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Executives

J. Barrett Strzelec - Director of Investor Relations

Peter Mccausland - Founder, Executive Chairman, Chairman of Management Committee and Member of Executive Committee

Michael L. Molinini - Chief Executive Officer, President, Director and Member of Management Committee

Robert M. McLaughlin - Chief Financial Officer and Senior Vice President

Analysts

Vincent Andrews - Morgan Stanley, Research Division

Michael J. Harrison - First Analysis Securities Corporation, Research Division

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

Thomas L. Hayes - Thompson Research Group, LLC.

David L. Begleiter - Deutsche Bank AG, Research Division

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Ryan Merkel - William Blair & Company L.L.C., Research Division

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Neal Sangani - Goldman Sachs Group Inc., Research Division

Jeffrey Schnell - Jefferies & Company, Inc., Research Division

Mark R. Gulley - BGC Partners, Inc., Research Division

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Holden Lewis - BB&T Capital Markets, Research Division

Airgas (ARG) Q3 2013 Earnings Call January 24, 2013 10:00 AM ET

Operator

Good morning, and welcome to the Airgas Third Quarter 2013 Earnings Conference Call. Today's call is being recorded at the request of Airgas. [Operator Instructions] For opening remarks and introductions, I would now like to turn the call over to the Director of Investor Relations, Barry Strzelec. Please go ahead, sir.

J. Barrett Strzelec

Good morning, and thank you for attending our third quarter earnings teleconference. Joining me today are Peter McCausland, Executive Chairman; Mike Molinini, President and CEO; and Bob McLaughlin, Senior Vice President and CFO. Our earnings news release was made public this morning and is available on our website, as are the teleconference slides. To follow along, please go to airgas.com, click the Investor shortcut at the top of the screen and go to the Earnings Calls and Events page.

During the course of our presentation, we will make reference to certain non-GAAP financial measures and unless otherwise specified, metrics referred to in today's discussion will be adjusted for the unusual items identified in our earnings materials. 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.

Please also note that as discussed on our first quarter earnings teleconference, prior period amounts have been adjusted for the retrospective application of a change in the method of accounting or a portion of our hardgoods inventory from LIFO to average cost methods. Please also note that we have changed our reference to sales adjusted for the impact of acquisitions and divestitures from same-store sales to organic sales. Growth rates presented in prior periods and the underlying calculation have not been materially affected by this change. We'll take questions after concluding our prepared remarks as time permits. And we plan to end the teleconference by 11 a.m. Eastern Time.

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

Peter Mccausland

Thanks, Barry. Good morning, and thanks for joining us. We'll start with Slide 2. I'd like to begin by giving you an overall view of the current business landscape, our quarterly results and our outlook for our fiscal fourth quarter. Throughout the third quarter, we saw moderating activity levels in our industrial customer base which were further exacerbated in late December by uncertainty around the fiscal cliff and by the timing of the holidays during the work week, which contributed to our earnings landing just below our guidance range at $1.04 per share.

Organic sales were up 4% this quarter with gas and rent up 6% and hardgoods down 1%. In the Distribution segment, organic sales were up just 2%. The relative strength of the U.S. metal fabrication and energy sectors which have been bright spots for the economy earlier this year have softened a bit, tempering our growth in those areas. But we continue to win new business in these sectors on the strength of our Strategic Accounts program, technical support for customers, breadth of our product and service offering, and outstanding customer service.

While macroeconomic conditions were not very cooperative during the quarter, we're pleased to be on target for our SAP benefits which contributed to the Distribution segment's 200 basis point year-over-year expansion in gross margin and 30 basis point year-over-year expansion in operating margins on very modest sales growth.

Although implementation costs were slightly higher than anticipated during the quarter, we demonstrated the ability to achieve the SAP benefits, and that serves as reinforcement that this program will create substantial shareholder value going forward.

