Yesterday, our thesis about Air Products & Chemicals was published on the Seeking Alpha website. You can read it here, but maybe you want to read the introduction first. We also discuss three option trades in this blog post.
Air Products: A Long-Lasting Growth Story
Last Friday, Air Products & Chemicals (APD) reported earnings which might have seemed to be a mixed bag at first sight. However, when listening to the conference call and digesting the financial statements and forward-looking remarks it was nothing but a solid quarter. After having raised the dividend for 38 years in a row now, which obviously makes it a robust Dividend Aristocrat while clearing the path toward obtaining the Dividend King status, the future looks bright for APD with a significant boost in CapEx spending for 2020.
Despite some calling the stock overvalued, I believe APD shares provide meaningfully attractive value right here with a share price trying to break out and recent optimistic remarks from its CEO Ghasemi for 2020 and 2021. The past 18 months filled with chatter about the US-China trade war didn't hurt the company's execution at all and with the recent "Phase One" deal, industrials may see their share prices revive which almost certainly would be beneficial for APD.
From now on, APD should be able to produce recurring free cash flows in excess of 2.7B USD before dividends and growth capex (including M&A). This represents a FCF/EBITDA conversion rate of 71.9%, a percentage which most other chemical companies barely achieve. After deducting the dividend payments of 1.01B USD, there's still a sizable 1.7B USD left to re-invest directly into the core business.
In my base case scenario, APD's fair value is near $283.91. My conservative assumptions are based on a starting annual growth rate of 9.3% (less than management's guidance of 13% for FY 2020 and FY 2021) which slows down to 5.3% in year 10. This translates into 17.6% upside potential from today's price.
*Selling covered calls
One could sell covered calls against the position to lower the cost basis thereby propelling the probability of profit. I selected the following strike price and took into account the upcoming dividend payment.
* Selling cash-secured puts
If you want to purchase the stock at a discount before selling covered calls, you could simply sell a put option and given my bullish view on the stock, I'm looking at a slightly in-the-money put option. Please note that when selling an in-the-money put option, you're agreeing the purchase the stock at a price higher than current market value, however, the option premium will compensate you for a potential loss on the stock side, as shown below. Time value is what reduces your actual cost basis if the shares are put to you.
* Buying in-the-money calls
Buying in-the-money calls that have little time value and plenty of time to go until expiration are an excellent long stock substitute. I use them to capitalize on growth stocks and attractive long-term opportunities. In case of APD, one could buy 1 call option to get the same long delta as the ordinary shareholder who owns 100 shares. Make sure that when you buy LEAPs, you are dealing with levered unlimited upside potential and you don't collect any corporate dividends. It also means that the impact of the option becoming worthless should be gauged carefully based on your portfolio value, in this example $150,000 of total portfolio value is reasonable compared to the premium paid.
As one can see, the return differential is huge. If the underlying trend is strong and allows for further upside potential, buying LEAPs is a much more efficient way of putting your capital to work. But if the market goes down, you're at risk of losing the entire premium. That's why buying long-term call options with little time value works best for steadily growing, low-volatility stocks that have below-average drawdowns.