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Airgas Inc.(ARG)

F2Q08 (Qtr End 09/30/08) Earnings Call

October 24, 2008 11:00 AM ET

Executives

Jay Worley - VP, Communications and IR

Peter McCausland - Chairman and CEO

Bob McLaughlin - SVP and CFO

Analysts

David Begleiter - Deutsche Bank Securities

Mike Harrison - First Analysis

Amy Zhang - Goldman Sachs

Kevin McCarthy - Banc Of America Securities

Mike Sison - KeyBanc

Lucy Watson - Jefferies & Company

David Manthey - Robert W. Baird

Mark Gulley - Soleil Securities

John Roberts - Buckingham Research Group

Steve Byrne - Merrill Lynch

Scott Blumenthal - Emerald Advisor

Operator

Good morning and welcome to the Airgas second quarter 2009 Earnings Call. Today's call is being recorded at the request of Airgas. All participants will be in listen-only mode until the question-and-answer session of the call. For opening remarks and introductions I will now turn the call over to the Vice President of Communications and Investor Relations Jay Worley. Please go ahead.

Jay Worley

Good morning and thank you for attending our second quarter earnings teleconference. Joining me today are Peter McCausland, Chairman and CEO; and Bob McLaughlin Senior Vice President and CFO.

Our earnings press release was made public last evening and is available on our website as are the slides that accompany this teleconference. To follow along please go to airgas.com, click on the investor shortcut at the top of the screen and then go to the conference calls and web cast page.

During the course of our presentation we will make reference to certain non-GAAP financial measures. Please note that reconciliations to the most comparable GAAP measures can be found in our earnings release in the slide presentation and on our website.

This teleconference will contain forward-looking statements based on current expectations regarding important risk factors, which are identified in the earnings release and in our slide presentation. Actual results may differ materially from these statements, so we ask that you please note our Safe Harbor language.

We will take questions after concluding our prepared remarks and we plan to end the teleconference by noon eastern time.

Now I'll turn the call over to Peter to begin our review.

Peter McCausland

Thanks Jay. I hope everyone's feeling great today, because we are. We're pleased to report record results for the second quarter of fiscal 2009. Our strategic growth initiatives, a diverse customer base and disciplined in our day-to-day operations once again produced strong sales and earnings growth in a moderating economic environment.

Recent events in the global financial markets have been sobering indeed and the anxiety over credit availability and a potential global recession has created extreme volatility in the equity markets and driven valuations to low levels. Despite these developments we are still confident in our approach and just reaffirmed our full year guidance and substantially increased our dividend.

We have solid strategies for the long-term and the right people to execute them. We believe that our diverse customer base with money non-cyclical segments and the infrastructure work we began in the late 90s have positioned us well in today's economy. We will continue to leverage our competitive strengths while maintaining a balanced approach to capital structure and a weather eye on the economy.

In spite of the excesses of Wall Street and its subsequent tumble companies and consumers continue to purchase goods and services in their pursuit of value creation. And we intend to keep expanding our role in that process.

On the call today we will review our strategies and initiatives and hopefully provide insight into some defensive characteristics of our business as well. Because this is the political season I have a little sum speech that I'm going to give. And I hope you will indulge me for a few seconds.

A few weeks ago Senator McCain was mocked by the media and Senator Obama for saying that the US economy was fundamentally sound. McCain wasn't talking about the homebuilders, many of which are struggling and most of which were very small companies or didn't even exist when the housing bubble started.

He wasn't talking about the unfortunate people who were told they could afford new homes when in reality they could not. He wasn't talking about the overbilled commercial and retail segments, which expanded at insane rates with the credit bubble.

He wasn't talking about the people on Wall Street, who had a major role in the formation of the credit bubble and who have been paid absurdly high salaries and bonuses for the last 15 years. McCain wasn't talking about Beverly Hills, Worth Avenue or Wall Street. He wasn't talking about people who specialize in credit default swaps or short selling, activities with no redeeming value.

He was talking about those places where real goods are produced and essential services are provided all across the country. He was talking about American manufacturers who survived the 1998, 2002 high dollar recession and which have become more competitive at home and abroad.

He was talking about the companies that provide healthcare to millions of Americans. He was talking about the places where important research is being conducted such as biotech companies, chemical companies, alternative energy companies and universities. He was talking about McDonald's and he was not talking about La Bernadine.

I'm not trying to underestimate the size or the destructive capability of the current financial crisis. And I'm not about to predict that it will have no impact on the economy of which John McCain spoke. And I do hope that our government is successful in protecting that economy, because it was finally starting to do well before this credit bubble burst. Good jobs were finally starting to be created in the US.

I recently read an article in the New York Times, which quoted a historian by the name of Frazier. He spoke of the deindustrialization of the American economy over the last few decades with its factory closings and loss of manufacturing jobs that paid decent wages and noted that it coincided with the heavy expansion of the financial sector where compensation soared.

And I don't remember our government adding capital to the industrial sector like it's adding capital to the financial sector today. The United States economy clearly got top heavy with financial services, retail and residential buildings and legal services.

The lesson is that the government needs to focus on promoting the parts of the economy which produce real goods and provide essential services and which build necessary infrastructure to keep the United States competitive.

No matter who is elected, I think that will be the result and that is why I am optimistic both with the respect to the US economy and with respect to Airgas' business prospects.

I don't agree with the geniuses who are predicting another depression, because these are the same general geniuses who got us into this mess by insisting that the markets would be self regulating, because people act in their self interest.

That would be true if everyone was managing their own money. But it's not the case when you have lots of untested overpaid billionaire wanna-bes managing other people's money. This might get worse before it gets better, but the silver lining is that the system will change and the US will adjust its priorities. My apologies.

Turning now to the quarter’s financial highlights. Record earnings of $0.86 pre diluted share exceeded the top end of our expected range by $0.02. Airgas’s Board of Directors increased the quarterly cash dividend on our common stock $0.16 from $0.12 a 33% increase and the reflection of the quality of earnings as well as the confidence we have in the future.

Operating margin the quarter increased 12.5% compared to 11.5% last year and 12.1% in the first quarter, driven by revenue growth, operating efficiencies and synergies gained from the Linde Package Gas and other acquisitions.

