Air Products & Chemicals Inc. F4Q08 (Qtr End 09/30/08) Earnings Call Transcript

| About: Air Products (APD)

Air Products & Chemicals Inc. (NYSE:APD)

F4Q08 (Qtr End 09/30/08) Earnings Call

October 22, 2008 10:00 am ET

Executives

Nelson Squires - Director of IR

Paul Huck - CFO

John McGlade - CEO

Analysts

David Begleiter - Deutsche Bank

Jeff Zekauskas - JPMorgan

PJ Juvekar - Citi

Peter Butler - Glen Hill Investors

Robert Koort - Goldman Sachs

Kevin McCarthy - Banc of America Securities

Chris Shaw - UBS

Don Carson - Merrill Lynch

Lucy Watson - Jefferies

Mike Harrison - First Analysis

Mike Judd - Greenwich Consultants

Mark Gulley - Soleil Securities

Mike Sison - KeyBanc

Operator

Good morning, everyone, and welcome to Air Products and Chemicals fourth quarter 2008 earnings results conference call. Just a reminder that you will be in listen-only mode until the question-and-answer segment of today's call. Also, this telephone conference presentation and the comments made on behalf of Air Products are subject to copyright by Air Products, and all rights are reserved. Air Products will be recording this teleconference and may publish all or a portion of the teleconference. No other recording or redistribution of this telephone conference by any other party are permitted without the expressed written permission of Air Products. Your participation indicates your agreement. Beginning today's call is Mr. Nelson Squires, Director of Investor Relations. Mr. Squires, you may begin.

Nelson Squires

Thank you, Shawn. Good morning, and welcome to Air Products quarterly earnings teleconference. This is Nelson Squires. Today, our CEO, John McGlade; CFO, Paul Huck and I will review our fiscal 2008 results and 2009 outlook.

We issued our earnings release this morning and it is available on our website, along with the slides for this teleconference. Please go to airproducts.com and click on the scrolling red banner to access the materials. Instructions for accessing the replay of this call beginning at 2:00 pm Eastern time are also available on the website.

Please turn to slide 2. As always, today's teleconference will contain forward-looking statements based on current expectations regarding important risk factors. Please review the Safe Harbor language on this slide and at the end of today's earnings release.

Before we start, please note that other than discontinued operations, we have not excluded any special or disclosed items from this quarter's results. However, in Q4 of last year, there were several items, which netted together, resulted in the gain of $0.17. This net gain is detailed in the appendix and notes to the earnings release, and is excluded from our prior year comparisons today.

Also as a reminder, we've revised our business segment reporting. Europe Healthcare results are now being reported in the Merchant Gases segment. US Healthcare results are reported in discontinued operations. Prior periods have been restated to reflect this reporting change.

Now I'll turn the call over to Paul.

Paul Huck

Thanks, Nelson. Good morning and thank you for joining us today. Now, please turn to slide number 3. Before we look at this quarter's results, I would like to spend a few minutes reviewing fiscal year 2008.

We entered in the year with goals of delivering our fifth consecutive year of double-digit earnings growth and improving our operating margin to 15%. We delivered 18% earnings per share growth, and we approached our 15% margin goal as we decided to exit the US Healthcare business.

Higher natural gas and raw material pass-through increased sales by more than $450 million, which effectively reduced operating margins by 70 basis points.

Turning to our top-line. Sales growth of 14% included underlying volume and price gains of 6%, excluding the Equipment and Energy segment. Natural gas and raw material contractual pass-throughs accounted for 5%, and currency added 4%. Consolidated operating income growth of 12% was driven by Merchant, up 21% and Tonnage, up 13%.

Performance materials showed significant improvement as well, but was partially offset by electronics, which declined as a result of a plant fire in Korea and weaker volumes in quarter four. Equipment and Energy segment income was down as expected.

Equity affiliates' income grew 27% due to strength in Mexico, India, and South Africa, along with some favorable adjustments in quarter two and quarter three. Net income grew 16%, and we repurchased a significant amount of our shares for the fourth consecutive year.

Our return on capital improved to 13%, up 50 basis points for the year. Additionally, we continue to improve our portfolio, having sold the Polymer Emulsions and High Purity Process Chemicals businesses, and we're continuing to make progress on selling our US homecare business.

In summary, 2008 was another strong year of improvement for us, with continued progress towards our goals. Before I move on to the quarter, there has been broad media attention concerning liquidity, commercial paper access, and debt repayment obligations of corporations.

Let me be clear. Our balance sheet is one of Air Products' strengths. We have a solid A rating and an A1/P1 commercial paper rating, and a $1.5 billion revolver to backstop that paper. We have had no issues with lenders or access to credit throughout this financial crisis. For next year, our long-term funding needs are minimal, as we only need to re-finance $37 million of maturing long-term debt. On the asset side, we have focused on lowering our DSO and it is down to 53 days from 58 days last year.

Now turning to slide number 4 for a review of this quarter's consolidated financial results from continuing operations. As we announced on September 23rd, hurricanes along the Gulf Coast and a plant fire in Korea impacted quarter four, limiting our growth this quarter.

For the quarter, sales grew 14% versus prior year. Underlying growth, excluding Equipment and Energy, was 4%, driven by better volumes and pricing in Merchant Gases and performance materials. Higher natural gas and raw material pass-through contributed 8%. Currency contributed 3%. Sales for the quarter were 2% lower due to the hurricanes.