Acquisition activity was another bright spot in the quarter as we added 7 businesses with aggregate annual revenues of $75 million including DnD power, a $25 million equipment rental and service business, which provides mobile power generation and light towers, as well as preventative maintenance and other services to the oil and gas exploration and production industry.

When combined with Red-D-Arc's rental welder business and Airgas On-Site Safety Services and complemented by the full breadth of Airgas' gasses and hardgoods products, services and expertise, our value proposition to customers in oilfield services, construction and other energy-related markets has never been stronger.

As we move into the new calendar year, January typically starts slow so it's tough to predict where the month will land based on the first couple of weeks. But to this point, hardgoods are still trending soft compared to December and gas is trending slightly better. Given the strength of January last year, the year-over-year comps are tough. With continuing soft conditions near term, we're expecting fourth quarter adjusted EPS in the range of $1.18 to $1.24, representing strong year-over-year earnings growth of 6% to 12% on organic sales growth in the low-single digits. Our balance sheet is solid and strong cash flow continues to be a hallmark of our business model. Year-to-date, our adjusted cash flow from operations increased 8% year-over-year to $451 million, and free cash flow increased 25% year-over-year to $219 million.

During the quarter, we purchased 2.47 million shares for $222.2 million, representing more than 1/3 of the board-authorized $600-million share repurchase program. But we did not realize EPS accretion as a result of the share repurchases due to the extraordinary number of option exercises including mine, which were driven by the federal government's tax policy or lack thereof. We also experienced higher interest costs because we prefunded the share repurchases. The good news is that in our next fiscal year, dilution from the share repurchases or accretion from the share repurchases will be more obvious in that many of these options were brought forward.

The strength of our balance sheet and cash flow generation will allow us to continue to execute on our share repurchase program in the fourth quarter, while continuing to fund our growth strategies including our acquisition program. Though we remain appropriately cautious about near-term business conditions, we're very optimistic about the long-term prospects for the U.S. manufacturing and energy industries, as well as nonresidential construction, and our ability to leverage our unique value proposition and unrivaled platform to drive growth. Some of the most challenging aspects of the SAP implementation are behind us. We're building momentum and we're ready to capitalize on any improvement in the U.S. economy.

Now, I'll hand it off to Mike to review some of our key initiatives.

Michael L. Molinini

Thank you, Peter. I'd like to start by providing a brief update on the helium supply issues that we in the industry at large have been dealing with for more than 18 months. I've said in the past, that this situation is very fluid and will be touch and go for some time. During the third quarter, our suppliers were able to meet their allocation commitments to us which offset our projected year-over-year impact on earnings in the quarter. This is certainly a positive development though product is still tight in many places and we expect to continue to see some level of supply chain disruption at least through the end of this fiscal year and most likely well into FY '14.

Please turn to Slide 3. As Peter said, current business conditions indeed present some near-term challenges, but we will continue to invest in our long-term growth strategies, including the further development of our sales and marketing strategies focused on key customer segments, our Strategic Accounts program, infrastructure enhancements and leveraging our SAP platform. Our sales and marketing strategy focused on tailoring our value proposition to the unique needs of each major customer segment continues to gain momentum and is a driving force behind the Airgas organic growth story going forward. Our Strategic Accounts program, which leverages this segment-driven approach, presents us with tremendous cross-sell opportunities in terms of product lines, services, locations, and represents more than 20% of total sales.

In the third quarter, our Strategic Accounts business was up 4% over the prior year as continued new account signings and cross-selling to existing customers was tempered by broad-based slowing in general activity across most of our customer segments. Our large metal fabrication customers continued to post the strongest growth on a relative basis, though showing deceleration from the second quarter growth rates. In the third quarter, sales of Strategic Products were up 5% over the prior year with solid growth in all gas categories. Safety products posted only 1% growth on broad-based moderation in core industrial customer activity.

Moving on to SAP. The implementation is on schedule with only one distribution region remaining to convert to the new system which is scheduled to occur in March. The third quarter marked a very important inflection point in the execution of our SAP initiative and that it was the first quarter in which we realized meaningful economic benefits. While implementation expense in the quarter was approximately $0.02 higher than expected, the magnitude of the benefits realized was as planned for the third quarter.

