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Praxair, Inc. (NYSE:PX)

Q3 2008 Earnings Call

October 29, 2008 11:00 am ET

Executives

Jim Sawyer - Executive Vice President and Chief Financial Officer

Liz Hirsch - Director of Investor Relations

Analysts

Edward Yang - Oppenheimer

Donald Carson - Merrill Lynch

Robert Koort - Goldman Sachs

Laurence Alexander - Jefferies

James Sheehan - Deutsche Bank

Michael Sison - KeyBanc

Michael Harrison - First Analysis

Prashant Juvekar - Citi

Mark Gulley - Soleil Cap Company

Steve Schuman - Lafayette Research

Christian Massey - Banc of America Security

John Roberts - Buckingham

Richard Ong - Evo Capital

Amy Zhang - Goldman Sachs

Jeff Zekauskas - JP Morgan

Chris Shaw - UBS

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 Praxair Incorporated earnings conference call. My name is Chanel and I'll be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's call, Mr. Jim Sawyer, Executive Vice President and Chief Financial Officer. Please proceed, sir.

Jim Sawyer

Good morning. Thank you all for attending our third quarter earnings call and webcast. Matt White, Vice President and Controller and Liz Hirsch, Director of Investor Relations are with me this morning. I'd like to begin this call with a few overall comments, Liz will then review our third quarter results after that, I'll discuss our outlook and fourth quarter earnings guidance and take questions.

Before I begin, let me say that today's presentation materials are available on our website at www.praxair.com in the Investor Section. And please note that the forward-looking statement disclosure on page two applies to all statements made during this teleconference.

We had another great quarter. We delivered 20% sales growth and 18% earnings growth in an economic environment, which became increasingly challenging as we moved into September. Excluding a help from currency translation of 5% and natural gas pass-through of 3%, sales growth was 12%.

These results validate not only the strength of our business model but also the ability of our people around the world to respond quickly to changing business trends while flawlessly meeting the needs of our customers.

Our backlog of projects to come on stream over the next three years grew substantially, moving from 44 projects up to 47 last quarter. Most notably we announced a second world-scale 3,000 ton-per-day oxygen feed to a coal gas location project being built by Anhui Chemical Company in China, which will use the same gas produced as a feedstock for making chemicals.

This is our second coal gasification project in China. Our first was SOPO will come on stream at the end of 2009 and this new project is expected to start up in 2011. We also announced a very large contract to build two world-scale hydrogen plants, which will supply the expansion of the BP refinery in Whiting, Indiana.

We continue to stick to our financial discipline regarding project returns in order to deliver the highest return on capital in the industry well into the future. In addition, I want to assure you that we expect to meet our long-term organic growth expectations. We will surely see a headwind from currency over the next several quarters as well as a slowdown in base business volumes as a result of macroeconomic contraction.

We are already responding to this by cranking it up a notch and managing our cost structure appropriately. Now Liz will review our third quarter results.

Liz Hirsch

Thanks, Jim and good morning everyone.

Please turn to page three for a summary of our third quarter results. Sales in the third quarter grew 20% to $2.85 billion. Currency appreciation contributed 5% to this growth. Acquisitions of North American Packaged Gas distributors contributed 2%. Underlying organic growth was 10% from higher volumes and higher pricing in all our geographic regions.

Sales growth versus the prior year was very diversified by end market, coming from energy, chemicals, manufacturing and metal. In energy, sales were primarily driven by strong growth in volumes of hydrogen sold to North American refiners.

Across our other end markets, sales benefited from moderate volume growth and higher pricing. Overall manufacturing demand remained reasonably strong but we began to see sequential softening of demand in September in the U.S. and Europe. Industrial manufacturing was strong in South America and Asia.

Operating profits was a record $544 million, 18% above the third quarter of 2007. This increase is lower than the growth in sales due to the pass-through of higher natural gas prices in our sales. We purchased natural gases as a feedstock for making hydrogen and we pass along higher gas cost to our customers in hydrogen prices.

Operating profit was reduced by about $10 million this quarter, which is the estimated impact of the two U.S. Gulf Coast hurricanes in September. The impact was primarily from lost sales, mostly hydrogen pipeline sales, during a period of time that our plants and our customer's plants were shut down without power.

This amount also includes some costs for facility repairs in the aftermath of the storms, but these costs were not significant. Offsetting this impact was income that we recorded in the quarter from foreign currency hedge gain.

Our currency exposure is the effect of translating the sales and earnings of our non-U.S. businesses back to dollars for financial statement reporting purposes at changing foreign exchange rates. The effects on operating profit and net income from foreign exchange translation is about the same as the effect on sales. We have been hedging forward on a rolling basis the next two quarters of net income in foreign currency.

We are required to mark-to-market the value of these hedges every quarter, even when the contract relates to anticipated net income in future quarters. Consequently, we recognized $13 million of net hedge gains in the third quarter and we expect to recognize additional gains in the fourth quarter depending on exchange rates in the fourth quarter.

Net income grew 16% to 355 million. Net income grew at a slower pace than operating profit primarily due to two factors. First, higher interest expense resulting from higher debt levels to finance common stock repurchases and second, a higher effective tax rate of 28% as compared to 26% in 2007.

Earnings per share this quarter were $1.11 versus $0.94 in the prior year quarter. EPS grew 18% from the growth in net income and fewer shares outstanding. We generated cash flow from operations of 630 million in the quarter.

Capital expenditures were 405 million, supporting our growing project backlog. We invested 35 million in acquisitions, primarily three North American packaged gas distributors. We spent 537 million repurchasing common stock in the quarter, net of issuances. Return on capital and return on equity both increased to 15.5% and 26.9% due to strong net income growth.

Please turn to pages four and five for our North American result. Sales in North America rose to 1.56 billion, 19% above the prior year quarter. Sales growth was 14% excluding the pass-through of higher natural gas prices to hydrogen customers.

Sales from acquired packaged gas distributors contributed 4% to sales. Higher pricing and modestly higher volumes contributed to the underlying growth of 9%. Reported volume growth was 1% year-over-year, but this understates the real growth because of the impact of the Gulf Coast hurricanes. Volume growth would have been about 3% excluding that impact.

What we are seeing in most of our end-markets is moderating volume growth on a sequential basis concurrent with slowing industrial production. We are growing our own business faster than the economy because of new business and positive pricing trends.