We continued to make progress reducing SG&A as a percentage of sales, and we are now at 10.1%. Operating income of $373 million was up 3% from prior year; again, due to better volumes and pricing, and also favorable currency. The plant fire and hurricanes, combined, reduced operating income by $28 million or 8%.

Our operating margin declined 160 basis points versus last year. 110 basis points are due to higher natural gas and raw material costs pass-through. The hurricanes and plant fire reduced margins by 70 basis points. For the quarter, our net income and our diluted earnings per share increased by 7% and 10%, respectively.

Now, let me turn to slide 5 and review the factors that affected the quarter's performance in terms of earnings per share. Our GAAP or as reported, earnings per share decreased $0.10, excluding discontinued operations and the prior year disclosed items, which resulted in the gain shown at the top of this slide, adjusted earnings per share from continuing operations grew by $0.11 or 10%.

Higher volumes added $0.06. Pricing and margins together, including energy and raw materials were favorable, netting to $0.03. Costs were unfavorable by $0.03. Favorable currency and foreign exchange added $0.07. The plant fire and hurricanes impacted us by $0.05 each. A lower effective tax rate added $0.04, and fewer shares outstanding contributed $0.03.

Now, I'll turn the call over to Nelson to review our business segment results. Nelson?

Nelson Squires

Thanks, Paul. Please turn to slide 6, Merchant Gases. Merchant Gases completed a strong year with a solid quarter. Sales of $1.1 billion were up 15% versus prior year. Pricing contributed 6%, volume 4% and currency added 5%. Sequentially, Merchant Gases sales grew 1%, with volumes contributing 1%, price 2% and currency reducing sales by 2%.

Merchant Gases operating income of $196 million was up 12% versus prior year. Segment operating margin of 17.9% was down 50 basis points versus prior year, and 90 basis points versus prior quarter, due to an asset write-down.

Let me now provide a few highlights by region. Please turn to slide 7. In North America, sales increased 14% versus prior year with volume growth contributing 5% and price 9%. Oxygen and nitrogen volumes increased versus prior year and prior quarter, despite some lost sales, due to the hurricanes. Oil field services continued to be strong.

Our pricing actions continue to deliver, and we were able to recover the diesel cost increases that impacted us last quarter. Our latest price increase went into effect on the 1st of October. Capacity utilization was unchanged in the quarter.

New business signings achieved a record for the fiscal year and were well ahead of target. We continue to see growth in energy and environmental applications. In Europe, sales increased 17% over prior year with price adding 5%, volumes 4% and currency 8%.

As we discussed on our 23 September conference call, business continued to be generally soft in the UK and Southern Europe, though we did see a rebound in liquid bulk volumes in September. Capacity utilization was flat versus prior quarter in the UK, up slightly in the Northern Continent, and down slightly in the Southern Continent. Signings were solid and higher than previous-year.

The numerous price actions we launched in the quarter were successful, and we expect that momentum to continue. In Asia, Merchant sales were up 12% over last year. Volumes contributed 4%, currency 3% and price 5%. We did see lower growth in China due to the Olympics and in Korea and Taiwan from electronics customers. The pricing actions launched in July are taking hold and are recovering energy and distribution cost increases.

Please turn to slide 8, Tonnage Gases. Sales of $940 million grew 21% compared to last year. Natural gas and raw material pass-through increased sales by 25% and currency added 1%. The two Gulf Coast hurricanes lowered sales by 6%. Sequentially, sales were down 4% with currency reducing sales 1% and the hurricanes reducing sales 5%. Volumes would have been up 2% versus the third quarter, absent the hurricanes.

Operating income of $135 million was up 14% compared to last year, and 7% versus last quarter. The increase over prior year was due to higher operating bonuses, lower maintenance costs and better operating efficiency. Operating margin of 14.3% decreased 90 basis points versus last year, due to higher natural gas costs. Sequentially, margins were up 140 basis points, due to lower natural gas costs, higher bonuses and lower maintenance costs.

We just announced two major projects with ExxonMobil. The Baytown project represents an opportunity to sell hydrogen long-term from the available capacity on our Texas pipeline, while the Baton Rouge project is a major capacity addition to our existing pipeline franchise in Louisiana. Our Tonnage opportunities remained very exciting and we will have more to say about this in our outlook.

Please turn to slide 9, Electronics and Performance Materials. Segment sales of $553 million were up 6% compared to last year. Volume gains accounted for 3%, pricing added 2%, and currency 1%. Electronics sales were down 1% compared to last year, impacted by softer volumes, partially due to product rationalization efforts and lower equipment sales.

In Performance Materials, volumes grew 4%, and our penetration of new products improved 30% versus prior year and now represents approximately 16% of our portfolio.

Overall, operating income of $42 million was down 31% versus prior-year. Operating margin of 7.6% was down 400 basis points versus prior year, due to the impact of the fire and lower electronics pricing. Sequentially, margins were down due to the impact of the fire, and lower prices and volumes. We started supplying Signet Solar this quarter, and are nearing agreement on other photovoltaic opportunities.

Please turn to slide 10, Equipment and Energy. Sales of $126 million in this segment increased 2% compared to last year and 18% sequentially, largely due to higher large air separation plant sales. Operating income of $16 million decreased 12% versus prior year due to lower LNG heat exchanger activity.

Income was up versus prior quarter, primarily due to favorable cost performance. Our backlog of projects in this segment now totals $399 million. We received new orders in the quarter for two large air separation units, and we expect two to three LNG heat exchanger orders later in FY09.