Similarly the operating margin expansion helped drive our return on capital to 13.6%, 40 basis points over last year. Our year-to-date free cash flow was $112 million compared to $92 million last year as we continue to produce high quality earnings. This in spite of recently elevated capital spending as we construct ASU's CO2 plants and cylinder fill plants, some green field and some associated with the Linde Package Gas acquisition.

Sales in the quarter increased 15% to $1.2 billion with acquisitions contributing 7% of the quarter sales growth. Total same-store sales grew 8% with price accounting for two-thirds and volume one-third. Gas and rent grew 12% and hard goods same-store sales grew 4%.

Looking across our geographies, results were relatively uniform among our distribution companies. The Mid South, Mountain West, East and Great Lakes regions posted the strongest gains related to add investments in energy and petrochemical industries, as well as medical and life science.

Sales in food and beverage and environmental applications were also strong. On balance our manufacturing segment has been stable. Weakness in autos, trucks and trailers has been offset by strength in metal fabrication, railcars, mining equipment and alternative energy.

Hurricane Ike impacted our business in the Houston area curtailing some industrial gas and consumable hard good sales while bolstering sales of dry ice, medical oxygen and welder generators. All told the hurricane was largely neutral to earnings. We do believe that there will be some future benefit from rebuilding in the area.

Hard goods volumes were mixed result, as equipment volumes ended below the prior year while filler metals were up over the prior year. Our August gas and rent price increase was both well designed and well presented to our customers and was effective in managing the cost curve.

As we survey our current results and future prospects we are encouraged by some favorable characteristics in customer segments and product lines and we have presented those in a table on slide 3. In some customer segments such as energy and infrastructure construction, medical, food and beverage and analytical research the macro growth rates are favorable and offer great growth opportunities for all participants.

You can see many of our strategic products target these customer segments partially accounting for the strong strategic product growth. But just as important our growth is attributable to new customer gains and expanding our presence in the supply chain of existing customers, which is not only taking place in high growth segments, but in lower growth old line segments.

Our distribution infrastructure broad range of product offerings, technical expertise and our ability to engineer the right solutions for our customers are real competitive advantage and should not be underestimated.

For example, we have invested in an expanded offering to the energy and infrastructure construction segment. Not only can we offer contractors the full range of gasses, welding and safety supplies they need, we can supply them anywhere in the US. We can provide them supply chain services such as onsite technicians and inventory, portable gas containers and logistics.

In addition we have the most comprehensive offering of rental welding equipment in the business through our Red-D-Arc line and we are able to provide onsite welder certification for the contractors workforce. When you consider our recently acquired capabilities in safety rental equipment and safety management services from the Oilind acquisition.

It becomes more apparent that our construction business is growing not only with segment, but the segment itself, but also by gaining new customers and expanding our supply chain presence within our existing customers.

It helps explain why our construction business continues to grow in excess of 20%. It also helps to explain why we still have a favorable outlook for the energy and infrastructure construction segment in spite of the uncertainty around the funding of government infrastructure projects or the future direction of energy prices.

Our strategic product categories of bulk, medical and specialty gasses, carbon dioxide and safety products make up about 40% of our revenue. They continue to outperform and drive growth as many of these product categories benefit from new application development and regulatory acceleration present significant cross-selling opportunities or are focused on non-cyclical customer segments like medical, life sciences, environmental and food and beverage.

Total strategic products posted 11% organic growth for the quarter in line with the 11% compound annual growth rate over the last three years. Bulk Gas same-store sales were up 16% for the quarter as we continue to capitalize on enhanced production capabilities and on a strong sales force.

For us bulk represents a great cross-sell opportunity, because prior to the Linde bulk acquisition we were primarily a cylinder gas company with limited bulk capabilities. Now with the eight plants we acquired in that deal and two new ASU's that we are currently building, we have a competitive bulk offering and a large base of customers who have historically purchased their bulk gasses elsewhere.

Our ability to engineer solutions to customer needs has also been effective in winning new bulk accounts. Specialty gas sales grew 12% for the quarter driven by demand from key customers in biotech, life sciences, research and environmental monitoring.

Specialty gas is an area where Airgas innovation has made a significant impact on the supply chain as we have implemented production automation that improves quality and consistency while simultaneously reducing lead times and expense. We are therefore in a good position to capitalize on emerging growth trends such as tightening environmental regulations that require increase consumption of protocol gasses for emissions monitoring.

Our growth is further propelled by our ability to engineer solutions for specialty gas applications. Medical sales posted 10% growth for the quarter. Our Hospital and Doctor Dental segments continue to grow at a consistent rate as an aging population drives increased demand for respiratory therapy. This is also a business where broad infrastructure and competitive offerings such as our walkabout oxygen cylinders give us a distinct advantage.

Safety products, which represent the greatest cross-sell opportunity of our strategic products were up 10% for the quarter. Almost all of our cylinder and bulk gas customers use safety products and we have a long way to go until they are all buying their safety products from Airgas.

Finishing out our strategic products category; CO2 and Dry Ice were up 7% on a consistent trend in food and beverage. Our strategic account business grew 17% for the quarter. Our national infrastructure technical expertise and broad product offering create real value for customers with multiple locations. And we have enjoyed recent success with contractors who work multiple job sites.

We are also seeing increased opportunities for our outlook supply chain management program, most recently in the Healthcare segment as customers with high volume needs for cylinder gas supply turn to us as onsite experts in managing their needs.

Finally customers facing tougher times tend to renew their interest in supply chain savings and we're seeing this in our customer base right now and our strategic accounts team is responding.

Our Radnor private label product line grew more than 30% this quarter. In addition to building brand loyalty with our customer base Radnor products enhance our profitability because they carry higher gross margins than comparable OEM products. Existing product lines continue to make strong contributions as do product line expansions and the addition of the Radnor brand in acquired stores.

This quarter we created a new business unit called Airgas Refrigerants. Coming on the heels of our August 1st acquisition of Refron. As a leading national distributor of refrigerants and provider of technical services and reclamation Refron generated $93 million in revenues in 2007 and significantly enhances our National Refrigerants distribution footprint.

A major element of our refrigerant strategy is to be a leader in reclamation as production of various refrigerants will be phased out over the coming years and the need for reclamation services will grow. We believe this combination will prove to be a powerful growth engine as the refrigerant business continues to develop.

Combined with our legacy business the Refron acquisition brings our refrigerant business to about $150 million in annual sales and we are expecting, a long-term double-digit growth rate. Airgas Specialty Products where our refrigerant business was managed prior to the Refron acquisition is now focused solely on ammonia and processed chemicals.