Strong hydrogen volumes to refiners and gas sales to oil well service companies continue to drive growth in the U.S. and we expect this to continue to be strong. The Canadian economy has been soft for several quarters due to weak auto demand and a strong currency.

Our business in Mexico is growing nicely, up 22% this quarter. Mexico needs to significantly increase its oil and gas production, and we expect that the energy sector will continue to fuel that country's economic growth, as well as, growth in our business.

Looking at page five, on-site sales were 18% above the prior year, excluding natural gas pass-through. Hydrogen volumes to refiners were up 9% and would have been up an estimated 27% ex-hurricane impact. Demand for oxygen and nitrogen was also higher driven by demand from steel and manufacturing.

Merchant sales were up 12% driven by strong pricing. In the quarter we saw a steady demand for merchant products across most market sector, oil well services, metals, food, water treatment and general manufacturing.

Packaged gases sales in North America grew 13% largely from acquisitions and higher pricing. Same-store sales for PDI, our U.S. and Canadian business, were up 5% from last year. U.S. same-store sales were up 6% and Canada up 2%.

On the same-store sales basis, gases were up 8% and hard goods up 1% due to lower capital equipment purchases. Demand for specialty and rare gases is strong. Sales of safety products and welding accessories showed good growth.

The trends we are seeing reflect the economic slowdown in the automotive transportation and construction industry. PDI announced the price increase in September to recover higher power and distribution cost. This action plus ongoing productivity initiative and good cost control will give us earnings growth in spite of expected lower volume.

Operating profit in North America grew 12% to 274 million. The operating margin of 17.6% is similar to last quarter, but below a year ago due to higher natural gas prices and higher electric power cost contractually passed on to customers.

Please look at page 6 for our results in Europe. Sales were 384 million, 18% above 2007 with currency contributing 13% of this growth. Underlying growth was 7% from higher volumes and higher pricing including pass-through of higher power cost. Sales of on-site and merchant gases grew in Spain, Italy and Germany.

Packaged gases weakened in Spain reflecting the slowdown in construction markets. Overall growth in manufacturing market is slowing but we expect our business will continue to grow from new applications, pricing and from markets like food and healthcare which are less tied to the economic cycle.

Operating profit grew 23% to 96 million. OP included a $9 million gain from net income hedges applicable to anticipated net income in the next two quarters. Excluding this gain, the segment operating margin was 23% which includes some severance and other restructuring cost.

Page seven summarizes our results in South America. Sales in South America of 527 million were up 26% compared to prior year including a 12% boost from currency translation. Underlying growth was a strong 14%, consistent with the growth rate we have been seeing all year. On-site, merchant and packaged gases all show good volume growth driven increasingly by growing domestic demand.

Industrial production in Brazil remained strong at 5.7% for the quarter, down only a little from 6.3% in the first quarter of this year. The recent sharp depreciation of the Real does not reflect economic fundamentals in the country, but is more related to a flight-to-quality in the credit market which always hurts emerging markets' currency. We have not seen any slowdown in the business or are preparing for a slowdown in growth and are managing our cost structure accordingly.

Proposal activity is strong and our backlog of new projects is increasing. We also continue to see strong growth in our businesses outside of Brazil, including Peru, Chile, Argentina and Columbia. Operating profit grew 32% to 111 million, this included $4 million of net foreign exchange hedge gains related to next quarter.

Please look at page eight for our Asia result. Sales in Asia grew 26% to 239 million resulting from strong growth in volumes and pricing. Higher on-site volumes were driven by new project start-ups, and merchant volumes grew 10% in the quarter from growth in China, India and Korea. Pricing trends are strong particularly for specialty gases.

Sales growth came from, primarily from chemicals, electronics and manufacturing markets. Electronic sales were up, reflecting new projects in China and Korea and growing sales to photovoltaic customers. We are seeing a sequential slowdown in electronics due to reduced semiconductor and flat panel manufacturing.

Project activity continues to be strong in the region. We announced our fourth oxygen plant for Shaoguan Steel to supply their new expansion. We also announced the oxygen plant to supply Anhui Chemical's coal gasification project that Jim mentioned.

China is a leader in coal gasification technology due to the country's abundant supplies of coal and shortage of liquid fuel. Our 3,000 ton per day plant design integrates well with the prevalent gasification technology, and so we expect more of these opportunities.

Operating profit grew 27% to $38 million. The operating margin is below last quarter due to pricing pressure on products sold to the electronics industry. Additionally there was a slowdown in production in China post-Olympics which was not surprising.

Please turn to page nine for Surface Technology Surface Technology sales grew 10% and 3% ex-currency. Sales growth was driven by higher coatings for the energy sector, industrial gas turbines and oil well parts.

Overall sales growth was slower than what we have been experiencing due to lower aviation coatings for jet engines. This is due to the Boeing machinists' strike as well as to the push out of the new large plane deliveries resulting from production delays. We expect to see the volume coming to us as production resume. The lower volumes this quarter resulted in operating profit of $25 million, 4% above the prior year.

Page 10 shows our global end-market trends. We're showing you here our year-over-year sales growth in our major end-markets, excluding currency, acquisitions and natural gas price pass-through. So this represents organic growth.

We've included the results for this quarter next to the results we showed you last quarter for comparison purposes. What you can see is that in the third quarter, sales growth continued to be very strong. The energy segment reflects the impact on hydrogen sales from the hurricanes, but was still up strongly.

We do not expect that the current level of oil and gas prices will impact the strong growth outlook for this part of our business. Hydrogen sales relate to desulfurization of crude oil, not directly to oil prices.

Gas well fracking has continued to be strong for us and should remain so as long as natural gas prices are above the $5 to $6 level. We may see some near-term curtailment of activity due to tight credit markets which can impact capital spending for some of the smaller drillers. But most of our customers are the larger companies who thus far have indicated that they do not expect a major reduction in plants, drilling and fracking activity for 2009.

Where we probably will see a slowdown is in the development of North American gasification project whose economics rest on higher gas prices. Significant project cost inflation and tight financing conditions will also cause project delays, we believe. But we do not have any of these projects in our current backlog.