Now, I'll turn the call over to John McGlade.

John McGlade

Thanks, Nelson. Now if you will turn to slide 11, I'd like to share my thoughts on our fiscal year 2009 outlook. This is surely the most uncertain external environment since September 2001. In the past month, the economic outlook has turned decidedly negative, as the financial crisis has worsened. Although forecasting at this time involves a high degree of uncertainty, we are currently projecting the following.

Globally, we saw manufacturing grow between 3% to 4% in fiscal year '08, with momentum slowing sharply in the last quarter. We now expect global manufacturing growth of 1% to 2% for our fiscal year 2009.

Our current thinking is that in the United States, we will see a decline of 1% to 2% in manufacturing. We expect to see Europe decline 1% to 2% as well, with growth in Central and Eastern Europe, and declines in the rest of Europe. We expect Asia, will continue to be the strongest area, growing 5% to 6%. Based on this economic outlook, we are forecasting our fiscal 2009 earnings from continuing operations to be between $5.10 and $5.35 per share, which represents year-on-year earnings growth of 1% to 6%.

Let me now turn to our outlook by business segment. We expect to bring 20 new plants on-stream in the fiscal year, representing nearly $0.5 billion of new capital, which will help drive growth. Capacity utilization remains relatively strong globally, and our efforts to raise prices and increase productivity should generate continued improvement in our Merchant Gases segment next year.

In addition, we will continue to benefit from the strong business signings we have won over the past year. We are targeting a 1% improvement in margins for fiscal year 2009, and to be above 20% in fiscal year 2010. In the United States, we are continuing to operate at a high rate across our system. Therefore to serve volume growth, we will continue to debottleneck plants and convert larger liquid customers to small on-sites.

In Europe, we're continuing to focus on improving our margins by raising our prices, streamlining business operations, and continuing to drive our shared service model into this region. In Asia Merchant Gases, we continue to expand our technology applications and offerings, and that, along with solid manufacturing growth, will continue to increase demand, loading our new capacity.

In our Tonnage Gases segment, we will see some benefit from new facilities, loading and productivity, with a full year impact of our second Petro-Canada plant and six other large plants which we will bring on-stream this year. On the new order front, refinery hydrogen project development remains active. And in 2010, we expect to bring on the two ExxonMobil contracts we just announced, as well as Marathon Oil, Garyville and Total, Port Arthur.

In Equipment and Energy, we expect profits to decline about $0.05 per share, due to lower LNG activity. We do anticipate signing two to three LNG orders this coming year, although these orders won't have a significant impact on our fiscal year 2009 profits.

Within Electronics, silicon process was up 4% to 5% in fiscal year '08. We expect it to be flat to down 5% in 2009. As we look at fiscal 2009, we expect weaker demand across foundries, memory, and flat-panel producers in the first half of the year, with a pick-up in the second half.

Our growth expectations in Performance Materials are based on the assumption that we can grow through a combination of share gain, new market and application successes, and from new products, as we have in the past. For the Electronics and Performance Materials segment, we continue to target improvement in our operating margins with a goal of delivering 15% in 2010.

In this economic environment, cost control and reduction are important drivers of earnings, margin and return improvement. For fiscal year 2009, we are taking a number of actions. As would be expected, we have already cutback on discretionary spending, significantly reducing travel, use of consultants, new programs and hiring.

We will also see the impact of a number of structural cost reductions we are making to reach our 2010 goal of 17%. Examples of these actions include continuing to capitalize on our SAP investment to further lower our finance, IT and customer service costs by using shared services globally and simplifying and automating our transaction processes. These actions will continue to drive down our SG&A costs.

We are also increasing energy efficiency of our plants by using Six Sigma techniques to reduce the variation in plant operations, therefore decreasing the natural gas consumption of our HYCO facilities and the power consumption of our air separation units. We are lowering our maintenance costs through the utilization of our system wide SAP data on our facilities to optimize maintenance scheduling and to leverage our global buying power. And we are reducing our distribution expense per unit of product delivered through investment in more fuel efficient equipment and more efficient route and delivery scheduling.

While we are likely to see an uncertain economy in 2009, we remain committed to delivering consistent, strong earnings growth along with improved margins and returns throughout the economic cycle.

Turning to slide 10. Our guidance for quarter one, is for earnings per share of $1.15 to $1.21 based on the following factors. On the positive side, we expect to see increased earnings sequentially from the following areas, higher prices in Merchant Gases; a much smaller impact from quarter four's plant fire and hurricane and improvement from our cost reduction actions.

Offsetting these sequential improvements are a number of seasonal impacts in our businesses. In Merchant Gases and Performance Materials, we will see lower seasonal demand. In Tonnage Gases, we expect higher maintenance spending and lower volumes in quarter one and lower operating performance bonuses. In addition as expected, our LNG activity will be lower, and we anticipate a higher tax rate in quarter one versus quarter four, and a currency headwind from a stronger dollar.

Please now turn to slide 13, for our capital spending outlet. In the longer-term, we see excellent demand for our products and significant opportunities for growth. Despite the recent decline, energy prices remain historically high and are likely to continue to do so. There will also be significant activity around alternative energy and climate change initiatives, which should also drive much higher demand for industrial gases in both our Merchant and Tonnage segments.