We continue to gain new customers in the ammonia business as power and other large plants come online requiring ammonia for DeNOX applications. While we focus on our many growth initiatives to build sales and gross profit we're pleased to announce that we have achieved our goal of $10 million in run rate savings from operating efficiencies this year.

UT cylinder test savings are the largest component of savings to-date, while distribution logistic initiatives are starting to take hold and produce meaningful results. Freight programs, fuel management and fill plant efficiencies are also making a difference.

Another step in our pursuit of operational excellence relates to our enterprise systems. As we mentioned in the first quarter teleconference we are moving forward with the multi-year phased implementation of the SAP system across our enterprise. We are nearing a decision on selecting a systems integration partner. After which we expect to spend the next year focused on design and testing followed by three to four years of phased implementation.

Recently investors have displayed significant concern about the credit crunch and the state of the economy. As evidenced by the severe contraction in the equities market. We continue to have good access to capital to fund our growth strategies. On you revolver matures in 2011 and we have no bond maturities until 2014.

Acquisition activity has been strong in the first half of our fiscal year and we have an active pipeline. We have made six acquisitions year-to-date with aggregate annual sales of $142 million. Our annual goal for the next few years is to acquire up to $150 million in annual revenues, so we are ahead of schedule right now with about half of the year left. We hope to announce new transactions this quarter.

The integration of Linde Package Gas business is near completion. There is still some infrastructure work in progress and migration of business to appropriate channels. But the heavy lifting is behind us and we look forward to realizing the value of this acquisition for years to come. As we have mentioned before we continue to evaluate international opportunities, although our primary focus on domestic core and product line acquisitions remains throughout fiscal 2009.

Bob will further discuss our capital structure and access to funds shortly, but I'd like to finish my discussion with an assessment of some defensive characteristics of our business. We have performed the systematic analysis of our various business exposures in the event of a downturn and we are prepared to pull levers in our business if necessary.

We will discuss those levers as well as several advantages that we did not have during the downturn of early 2000. First during that downturn, which started really in '98 I guess, our annual same-store sales growth was never worse than negative 2%. And that result was driven by hard goods and it included Rutland, the tool business that we no longer have, which really plunged.

We never had a negative year for gas and rent same-store sales during that period or at any time in the history of Airgas for that matter. Furthermore, at that time gas and rent was only 50% of our sales, today it's more than 60%. Part of the resiliency in gas and rent comes from a very stable rent stream and rent is close to being pure cash flow.

That bodes well for our margins as gas and rent margins are more favorable than hard goods and we therefore enjoy a natural and defensive margin expansion when gas and rent outperform hard goods. And in fact we managed to increase gross margin in every year during the last downturn.

Keep in mind that overcapacity and the US and the high US dollar were also significant factors in the last industrial downturn. Manufacturing businesses were fleeing the US in droves at a time when industrial gas producers had significantly overbilled capacity. Today's environment is different in both regards as the dollar is no longer an overvalued currency and capacity utilization in the industrial gasses market is much higher than before.

Second, we have multiple levers to pull in the event of a downturn. Much of our compensation expense is variable. If our shareholders don't get paid, we don't get paid. This includes overtime, temporary help, commissions, gain sharing and annual bonuses. We can quickly curtail travel and discretionary expenses as well.

Our operating efficiency programs and their associated run rate savings as well as our acquisition synergies are independent of the overall economy and we expect to realize those benefits both in the near and long-term.

Another lever we have is the counter cyclical nature of our cash flow. In general we consider our maintenance CapEx to be about 3% of sales. Therefore in slow times we can dial back our capital spending. As a distributor we also reduce our investment in working capital as sales decelerate. However our stable rent revenue stream enhances the cash quality of our sales. Rent is dependent on the installed base of containers at customer locations which doesn't change much as gas or hard goods volumes.

Finally as I mentioned we believe that the infrastructure work we began in the late 90s has us well positioned in today's economy. Our regional company platform and hard good supply chain infrastructure are in place. Gas and rent now account for over 60% of sales. Bulk gas capabilities have grown significantly and we are now engineering the right solutions to respond to customer needs.

We have made vast improvements to our specialty gas supply chain. Our operating efficiency programs are yielding real run rate savings and our balance sheet leverage is about half what it was in the year 2000. I honestly believe that we are a better company today than we have ever been. I'm confident that we're well positioned to execute on our growth strategies and create value for our shareholders in the coming quarters.

Bob will now give you the financial review.

Bob McLaughlin

Thanks Peter. Good morning everyone. We continue to execute well across the board and we delivered strong results for our second quarter. To review our results we will start on slide number 4, as I go through these results please note that we have GAAP reconciliations for various metrics on slides 8 through 11.

Second quarter earnings per diluted share grew 43% to $0.86 compared to $0.60 in the prior year. The prior year quarter included $0.04 per diluted share of integration expense primarily associated with the June, 2007, acquisition of Linde US Package Gas business and a one time non-cash charge of $0.03 per diluted share related to the conversion of National Welder Supply Company from a joint venture to a wholly owned subsidiary.

Adjusting for these charges year-over-year earnings per diluted share grew at a very strong rate of 28% for both the quarter and year-to-date. Sales increased 15% to $1.2 billion reflecting strong performance in our strategic product categories with acquisitions contributing 7% of that growth. Same-store sales increased 8% with gas and rent growing at 12% and hard goods at 4%.

Overall price contributed two-thirds and volume accounted for one-third of our same-store sales growth. Gas and rent represented 61% of our sales mix an increase of 200 basis points over the prior year. Gross margin improved 20 basis points from last year to 52% and also improved 20 basis points on a sequential basis.

Strong expansion of 90 basis points in our distribution segment was partially offset by lower gross margins in our All Other Operations segment due to a sales mix shift to refrigerant and ammonia products, which carry lower gross margins.

Excluding depreciation and amortization operating expense as a percent of sales was 34.8%, an improvement of 70 basis points over the prior year driven by operating efficiencies, acquisition synergies and reduced acquisition integration expenses.

Operating income for the quarter was $145 million up 26% over last year. Operating margin was 12.5%, a 100 basis point increase over the prior year, reflecting strong organic sales growth, gross margin expansion and operating expense leverage.