We've said all along that we would be prudent and get this done the right way to ensure the long-term success of this initiative. In keeping with that commitment, we expect to incur slightly higher than anticipated SAP-related expenses in our fourth quarter and to continue to incur some SAP-related costs during the first half of fiscal 2014 for post-conversion support, training and process improvement initiatives. Our expectation that we will achieve our projected $75 million to $125 million in run rate operating income benefits by the end of calendar 2013, however, remains unchanged. And even with the additional cost, we believe we will realize net benefits in fiscal year 2014, that's the fiscal year that begins this coming April, in the range of $0.45 to $0.55, consistent with the projections presented at our Analyst Meeting in December.

The rollout of our expanded telesales channel, Airgas Total Access, continues to gain momentum across the Airgas regions that have converted to SAP. We now have more than 80 full-time Total Access telesales representatives trained and deployed in calling on customers in the target size and spend range selling gas and welding-related hardgoods in addition to our traditional telesales offering of safety products.

About half of our regional companies are leveraging the data mining and functionality of SAP to take a more strategic approach to product pricing and discount management. These SAP milestones and the growth initiatives we presented at our Analyst Meeting in December, which support our fiscal 2016 financial goals, all make for a bright future for this company.

Thank you. And now, Bob will give you our financial review for the quarter and provide updated guidance for the year.

Robert M. McLaughlin

Thank you, Mike, and good morning, everyone. Please turn to Slide 4 for a review of our consolidated results for the third quarter.

Sales increased 5% year-over-year to $1.2 billion, reflecting acquired sales growth of 1% and organic sales growth of 4%, comprised of a 6% increase in gas and rent and a 1% decline in hardgoods. Total price was up 5%, and volumes were down 1%. Gas and rent represented 64% of our sales mix in the quarter, up 150 basis points from the prior year and up 80 basis points from the second quarter. Gross margin for the quarter was 56.3%, an increase of 140 basis points from the prior year and 120 basis points from the second quarter, driven by the sales mix shift towards higher-margin gas and rent, as well as margin expansion on gases and hardgoods, reflecting normal inflationary pricing actions and the realization of SAP-related benefits during the quarter.

Adjusted operating income of $146 million was up 7% from last year and included the impact of the SAP-related benefits achieved during the quarter.

Not included in adjusted operating income was a pretax net benefit of approximately $2 million related to certain lower-than-previously-expected business support center restructuring charges.

Adjusted operating margin was 12.1% compared to 11.8% in the prior year. Excluding the $0.01 net benefit related to the restructuring adjustment, adjusted earnings per diluted share were $1.04, an increase of 7% from $0.97 in the prior year. The adjusted EPS of $1.04 included $0.03 of SAP implementation costs and depreciation expense, net of benefits realized, reflecting a favorable year-over-year swing of $0.07 compared to the prior year's expense of $0.10 as we realized SAP-related benefits as planned, though SAP implementation costs were approximately $0.02 higher than expected.

During the third quarter, the company repurchased 2.47 million shares on the open market for $222 million, reflecting an average price of $89.93 per share. There were approximately 79 million weighted average diluted shares outstanding for the quarter, up 2% year-over-year and flat sequentially as the impact of share repurchases on the weighted average diluted shares outstanding was largely offset by stock option exercises in the quarter.

Return on capital was 12.4% for the 12 months ended December 31, 2012, an increase of 10 basis points over the prior year.

We generated strong free cash flow year-to-date through the third quarter of $219 million, an increase of 25% over the prior year and adjusted cash from operations was $451 million, an increase of 8% over the prior year.

Total debt increased by $119 million year-over-year to approximately $2.3 billion at December 31, driven primarily by share repurchases and acquisitions in the third quarter, partially offset by net debt paydown activity during the past 12 months. Our fixed-to-float-debt ratio at the end of December was nearly 60% fixed and our debt-to-EBITDA ratio was 2.6, comfortably within our target range of 2 to 3. We are well-positioned to continue to effectively manage our balance sheet leverage while making acquisitions, investing in growth CapEx and executing the share repurchase program.