We continue to work on opportunities for the future. These include hydrogen for clean fuels; oxygen for gasification of coal, petroleum coke and other heavy carbon materials to produce both power and petrochemicals; and oxygen for capturing carbon emissions. These opportunities are driving increased capital spending in 2009 and beyond.

We are currently forecasting our CapEx to be $1.6 billion to $1.8 billion, up from $1.4 billion in 2008. This forecast is slightly lower than our previous forecast, due to the stronger dollar, since a significant portion of our spending is outside the United States; lower project costs, as commodity pricing has declined; and an allowance for some customer project delays due to the financial crisis and its impact on global economic demand.

This spending is broken down between $400 million for maintenance and support capital, and $1.2 billion to $1.4 billion for growth. Of the growth expenditures, approximately 60% are in our Tonnage segment. As we stated before, each dollar of CapEx, growth CapEx translates to about 70% of revenue growth two years out.

In closing, I'm on the call today to assure you that the 20,000 Air Products employees, most of whom are shareholders, are committed to delivering increased shareholder value. We are taking the actions to deliver our 2009 guidance, while continuing to take advantage of our excellent market opportunities in the future. We are ready for this challenge.

Thank you, and now I'll turn the call over to Shawn to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will start with David Begleiter, Deutsche Bank.

David Begleiter - Deutsche Bank

Thank you, good morning.

Paul Huck

Good morning, Dave.

David Begleiter - Deutsche Bank

John, could you quantify the impact of the 20 new plants in Merchant and the six new plants in Tonnage on the sales and earnings in 2009?

John McGlade

Yes. The 20 plants in total include the six, that's about $0.5 billion of CapEx. And as we've said, that CapEx should translate into about $0.70 on the dollar in terms of revenue.

David Begleiter - Deutsche Bank

Given the locked-in growth from those projects, how would $5.10 be realized? What would be declining in the business, Electronics I assume, Performance Materials?

Paul Huck

Yeah, Dave. And if you take a look at our guidance and you think through that, one of the things which doesn't come across actually in the numbers for the thing we talked is the currency headwind which we're facing. So, if you take a look at this, I estimate that we probably are facing about a $0.30 to a $0.35 a share headwind in currency, allowing for a euro somewhere in the $1.30 range and appropriate other currencies as you go out there. We're also exposed to the won, the Taiwan dollar, the pound, etcetera. So that's a headwind.

The other thing is we have equipment as John talked about, which is a headwind of about nickel from there. So if you look at that, the volume growth which we have locked-in, continues about $0.30 a share next year, as I can look at it right now Dave. So that translates to a 5% or 6% gain in our EPS just from the volume, which we have.

David Begleiter - Deutsche Bank

And Paul, last. What's the benefit from cost and productivity actions in '09?

Paul Huck

We're probably somewhere in $0.10 to $0.20.

David Begleiter - Deutsche Bank

Thank you very much.

Operator

And we'll go to our next question from Jeff Zekauskas of JPMorgan.

Jeff Zekauskas - JPMorgan

Hi, good morning. If I could start with a question of clarification. In your press release, you say that the effects of the fire are in other income. Is that other income on a consolidated basis or other income on a segment basis?

Paul Huck

On a consolidated basis, Jeff.

Jeff Zekauskas - JPMorgan

Okay.

Paul Huck

On the line on the P&L.

Jeff Zekauskas - JPMorgan

Okay. So if what we do is, we add back the $15 million to your $42 million in operating income in Electronics, we get $57 million. And you had positive volumes, positive price and positive currency. Your sales are up roughly from $520 million to $550 million, but the operating profits are down, and this even adjusted for the fire, and this is the area where you've intensely focused on cost reduction. So why is that?

Paul Huck

Well, one of the things is that we did have extra costs, obviously, in this quarter in the Electronics area for us. If you look at the other aspect of that thing is that price in Electronics was down year-over-year for us. In the slide, what you see is 2% price gain. A lot of that is in the performance end of the business, that's recovery of the raw materials aspect of that. And so, on net that is a positive.

If you look just at the Electronics portion of the business, as we've talked about this before, we continue to see declines in our special materials pricing. So the 2% price is a net of those two. The 2% price really is recovery of the raw material costs in the performance end of the business.

Jeff Zekauskas - JPMorgan

Okay. Finally, I think John McGlade in his preliminary remarks said that you still maintain your 15% margin target for Electronics and Performance Materials for 2010. So you're at 11% now and you're projecting negative volumes for next year or for most of the next year? So how are you going to get from 11% to 15% with no volume growth?

Paul Huck

First in 2010, we are going to project growth in 2010. In fact, if you look at this Jeff, I think the way in which John phrased is, we're expecting the first quarter and the second quarter of the year to be down and then start to see a pick-up in the third and fourth quarters, continuing into 2010.

Jeff Zekauskas - JPMorgan

Okay. And then I guess lastly, what's the millions of standard cubic feet that you've just booked with ExxonMobil for the two contracts?

Paul Huck

It is about 160, I believe.

Jeff Zekauskas - JPMorgan

For the two combined?

Paul Huck

For the two combined.

Jeff Zekauskas - JPMorgan

Okay, thank you very much.

Operator

All right, and we will go next to PJ Juvekar of Citi.

Paul Huck

Good morning, PJ.

PJ Juvekar - Citi

Yes, hi good morning. I don't understand your CapEx guidance. At the midpoint of your CapEx guidance, it will go up, CapEx will go up 20%. You're saying that operating profit will go up only 1% to 6%. So your return on capital is going to fall. That suggests that you're going after projects with marginal returns. Can you just talk us through that, why are you raising your CapEx if you are expecting earnings growth to be lower?