There were 84.7 million weighted average shares outstanding for the quarter, up about one half percent from last year and down about one half percent sequentially. Since our reinstatement of our share purchase program in March we have purchased approximately 2.1 million shares at an average price slightly below $53. We currently have $25 million of authorized spend available in our buyback program and the Board of Directors will consider authorizing a new repurchase program at our November meeting.

Our return on capital was 13.6%, up 40 basis points over the prior year and 30 basis points sequentially. Free cash flow was $112 million compared to $92 million last year driven by strong growth in operating cash flow, partially offset by elevated capital spending concentrated largely on plant construction projects and post acquisition facility consolidations.

Adjusted debt at the end of the quarter was a little over $2.1 billion, reflecting acquisition activity, share repurchases and strong cash flow. Our current fixed to float ratio is approximately 50:50. Our adjusted debt to EBITDA ratio is below three, comfortably in our target range of 2.5 to 3.5. As of the end of September approximately 300 million was available under our long-term credit facility. And we have not experienced nor do we anticipate any funding issues at this point. The credit agreement matures in July, 2011.

We also have 360 million of funding through our AR securitization program. Three of our largest banking relationship lenders participate in this program through highly-rated special purpose subsidiaries. Our primary working capital metrics held consistent with recent trends with DSO at 48 days and inventory turns at 4.5. At the moment, we have not seen any significant deterioration in our DSO or bad debt expense, but we continue to monitor these metrics very closely.

Please turn to slide 5 and we will look at our segment results. Distribution sales were up 13% to 942 million for the quarter with same store sales growth at 7%. Distribution gas and rent same store sales were up 10% and hard goods up 4% with price accounting for the majority of the increase in both categories.

Gas and rent represented approximately 55% of our distribution sales mix, up 110 basis points from the prior year. Distribution gross margin was 51%, an increase of 90 basis points over the prior year reflecting a favorable sales mix shift to gas and strong execution of our August gas and rent increases as well as effective management of our cost.

Operating income in the distribution segment was 118 million, up 29% over the prior year reflecting strong leverage on our sales growth. The related operating margin improved 150 basis points to 12.5% driven by strong organic sales growth, gross margin expansion and realization of the operating efficiencies that Peter outlined in his comments. The prior year also included incremental acquisition integration expense that accounted for 50 basis points of the margin expansion in the quarter. Sales for all other operations increased 32% with same store sales up 20% due primarily to continued strong growth in refrigerant and ammonia sales, as well as dry ice.

Operating income was up 14% for the quarter. Operating margins decreased by 150 basis points due to mix shift towards refrigerants including the impact of the Refron acquisition and margin pressure on ammonia prior to full realization of the pricing actions taken during the quarter. Sequentially, operating margins are up 70 basis points resulting from cost recovery in ammonia and atmospheric gas pricing actions with AMG.

Please turn to slide 6, capital expenditures. Year-to-date capital expenditures were 185 million versus 129 million last year. The vast majority of this increase is in the category of construction in progress driven by major projects such as the construction of the two air separation plants, CO2 plants and cylinder fill plants. Excluding this category, year-to-date, capital expenditures are up 8% over the prior year, well in line with sales growth.

We are encouraged by the progress that we are making two air separation plants. Both are on schedule and are ahead of original loading estimates. The new Carlisle, Indiana plant should be operational in January and the Carrollton, Kentucky plant is scheduled to be on some stream in April. We're often making good progress on our CO2 plants and cylinder fill plant consolidation. As such, we expect elevated capital spending related to major infrastructure projects to moderate in a few quarters and we look forward to enjoying the benefits of the projects as they come online.

Please turn to slide 7 to discuss our free cash flow. This is a slide we have shown before and I believe is worth revisiting. The dotted line represents our distribution same store sales trend measured on the right axis. While the shaded area between operating cash flow and the CapEx lines represents our free cash flow measured on the left axis. We can use free cash to invest in acquisitions or growth CapEx, pay down debt, pay dividends or repurchase shares.

One of the interesting observations of this graph is that during moderating or slower growth period, we can dial back road CapEx and working capital, thus generating incremental free cash. As you can see from the trailing 12 month numbers as of September and March, 2008, we have significantly grown our free cash flow at same store sales rates have moderated from the high rates of fiscal 05 and 06 and into the first part of fiscal 07.

A similar expansion of free cash flow was realized in fiscal 02 and 03 when sales growth rates had moderated as well. Also during this period on the graph operating cash flow has grown from approximately a $130 million in fiscal 2001 to $550 million for the 12 months ended September, 2008. This represents a 21% compounded annual growth rate, consistent with strong sales growth over this extended period.

Now to review our guidance. For the third quarter we expect to earn between $0.82 and $0.84 representing a 22% to 25% increase over the prior year. The third quarter has two fewer sales days than the second quarter and we will also have some interest head wind. We are reiterating our full year guidance expecting $3.30 to $3.40 per diluted share. Our guidance uses the forward LIBOR curve yield for variable interest rate debt and the range provides for some moderation of same store sales growth in light of current economic conditions.

And now I'll turn it back to Jay to begin the Q&A portion of the call.

Jay Worley

That concludes our prepared remarks. As we begin the Q&A portion of our call, we ask that you limit yourself to two questions and one follow-up and then get back in the queue if you have further inquiries. Jill will now give instructions for asking questions.

Question-and-Answer Session

Operator

Today's question and answer session will be conducted electronically. [Operator Instructions] And we will take our first question from David at Deutsche Bank.

David Begleiter - Deutsche Bank Securities

Good morning. Peter, just on distribution volume, which you said was flat in the quarter, are you expecting that volume to be down in the back half of the year?

Peter McCausland

Well, it's hard to say, because we have seen no impact on our sales from everything that's going on on Wall Street. But I mean, it could, it could happen and we think, and Bob could fill you in on what impact it might have on our EPS and how it impacts our range.

Bob McLaughlin

Really over the last year and a half there has been some moderation in pockets of our business that we have seen. And, certainly price has helped, but the lower-end of our guidance does build into it, you know, approximately three plus percent of moderation with respect to the current trends, volume trends that we're seeing in the business.

David Begleiter - Deutsche Bank Securities

Would that take that volume to negative in the back half of the year?

Bob McLaughlin

It could in certain categories.

David Begleiter - Deutsche Bank Securities

And just remind us, in distribution gas and rent, how much is gas, how much is rent?

Peter McCausland

Rent represents approximately 12% to 15% of the revenue.