Electronics was up nicely this quarter on a year-over-year basis, but we are seeing a sequential slowdown in line with the forecasted drop in semiconductor chip productions in the fourth quarter and in 2009, as well as lower demand for flat panel displays. We expect to see growth from solar customers which is a small but rapidly growing part of the business.

Sales to the chemical sector were up 13%, with strong volumes from U.S. Gulf Coast customers prior to the hurricane due to export and help by a weak dollar and relatively low natural gas prices. In addition, strong demand in Germany and project starts in Asia contributed to the growth.

Sales to metals were up 14% in the third quarter year-over-year. The major U.S. fuel producers have since announced the number of production cut back in an attempt to work down service center inventories and avoid rapid price decline in the face of slowing demand. So we will see lower U.S. volumes in the fourth quarter, perhaps as much as 20%. This is similar to what we saw in the second and third quarters of 2005.

A 20% reduction in our volumes to the sector has about a $0.02 EPS impact per quarter, and this is built into our current expectation. Globally we are expecting some impact from this sector in South America and Asia but not to the same extent because these regions are global low-cost producers.

You can see that year-over-year growth in the manufacturing sector has slowed a bit. This is particularly true in the U.S. and Europe. It has remained reasonably strong in South America and Asia driven by infrastructure spending. We see the impact of this primarily in our packaged gas volume but also in the slower but still positive growth in merchant liquid.

Within global healthcare, we have steady growth in our hospital business and in homecare in Spain and Brazil. U.S. homecare partially offsets that growth due to reimbursement rate cuts.

Sales to aerospace were lower this quarter due to the lower coating volumes in PST that I just mentioned. The food and beverage segment continues to provide good, steady, and non-cyclical growth. And now I'd like to turn this call back to Jim who will discuss our outlook and our earnings guidance.

Jim Sawyer

As we just outlined, we had a great quarter. But the world has changed dramatically in the last month with the global banking and liquidity crisis. I want to re-emphasize that we do not have any direct impact from the credit crisis in terms of our own balance sheet, cash flow, or refinancing requirements. So I thought it would be helpful to briefly review our cash flow and debt structure which is summarized on page 11.

Our business strategy is to maximize the spread between our recurring capital and our cost of capital, lock the return in with our customer contracts, minimize risk exposure, and finance as cheaply as possible.

So our method of financing is largely A1/P1 rated U.S. commercial paper in 7 to 10 years of public debt issues. We're issuing commercial paper today at 2% to 2.5%, and our paper is backed by $1.8 billion of committed bank credit facilities.

The average interest rate on our long-term bonds is 5.2%. In addition we have some international debt which we use for tax and currency hedging benefits. We do no project or structured financing either on or off balance sheet.

For the full year of 2008, we're forecasting operating cash flow to be well over $2 billion or about 20% of sales. This is a high number, and as a result of a high return on capital which is 15.5% this quarter after tax.

We're forecasting CapEx to be about $1.5 billion or 14% of sales. This is the high-end of our historical range and is consistent with the large number of on-site projects in our backlog that will start up in 2009 to 2011. This leaves us about 6% of sales to pay dividends and repurchase stock.

We have aggressively purchased shares this year because the decline in the stock price has provided a good opportunity. During the third quarter, we purchased $537 million of stock. This will decrease the number of shares outstanding in the fourth quarter by about 3% and will be earnings accretive.

Now, please turn to page 12 for our earnings guidance. With the banking crisis now approaching 2 months, it appears that the damage has been done to global economy with credit essentially unavailable to small businesses and with businesses in all industries reducing inventories, cutting production, and holding off on new spending.

So we're now expecting a meaningful economic slowdown. I think the handwriting is on the wall even though we have not seen a significant slowdown in our business yet. So we're preparing for contraction in manufacturing output in the U.S. and Europe.

We're prepared for the U.S., Canada, and Europe to have up to 5% negative industrial production growth in the fourth quarter in 2009. In South America and Asia, we expect some slowdown in industrial production but growth should still be in the range of 5% to 8%.

So although we've not seen it yet we're going to stay ahead of the curve, plan for the worst, but hope for the best. Consequently, we plan to reduce our fixed costs in line with slowing volumes in order to protect our operating profit margin.

Due to the rapid decline of the Euro, Canadian dollar, and Brazilian real of about 30%, it appears the currency will become a headwind over the next several quarters. This headwind will be about 8% on a consolidated basis next quarter based on current exchange rates.

Keep in mind that currency headwinds and tailwinds of this magnitude rarely last for more than four quarters because they lap each other and currencies don’t devalue at these rates year after year.

It appears that due to the strengthening dollar, we will be getting back in 2009 the extraordinary tailwind we got from a weakening dollar over the past year. Therefore for the fourth quarter we’re expecting diluted earnings per share of $1.03 to $1.08. This represents 5% to 10% growth versus the prior year. This guidance assumes a negative currency translation impact of about 8% on sales, operating profit, and net income based on current market rates.

For the full year of 2008 we expect sales to be about 11 billion, 17% above 2007 which is in line with our prior guidance despite the negative currency impact which we now expect in the fourth quarter.

We’re expecting diluted earnings per share in the range of 421 to 426 excluding two items. First, the $.03 pension settlement charge we took in the first quarter and second any potential restructuring cost that we may take in the fourth quarter to accelerate our productivity gains.

Excluding these items our full year guidance represents 16 to 18% growth versus 2007. 2008 capital spending will be about 1.5 billion, increasing in 2009 up to 1.8 billion purely the function of our project backlog. Obviously we will carefully manage our maintenance and discretionary capital spending of about 300 million.

We’re confident that our base business model will continue to deliver organic growth and sales over the long cycle of 8% to 12% and earnings growth in the range of 12 to 16%. In the short-term due to slowing demand growth you should expect that organic growth will be at the low end of the range just as it has been at the high end of the range during the up cycle of the past couple years.

The negative currency impact of about 8% at current rates could therefore make sales growth flattish over the next couple of quarters and make earnings growth in the mid-single digits. Once the year-over-year exchange rate changes lap each other earnings growth will be higher.

Let me conclude by saying that no matter what 2009 brings us in terms of the global macro picture we expect to deliver growth in earnings and cash flow. Our revenue model allows us to be more stable and resilient than many of the markets we serve because of our contract structures. We’re not immune from reduction in our customer’s volume of production. However, we are not impacted by the cyclicality that they may face in their pricing and their margins.