Now, turn to Slide 5 and we'll look at our segment results. SAP implementation costs, which are included in our consolidated adjusted operating results, have not been allocated to our business segments, nor have the special items that have been excluded from consolidated adjusted operating results.

Distribution sales for the quarter were up 3% versus the prior year to nearly $1.1 billion. Organic sales for the Distribution segment were up 2%, with pricing up 5% and volume down 3%. Gas and rent organic sales were up 5%, with pricing up 6% and volume down 1%. Organics -- hardgoods organic sales were down 1%, with pricing up 3% and volume down 4%. Gas and rent represented 59.7% of distribution sales in the third quarter, up from 58.7% in the prior year and up from 58.4% in the second quarter. Distribution gross margin was 57.1%, an increase of 200 basis points from the prior year and 130 basis points from the second quarter, driven by the sales mix shift towards gas and rent and margin improvements on gases and hardgoods, reflecting both the normal inflationary pricing actions, as well as the realization of SAP-related benefits during the quarter.

Operating income in the distribution segment increased 6% year-over-year to $140 million while operating margin increased 30 basis points to 13%. Operating margin expansion was driven by the realization of SAP benefits, partially offset by pressure from moderating sales growth.

All Other Operations reflects our CO2, dry ice, refrigerants, ammonia and nitrous oxide businesses.

Sales for all operations were up 15% from the prior year with organic sales up 14%, largely driven by an increase in R-22 prices in our refrigerants business, by both price and volume in our ammonia business and by higher outage surcharges and hurricane-related sales in our CO2 and dry ice businesses. Sequentially, sales in All Other Operations segment decreased by 10%, reflecting the normal seasonality of the businesses in that segment, partially offset by higher outage surcharges and hurricane-related sales in our CO2 and dry ice businesses.

Gross margin for All Other Operations was 47.3%, a decrease of 160 basis points from the prior year, primarily driven by rising feedstock costs in our ammonia businesses and a sales mix shift to our lower margin refrigerants and ammonia businesses.

Operating income for All Other Operations was $15 million compared to $13 million in the prior year. Operating margin of 10.4% was down 40 basis points year-over-year, primarily driven by the gross margin drivers I noted -- I just noted.

Please turn to Slide 6, capital expenditures. Year-to-date, CapEx represented 6.6% of sales, down from 7.5% of sales in the prior year on decreases in most categories. Rental welder spend increased by $28 million on the strong growth on our Red-D-Arc rental welder business. Excluding major projects, CapEx as a percent of sales was approximately 4%.

Now, I'd like to discuss the guidance for our fourth quarter and full year.

Fiscal 2013 adjusted earnings per diluted share excludes the following restructuring and other special charges and net benefits: A $0.05 charge in the first quarter; a net $0.02 charge in the second quarter; and $0.01 net benefit in the third quarter; and an expected charge of $0.01 in the fourth quarter, resulting in an expected net charge of $0.07 for the full year. Fiscal 2013 guidance also excludes a $0.07 gain from the sale of businesses in the first quarter. Special gains and charges and net benefits in fiscal 2012 were a net total charge of $0.11. Please also note that our guidance does not reflect the impact of potential share repurchases in the fourth quarter under our current share repurchase authorization.

Slide 7 presents a walk through the primary elements of our fourth quarter and full-year adjusted EPS guidance. The left-hand column of this slide shows the sequential walk for the fourth quarter using the third quarter adjusted EPS of $1.04 as the starting point. We expect a $0.03 tailwind from the impact of 1 additional selling day and the falloff of the impact of the holidays in the third quarter, partially offset by 2 less calendar rent days. A $0.01 headwind from a higher tax rate in the fourth quarter, SAP benefits net of implementation cost and depreciation expense are expected to contribute $0.07 to $0.09, which represents the difference between the $0.03 of net expense in the third quarter and an expected $0.04 to $0.06 of expected benefits net of implementation cost and depreciation expense in the fourth quarter. On a sequential basis, our base business is expected to contribute additional earnings of $0.05 to $0.09.