David Begleiter - Deutsche Bank Securities

Thank you very much.

Operator

And our second question today is from Mike Harrison with First Analysis.

Mike Harrison - First Analysis

Hi, good morning.

Peter McCausland

Morning.

Mike Harrison - First Analysis

Pete, I was wondering if you could walk through some of the components that were driving the 20% same store sales growth in all other. Obviously there were, there were some components more in the 10% range and some had to be in the 30% range. What was growing faster than that average and what was lower.

Peter McCausland

Well, ammonia and refrigerants were the two big drivers. And part of that was driven by price and part of it was driven by volume. They tend to be more volatile businesses than our core distribution business. And dry ice was also up and that was driven by just general business growth, but also the hurricane accounted for like a couple million, a million and a half dollar of sales or so of additional sales. But we get hurricanes every year now it seems, so I guess it's somewhat unusual, but that was part of it.

Mike Harrison - First Analysis

And obviously you have some tougher prior year comps coming up in the second half looking at the all other business, what kind of growth rates do you think are sustainable in the second half and as you look longer term for that segment?

Peter McCausland

The outlook is actually pretty good for the all other. And, you know, it's mostly you're selling to counter cyclical businesses, electric utilities and refrigerants is all counter cyclical, and dry ice is to a large extent, food and beverages companies -- non-cyclical, not counter cyclical, excuse me. And I know the outlook for our refrigerants business is good the next quarter, because I just went through a business review there and I feel the same way about ammonia. In fact, ammonia, some of the inputs the pricing is coming down and so where we were pinched going up we might get a benefit on the way down. So we expect these growth rates to moderate a little bit, because to some extent they reflect catch up in pricing, but we, but overall we think they're going to be pretty strong.

Mike Harrison - First Analysis

All right, and then in terms of the refrigerants business, where are you in the process of ruling that business out across the country, are you at this point be able to offer those services anywhere nationwide or maybe what portion of your branches currently offer those reclamation services.

Peter McCausland

We're in the infancy of that program to tell you the truth. We bought a couple of companies both of which were very good companies. The latest being Refron. The integration though, we're taking a go-slow approach in making sure that we get it right. And not only the integration of Refimax and Refron into a unified refrigerants capability, but also the integration of the refrigerants business into our branches across the country. We have had some limited rollouts with the OEM programs, but it's only just starting.

Mike Harrison - First Analysis

All right. Thanks very much, Peter.

Peter McCausland

Sure.

Operator

The next question comes from Bob court with Goldman Sachs.

Amy Zhang - Goldman Sachs

Good morning. This is Amy Zhang sitting for Bob. Peter, I have two questions. First, can you just give us a quick update on your price initiative rollout this summer, because last quarter, I mean, the first quarter looks like you're a little bit beyond your cost curve, any progress in second quarter? And also facing a weakening economic environment and falling energy price, how spiky would you think of pricing power could be?

Peter McCausland

Well, our price increase was very successful, because we did a good job explaining it to our customers and actually going out and making it happen. And we had real cost driving our need, cost increases driving the need. Of course when, when major inputs are going in the other direction you're not going to have as much pricing power in the market. But, the cost of the gas is a small part of our total revenue.

And so to the extent that we're faced with other cost pressers in our business we're confident that we can increase our prices and, you know, when customers aren't doing well you try to, you do try to refrain and we're doing a hell of a lot to cut our own costs through our efficiency programs and we're telling our customers about those programs and what we're doing and that's being well received.

So, it's hard to make any prediction about how much, how well we would do in future price increases, but I would just urge you to go back and look at the last recession if you believe we're going to have a big recession here, go look at the last one and look at our gross margin performance.

Amy Zhang - Goldman Sachs

Sure. And then the second question, I understand there have been a lot of structural changes pretty encouraging trend for Airgas since last recession and I do believe this cycle Airgas has a much stronger position in this market than the last recession. But we want to prepare for the worst and hope for the best, then what would you say, really having a deeper recession, what would be the hard landing scenarios for your same store sales growth and EPS growth?

Peter McCausland

Well, you know, I don't know. I mean, there's a whole number of hard landing scenarios. We have been looking at a few of them. I'm not going to make a prediction. We have been talking to the people in the field, they feel good about the rest of this year anyway and that's why we reaffirmed our guidance. Although, you know, there's been pockets of weakness, some of which have gotten worse recently. All set by pockets of strength. But we have got a lot of levers to pull. And I'm not going to speculate on how bad the economy's going to be.

And I am not as you can tell from my stump speech, I am not a pessimist that a lot of people are and I feel that we're going to need the food and we're going to need the electric power and we're going to need a lot of the things that our customers produce and research will go on, health care will go on, and, you know, we're fortunate, we don't get the huge run-up in sales that most industries get, but we're a good steady business and we have a platform that allows us to grow faster than the market overall and we're just going to continue to execute our strategy and we will pull whatever levers we have to make sure that we're responsive to any economic environment.

Amy Zhang - Goldman Sachs

Okay, thank you very much.

Peter McCausland

Sure.

Operator

And our next question comes from Kevin McCarthy with Banc Of America Securities.

Kevin McCarthy - Banc Of America Securities

Yes, good morning.

Peter McCausland

Good morning.

Kevin McCarthy - Banc Of America Securities

Peter, outside of the industrial gasses arena a lot of companies have talked about a precipitous decline in demand. I think mostly in Asia. But what are you seeing domestically here in your October order book and what level of same store sales would be implicit in your guidance of 82 to 84 and recognizing the differential in the day count that you mentioned.

Peter McCausland

Well, the sales are about the same. We have seen no falloff of sales. We saw a pickup in August and we're sort of at that August level. That's typical in our business. And in fact our order book looks pretty good, it looks even a little better than our sales right now. And we're, but we're a daily sales business. So, you know, we don't have the visibility of, you know, an architect for instance that gets three year project or someone who's building unlike a TNT company or somebody. But I think Bob is, we're talking about mid-single digits in our…

Bob McLaughlin

Yeah, there's a slight moderation, you know, relative to the numbers that we just posted that are incorporated not only in the full year, but in the second quarter as well. And I mean third quarter excuse me, and the third quarter also in addition to the two days there is a sequential decline in the dry ice and refrigerants business as well as ammonia. Not on a year-over-year basis in Q3, but certainly sequentially from Q2 and that's reflected as well.