Paul Huck

PJ, if what you look at is the CapEx, which we are spending next year, is going to go principally into the construction and progress account for those things. So, what that does is, a lot of that CapEx comes on two years from now. So we'll have some of it come on in 2010, as John talked about, and then other come on in 2011. And so, the sales and profit impact really of this these things is one to two years out.

PJ Juvekar - Citi

But you and the rest of the industry, you ramped up your capital spending, as the returns are going down. Are you just worried long-term that returns could be lower and the oligopoly that we had expected, this may not work out as people expected?

John McGlade

No, P.J. As we've talked before, this is John. We are constantly focused on looking at the quality of the returns of the projects that we have. We aren't deteriorating the returns on the projects that we're taking on. The CapEx ramp-up, which is largely in the Tonnage segment, is a direct function of the opportunities that exist in the energy sector.

PJ Juvekar - Citi

Okay. On that, with oil below $70, some of these projects like enhanced oil recovery or even Canadian tar sands, is there any anticipation of slowdown in any of these projects?

John McGlade

This is John again. I mean, in our guidance, we did lower our forecast for this year a bit from what we had been out saying a couple of quarters ago. I still think, however, the fundamentals of basically the North American demand for transportation fuels and the security of supply that the tar sands or the oil sands offer to that very large marketplace really, really does bode well for the long-term development of those reserves.

Certainly, as oil has come down to this price range, we believe these projects make sense in the broader North American dynamics. And then quite honestly, the pressure that had been on the resources to execute all of these projects that had been announced, really made for a fairly high escalation of the cost and the tight demand on resources. So there's probably a little bit of natural sorting out of that oil curve. But our view long-term for the prospects here is still very bright.

PJ Juvekar - Citi

Right. For short-term, maybe some slowdown, but long-term you are positive?

John McGlade

Absolutely. And the short-term, we've tried to build into our revised CapEx.

PJ Juvekar - Citi

Okay, thank you.

Operator

We will go next to Peter Butler of Glen Hill Investors.

Peter Butler - Glen Hill Investors

Good morning. Is there a bigger picture on your Exxon contracts? What does this do to your competitive position on the Gulf Coast versus, say, Praxair? Are there any longer-term implications on raising your market share? What about possibilities of follow-on business with Exxon at other locations around the world? Do these contracts say that you have a significantly improved position with the company?

John McGlade

Well, first off Peter, in this business, it's never been about market share from our perspective. It's been about really generating projects that give us returns that are consistent with our goals and objectives. Certainly these two projects with Exxon, we're very pleased to be the supplier to these. We believe that we won these on the basis of our ability to provide the value proposition that Exxon expects.

We are obviously, in the supply of hydrogen to any refinery, we're a critical element to the ability of that refinery to run and to run consistently without interruption. I think having been at this game the longest, we've been able to demonstrate that the best of our competitors. As you know, each and every one of these projects, given the large scale of them, tend to be discrete decisions, that among other things are based on your credibility in the marketplace, your relationship and credibility and the fact that you've been able to prove to that particular customer through years of operating experience, that you can deliver the value proposition that they're expecting.

Peter Butler - Glen Hill Investors

I guess what I was looking for was your thoughts that your experience to date and including winning these two contracts would in fact, improve your betting average on contracts yet to be negotiated and completed.

John McGlade

Well, I think from the standpoint of, I'm not going to speak specifically to ExxonMobil, but from the standpoint of my earlier comments on the market positioning, I think the market is, and in this case, on these two, ExxonMobil is voting that we do have a compelling value proposition. I think on future projects, we really have to talk to them.

Peter Butler - Glen Hill Investors

Okay. Great. Thanks for your help, guys.

John McGlade

Thank you.

Operator

Our next question comes from Robert Koort of Goldman Sachs.

Robert Koort - Goldman Sachs

Thanks, good morning guys. A couple of questions. One, John, where is the incremental demand from Exxon coming from? Is that a de-captivation of existing, or are they going to adjust their refinery and need more hydrogen? Or why did you get that incremental business?

John McGlade

Well, in both cases, I think that they are just moving towards a greater transportation fuel production. Some of it's probably related to some of the diesel regulations that came into play. It's really an incremental debottleneck at both facilities, the one in Baytown and the one in Baton Rouge.

Robert Koort - Goldman Sachs

Got you. Then your well respected economist seems to have a much more pessimistic view than the IMF or some others in terms of his economic forecast. So, do you think that's a reflection of some stuff you've seen more recently in extrapolating that forward or are you just being particularly cautious? Why such a somber outlook compared to maybe what others have said?

Paul Huck

Bob, I think it pays to be conservative at this point in time from our plans on everything. As John said, it's a place in which the uncertainty is very high here. I would rather add on this, here on the downside, I'm not going to miss anything, but I'll be prepared for the worst things, we think. The other thing is that, I'm the first out on the full year.

Robert Koort - Goldman Sachs

Then lastly, if I might, a lot of your on-site projects are based on achieving some sort of return on capital target. How much wiggle room is there in your own procurement of raw materials, ENC constant labor cost, and that sort of thing where you could actually get an improved margin as the global deflation starts to take hold a bit?

Paul Huck

That is possible for us. It's one of the things in which we put forth, as far as the change in the capital outlook. We expect the commodity prices to bring capital costs down by a bit also.