The middle column of this side shows the year-over-year walk for the fourth quarter using 2012 fourth quarter adjusted EPS of $1.11 as the starting point. We expect headwinds of $0.04 from the impact of 1 less selling day in the fourth quarter of this fiscal year, $0.01 related to helium supply constraints and $0.02 from a higher tax rate. SAP benefits, net of implementation cost and depreciation expense, are expected to be a tailwind of $0.13 to $0.15, which represents the difference between $0.09 of net expense in the fourth quarter of fiscal 2012 and an expected $0.04 to $0.06 of expected benefits net of implementation costs and depreciation expense in the fourth quarter of 2013. And base business growth is expected to contribute an additional earnings of $0.01 to $0.05.

In aggregate, when factoring in the headwinds and the contributions from incremental SAP and base business growth, we are estimating adjusted EPS for our fourth quarter to be in the range of $1.18 to $1.24, which represents year-over-year growth of 6% to 12%.

The right hand of this slide shows the year-over-year walk to our revised fiscal '13 adjusted EPS guidance range. We expect headwinds of $0.07 from the impact of 2 less selling days this fiscal year, $0.07 related to helium supply constraints and $0.02 from a higher tax rate. We are expecting year-over-year SAP benefits net of implementation cost to contribute $0.16 to $0.18, which represents the difference between the $0.34 of net expense in fiscal 2012 and the expected $0.16 to $0.18 of expense net of benefits this year.

On a year-over-year basis, our base business growth is expected to contribute an incremental $0.29 to $0.33, representing 7% to 8% growth.

In aggregate, when factoring in the headwinds and the contributions from incremental SAP and base business growth, we are now estimating adjusted EPS for our fiscal 2013 to be in the range of $4.40 to $4.46, which represents year-over-year growth of 7% to 9%.

And now, I'll turn it back to Barry to begin our question-and-answer session.

J. Barrett Strzelec

Thanks, Bob. That concludes our prepared remarks. [Operator Instructions] Jennifer will now give instructions for asking questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go to Vincent Andrews with Morgan Stanley.

Vincent Andrews - Morgan Stanley, Research Division

I guess my first question would just be, can you talk a little bit about the dynamics in hardgoods and -- should we be at all concerned about the trends there? And what do we need to look for in the fiscal fourth quarter, obviously, other than just an improvement in the trend to know that this isn't a leading indicator of something we should be concerned about?

Peter Mccausland

Well, I mean, hardgoods through the entire quarter were -- October was relatively weak compared to previous quarters. November rebounded somewhat, and then December was really very, very difficult, particularly the second half of December. And some -- so at this stage, it's a little early to determine whether or not the December trend is -- to what level it's going to rebound, but that's something we need to watch closely.

Vincent Andrews - Morgan Stanley, Research Division

Okay. And just as a follow-up, as we look ahead to fiscal '14, obviously, we're all waiting and seeing what happens with the base business. But looking at that Slide 7, and there are a bunch of things that impacted '13, could you just help us understand what '14 looks like in terms of were there more or less selling days? Should helium cost be lower? I think you've already told us enough about SAP, but just what are the puts and takes going into '14 all else equal?

Robert M. McLaughlin

Well, I think we're going to have some help relative to helium. We certainly don't know whether -- we won't recover the full hit to this year, but we should have some incremental tailwind as it relates to that. We will not have the headwinds relative to less business days going into next year, so that will be a net positive. And we've completed some acquisitions and are optimistic that we'll complete some more, so...