Bob McLaughlin

And they're seasonal changes.

Peter McCausland

Yeah. Sure. In terms of what we're seeing out there, you know, God knows, we have been bugging our people quite a bit lately and there are pockets of strength in manufacturing and even though there's a sort of a general malice and weakening of the overall manufacturing environment. And then there's other segments, and I identified them in my little talk which are pretty strong. And nonresidential construction, I know I've read all this stuff about that falling off, but there's a lot of new projects are starting up in the next few months and our regional companies are ready to serve those projects.

So that's a secular trend that certainly will be impacted by this cyclical trend. But I don't think it's going to wipe out the secular trend or the need for infrastructure. Bridges are still going to be, need to be repaired, power plants, we are going to need to build them to meet the power requirements of the country, people, you know, so I think the construction business, the outlook for us at least in construction is pretty good.

Kevin McCarthy - Banc Of America Securities

Great. Then on the subject of uses of free cash flow, you've obviously accelerated your share repurchase activity in the September quarter. As I think about Airgas broadly, you obviously have a long history of acquisition activity, given the volatility in the capital markets, you know, I think it's fair to say that public market values are probably a lot more dislocated than private market values at this point. So should we expect, you know, an ongoing meaningful change let's say over the next year or two in the way that Airgas is going to be deploying cash flow?

Peter McCausland

We're not planning on it and, you know, our board had a special meeting and looked at share repurchase and the dividend, decided to raise the dividend. We have 26 million left to spend on our existing authorization and we will take a look at that. The board will look again at share repurchases at the November meeting, you know, we wish we bought those shares at lower prices, but when I look back at the history of Airgas, there were a number of times we bought shares and our purchases were underwater temporarily. But if you go back and look at them they were all great buys.

We have taken care of the creep that or like two years we are the creep with those purchases. But I think, I think that the board wanted to didn't go forward with another share repurchase agreement because of what was going on in the credit markets and all the fear and panic that is being spread around by a lot of people including the media. And, we'll look at it again, hopefully the dust will settle. The credit markets are improving as we speak, we have seen good improvement in the last week.

And in our analysis that we gave to the board for this special meeting and we will give it again, we compare buying back shares to core acquisitions and adjacencies and foreign acquisitions and green field projects. We look at it all. And even at these low, low prices for Airgas core acquisitions still are the way to go. We're here for the long term. We know our INTIN sick value is a lot higher than our share price right now. This has happened before. Our people have seen it before. They know in their hearts that it's not right, but it is what it is and we're moving forward with our long-term plan. So basically our view of how to deploy free cash flow is unchanged, although we're keeping a close eye on the credit markets.

Kevin McCarthy - Banc Of America Securities

Fair enough. Thank you very much.

Peter McCausland

Sure.

Operator

And the next question comes from Mike Sison with KeyBanc.

Mike Sison - KeyBanc

Hey, guys, congratulations on a great quarter.

Peter McCausland

Thanks, Mike.

Mike Sison - KeyBanc

Peter, in terms of the last downturn, can you just give us a feel for how big your strategic platforms were relative to the 40% now?

Peter McCausland

I think they're about half the size. And our infrastructure was pretty weak. And pretty dilutive. Just getting started and so there was a big, big difference in Airgas between the two.

Bob McLaughlin

The other way I like to look at it too Mike is our strategic products now are larger than the total sales were back at that time.

Michael Harrison - First Analysis Corporation

Right. And then in terms of a slow down as some have suggested, would the strategic platforms, they should be able to continue to grow at a pretty good level, right?

Peter McCausland

Well, we think so, because, you know, they, they grow faster than the core business for a lot of different reasons. Many non-cyclical and counter cyclical businesses buy those products. They represent cross-sells to a lot of Airgas regions and companies and geographies, and to Airgas overall. And many of them grow faster than the overall economy like bulk gases is probably a two times GDP number, spec gases is one and a half times GDP.

And some of these products they're both cross sells for us and they grow faster than the economy. So some of them even go to the non-cyclical and counter cyclical companies. Yeah, we think we can, we have grown them pretty quickly over the years and I think double digits ever since we instituted the program. And certainly 11% we have measured over the last three years, 11% this quarter. So we feel pretty good about it and that's about it and that’s it.

Michael Harrison - First Analysis Corporation

Great. Then the last question, in terms of acquisitions, clearly there's going to be some high quality businesses that may struggle during this time period. I mean, is this an opportunity to take advantage of those type of acquisitions and what do you think makes the most sense, is it to look for areas where you're not as big and sort of get in now or maybe for the identify areas where you are big to sort of continue to increase your density in certain geographic regions.

Peter McCausland

Will with, first of all there aren't many high quality businesses in our industry that are struggling right now. And in fact, there are not many high quality businesses in our industry that ever struggle.

Michael Harrison - First Analysis Corporation

Right

Peter McCausland

So and I would caution you to assume that we can buy these companies really cheaply, because the prices for industrial, good industrial gas distribution companies are pretty inelastic, they're not like general run-of-the-mill manufacturing companies where you may get 500 basis point spread on the multiples. We're talking about one and a half range of one and a half on the EBITDA multiple for purchase price.

It doesn't matter whether it's a fill in or an anchor acquisition for us. But we're out working hard trying to drum up prospects. In fact I leave on Monday morning with Les Graff, our Vice President of Corporate Development and we're going to see six companies and maybe some of them will sell to us. And we have got plenty of liquidity to buy these companies and, and we will be after them

Michael Harrison - First Analysis Corporation

Great, thank you

Peter McCausland

Sure. Thank you

Operator

And the next question comes from Lawrence Alexander with Jefferies and Company.

Lucy Watson - Jefferies & Company

Hi, this is Lucy Watson sitting for Lawrence.

Peter McCausland

Hi.

Lucy Watson - Jefferies & Company

Just wondering if you could quantify the magnitude of the boost you might see from the post-hurricane construction?

Peter McCausland

It's really hard to say. If there was a lot more damage down there than a lot of people think and a lot of bent metal and things that need to be replaced and not nearly as bad as Katrina, but we had a big pickup, in that Gulf region after Katrina. So I'd be speculating, but, what do you think Bob.

Bob McLaughlin

It's difficult to put a specific number on that. It will clearly be beneficial and we will see an increased activity both in gas and on hard goods, but we don't have a tangible number to share with you.