We have a record backlog of large projects which will come on stream over the next three years and that are contractually locked in. We will stick to our financial discipline and continue to run the business for cash flow and we plan to react swiftly to the changing environment and accelerate our cost reduction and productivity initiatives as necessary.

And now I’d like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Edward Yang of Oppenheimer.

Edward Yang - Oppenheimer

Hi good morning Jim.

James Sawyer

Hey Ed.

Edward Yang - Oppenheimer

On the backlog are customers already trying to delay some projects and if they are trying to do so how long would you allow them to push out projects before you enforce your contracts?

James Sawyer

Well we basically specified startup dates or startup windows in the contracts. And so far we have not heard much from customers about an interest in deferring or delaying those projects. But we’ll wait and see how that goes. But I don’t expect any major cancellations of contracts and any major push outs, really other than those which are a result of our customer’s projects themselves being delayed by delays in construction.

Edward Yang - Oppenheimer

Well what would your tolerance level be in terms of those types of delays? Would you let them push it out for a quarter, two quarters, a year?

James Sawyer

No we wouldn’t do that.

Edward Yang - Oppenheimer

Okay. And you had some hedge gains this quarter. Next year do you have any currency hedges? Are they increasing versus this year or remain constant?

James Sawyer

What we’ve been doing in terms of net income hedging is hedging out usually on a rolling basis the following quarter or the following two quarters. And as we hedge those out when you come to quarter end you have to mark to market the hedge which you’d put on for the following quarter. Okay? And so that’s why we had a gain in the third quarter and we should probably have a similar size gain in the fourth quarter depending on where exchange rates end up on December 31st.

Edward Yang - Oppenheimer

Okay, thank you very much.

James Sawyer

Yes.

Operator

Your next question comes from the line of Don Carson of Merrill Lynch. Please proceed.

James Sawyer

Hi Don.

Donald Carson - Merrill Lynch

Hi Jim. Jim, can you talk about the impact of lower energy prices? I guess a couple different dimensions to that. One, what are you seeing in terms of net guess low fracking demand. And then on the hydrogen side we are seeing lower refinery run rates here which presumably represent some volume risk to you as well. So just talk about your view of energy prices and the impact on demand there.

James Sawyer

Right. So far we’ve not seen a decline in fracking activity and I don’t - it’s hard to say where those guys are going to go. But what we’ve heard back from most of our customers is that they don’t expect to delay drilling and well completion with gas prices where they are today.

On the refinery side, yes, you’re going to see declines in refinery output. I believe they will be about 5%, somewhere around that range. That’s what I’ve heard from the industry. And that’s just kind of similar to declining output in other end markets that we’re probably going to see also.

Donald Carson - Merrill Lynch

And that - you’ve incorporated that kind of decline into your guidance?

James Sawyer

Yes.

Donald Carson - Merrill Lynch

And one follow-up on your fourth quarter guidance, so basically you’ve got sort another $.03 hedging gain in there and what is the potential range of restructuring costs which I know you said was not in the guidance.

James Sawyer

Right. Well we don’t know what currency hedge gain or loss is going to be. I mean the biggest uncertainty right now in our guidance is currency. And the markets have been all over the place and I don’t know where they’re going to end up at the end of the year. So I can’t really answer that question.

And then on the cost reduction programs, we’ve been generating about $300 million a year of productivity savings annually and we normally expense within our earnings without breaking it out somewhere in the neighborhood of $20.5 million of severance and restructuring costs. But that’s just the cost of normal doing business.

As we look forward we’re going to have to step it up on the productivity programs. And we’re going to have probably some additional costs above and beyond that. But above at this point in time I’m reluctant to give a range because we haven’t really figured out what those programs are going to be.

Donald Carson - Merrill Lynch

Okay, thank you.

James Sawyer

Yes.

Operator

Your next question comes from the line of Bob Koort of Goldman Sachs.

Robert Koort - Goldman Sachs

Thanks very much. Good morning.

James Sawyer

Bob. Glad to hear you on the phone today.

Robert Koort - Goldman Sachs

Can you hear me better?

James Sawyer

Yes, that’s great.

Robert Koort - Goldman Sachs

Okay, sorry about that. I’m curious if you’ve seen any adjustment in your finding outlook given that sweet sour cracks has sort of come in and that might adjust the crude slate at all. You get any indication from your customer base that that could happen?

James Sawyer

No. I’m not and I think our hydrogen volumes will continue to grow sequentially quarter after quarter.

Robert Koort - Goldman Sachs

How about - you mentioned you’ve got a lot of projects in the backlog that are bronze sights and presumably you bid those out based on an expected cost. I don’t know if you get a turnkey quote from your ENC providers but clearly the cost of materials is going to be going down. Do you get to harvest any of that cost relief if it shows up on the projects and backlogs?

James Sawyer

It would be greater on projects that are in the beginning of construction rather than projects which are nearly complete. But I think most of you know that before we sign a contract with a customer we try to lock in about 80% of the cost of billing the project. And that has kept us from having cost overruns over the past couple of years.

Going forward I do expect that with material costs, steel costs, and so forth being down, pipe cost being down, and component costs being down and hopefully the current labor shortage going away that we would get some benefit on the cost of billing those projects. But we’ll just wait and see. And those would all be capitalized into the projects anyway.

Robert Koort - Goldman Sachs

Thanks very much.

James Sawyer

Yes.

Operator

Your next question comes from the line of Laurence Alexander of Jefferies.

Laurence Alexander - Jefferies

Hello Jim, two questions. The first on North American pricing, how much of the pricing that you’re reporting is due to scarcity in argon and helium and molecules like that that are in tighter supply to balances.

James Sawyer

Well there’s good pricing taking place everywhere. And it’s - there’s a couple of categories obviously. First of all energy - or electricity price is up about 15% year on year and so within our price number we opted to include the price which is passed on to onsite customers just as a result of higher electricity price.

And then in the merging markets which are very tight we’ve been able to get significant price increases because our customers need the product. And then in argon and helium and specialty gases we’ve had greater price increases. But they’re not that big in total size to have that much of an impact.

