African Oxygen Limited, better known as Afrox, is a leading supplier of atmospheric gasses, liquid petroleum gas (LPG) and gas equipment in South Africa. It is currently controlled by the global industrial gases and engineering company, The Linde Group, who provide Afrox with technological, research and developmental support.

Following a change of management in 2015, Afrox adopted a new strategy that focuses on resetting the cost base and shifting capital spend towards building capacity for its growth markets. Management has executed this strategy well – delivering a 14% per annum growth in earnings over the last five years. The company has excellent financial metrics with high margins, good cash conversion and consistently high returns on capital. We believe Afrox also has many underappreciated fundamental strengths and material near-term growth opportunities, which we will unpack in more detail.

Bases covered in gas and gear
As charted below, Afrox is structured into three main divisions, with atmospheric gases delivering the highest profit contribution. The business is well diversified across markets, selling products into consumer markets (primarily for heating and cooking), manufacturing industries (iron and steel, automotive and industrial ceramics) and niche speciality sectors (including food preservation, water treatment and healthcare).

Atmospheric gas is a mixture of individual gases found in the air around us, each with its own unique properties. This division supplies gas to key customers through custom-built air separation units (ASUs) that separate atmospheric air into its primary components, typically nitrogen and oxygen (and also argon and other rare inert gases). Tonnage customers, such as large oil and steel companies, require very high volumes of gas that is delivered by a dedicated onsite ASU, whereas smaller customers are serviced through filling sites, gas outlets and other tailored, industry-specific product package options.

LPG is extracted from heated crude oil during natural gas processing and oil refining before being pressurised and stored in liquid form in cylinders and tanks. While many of us are familiar with its uses in the home, it is used widely in business and industry, agriculture, transport (Autogas), power generation, healthcare and hospitality. Afrox is the leading reseller of LPG to large industrial and hospitality customers, and the retail market.

Hardgoods, including gas equipment and welding products, are sold through Afrox’s regional sales infrastructure and exported throughout sub-Saharan Africa. These goods are typically commoditised and competition is high – limiting Afrox’s pricing power.

Atmospheric gases a hidden gem
Afrox’s largest division is also the economic gem in the portfolio, given its sizeable competitive moat, defensive earnings profile and pricing power.

Tonnage customers typically have a large ASU plant onsite dedicated to producing gases. The plant is often owned and operated by Afrox and built with capacity in excess of the anchor client’s gas requirements. In the case of an ASU not being onsite, gas would be supplied to the client via a pipeline. Supply contracts are long term in nature (15 to 20 years), with an agreed guaranteed minimum off take. Alternatively, a ‘take-or-pay’ contract option ensures a suitable return on capital over the life of the plant, with initial pricing structured to compensate Afrox for the capital commitment and ongoing fixed costs in real terms.

Excess gas is supplied to other industrial customers within a few kilometres of the ASU – gas can only be transported profitably within a small radius due to high transport costs resulting from logistical challenges associated with getting gas to customers. Proximity to end users, therefore offers an enormous competitive advantage and gas suppliers consequently tend to have strongholds at a regional level. The high initial capital cost of ASUs and natural transportation barriers to competition help deliver the robust returns commonly earned by gas companies.

Utilisation rates at some existing ASUs is currently low at around 60%, reflecting the weak manufacturing sector conditions in South Africa. However, this capacity presents an opportunity to improve earnings if the local economy improves and utilisation rates rise again. Given the capital-intensive nature of an ASU, these plants have a high fixed cost base and therefore any improvement in sales will largely translate into additional pure profits for the division.

Furthermore, significant industry consolidation over the last few years has resulted in greater market concentration and lower competitive intensity across the gas market. This has further strengthened Afrox’s position and pricing power.

Capacity boost alters LPG market dynamics
LPG is cleaner and safer compared to other energy sources (particularly coal, paraffin and candles) and while demand from industrial clients has been under pressure recently, we have seen significant growth in the consumer market, which remains an attractive long-term opportunity.

Historically, the South African LPG market has been under supplied as local refineries have not produced enough LPG to satisfy local demand. There has been little incentive to increase local production as LPG sales are less than 1% of total refinery sales and it is more profitable to use the components of LPG in the production of higher value chemicals. This structural impediment to supply increasing has resulted in consumer LPG usage being very low compared to the rest of the continent.

In recent years, Afrox has been forced to source LPG from outside of South Africa to bolster supply and, in 2015, signed an agreement with Petredec (a leading global trader) for the import of LPG into the country. Petredec subsequently partnered with Bidvest to build a new LPG storage terminal at the Richards Bay port (graphic below). Bidvest is committed to investing over R1 billion for the development of this terminal, which will be the largest in Africa, with 24-hour road and rail access facilities. Operations are set to commence towards the end of 2020 and the facility will offer four 5 650 tonne tanks, providing the capacity to increase current domestic LPG supply by over 50%.

This increased storage capacity will structurally alter the supply dynamic of the local market, allowing Afrox to grow its LPG revenue substantially. The new terminal will also enable the use of large gas carrier ships when importing LPG instead of the smaller, more expensive carriers currently used. We estimate that this will result in a 20 to 40% reduction in the landed cost per tonne of LPG. This cost reduction should materially boost the profitability of Afrox’s LPG business and allow for price reductions to boost consumer demand.

Reset and grow
Afrox has delivered a robust growth in earnings over the last five years, in part due to the realisation of around R1 billion of cumulative cost savings. With the cost base now reset, management’s focus has shifted to capitalising on material near-term growth opportunities, particularly around LPG. Furthermore, any improvements in the South African manufacturing sector will benefit ASU utilisation, resulting in a significant increase in earnings over the medium term.

With the company trading at a low rating – a deep discount to global competitors despite its excellent financial performance, numerous fundamental strengths and clear growth opportunities – Afrox represents a very attractive investment opportunity. The Linde Group is very aware of these attractions and has recently made an offer for all Afrox shares it does not currently own. Our clients will be benefitting from this value unlocking transaction.