Peter McCausland

The best, the best prospect for post hurricane same-store sales is to contractors that are repairing the oil rigs that were hit hard and that's all metal fab business and we're very well positioned to take advantage of it. So, I don't know, that region will do well for us for awhile, but it's only a small region in the country.

Lucy Watson - Jefferies & Company

Okay. And of the two-thirds price and same-store sales growth this quarter, I guess how much would you expect comparably in the second half of 09, from price.

Peter McCausland

It's been fairly consistent for year-to-date and for the quarter was two thirds overall for Airgas two- thirds and, and one- third volume. As best as we can tell it will be somewhat in that area, maybe slightly more towards price in the back half.

Lucy Watson - Jefferies & Company

Okay, thank you.

Peter McCausland

Thank you

Operator

And the next question is from David Manthey with Robert Baird

David Manthey - Robert W. Baird

Hi guys, thanks.

Peter McCausland

Hi Dave.

David Manthey - Robert W. Baird

Hey, could we talk about this, the air securitisation, just if you could remind us, is this one of these 364 day facilities.

Peter McCausland

It's a facility matures in March of 2010.

David Manthey - Robert W. Baird

Oh, okay. So it is longer term. All right. And could you tell us how much you have out on that as of September 30th?

Peter McCausland

360 million.

David Manthey - Robert W. Baird

Okay. And what kind of head room do you have under your revolver right now?

Peter McCausland

300 million.

David Manthey - Robert W. Baird

Okay. Fair enough, thanks guys.

Peter McCausland

Yeah.

Operator

And the next question comes from Mark Gulley with Soleil Securities

Mark Gulley - Soleil Securities

Good morning Peter. I actually enjoyed your [stump] speech. I thought a lot of your comments were right on.

Peter McCausland

Thank you.

Mark Gulley - Soleil Securities

The one thing though you didn't talk about though was the strong dollar. I mean you talked about a lot of things that your are doing, you are doing it right. But you have no control over currency. I mean to the extent that [cat, deer] are poster children for your metal fab base and to the extent they're not doing so well now. Can you talk a bit about how a strengthening dollar from here, might be able to put some head winds in front of you.

Peter McCausland

Well, no question that that could be the case. And because of the panic that's going on right now people are flying to the dollar. I think that will come back down a little bit. And I think a slight strengthening from the dollar's lows is not a bad thing. And, but it is what it is. I do think that the strengthening might be a little overblown right now, but that could hurt, but I don't think oil is going back to $30 a barrel. It might go to $70 a barrel and or it's at $60 or something now or $60, $70 and distribution costs are major factor in international trade that have been discounted back before in the 98 to 2002 period, not only did we have a ridiculously high dollar, oil got down to $12 a barrel. And it was really cheap and so I think that was really negative. It might be a slight headwind, strong dollar now, but I don't think it's going to hurt that much.

Mark Gulley - Soleil Securities

Bob, can you tell us approximately the sales number that will come out of each of those new ASU's when they start up on the schedule you gave us earlier.

Bob McLaughlin

Well, they're going to be at, kind of the first 12 months, somewhere in the $6 million to $8 million neighborhood.

Mark Gulley - Soleil Securities

That’s $6 million to $8 million each?

Bob McLaughlin

Yes.

Mark Gulley - Soleil Securities

Okay. So is that incremental sales that you get because you have those plants that you would not have gotten otherwise.

Bob McLaughlin

It will be a combination, there will be low shifting relative to that, but there will be a significant amount of new signings.

Mark Gulley - Soleil Securities

Then my final question is this. Obviously your ammonia prices have skyrocketed. So how much of that same-store growth in other operations is simply the pass through of rising ammonia prices and of course if ammonia goes back down again, I would imagine over time you will be passing on those lower ammonia costs to your customers.

Bob McLaughlin

Overall in the all other segments the 20% was evenly spread between price and volume.

Mark Gulley - Soleil Securities

Was all that price just passed through ammonia?

Bob McLaughlin

No, it was all businesses.

Mark Gulley - Soleil Securities

Okay. Thank you.

Operator

And the next question is from John Roberts with Buckingham Research

John Roberts - Buckingham Research Group

Morning guys. Can you hear we

Peter McCausland

Yes.

Bob McLaughlin

Yes.

John Roberts - Buckingham Research Group

First a quick comment Peter, I think you might want to talk about your strategic businesses going GDP plus a couple of percent rather than one and a half or two times GDP. Just in case GDP doesn’t zero?

And then secondly there are a fair amount of depressed areas in the country, whether Detroit or the Ohio area because of automotive or maybe the Miami area because of construction activity. Can you pick one of the weak areas of the country where you have got a meaningful presence and talk about how your business is doing in that weak area?

Peter McCausland

Yeah, I'd start with the auto belt around Detroit. Our company Great Lakes Airgas is knocking the cover off the ball. They have seen some weakness and of course the auto companies in the second tier suppliers are really, really down. So, auto is a big user of our products and for it to be so far down and us to be doing so well is, I think probably a good sign. But there are a lot of other industries in that auto belt right now and they are capitalizing on them. We have a very diversified product offering and a diversified customer base. They're doing really well. So that’s a - I guess you call that a total disconnect. Regarding the auto industry, there's like five or six brand new plants being constructed in the US now, more in the southern part of the country by foreign automakers and so I think overall the auto business is going to be an upside for us when it turns around, because we're doing pretty well in those regions at this level.

You say construction is off in Florida. It is, but the kind of construction that we serve is really, really good in Florida. There's three major -- we just finished a major job down there, there's three major jobs that we’re going to start in Florida for our major construction customers. That are going to be very good for us and they're mostly power related.

And then what's another area where there's a business that's not doing well. California I would say; let me make a comment on California. And I'll try not to be political, but it's hard not to be when you talk about California. The California economy has been the most vibrant part of the US economy for years up until the last few years. That's kind of hurting, although northern California is doing very well. But in southern California we haven't performed as well as we would like and all of California with its regulation and bureaucracy is driving businesses out of the State of California. And it's a real shame.

But that said, there are a lot of construction products either started or starting in California, the Bay Bridge project isn't finished. As soon as that finishes they are going to start cutting up the old bridge. There's power plants and we're doing very well in northern California even though the California economy overall is pretty hurting. And I guess I would say that, I don't know what's going to happen in the future and I'm not an economist, but I would say that all the carnage in residential construction, retail, Wall Street and whatnot, really doesn't have a lot to do with yet. Now, I don't know what's going to happen, we're ready for anything though.