Laurence Alexander - Jefferies

And then I guess the other question, this is more of a longer term question, back in 2006 when you set the targets of 8 to 12% for sales and 12 to 16 for earnings, since then there’s been more consolidation, the sector, your capital spending has more than doubled and you’ve also had tighter supply demand balances in several regions. If you were rolling out the same five year plus target now is there - what would - would the bias be to the upside or do you think it would still be same targets and if so why?

James Sawyer

Well what I think is that those were kind of meant to be a reflection of our business model and how our business model works in terms of getting growth. And they were meant to be kind of through in and throughout the cycle with some years having strong GDP growth and other years having weak GDP growth.

And obviously the currency was not part of that. But we’re still on the same - in the same business model. We’re still doing the same things and so we’re still in the same range as that chart that I put up in 2006 in terms of 8 to 12% sales growth and low double digit earnings growth.

But if you look back over the last eight quarters or so the economy was in an up cycle and we were much higher than that, even above the top of the range. And now we’re expecting contraction in the economy and that would be at the bottom of the range. But I wouldn’t really change that picture.

Laurence Alexander - Jefferies

Thank you.

James Sawyer

Yes.

Operator

Your next question comes from the line of James Sheehan of Deutsche Bank.

James Sheehan - Deutsche Bank

Yes. Do you full offset your energy and other costs in Q3 with pricing and productivity programs? And related to that what is your outlook for margins as energy costs decline going forward aside from the rare gases that are in short supply. Do you think you can sustain your real price increases given the weaker macro environment?

James Sawyer

I do. I think - first of all to answer your question we do offset our costs. We did offset our costs in the third quarter of higher electricity costs and so forth. And we’ve got more room on the pricing front going forward.

You can’t change prices overnight in this business because you’ve got long-term contracts both in the on-sight and merchant sector. But as those contracts roll over and so forth you can bring old contracts up to current market pricing. And so I do expect the average pricing will continue to go up.

James Sheehan - Deutsche Bank

Okay. And I think you were targeting your Solar-Voltaic's Market opportunity as around a 2 billion opportunity by 2015. Given the decline in energy prices have you tempered your expectations for growth in that sight segment of the market?

James Sawyer

My guess is that there will be probably actually caused by two things or three things. First of all lower energy prices than people anticipated, secondly less money available for the government for government subsidies, and thirdly less money from the capital markets for people who want to produce solar panels. So I do expect that what we talked about earlier about $1 billion market, it’s probably going to be smaller than that.

James Sheehan - Deutsche Bank

Okay, and then on PDI, what’s your outlook for same store sales in that segment? Do you still see the potential for a positive number given your acquisitions?

James Sawyer

Well the same store sales excludes acquisitions, okay? And we’re looking at the same store sales number of about five. The U.S. is more like six but Canada, the economy’s weaker and it’s more like two. I think we can probably sustain that growth rate. But on the downside if we really do see a big contraction in manufacturing that would impact the same store sales growth.

James Sheehan - Deutsche Bank

Thank you very much.

James Sawyer

Yes.

Operator

Your next question comes from the line of Mike Sison of KeyBanc.

Michael Sison - KeyBanc

Good morning. Nice quarter again in difficult times. Jim, when you talked about sales growth next coming quarters being flattish, sounds like there could be a headwind 7, 8, 9% for foreign currency and the rest would come from organic growth to get the flat. Is the bulk of the organic growth sort of the mid to high single digits you eluded to coming off from the backlog?

James Sawyer

Yes. Let me just add to that. In this quarter well there are two things to adjust out. One is about 8% currency in fact if the exchange rates stay where they are today. The second one is we had 3% up from higher natural gas prices and we think that’ll go away. So that’ll be another 3% down. That’s how I get the kind of flattish number for sales growth.

And probably the organic growth inside of that which would be in the 8% area, about 5% of that will be coming from new projects.

Michael Sison - KeyBanc

Okay. And then in terms of the backlog for projects that are coming on stream in 2009, I mean, is there any case or precedence that these could be canceled?

James Sawyer

No. No. They’re all coming on stream and they’re all - the one’s especially in 2009 - are close to completion. But I will tell you that because our wind rate has been accelerating from 2007 to 2008 we expect another step up in 2010 and 2011 of projects coming on stream.

Michael Sison - KeyBanc

Great. And last question in terms of merchant pricing I guess in an environment where the economic climate would be very slow as you may - as someone suggested. Would you - would pricing remain positive, flat, down?

James Sawyer

I think pricing would remain positive. There’s no reason why it should be going down.

Michael Sison - KeyBanc

Okay, great. Thank you.

Operator

And your next question comes from the line of Mike Harrison of First Analysis.

Michael Harrison - First Analysis

Hi, good morning.

James Sawyer

Hi.

Michael Harrison - First Analysis

Looking at PDI and specifically the hard goods growth number of 1%, how much pricing is in that number?

James Sawyer

It’s actually, their price’s - is a couple of percent and the volume is actually negative. And that’s for two reasons. First of all the part of the argue is that our like, laser welling equipment and capital investment for the customers, both purchases have been deferred and so that’s a reduction in the hard goods.

The other thing is that we’re not really a hard goods company. We’re an industrial gas company and we sell hard goods because our customers want to have them available when they buy the gases. But we have been over the last five years continuing to manage the number of SKUs and keep the pricing up on the consumables. So that’s where that’s going, but I think that the hard goods is a good leading indicator for slowing industrial production.

Michael Harrison - First Analysis Securities 

When you talk about what you’re seeing with hard goods, particularly on the equipment side of the leading indicator, I mean your competitors seem to indicate that they don’t think the financial crisis is going to affect their business too significantly. Are you less optimistic than they are on the package gas side?

James Sawyer

Well, not as happy as they are, but they’re focused on expanded the SKUs and so forth that they sell and they’re going more with the safety products. They’re in the hard goods business. That’s what they do. So they’re expanding their hard goods business while we just kind of run ours because our customers want to buy certain consumables when they buy gas.

Michael Harrison - First Analysis Securities 

Alright, and then in terms of the natural gas impact, I think you kind of covered the impact on well fracking, but what about the conversion of customers to oxygen that’s used for combustion with natural gas? Is that a significantly harder sell when natural gas is in the $7 range than when it’s under $12?