Operator

We'll go next to Mike Harrison with First Analysis.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Just building on that question, I would assume also that the share repurchases do contribute some component. I guess, I was just hoping to get a little bit better guidance around what the diluted share count could look like going forward. I don't really understand, the diluted share count should already account for potential options exercises. So if they were actually exercised, I guess I don't really understand why the share count would not been and offset the -- can you explain that better?

Robert M. McLaughlin

Well, the diluted option calculation assumes that you take the proceeds and repurchase shares. So when you actually exercise them, it's more dilutive if you don't, in fact, take those proceeds and repurchase the shares. The other dynamic that challenged us in a positive way is our price appreciation makes the dilution -- makes the options that haven't been exercised even more dilutive. So it's clearly more dilutive once the options are exercised as the calculation doesn't fully take in the dilution as it assumes that you're taking the proceeds to buy back as many shares as those proceeds will allow you to buy back.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

And so, for the share count going forward, is 79 a good number? Is it lower than that, assuming no further repurchases?

Robert M. McLaughlin

Yes. I mean, we typically -- Mike, if you go back and look at the history, you'll see that we typically have share creep as a result of normal option activity, absent a buyback. But I think it's been in the neighborhood of 1.5% to 2% a year. So absent some unusual activity on that front and absent share repurchases, that might be a good gauge.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Okay. But share creep should be lower, right?

Robert M. McLaughlin

Well, given that we've had so much...

Michael L. Molinini

Right. It's been pushed forward, so we expect to have lower share creep -- less than normal for the next year or so at least.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Okay, that's useful. And then just looking at the SG&A as a percent of sales in the distribution segment, 38% is the highest it's been since 2009. Could we get some details on kind of what's going on with costs broadly in the distribution segment?

Robert M. McLaughlin

Yes. I think if you look at -- they certainly have been pressured, and that ratio is going to be pressured anytime you have a drop in sales which we've had over the last 2 quarters. The other thing that has exacerbated that, Mike, is that declines have been deeper in hardgoods which carry lower relative variable cost with them and the gas sales, which have been -- the shift mix has been going to gas, they carry a much higher operating cost. If you look at those ratios as expense as a percentage of gross margin, which is more an indicator of an underlying activity, that percentage is relatively consistent at 66.5% on distribution versus 66.2% last year and actually down sequentially from 67.1% in the past. We're also -- underneath the expenses are certainly acquisitions have contributed to an increase as well as we do have expenses tied to driving the SAP benefits outside of the implementation and training costs. So I think on -- relative to GM, it's a different story when you match it up with the related sales.

Operator

We'll go next to David Manthey from Robert W Beard.

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

I was wondering if you could talk about trends in Red-D-Arc versus trends in the sales of welding equipment in recent months? And if there's any implication in that trend for the construction outlook.

Michael L. Molinini

The Red-D-Arc trends have been very strong. They've been much stronger than the sales of welding equipment. And probably -- there's a couple of things going on here. One is the rental of equipment to contractors that are doing turnarounds and maintenance has been strong. The expansion of our Red-D-Arc product line into portable power generation equipment, particularly for the natural gas frac-ing industry, not so much from drilling wells, but from a power to extract the natural gas from the well after the well is drilled has also been very strong. And we've also seen a nice uptick in industrial customers who have chosen to lease their equipment from us rather than buy it. So I think it's probably those 3 areas are the drivers of Red-D-Arc's strong performance.

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

Okay. So Mike, none of those that you mentioned really have implications for construction? I'm trying to gauge here in terms of leading indicators if there's a trend that construction companies would rent first and buy later as things picked up. Or anything subtle in there that you've seen from your...

Michael L. Molinini

Well, I mean we know that rental, as opposed to buying, in other parts of the world is much more prevalent than it is in the US. I mean, we've known that for a long time. But I wouldn't say that we've got anything near-term that would indicate that...

Peter Mccausland

Most of Red-D-Arc's activity has been in turnarounds and in the energy areas. Nonresidential construction's been very weak. In fact, a lot of projects finished up in the last 6 months. And there's a ton of shovel-ready projects and utilities and pet-chem and fertilizer, but they really haven't happened yet, with the exception of some pipeline extensions that we're benefiting from and other energy infrastructure where there's some benefit. Most of non-res construction is in a big pause right now.