Robert Koort - Goldman Sachs

Do you share that with your customer if that happened or not?

Paul Huck

Sometimes we do and sometimes we don't, it depends upon the contract.

Robert Koort - Goldman Sachs

Got it. Thanks very much.

Paul Huck

Thank you.

Operator

We'll go next to Kevin McCarthy, Banc of America Securities.

Kevin McCarthy - Banc of America Securities

Yes, good morning. Would you elaborate on what you're seeing in Asia in the Merchant Gases business? Obviously, volume decelerated to 4% from 15% last quarter. But I know it's an unusual quarter with the Olympics, and a lot of macro volatility. So, as you look to the first half of '09, would you expect to rebound from that level, continued pressure? What's your outlook there?

Nelson Squires

Hey Kevin, this is Nelson. Yeah, we've looked at this pretty closely, obviously. Most of the slowness that we would see is due to the Olympics and the Para Olympics period. In addition to that, certainly some Merchant volume going to Electronics customers in Taiwan and Korea has slowed a bit. One of the things to point out here though is that, overall from a macro standpoint, we have been short of molecules in many regions in Asia, and have brought on plants in China, Korea, and Taiwan to serve what I'll call the general market. So we do expect to see some volume kick from that this fiscal year, because ultimately capacity is still pretty tight there. So we do expect to see volumes bounce back and we do expect to see decent volume growth in Asian this year.

Kevin McCarthy - Banc of America Securities

Okay. And then on the pricing side in Merchant, I think you had some relatively recent increases just about three weeks ago, on October 1st.

Nelson Squires

Right.

Kevin McCarthy - Banc of America Securities

Given that it's early, what is your experience in terms of realizations and customer push-back relative to prior rounds of increases?

Nelson Squires

It has not changed, which means it's still very positive in terms of the effectiveness of the increases. I mean the key point is, as we spoke to in the script, the first part of the call, was the capacity utilization is still pretty tight, we haven't seen any movement in North America. By the way, we and a few of our competitors have actually brought on capacity this year. It's been incremental capacity as you know, but that has been basically taken into the market. We are, so far, as good or better than expected on these latest increases.

Kevin McCarthy - Banc of America Securities

Final question for Paul, if I may, on the subject of repurchases. Do you have any thoughts on the pace of future repurchases given the volatility in the capital markets?

Paul Huck

It's certainly something which we are going to pay a lot of attention to Kevin, because we want to have the funds to address the market needs and stuff like that. But as we maintain our debt rating today, and our commercial paper in A1/P1, and if we go out and have the additional cash over that which under this plan, we would project to still have even with the capital spending which I have here, we will go back and buy back shares. I probably would not do that in advance or in anticipation of earnings, though.

Kevin McCarthy - Banc of America Securities

Thank you very much.

Paul Huck

You're welcome.

Operator

We'll go next to Chris Shaw of UBS.

Chris Shaw - UBS

Good morning. How are you doing?

Paul Huck

Hi, Chris.

Chris Shaw - UBS

Just given to sort of where the Energy markets are going, do you have any expectations for lower hydrogen volumes in the Tonnage business for 2009 or do you think those will hold up? Is there a big spread between what you guys have been earning? What are the take levels?

Paul Huck

Yes, if you look on the refineries in the US. The refineries have continue to operate in the mid 80s. And so, we would anticipate that to continue, Chris. So no, it's not a factor in there and we don't expect to see it.

Chris Shaw - UBS

Then general, on your 2009 guidance, what sort of expectations do you have in there for pricing year-over-year?

Paul Huck

Yes, the pricing is already in there. A lot of it, a lot of the improvements year-over-year are included in there. As you can see, we went out on the 1st of October in the US to raise prices and we're continuing to raise prices in places like Europe and Asia also. The capacity still looked very good across the globe for us.

Chris Shaw - UBS

But there's not like a discrete number in there, a number like 2% up?

Paul Huck

No. But the thing I said is, if I take a look at the overall pricing, cost mix for us, I think it's $0.10 to $0.20 positive this year for us.

Chris Shaw - UBS

In 2008?

Paul Huck

2008 to 2009.

Chris Shaw - UBS

Okay. Were there any energy surcharges you had for delivery that might be coming off because of lower gasoline cost?

Paul Huck

We did have surcharges on diesel, and if diesel comes off and stays down, they will come off.

Chris Shaw - UBS

Okay. Great, thanks a lot.

Operator

We will go next to Don Carson of Merrill Lynch.

Don Carson - Merrill Lynch

Thank you. 2009 is shaping up to be another 2001 in terms of a downturn. This time around, you see an improvement in earnings in a recession versus a slight deterioration last time. What gives you that confidence? Is it the portfolio improvements you've made since the last recession? Is it that the higher backlog? What exactly gives you the confidence that you can do better in a recession than you did last time?

John McGlade

Well, Don, it's frankly a combination of both of those things. As you well know, we have worked really hard at transforming the portfolio of this company, but also at transforming the foundation of how we execute our business. Then when you combine that with some of the growth that we have locked-in, the applications that we do see, certainly a better discipline on our side in terms of the investments in aspects of our business and maintaining a much higher utilization rate in the operation of our businesses.

We worked really hard to get here, and this management team is absolutely focused on doing what we've said we were going to do, which is to perform during an economic downturn.