James Sawyer

Yes, but you know, the thing is on those conversions, customers have to be convinced that prices are going to be in a certain area over the next ten years in order to make those conversions, not just a spot decision. And so I think customers are generally looking at $6 to $7 gas for the long-term forecast for gas in spite of the fact that has peaked up to $12 from time to time and we’ll probably see it peak again at $12 from time to time.

But that’s because there’s not much inventory for natural gas in the system. I don’t expect that to slow down all that much. And also they are converting as much for air emission reasons as they are for energy cost-savings.

Michael Harrison - First Analysis Securities 

And do you guys have any estimates for any sort of bottom based price at which those conversions to oxygen make sense?

James Sawyer

It really is a very customer-specific situation. There are all different kinds of customers. There are all different kinds of things and it’s just very customer-specific.

Michael Harrison - First Analysis Securities 

Got it, and then the last question I have is on the FX impact in Brazil. Obviously the translation impact is negative, but as you look at your customer base, how many of those customers are exporters who you might expect to see an increase in demand as the currency is weakening?

James Sawyer

I think what’s going on in Brazil is that domestic demand is strong as well as exports. And we often single out Brazil, but when you look at the countries that we operate, the devaluation is about the same in Europe and Brazil and Canada and Korea, so what it really is, is the strengthening of the U.S. dollar and that remains to be seen where it goes. But I wouldn’t expect that there’d be any significant impact on the trade balance as a result of the currency changes.

Michael Harrison - First Analysis Securities 

Right.

James Sawyer

And therefore not that much upside in Brazil.

Michael Harrison - First Analysis Securities 

Alright, thanks very much Jim.

James Sawyer

Yes.

Operator

Your next question comes from the line of P.J. Juvekar of Citi.

Prashant Juvekar - Citi

Yes, hi good morning. Jim, you have been in Brazil for a long time and you’ve seen these kind of devaluations before. But based on that experience, what do you think will happen in Brazil in terms of the underlying economic growth when you see certain currency devaluation?

James Sawyer

Well, I think the main thing we’re seeing is actually the dollar revaluing. And the exchange rate across the other currencies from the euro to Canada and so forth and Brazil hasn’t really changed that much. The dollar is stronger by about 8% and it’s hard to say why.

It’s mainly, I think, a function of capital movements and cash flows rather than investors making long-term statements on where the currencies ought to trade. But clearly a stronger dollar hurts us both in terms of the translation of our foreign earnings but it also tends to hurt U.S. exporters as well, some of whom are our customers.

Prashant Juvekar - Citi

No, I understand that, the translation. But do you expect the underlying economy in Brazil to slowdown?

James Sawyer

In the U.S.?

Prashant Juvekar - Citi

No, in Brazil.

James Sawyer

In Brazil, I think it will probably slow down but it’s been growing very rapidly and part of that growth has been simulated by credit availability and there’s still lots of credit available in Brazil, but I do think that the credit unavailability in the U.S. will reduce credit availability in Brazil and that will probably slow the growth down somewhat.

Prashant Juvekar - Citi

Right and just one quick question on project backlogs, there has been a lot of discussion on the call about this backlog. How much visibility do you have on the project timeline? And what I’m trying to get at is a customer can decide to delay a project based on their own outlook. So at what point do they come and tell you that they are going to delay the project?

James Sawyer

Well, we are on top of that project by project and our project managers are working in the field with those folks and we also have a high level of communication with the customers as well. So if they want to come and if they’re going to delay their project, they’ll let us know. But that doesn’t mean we’re going to change any terms of our contracts.

Prashant Juvekar - Citi

Alright, thank you.

James Sawyer

Sure.

Operator

Your next question comes from the line of Mark Gulley of Soleil Cap Company.

Mark Gulley - Soleil Cap Company

Good morning guys, a couple questions if I can. One, Jim are you still pricing your projects in Brazil in U.S. dollars as a natural hedge? I think it’s something you talked about years ago with respect to onsite deals.

James Sawyer

Yes, and we’ve been doing that for about five years now, maybe a little bit longer, but all the new major onsite contracts in Brazil and in Mexico have been index dollars. And those are really customers who make commodities where the world market price is in dollars and specifically Panex in the oil business and a couple of the steel makers and so forth.

So we’re continuing to do that and what that means is that only about 20% of our earnings coming out of Latin America are directly indexed to the dollar and then there’s a big chunk that everything else is indexed to energy prices. And energy prices tend to follow the dollar as well.

Mark Gulley - Soleil Cap Company

Okay, with respect to the 5% of sales that’s free cash flow, the 20 minus the 15 going forward. To what extent do you think you might be able to refocus on acquisitions and not just PDI-type acquisitions, Are there small merchant producers around the world, maybe even joint venture acquisitions which would represent a use of free cash flow for somewhat larger deals?

James Sawyer

Right, well that’s just a function of what the availability of those companies is going to be. There are a handful of $50 million or $100 million size independent industrial gas companies around the world, but it’s only a handful and they are family-owned and families decide based on the family’s interest when to sell the business.

So we know all those people and we know that if they’re interested in selling the business, we’ll be talking with them. And at that point in time, we’d definitely be willing to spend the free cash flow to buy them.

Mark Gulley - Soleil Cap Company

Then a final question, you talked about continued growth in refinery hydrogen. I know it’s an old subject, but could you update us on BP, Texas City, where they stand now relative to total potential take when they’re fully back on line?

James Sawyer

Right, they’re still thinking about 50% of their total potential take.

Mark Gulley - Soleil Cap Company

And if they went to 100% in EPS, that would be --

James Sawyer

That would be a couple of pennies worth, yes.

Mark Gulley - Soleil Cap Company

Okay, thanks.

James Sawyer

And that’s what I said before. I think our consumption of hydrogen will continue to grow sequentially as BP takes more product as well as a number of the other refineries down there.

Mark Gulley - Soleil Cap Company

Thanks Jim.

James Sawyer

Yes.

Operator

Your next question comes from the line of Steve Schuman (ph) of Lafayette Research.

Steve Schuman - Lafayette Research

Hi Jim. You talked both positively and negatively about gasification technologies. Could you triage some of those different opportunities, whether it’s for chemical production, power, hydrogen, et cetera?

James Sawyer

I think they’re pretty much dead except for the ones in China which are guided for chemical production because it’s like a triple storm happening. The cost of gallium is escalating rapidly. Maybe that will slow down a little bit in the future. Secondly, the price of natural gas doesn’t look like it’s going to be that high and they’re all contingent on what the expected price of natural gas is going to be over time.