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

Right, okay. Then one last quick one here. When you look at the price benefit you're getting today, is there any way to parse out what the impact of just helium is on that -- on the price realization?

Michael L. Molinini

In the near term, there has not been much change in helium. In the helium -- early in the year, like January, was really the last time of, what I would consider, a meaningful change in the price of helium.

Operator

We'll go next to Tom Hayes with Thompson Research Group.

Thomas L. Hayes - Thompson Research Group, LLC.

I was just wondering if there's been any level of change in the activity on the smaller customer. Peter, we've talked about that previously where the small customer has lagged. Just wondering if you saw any change to this in this previous quarter?

Peter Mccausland

Not really. It's been a large customer recovery throughout. Slight upticks we've seen, but very, very slight. And it's hard to really figure out, to tell you the truth.

Thomas L. Hayes - Thompson Research Group, LLC.

Okay. I guess as a follow-up, as for the margin expansion we've seen on the Distribution segment, how much of that is kind of roughly tied to the positive mix shift versus the SAP-driven benefits, or is that kind of all intertwined?

Robert M. McLaughlin

It's definitely all intertwined. But I would say roughly, the mix was probably in the neighborhood of 60 basis points plus or minus of that 200-basis point improvement, which leaves around 140 basis points related to pricing. But that pricing was contributed to both the normal inflationary pricing that went across all our business and then the strategic pricing also contributed, but that was a smaller percentage of our portion of our business.

Thomas L. Hayes - Thompson Research Group, LLC.

Okay. Just real quickly. The 13% operating margin on Distribution segment was kind of a near-peak level. Just kind of thinking, this '14 and '15, where can that realistically go with SAP fully kicking in?

Robert M. McLaughlin

Well, we haven't given out guidance with respect to that. But as we presented at the Analyst Meeting, with the targets that we put out for fiscal '16, there is substantial, substantial operating margin leverage that we put out in our goals, and I think that will give you a good sense of where we think we can head.

Operator

We'll go next to David Begleiter with Deutsche Bank.

David L. Begleiter - Deutsche Bank AG, Research Division

Peter, Mike, on SAP, where exactly are the initial benefits being realized in terms of the regions and the actual functions in the cost structure?

Peter Mccausland

Well, the benefits in general are being realized in the area of improved pricing, but not across the board because we're -- not all our companies have been engaged on that part of the pricing program. And from improved sales through Airgas Total Access. The administrative savings aren't there yet and won't be there for I'd say at least another few quarters because we're doubling back and making sure that we do this right, and that's why we have the extra SAP expense in this quarter, and as Mike pointed out, we'll have it into next year. But they're on target, they're within the ranges that we fully -- that we expected, and we're pretty encouraged by it.

David L. Begleiter - Deutsche Bank AG, Research Division

Peter, just one last thing. In your energy business, as you've seen the rig count shift from oil -- from gas to oil, is there any impact on your business?

Peter Mccausland

Sure. I mean, all the energy segments impact our business, like coal has really hurt us recently. But yes, some of the gas fields aren't as active as they were a year ago and certainly, the oilfields are very, very active. But there's still good activity in Marcellus and a couple of the other fields and we're doing well there. So it's spotty. Some of the old gas and oil wells that are expensive -- where it's expensive to extract, aren't active at all. So we've been hurt in coal, we've been hurt in secondary or tertiary recovery with nitrogen and old wells. But we've been -- but that hurt has been offset by strong growth in Bakken and Marcellus and Eagle Ford down in Texas.

Operator

We'll go next to Don Carson with Susquehanna Financial.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

I just want to get into a bit more on some of the hardgoods weakness. Peter, is this all in capital equipment, whether it's automation or machines? Or are you seeing weakness in consumables as well? And then, I have a follow-up on the gasses' side.