Don Carson - Merrill Lynch

Just a couple of follow-ups on the backlog. You mentioned that backlog is at an all-time high. Can you quantify that in dollar terms or number of projects? You talked about building in or factoring in some delays in the backlog, but what cancellation potential is there in the backlog, can you comment on that?

Paul Huck

Well Don, as far as the cancellation potential, if that were to happen, we would have coverage on our costs. Now, the likelihood of projects being canceled I think is quite small. I am not concerned about that, and we have factored something in for projects delaying a little bit. So I think we are in good shape there. With regard to the size of the backlog, it is currently about $2.5 billion in spending. The other portion about that is that the bulk of this is in the Tonnage area with 60% to 65% of that being in the Tonnage area.

Don Carson - Merrill Lynch

Paul, just one clarification. I don't know if you had mentioned this before, what's your assumption on the foreign currency headwind in 2009 from an EPS standpoint?

Paul Huck

EPS, it's $0.30 to $0.35 Don.

Don Carson - Merrill Lynch

Alright, okay. Thank you.

Operator

We will go next to Laurence Alexander of Jefferies.

Lucy Watson - Jefferies

Hi, this is Lucy Watson sitting in for Laurence.

Paul Huck

Good morning, Lucy.

Lucy Watson - Jefferies

Good morning. Just wanted to clarify, that $2.5 billion in spending, that's capital spending, right?

Paul Huck

That is a backlog in projects. The capital spending for '09 is going to be between $1.6 billion and $1.8 billion.

Lucy Watson - Jefferies

Okay. Have you clarified or do you know what the impact of pensions will be on 2009 earnings and cash flow?

Paul Huck

About flat.

Lucy Watson - Jefferies

Okay. What is the contribution to Merchant Gases profits from the European Healthcare business?

Paul Huck

That is disclosed, it runs profits about $23 million to $24 million a quarter.

Lucy Watson - Jefferies

Okay. Just one more. At what point would you expect to start cutting CapEx spending? Are there any external indicators that we could possibly look at or that you look at to track for cutting back?

Paul Huck

On the CapEx, the thing which everyone should realize is that is driven by us, and having the product sold, and the customers. So, the customer base is there. So, I would not anticipate a cutback in CapEx.

Lucy Watson - Jefferies

Thank you.

Paul Huck

You're welcome.

Operator

Alright, we'll go to Mike Harrison of First Analysis.

Mike Harrison - First Analysis

Hi, good morning. In the past, you've talked about improving your plant efficiency and how the savings are larger when energy costs are higher. I was wondering if you're still moving forward with as many plant efficiency projects, now that energy prices have come a little bit lower and how are you looking at those projects longer-term?

Paul Huck

Mike, they have come a little bit lower, but if you look at the cost of power, if you look at the cost of gas, it's still two to three times the historical rate. So the benefits of these things look good. No, we would not back off. As we try and take a look at this stuff, I'm not factoring in $150 a barrel oil or $12 gas in the economics long-term to make these things work.

John McGlade

The only build I'd put to that is, is the fact, the comment I made around utilizing Six Sigma techniques advanced tools, getting better, tighter operating capability around our plants, gives us opportunities to do this that don't always require a lot of capital investment in the facility to achieve these returns or improvements.

Mike Harrison - First Analysis

As you see, maybe some slowing or delays in your growth CapEx or in some of the projects from your customers, do you have kind of a backlog of your own of plant efficiency projects that you can put into the pipeline to make those higher priority in a slower economic environment?

John McGlade

That's a great question. Of course, I'll go back to the point Paul made a moment ago. We're watching the capital stock that we're executing very closely. But these additions are largely in our Tonnage business. They are largely tied to contracts that are either executed or working under some sort of a commercial agreement. So, our view is that we've got a reasonable CapEx forecast here for the next couple of years, or for next year, and expect similar type going forward.

Having said that, you're absolutely correct in the fact that you're constantly balancing the trade-off of resources between executing against your growth capital, while continuing to optimize the asset base you have. That would certainly be a lever we would pull. What we're really trying to do is ensure that we can do both of these things in the environment that we're in.

Mike Harrison - First Analysis

Alright. Then looking at the Merchant business and the performance you showed in Europe this quarter, it looks like the strongest organic growth that you've shown there all year. I was wondering if you could explain why that was the case, given what we're hearing about slowing in Europe? At least the things I've heard, that August slowed down significantly and September didn't really pick up like it normally does.

Nelson Squires

Hi Mike, this is Nelson. Our September volumes in liquid bulk did pick up. So we were obviously happy to see that. But the growth is really being driven by new application successes. A couple of specific applications that were out there are proliferating in the European markets, some of the things that we've carried over from success in the US. We would basically attribute all of that gain or a lot of that gain, certainly, to new application success, Energy related as well.

Mike Harrison - First Analysis

Do you think that you guys can hit the 6% to 7% underlying growth rate that you had talked about for Merchant in Europe?

Paul Huck

The 6% to 7% of growth which we talked about previously, it really applied to the whole company. And right now in the economic forecast, which I have in here, it's probably about 5% overall.

Operator

Okay. We'll go to our next question from Mike Judd of Greenwich Consultants.

Mike Judd - Greenwich Consultants

Yes, thanks. I'm just wondering if you could give me a little bit of an update on your pension plans and how they are structured. You mentioned to an earlier question that you don't expect any additional or any increase in the level of funding for the next fiscal year. Can you just walk us through that, given that some of the equity markets are down?

