Some investment themes simply capture the imagination. For example, AI’s ability to transform how we all live and work, new solid-state batteries that could power electric vehicles into the 22nd Century, and biotech breakthroughs that could give us all longer, healthier lives.

Industrial gas doesn’t sound like one of them. On the face of it, this is a sector more likely to send investors to sleep than spark a mad rush for stocks and funds. But just like Warren Buffett built his fortune on dull but predictable industries like insurance (Geico), insulation (Johns Manville) and household batteries (Duracell), many ordinary investors might be missing a trick if they don’t look at the industrial gas space.

The industry is dominated by three companies – France’s Air Liquide (AI:EPA) – (or L’Air Liquide Societe Anonyme pour l’Etude et l’Exploitation des Procedes Georges Claude, to give its full name), Air Products & Chemicals (APD:NYSE) of the US, and Linde (LIN:NASDAQ), which has roots in Germany but has a US stock listing. Linde owns the old BOC (British Oxygen Company), for those who remember it.

CONCENTRATION IS GOOD FOR PROFITS

Together, these three companies generated global sales of nearly $75 billion in 2022 and capture roughly 70% of the industrial gas industry market share, according to company estimates. That’s up from about 40% in the 1990s, thanks to consolidation and steady growth.

Such market concentration is good news for their profits because it gives them pricing power, namely the ability to hold or push up prices without dampening demand or risking clients shopping around for better deals. 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.

It’s also an industry with high barriers to entry which make it hard for someone new to enter the sector. A newcomer in this industry would need to be able to invest enormous capital to get started and have the right technology to build big, dedicated air separation units that are generally set-up next door to large customer plants.

Even if a new entrant manages to get a foot in the door, it will still need to build relationships and prove capable of supplying gas consistently and reliably to customers who stand to lose millions if there was any supply disruption.

The capital intensity of the industry demands scale, but it also means participants can generate strong returns through economies of that scale. For example, after the first initial investment of building an air separation unit, every subsequent sale is high margin profit.

The higher the utilisation rate of the plant, the higher the profitability. Customers typically sign up to minimum utilisation rates, which guarantees at least a certain level of income, even in a recessionary environment.

That makes these companies defensive, with sales stemming from long-run contracts that offer good visibility. Sales also tend to grow with inflation, because industrial gas companies can pass on cost increases easily. It helps explain why operating margins are unusually high for industrial stocks, trending in the mid-teens to low-20 per cents, and they’ve been even higher in the past.

According to Statista data, the industrial gas market was worth $93.7 billion in 2021 and is expected to surpass $129.1 billion by 2029, implying about 5% growth a year.

RISE OF THE HYDROGEN ECONOMY

Hydrogen is predicted to play a leading role in the energy transition with the ‘green oil of the 21st Century’ increasingly promoted by governments worldwide.

‘As an alternative to fossil fuels, it could be a valuable tool for tackling climate change in the future, helping many industries to reduce their CO2 emissions,’ says asset manager Allianz.

Hydrogen offers several options for the transition to a renewable economy: as an energy carrier and storage medium for conversion back to electricity; as fuel for all means of transport and mobility; and as a substitute for fossil hydrocarbons in different industries, such as steel production, petrochemicals and refineries.

This is not tomorrow’s world; government initiatives mean that project activity is picking up speed globally. According to an analysis by consulting firm McKinsey, there are more than 200 large-scale production projects in the pipeline and, if all projects come to fruition, total investments will exceed $300 billion in hydrogen spending through to 2030 – the equivalent of 1.4% of global          energy funding.

Air Liquide, Air Products and Linde have been investing in hydrogen infrastructure for some time, but the Inflation Reduction Act 2022 in the US has significantly accelerated the growth potential for them.

Linde estimates it could make more than $20 billion of potential investments in the coming years, with some of the larger ones related to blue and green hydrogen and blue ammonia. Air Liquide aims to triple its hydrogen sales by 2035.

In its recent earnings statement (8 Nov), Air Products highlighted its blue hydrogen project in Europe, expected to be operational in 2026, which involves capturing emissions from existing hydrogen facilities and supplying low-carbon hydrogen to Exxon Mobil (XOM:NYSE) under a long-term offtake agreement.

It also flagged plans to invest over $30 billion over the next decade, and crucially, expects to maintain steady progression in return on capital employed, implying ambitions to catch up to its peers’ low double-digit performance.

A slowing global economy will present challenges for these industrial gas giants, as could prolonged higher interest rates, making business investment more expensive for these companies and their customers. If recession comes to pass, we expect share prices to come under pressure on the elevated risk that some customers struggle, others go to the wall.

But taking the longer-run view, there’s a lot to like about these three stocks. They have seen economic downturns many times before, and they have survived and prospered. Gas products are becoming more crucial not less, and there are new opportunities emerging. With proof of disciplined capital management, strong free cash flows and reliable (if modest) and growing dividends, shares in Air Liquide, Air Products and Linde offer investors, we believe, plenty of portfolio appeal.

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