Praxair, Inc. (Praxair) is an industrial gas supplier. Praxair’s primary products for its industrial gases business are atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). It also designs, engineers, and builds equipment that produces industrial gases for internal use and external sale. Its surface technologies segment, operated through Praxair Surface Technologies, Inc. Praxair serves approximately 25 industries, such as healthcare and petroleum refining; computer-chip manufacturing and beverage carbonation; fiber-optics and steel making; and aerospace, chemicals and water treatment. During the year ended December 31, 2010, 94% of revenue was generated in four geographic segments (North America, Europe, South America and Asia). As of December 31, 2010, it had acquired a 49% interest in Refrigeration and Oxygen Company Limited (ROC).
Source: Reuters
Valuation
I estimated the intrinsic value of PX to be $77.05. Key assumptions included:
Core growth rate: 12.4%
Terminal growth rate: 5.0%
Risk-adjusted discount rate: 10.2%
Cost of sales: 66.0%
Selling, general, & administrative costs as % of sales: 12.0%
Research & development as % of sales: 1.0%
CAPEX as % of sales: 14.0%
Depreciation as % of sales: 9.0%
Effective tax rate: 28.0%
Day sales in receivables: 60
Day sales of inventory: 22
Days payable outstanding: 45
Given the current market price of $102.51, PX is overvalued by 33.0% to its intrinsic value. The risk-adjusted margin of safety was calculated to be 10.5%. Since the actual margin of safety (-33.0%) is less than the risk-adjusted margin of safety (10.5%), this indicates PX is overvalued and should be purchased at a lower price per share.
Dividends
The dividend appears to be growing faster than earnings growth, but has slowed in recent years. From 2000 to the 2010, the dividend has grown from $0.31 per share to $1.80 per share. The compound annual growth rates for the past ten-, five-, and three-years are:
Ten years: 21.6%
Five years: 25.7%
Three years: 14.5%
Although growing faster than earnings, the dividend appears to be sustainable. Based on either net income or free cash flow, the dividend payout ratio has not exceeded 50%. A dividend payout ratio of less than 50% allows for sustainable growth and a cushion for short-term earnings volatility. From 2006 to 2010, the dividend payout ratio based on net income has increased from 32.7% to 46.1%. Below is the dividend payout ratio for the past five years:
2006: 32.7%
2007: 32.4%
2008: 38.6%
2009: 39.2%
2010: 46.1%
In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return. The model is called the Dividend Drill Return Model (DDRM). It is based on the premise that the dividend total return is equal to the yield plus dividend growth. Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase).
Given a core growth rate of 12.4% and current dividend yield of 2.0%, PX’s cost of growth is $2.48 per share. After reducing this amount and dividends of $2.00 per share, the funding gap is $0.59. PX will need to borrow an additional $0.59 for any additional cash deployment items like share repurchase. Ths amount is forecasted to have a (0.6%) impact on share price. As a result, the DDRM forecasts the projected total return for UTX to be 13.8%. Below is a breakdown of the total return:
Core growth rate: 12.4%
Dividend yield: 2.0%
Funding surplus: -0.6%
Total return: 13.8%
Summary
Based on a valuation $77.05, shares are trading at a 33.0% premium to the intrinsic value. PX has a history of dividend increases that grow faster than earnings and the dividend appears sustainable as the payout ratio is less than 50%. Based on the DDRM, the projected total return for PX is 13.8%.
Disclosure: I have no positions in Praxair (PX), and no plans to initiate any positions within the next 72 hours.
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