Paul Huck

Mike, sure. As we look at our pension plan, the major plan which I have exists in the US. The unfunded liability overall is about $400 million. I would not anticipate it to get a lot larger this year, because the other thing which is going to happen is that the rate of the discount rate to calculate the PBO and ABO are is actually going up. So, I think we're going to be fine there.

Mike Judd - Greenwich Consultants

Thank you.

Paul Huck

Yes.

Operator

We'll go next to Mark Gulley of Soleil Securities.

Mark Gulley - Soleil Securities

Good morning, guys. A couple of questions.

John McGlade

Good morning.

Mark Gulley - Soleil Securities

With respect to the Texas opportunity, I guess Baytown, Texas for Exxon, it sounded like you have available capacity in that pipeline system, which you're making available for this new application. Is that correct that your operating rates there are perhaps low enough that you already had the capacity for Exxon in Baytown?

John McGlade

Well, it is available capacity in our system, but it's also consistent with our strategy on our franchises, which is, you add discrete plants on large requirements, but then you try to add plants that fit either a standard envelope or an actual size to be added. And it's a real opportunity to put a little bit of extra capacity on a facility in a franchise such as Texas or Louisiana, where you have substantial network of pipes, multiple customers feeding, and taking product in and out of that system. So this is just a natural progression of how we develop any franchise over time.

Mark Gulley - Soleil Securities

Particularly, I want to talk about the economic forecast. I actually thought it was a little bit more optimistic than I would have thought. It seems to me like this recession is going to be very much more global than the '01 recession, like both, the consumer and industrial customers are going to get hit here pretty hard. So I would have thought that perhaps the outlook from your economist would have been more somber than it is?

Paul Huck

Thanks.

Mark Gulley - Soleil Securities

Can you elaborate on why this one is going to be the way you think it is?

Paul Huck

Well, I think if you take a look at what we have predicted, what we're showing is a drop in the manufacturing climate which is about equal to the 2001 area right now for us. It's going to be global, we think, because of the crisis which has gone global also, and the mood of consumers. It is below the consensus though right now, Mark. So it is worse than a lot of people are predicting at this point in time.

Mark Gulley - Soleil Securities

Finally, I know all Energy projects have individual energy cost thresholds, but if oil were to continue to fall, are there any projects, any applications which really do get pushed aside if oil or natural gas falls a whole lot more?

John McGlade

Certainly, this is not an exact science; it's an art. It really gets down to, frankly, most of the time our customers in planning for a new project are not planning at the current price of oil on that day, but generally a much more normalized cost of oil, if you will, over a longer period of time. But clearly, one of the first areas that go when you get down to lower thresholds would be natural gas, probably down around $5 per 1 million BTUs.

So that's more of a hit to the Merchant business, should that occur. On the longer-term, as I mentioned on the longer-term projects driven off of energy, I don't think any of our customers were planning anywhere near the scenario of the oil prices that we saw throughout this summer.

Mark Gulley - Soleil Securities

Thanks, John.

Operator

Alright. We'll go to our next question from Mike Sison of KeyBanc.

Mike Sison - KeyBanc

Hi. When you think about the 20 plants or so you're bringing on next year, The odds of a cancellation considering that it's so close to being built, your customers must be well financed, must have their plan on the go. It's pretty low, right?

Paul Huck

It is zero.

Mike Sison - KeyBanc

Okay. And then when you think about the backlog that you have, the 1.6, 1.8, is that all growth or there is some maintenance CapEx in there?

Paul Huck

The maintenance CapEx is about $400 million.

Mike Sison - KeyBanc

Okay.

Paul Huck

The 1.2 to 1.4 of spending in '09 on growth, and a growth backlog of about 2.5 right now.

Mike Sison - KeyBanc

Right. And historically, why does a customer cancel? Is it that they don't get financing? They go bankrupt? Historically, I do know that you don't have a lot of cancellations, but if there has been some, why did they cancel?

Paul Huck

We rarely see a cancellation in this business. We're more likely to see our delays and not cancellations.

Mike Sison - KeyBanc

Right. And the reason you're confident is that, within the CapEx backlog are actual customers who have signed a long-term, five or 15-year contract?

Paul Huck

Yes.

Mike Sison - KeyBanc

Okay. Then, John, when you take a look at return on capital of 13% for '08, I didn't really have time to do the math, but when you look at your guidance for '09, is there improvement there? Then when you look longer-term to 2010, can you give us sort of, maybe direction to where you think return to capital should go?

John McGlade

Well, I'll let Paul address the specifics, but our goal is to continue to improve our return on capital. I mean, part of our challenge to ourselves and our commitment to our shareholders is to drive our margins to 17%, which would in turn translate into a return on capital of around 15% type of ROCE number.

Paul Huck

That's what our goal is out there, it is to take the margins up and drive the returns up along with that, Mike.

Mike Sison - KeyBanc

Will there be some improvement next year?

Paul Huck

Yes, a little bit.

Mike Sison - KeyBanc

Okay.

Paul Huck

That's right.

Mike Sison - KeyBanc

Alright. Thank you.

Operator

That's all the time we have for questions. I would like to turn the call back over to Mr. Squires for any additional or closing remarks.

Nelson Squires

Thanks, Shawn. Please go to our website to access a replay of this call beginning at 2:00 pm today. Thank you for joining us and have a nice day.

Operator

Again ladies and gentlemen, this does conclude today's conference. We thank you for your participation. You may disconnect at this time.

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