And then lastly financing because some of those were intended to be project financed and obviously there’s not going to be any project financing available. And even amongst the others where you would have an oil company doing the gasification, they’re seeing slim refinery margins and don’t have a huge amount of cash flow available. So I think at this point those projects are pretty much dead except for the ones in China.

Steve Schuman - Lafayette Research

I guess the Northwest deal is sort of a one of situation where they needed power steam and hydrogen.

James Sawyer

Yes, but the Northwest is part of the expansion of the tar sands, okay. And at this point in time, I think the expansion of the tar sands is going to slow down. And that particular deal also requires financing.

Steve Schuman - Lafayette Research

Great, thank you.

James Sawyer

Yes.

Operator

Your next question comes from the line of Kevin McCarthy of Bank of America Security. Please proceed.

Christian Massey - Banc of America Security

Yes, this is Christian Massey actually sitting in for Kevin this morning. I was wondering if you could talk a little bit about your portfolio versus 2001 and how it’s different this go around. Obviously there’s a more attractive industry structure and FX is more of a headwind this time, but I was wondering if you could just talk specifically about your portfolio and what’s changed.

James Sawyer

Well, actually a lot has changed. I’m going to first of all talk about our existing business and then we have backlog on top of that. But the existing business is much more diversified in terms of both geography and in market. We are much stronger. We didn’t have energy as a sector back then and we’re much more diversified across electronics and healthcare and so forth.

Secondly, in terms of geography, back then most of our business was either in North America or in South America. And now we’ve got a sizeable business in Europe and a sizeable business in Asia that we didn’t have back then. So we’ve got that kind of global diversification as well.

Now, on top of that, we’ve got a higher proportion of our business in onsite than we did back then and so we’ve got more pay for pay type of protection in our revenues. And then looking forward, the backlog of new projects that we’ve got coming on stream is four times what it was back then in terms of dollars of revenue.

So we were able to get through the 2000 to 2003 downturn. While many companies had 30% reductions in earnings, we continue to grow earnings through the downturn in spite of a large result evaluation during that period. And in spite of volumes which slowed down by about 5% in the U.S. because we brought our new projects. But this time going forward, we’ve got four times as much projects to bring on stream to offset decline in the base business.

Christian Massey - Banc of America Security

Okay, that’s helpful. Then, looking at share repurchases, obviously you were pretty active this quarter. Has that continued into 4Q thus far and can you just update us on your free cash flow priorities?

James Sawyer

Yes, we’re continuing to repurchase stock. We see it as a good value at this price. It’s much more earnings accretive at this price than it would have been at $80 or 90. So we’re continuing to buy stock and obviously in terms of free cash flow, the capital spending average project has a return of about 18% so that’s obviously the priority over anything else.

And then the acquisitions are purely opportunistic as when a good one comes around we’ll buy them, but they’re probably not going to be that many or that big. And then we’ll continue to buy back stock above and beyond that because as the operating cash flow grows, our ability to handle debt grows and we have the lowest debt to EBITDA ratio of anybody in the industry and we have plenty of room if we want to to continue to buy back stock there.

Christian Massey - Banc of America Security

Okay, that’s helpful, thanks.

James Sawyer

Yes.

Operator

And your next question comes from the line of John Roberts of Buckingham.

John Roberts - Buckingham

Thanks, Jim if you look at page 14, delta between manufacturing with FX and acquisition and without is about 14 percentage points. Is that all the three package gas acquisitions and does that equate to the 8% delta between PDIs same-store sales and their total sales growth?

James Sawyer

I’m trying to follow your question, yes.

John Roberts - Buckingham

I’m on page 14 and manufacturing is 20%.

James Sawyer

Yes, okay, and manufacturing on this, yes this is the appendix chart we were talking about. Yes, that 22% included currency and acquisitions, most notably the acquisitions of PDI.

John Roberts - Buckingham

Okay.

James Sawyer

And when you strip that out, it’s 8% without the FX and acquisitions.

John Roberts - Buckingham

The FX or acquisitions a bigger affect in that 14 percentage point delta there?

James Sawyer

The acquisitions is bigger.

John Roberts - Buckingham

Thank you.

James Sawyer

The acquisitions is about 70% of the difference, so the acquisitions would be about 16 percentage points.

John Roberts - Buckingham

And currency was -2 then?

James Sawyer

No, no I said that wrong. The acquisitions would be about eight percentage points and currency about four.

John Roberts - Buckingham

Okay. Thank you.

James Sawyer

That difference from 8 to 22.

Operator

Your next question comes from the line of Richard Ong of Evo Capital. Richard, your line is now open.

Richard Ong - Evo Capital

Okay, I’m sorry. Can you hear me now?

James Sawyer

Yes.

Richard Ong - Evo Capital

Okay, I’m sorry about that. Jim, could you just talk about China and how you see the outlook in terms of growth there if you exclude some of the new projects as more of the current organic growth there?

James Sawyer

Yes, there’s a lot of reports about China and there was obviously a slowdown during the Olympics and what you’ve seen generally in industry in China is that a lot of the stuff that slowed down during the Olympics didn’t start up again or didn’t speed up again. So they are definitely seeing a slow in rate of growth versus what we saw over the past couple of years. And that’ll probably stay. I don’t expect to see China GDP growth over 10% again for a while.

But our projects over there are mainly for customers who make things that China is a net importer of. So, for example, China is a net importer of chemicals and chemical materials. And I think regardless of whatever the industrial production growth is going to be, they’re going to continue to build these chemicals and plastics facilities and continue to build gasification units as a feedstock for them because they don’t want to be dependent on imported oil.

The other main one is semiconductors. China imports 90% of the semiconductors that it assembles into cell phones and computers and so forth. And so they’ll continue to build fabs as a result of that no matter what the economy does.

And then on the steel side, you’ll probably see less growth going on in the steel side because of less demand, most of that has been going with construction steel and if the economy slows down, presumably construction will slow down as well.

Richard Ong - Evo Capital

Okay, thank you.

James Sawyer

Yes.

Operator

Your next question comes from the line of Bob Koort of Goldman Sachs.

