This Quiet Industry Has A Long Habit Of Beating The Market

Finding an attractive industry is great. Industries are simpler to understand than individual company financial statements, and when you do spot a good one, you instantly have a bunch of possible firms you could invest in. So, I’m going to tell you about one of my favorite industries – industrial gases – and explain what I like about it.

What are industrial gas companies?

As the name suggests, industrial gas companies supply atmospheric and rare gases like oxygen, hydrogen, carbon dioxide, and neon to customers that need them. Now, that’s not to be confused with oil and gas companies, which extract natural gas from the ground. These companies supply the kind of gas that’s found in the atmosphere. Yes, that’s right: the gases they traffic in are found abundantly in the atmosphere, and these companies have got the technology that can separate air at different temperatures. That gives them the gases that they can sell to a multitude of other industries: like chemicals, steel, refining, oil and gas, electronics, and healthcare.

The three biggest global companies in industrial gases are Linde, Air Liquide, and Air Products. These firms tend to have three main business lines, corresponding to the way they distribute their gases:

On-site: They sell gas from dedicated air-separation units (ASUs), which they can build adjacent to a customer’s site. Industrial gas companies bid for these projects and win contracts based on how cheaply they can supply gas. The deals usually come with a minimum guaranteed rate of return, and long-term take-or-pay contracts ranging from 10 to 20 years. That means the industrial gas companies will still be compensated for a guaranteed minimum amount of gas supplied, regardless of whether it’s actually used, and that helps reduce the risk of the huge upfront investment in the unit itself.

Merchant: This line of business also supplies gas, but to much smaller customers, through tanker trucks. The gases are supplied from the dedicated on-site plants to other customers within a short distribution radius. Unlike the on-site business, the merchant business has shorter contracts ranging from three to seven years.

Packaged gas: These gases come in a smaller form, through cylinders supplied to a whole range of customers. They’re typically the most volatile part of the business, trending with economic activity, as contracts are very short-term in nature.

All three business lines are integrated, with products from all three modes coming from the same plant. Industrial gas companies make money by winning on-site contracts, and increasing the utilization rates of their ASUs by supplying other local merchants around the plant.

So, what makes this industry so attractive?

The big industrial gas stocks have outperformed the S&P 500 over the past 20 years. In fact, if you’d had equal-weighted allocations to the three gas companies in the same period, you’d have made close to nine times return – double that of the S&P 500.

Source: Datastream. Price performance of industrial gas companies vs S&P 500 over time.

There are five reasons why they’ve outperformed – and why they might continue to do so:

1. It’s an oligopolistic industry.

The number of competitors in an industry helps determine the long-run profit potential of companies operating in it. Generally, the more consolidated an industry, the better it is for companies. After a series of mergers and acquisitions over the last three decades, Linde, Air Liquide, and Air Products are now the top three players in the industry with a collective market share of close to 70%. Even when demand was slow in 2008-09, all three companies had strong pricing discipline, which meant that margins and returns were much more resilient compared to other industries.

Source: Company data. Market share of industrial gas companies over time.

2. There are high barriers to entry.

Having an oligopolistic industry isn’t enough without sufficiently high barriers to keep out new rivals. A newcomer in this industry would need to be able to fork over huge capital to get started and have the right technology to build big ASUs. And if it manages that, it’d still need to build relationships with customers, and prove that it’s able to supply gas consistently and reliably. That reliability is a massive consideration for customers: a breakdown can disrupt operations and cost millions.

3. Its growth is defensive.

One of the best things about industrial gas companies is the defensive nature of their income. Because the majority of their sales are from long-term take-or-pay contracts, there is good visibility on earnings and cash flows. In a recessionary environment, customers pay for a minimum quantity of gas supplied even if they don’t require it. Sales also grow with inflation, because industrial gas companies are able to pass on cost increases easily. The chart below shows how Air Liquide’s sales growth during the global financial crisis in 2008-09 and the Covid pandemic in 2020 proved more resilient, compared to global industrial indicators. What’s more, the company has even managed to pretty consistently outgrow the economy.

Source: Company data, Datastream. Yoy comparable sales growth for Air Liquide vs US and Europe industrial production growth over time.

4. It’s got economies of scale.

Even though industrial gases is a capital-intensive industry, its companies are quickly able to generate strong returns through economies of scale. See, after the first initial investment of building an ASU, every subsequent sale is pure profit, dropping down to the bottom line. The higher the utilization rate of the plant, the higher profitability. And the beauty of it all is this: with a minimum utilization rate guaranteed by the on-site customer, there is a limit to how low profitability can fall.

5. It benefits from a low-cost, high-value ratio.

Providing gases that are already all around us may not seem like much, but for industries, having a consistent and reliable supply is crucial. For example, hydrogen is needed during the oil refining process to reduce the sulfur content in fuels. Any disruption in the flow of hydrogen will result in the shutdown of the refining plant, which will be costly for the refiner. It’s no wonder that companies don’t just look for the cheapest provider of industrial gases, but also look for a supplier with a reliable track record. The cost to supply gas is low, but the value of the gas is high, so industrial gas companies have strong pricing power.

What could go wrong?

No industry is an island, so you’ll want to be aware of the economic changes that could affect the ones you invest in. With industrial gases, the business model relies heavily on the on-site business and the valuation premium you pay for these companies usually hinges on those long-term take-or-pay contracts. However, a substantial number of the companies’ customers going bankrupt because of rising interest rates and slower economic activity could certainly compromise an industrial gas company’s defensive sales growth.