merger at the sixth (Diversified Healthcare Trust). The firm is known for its deep quantitative and technical research. This is exemplified in its Oct. 2 presentation on Air Products. D.E. Shaw thoroughly outlines the company’s issues and offers proposed fixes.

It is not uncommon to see multiple activists in the same stock, especially at a company with such a strong underlying business paired with relative underperformance, capital allocation missteps and corporate governance red flags. On Oct. 4, Mantle Ridge announced a more than $1 billion position in Air Products, and echoed a similar sentiment and identified similar issues as D.E. Shaw. The main difference between the two is that D.E. Shaw historically adds a minority of directors to the board and generally not a principal of the firm. Mantle Ridge has historically reconstituted a majority of boards with the inclusion of its founder, Paul Hilal. While certain investors and CEOs may look at the activist principal being on the board as a negative, we see it a significant positive in that it signals long-term engagement, and the activist investor is often the most prepared and assertive independent director at board meetings. It should also be noted that in three prior campaigns, Mantle Ridge never placed more than one of its own insiders on the board, and the firm always had a slate of impressive, independent directors.

D.E. Shaw is only seeking three seats on Air Products’ nine-person board, including one for Scott Sutton, the former CEO of Olin, who oversaw a stock appreciation of 379.2% as CEO from Sept. 1, 2020 to March 18, 2024, versus 28.3% for the Russell 2000 over the same period. The two others will likely be impressive public company executives with a track record of creating shareholder value. While D.E. Shaw’s investment thesis has plenty of overlap with Mantle Ridge’s plan, there are two glaring issues that both investors prioritize: CEO succession planning and capital allocation refocus. We strongly expect that many of Air Products’ other shareholders are concerned about the same issue. So, the question here is not whether there will be change, but what will that look like. Having two different activists gives the company some optionality to settle with the one it thinks will be a better fit. D.E. Shaw likely means fewer new directors and no activist principal. But Mantle Ridge has a pre-existing relationship with the company, as well as some of the current directors and CEO Ghasemi, going back more than ten years, and it has a reputation of working well with management. As both activists will insist on better capital allocation and a firm succession plan, either way it should be a win for shareholders.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.