Amy Zhang - Goldman Sachs

Hi, this is Amy Zhang sitting with Bob. Actually I have a follow-up question Jim. Can you give us a little bit more color about your steel exposure probably by region. And also, how much of your steel relative to business is protected by a long-term contract? And then lastly, if it was the global steel production growth of 3%, 4% in 2009, what could be the base case growth for your business?

Jim Sawyer

I'm not sure I can answer all that. But there is -- in terms of currency exposure, there is a chart in the appendix which shows the change in the exchange rates for the four currencies, Brazil, Canada, Europe, and Korea.

And if you look at that chart, the red line is 2008, the blue line is 2007, and what you see is that in the first three quarters of the year the distance between those two curves was the tailwind we had from currency.

And then as the dollar strengthened about 30% at the end of September, it reverses into a headwind for the fourth quarter. And that's just meant to show that. So that kind of shows the currency exposure by region. And maybe you could repeat the second part of the question.

Amy Zhang - Golman Sachs

So I was asking, the color about steel exposure by region. How much of your steel exposure is protected by long-term contract? So if we assume 3%, 4% of global steel production growth for next year, what could be the base case assumption for your business?

Jim Sawyer

Right. Well, actually, about 60% of our steel sales are outside the United States and for the most part I don't see much exposure there because Brazil is extremely low-cost producer of steel with the best and the cheapest iron ore. Tata in India is also a very low-cost producer.

And then we're not expecting any impact in Europe from steel either. So I don't -- I think what we're going to see probably is about (inaudible) contraction in production volume in the U.S. for a couple of months. And then some of that will come back on stream, and the 20% reduction in the U.S. will hurt EPS by about $0.02 a quarter. But internationally, I don't think we'll have any material downturn or exposure there.

Amy Zhang - Golman Sachs

Alright. Thank you.

Jim Sawyer

Yes.

Operator

Your next question comes from the line of Jeff Zekauskas of JP Morgan.

Jeff Zekauskas - JP Morgan

Hi, good morning, Jim. Two questions. The first is that on a sequential basis, your shareholder's equity went from $5.67 billion to $4.89 billion, and basically if you net out dividends and stock repurchase and your net income, that nets out to about a negative $300 million change. What accounts for the other 480 in decrease?

Jim Sawyer

Okay. The third thing in there is the currency translation. And when we consolidate our businesses around the world as the currency rates change each quarter, the difference goes straight to the equity account. So there are three things in there, there are the dividends, the stock buybacks, and the currency translation.

Jeff Zekauskas - JP Morgan

But why would you have a positive currency translation in your earnings but a negative currency translation in your equity?

Jim Sawyer

Because the currency translation in equity is the end of the quarter exchange rates at June 30th moving to September 30th where you had a strengthening of the dollar, okay, but almost all of that change took place in the last two weeks of September.

And so the earnings during that period had a positive tailwind because that's calculated on a daily basis going through the quarter., but if you look at the charts, the currency swing all took place in the very end of September.

Jeff Zekauskas - JP Morgan

Okay. And then lastly, I think you said you thought your operating cash flow for the year would be about $2 billion, which is about flat with last year --

Jim Sawyer

No, I said it would be well over $2 billion.

Jeff Zekauskas - JP Morgan

Oh, forgive me. In the quarter, your nine month cash flow was flat with the year-ago period. And there's this other item where I guess -- that is, it looks like there's higher receivables and it looks like there's maybe some higher other items. Can you describe why the operating cash flows are around flat to the nine months?

Jim Sawyer

Right. It's because of that other category and what is in that other category is also related to the translation gain and loss. So you have the equity going down with the translation loss, you also have the accounts receivable and inventory going up or going down with the exchange loss and then the other is an offsetting item to that. But it's not a real cash, cash flow, it's just the way that the accounting world asks you to describe the cash flow.

Jeff Zekauskas - JP Morgan

Okay. Thank you very much.

Jim Sawyer

Yes.

Operator

And your final question comes from the line of Chris Shaw of UBS.

Chris Shaw - UBS

Good afternoon now. Can't believe I'm last. I was confused on the whole hedging of currencies and what the strategy there is exactly. So I understand you're doing it on a ruling basis on net income, but is it not just a full hedge? Is that why there's still this, you foresee this 8% headwind, or is it because it was so rapid?

Jim Sawyer

Right. The hedging strategy on net income is to hedge forward one or two quarters of net income, okay and we were hedged forward two quarters, okay. And so we can't hedge sales, all we're hedging is net income.

And so the sales is just going to be a total reaction to what's changed in the currency is, okay. But all we're hedging is actually the cash flow part in net income. And because of mark-to-market accounting, the $13 million gain that we took in the third quarter really was a hedge of the fourth-quarter earnings.

Chris Shaw - UBS

Oh, I see. Okay, yes, because that hadn't flown through yet and that's a balance sheet item, right?

Jim Sawyer

Yes. It's just because they're not allowed to give hedge accounting for net income hedging, you have to mark to market the hedges every quarter. And so where you have a gain pertaining to the fourth quarter, we had to take that gain in the third quarter.

Chris Shaw - UBS

Okay. That makes sense. And then do you guys ever give an indication or can you on what may be across your on-site projects what the level of sales were above the minimum take or pay levels are? I mean can you give any color on that?

Jim Sawyer

Yes. I mean, generally, the sales levels are above the take or pay levels. It depends on the project. Projects where the production capacity is 100% dedicated to a single customer such as the Pemex enhanced oil recovery project and other projects, those ones are 100% take or pay, and that doesn't change.

But other places, and in particularly where we have pipeline on plays, we are willing to agree to percentages, more like 70% and so forth in the take-or-pay volume. So in aggregate, you don't really end up seeing -- you'll end up seeing the volumes move with the customers' volumes, unless the customer, goes into a shutdown mode or something like that. So the take or pay is actually better protection than on a customer-by-customer basis than it is on a macroeconomic basis.

Chris Shaw - UBS

I'm sorry, you said in aggregate it will move with of customer volumes.

Jim Sawyer

Yes.

Chris Shaw - UBS

Okay. That's it. Thanks a lot.

Jim Sawyer

Okay. Thank you all for attending the conference call. And we look forward to meeting with you all soon. Good-bye.

Operator

Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may disconnect. Have a great day.

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