Transformative Industrial Gas Merger Takes Shape

The proposed merger of two industrial gas giants--wide-moat  Praxair (PX) and narrow-moat  Linde--would create a clear market leader and is likely to establish the status quo for the competitive landscape for the next decade. We expect a thorough regulatory review will ultimately result in the merger’s approval, albeit with meaningful required divestitures.

Consolidation among industrial gas companies has been popular for the past two decades because it has been successful. Bidding discipline has improved and bottom-line focus has intensified.

All four global industrial gas companies possess economic moats, and we project improving margins and rising returns for each. Competition is increasingly based on commitment to providing the supply reliability that customers require, married to vertical integration and geographic sales density strategies that leverage production and distribution assets to drive improved margins and returns.

Investors have warmed to the possibility of a Praxair-Linde merger, rewarding both with group-leading stock performance over the past six to nine months. We believe management’s synergy targets of $1 billion in cost savings and $200 million in capital-spending efficiencies within three years are aggressive but achievable. From the perspective of a Praxair shareholder, the merger elegantly monetizes Praxair’s operating advantages in the form of economic benefits derived from control over new assets and revenue.

The merger also highlights our view that the industry has long been undermanaged, guilty of favoring technological expertise and showcase project development over operating efficiency and optimized networks. We believe applying Praxair’s proven operating and capital-allocation strategies can wring even greater synergy benefits and cost reductions over time from the sprawl of a combined $60 billion asset base.

We anticipate required divestments from a merged Praxair-Linde could represent annual revenue of $1 billion-$2 billion and $3-$8 billion in market value, respectively. Air Products (APD), the smallest of the Big Four industrial gas companies, seems well positioned to pounce. Initially, it may be the company with the most dry powder that captures the best assets. Later, it may benefit from customers’ and regulators’ preference for greater supplier diversity and regional competition.

The oligopolistic industrial gas industry, which supplies oxygen, nitrogen, argon, and hydrogen to petroleum producers and refiners, steel, glass, and chemical makers, chipmakers, food processors, and dozens of other industries, is in many ways a study in contradictions. Several of these are highlighted and amplified by the proposed merger of equals between Munich-based Linde and Connecticut-based Praxair, the industry’s second- and third-largest suppliers, respectively. The largest suppliers have exposure to mature and well-developed markets that offer attractive economics, but suboptimal management of production and marketing assets means their profitability has lagged what we believe is its natural level. As a result, our industry models reflect the expectation that each global major will be able to steadily improve operating margins and returns on capital in coming years.

The proposed merger is driven by the highly complementary nature of the strengths, needs, and priorities of the two companies, in our view, as well as the evolving basis of industry competition. Smaller, higher-performing Praxair wants to accelerate its plans to achieve a broader geographic footprint and gain greater exposure to faster-growth emerging economies, as well as tap into the engineering breadth and innovation that Linde offers. With roughly twice the revenue and gross assets of Praxair, Linde requires the updated operating and capital-allocation model that Praxair offers to exploit its huge, underperforming asset base. The proposed combination offers an elegant solution, and the timing seems propitious for sidestepping major management clashes and governance controversies.

Over the past two decades, serial merger and acquisition activity has consolidated the industrial gas industry and in turn reduced risks from overly aggressive bidding and growth strategies. More recent history, which includes the very sharp margin improvement achieved at Air Products, currently the number-four player by revenue, plus rising M&A valuations, highlights the somewhat counterintuitive notion that assets have been underutilized. In addition, even well-established companies have a variety of methods at their disposal to improve performance in the absence of notable improvement in merchant gas selling prices, a trend we expect to continue indefinitely.

Assuming the merger is completed, we believe all eyes will turn to Praxair as it applies its well-honed core program of cost discipline, vertical integration, and geographic density to the sprawling empire that Linde has created over the past two decades of focused acquisition and investment.