John Roberts - Buckingham Research Group

Thank you

Peter McCausland

Sure

Operator

And your next question comes from Steve Byrne with Merrill Lynch.

Steve Byrne - Merrill Lynch

Hi, it seems both presidential candidates are in favor of regulating greenhouse gases and given your size in CO2, would you see yourself in a position of putting in capital to capture CO2 or do you see yourself more as a partner for the distribution of CO2? How do you see that playing out for you longer term?

Peter McCausland

Well, I'm not sure there is a quick answer. We're probably more as a partner if it's a huge sequester operation project or something like that. And, but I don't see us building or owning infrastructure to sequester CO2 from big coal fire plants or anything like that. But he will we will certainly benefit from the construction of those pipelines and sequestration facilities and possibly use some of the off gas, liquefy some of the CO2 and use it in the merchant market.

Steve Byrne - Merrill Lynch

And given the credit challenges are probably more significant for your smaller competitors and they may be more concerned about a decline in IP, have you seen any increased, unsolicited limitations from some of your weaker competitors for you to come and take a look at them as potential acquisition candidate?

Peter McCausland

No.

Steve Byrne - Merrill Lynch

Is the pipeline strengthening just from your own due diligence, they're not coming to you, this is your efforts?

Peter McCausland

Usually, I mean people do try to time their purchase to their sales in this business. It's better to sell on the way up than at the bottom. But as I said, the prices are pretty inelastic in this business and so you don't get a big rush at the top and quite frankly, I think most of the people in our industry are pretty happy with their businesses and what's going on right now.

So most of the people we are considering, it's because it's time for them in their careers to sell or we have gone and beaten the bushes and gotten people interested in selling now and coming to work for us.

Steve Byrne - Merrill Lynch

Thank you.

Peter McCausland

Sure.

Operator

And due to time constraints our final question comes from Scott Blumenthal with Emerald Advisors.

Scott Blumenthal - Emerald Advisor

Good morning gentlemen. Congratulations on the quarter.

Peter McCausland

Thank you Scott.

Scott Blumenthal with Emerald Advisor

Peter in your remarks you talked about how different Airgas is compared to what it was like in the last economic downturn. And one of the things that you have done is you have become a little bit more of a manufacturer than you were just a pure distributor back then. Can you talk about maybe and specifically with regard to the new air separation capacity that you have coming on board. How much more of a fixed costs structure you have now to cover? And I guess specifically with the ASU's, how much of that do you have kind of booked with your anchor customers? And if there's any risk there in not being able to fill those up and kind of carrying those increased fixed costs into what we see as kind of a soft economy?

Bob McLaughlin

Sure. Well, first of all, the [loading fillers] plants are ahead of schedule, number one. Number two, we have great opportunities in bulk regardless of the economy because it represents a cross-sell for us as I explained in my remarks. Until we bought the Lindy acquisition we really didn't have serious bulk capabilities and this puts us in the game and we have hundreds of thousands of customers that buy a lot of products from us except bulk. And then the third thing I would say is that we buy 70% of the gases that we sell and only produce 30% of them. So to the extent that our gas business did turn down, which didn't happen the last recession, we could load-shift to our plants. So we think the risk of carrying high fixed costs investments in a downturn is pretty minimal for Airgas.

Scott Blumenthal with Emerald Advisor

Okay, that's really helpful thank you. By the way I did like your speech as well

Peter McCausland

Oh, thanks.

Scott Blumenthal with Emerald Advisor

And Bob, could you -- a couple years ago we -- prior to an investor conference in Arizona we had a quarter where we suffered a little bit from energy costs. Because there were shortages in certain parts of the country and we were moving products around and we kind of got hit by that. We have seen energy costs come down significantly and a lot of that has occurred in the past month or so. Can you talk about if any, how much of a tail wind you might get in operating your fleet, from the fact that we're now at $62 a barrel oil as opposed to up into the $120 and $130.

Bob McLaughlin

I think since that timeframe we have done a much better job as a company in terms of passing on vis-à-vis deliver fuel surcharge in all our business unit that get marked against published diesel fuel rates. So, we have been able to capture a significant amount of the increase that has taken place through the surcharges. Consequently on the downturn, we pass that back to our customers. So it's not net, it's not a hundred percent coverage. So there will be some tail wind with respect to the delivery aspect with decreasing fuel costs. But not a significant needle mover because we have got them so well linked, relative to our processes.

Scott Blumenthal with Emerald Advisor

How sticky is that on the way down would you expect do you get a quarter's benefit, half a quarter's benefit?

Bob McLaughlin

We set these every two weeks to one week.

Scott Blumenthal with Emerald Advisor

Okay. All right. And I guess the last one is, we haven't heard a lot about Argon Helium situations for awhile. Can you talk about those and maybe if there are any other kind of capacity or availability constraints in any other gases.

Peter McCausland

In Argon the there is Argon available in the market today because of two things. We have had high steel production up until recently and also we have had a decline in stainless steel and aluminum welding among fabricators. So there is some more Argon in the market. I wouldn't say the streets are running with Argon, but it can be had. Now, the problem with Argon is as fuel production comes down, and it is coming down it looks like. The oxygen that is produced in the steel -- for the steel making process is dialed back and when you produce less oxygen you get less Argon. So it looks like we might be in another Argon shortage situation in the near future. We think through our arrangements with our suppliers and our own production that we are very well positioned to supply our customers in that situation. So we're feeling good about the Argon market overall and have taken -- have gotten some nice business recently in Argon.

In the Helium market that too has eased. And we lost some customers because of allocation and because we had to raise the price. But we're starting to regain those customers and we have enough Helium to grow our business nicely. So I still think the long-term outlook for Helium is for pretty tight market. Some of these large streams that people are talking about aren't going to be on stream for a long time. And, but the crisis that we were in a year ago has certainly eased quite a bit.

Scott Blumenthal with Emerald Advisor

Great, thank you and thank you for taking my questions.

Peter McCausland

Sure.

Jay Worley

Well, this is Jay Worley and again we thank you all for joining us today. I will be available all afternoon for follow-up questions

Operator

We thank you for your participation on today's call and have a wonderful day

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Source: Airgas Inc. F2Q08 (Qtr End 09/30/08) Earnings Call Transcript
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