Peter Mccausland

It was across the board. You tend to get a pickup in capital equipment in the last quarter as people used up their budgets, and we didn't really see that this year. And Mike, you might have more color.

Michael L. Molinini

Yes. One indicator -- a good indicator for us, as far as the level of general activity, is our safety products because that's much more related to employment and activity levels. And even our safety growth was down. It was only just like 1%. So that was very, very weak. We have seen some moderation in filler metals, so -- but we did have a little boost in December for the year-end capital as people spend their budgets and things, but much more than just capital. But on the other hand, the level of activity on the really big stuff, the really -- the automation, the robots, I think we probably had a -- maybe had a record quarter on sales of those kinds of things. And the quote level and activity level on the really big systems and sophisticated systems is still very strong. So that's why we kind of think more of this is -- I mean, we're in a speed bump here that we've hit more so than a major change.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Then on the gasses' side, what trends did you see in liquid? I know one of your competitors is talking about weakness with argon demand, what were your trends? I know last quarter, you were running your merchant plants in the mid-80s excluding your Tennessee plant. What are your current operating rates? How is the liquid business going?

Peter Mccausland

Well, we saw a nice dip, or a not nice dip in our operating rates towards the end of the year from the low- to mid-80s down into the 70s, and we've seen it come back somewhat in the last couple of weeks, but it's too early to tell whether it's stabilized. And yes, liquid argon, that was pretty tight. Has softened quite a bit, but I wouldn't say it's fallen off the table.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

And then, just finally Peter, with the acquisition activity, do you think there was a run-up as people tried to sort of, like your options exercises, people tried to sort of beat the capital gains increase at year end. Do you see acquisition activity trailing off in the first half of calendar '13?

Peter Mccausland

Yes. Let me just add to the -- Don, to the argon thing. Remember I said earlier, as a lot of these reconstruction jobs wound down and the new ones haven't started, a lot of them use a lot of liquid argon. So that, I think, is what's responsible for freeing up the argon. Overall metal fab, non-construction, I think the argon was pretty steady. The acquisitions. Yes, I think, definitely, some of them were driven. I know some of them were driven by the low capital gains rate and the whole uncertainty regarding tax policy or lack thereof and -- but we have about 25 deals we're looking at right now. And I'm sure there's going to be a little slack from it, but cap gains are still 20% and -- or 23.8%, I guess. And so, I don't think it's going to have a huge impact. I don't think that much was pulled forward. And the market is still active. We have competition. Sometimes the competition likes to pay a lot more than we like to pay, but they have to and we don't. So we're -- we continue to be judicious and look for good opportunities. So we have our goal at 150 this year. I don't know if we'll make it or not. I mean, we have a chance of making it given who we're talking to right now, but the year ends in March, so we should be pretty close.

Operator

We'll go next to Ryan Merkel with William Blair.

Ryan Merkel - William Blair & Company L.L.C., Research Division

I wanted to start off with a high-level, kind of macro question. I think, Peter, your view had kind of been we're in a soft patch and then return to stabilization. Is that kind of your view now on 2013? And maybe comment on customer tone. Are customers generally getting a bit more optimistic?

Peter Mccausland

I think the customers are confident. I don't know that they're optimistic. You're right. It started in around April -- March, April, when we got into this soft patch and it's continued. Mike pointed out that a lot of customers are buying automation. I was out at Great Lakes Airgas for the last couple of days and it's amazing how many automation systems, robots and fixed automation systems that they're selling. And customers are obviously gearing up to produce and also seeking efficiencies. My view is that there is huge potential in the U.S. manufacturing sector and in the energy sector, and of course, they're interrelated. And also, some of the sectors that are noncyclical like healthcare and research, they're coming back. Hospitals are expanding again. So I see huge potential in the U.S. economy, and it's a question of just when it's going to happen. I mean -- and I'm baffled by how long this slowdown has been, but I would say that our customers are pretty confident.

Ryan Merkel - William Blair & Company L.L.C., Research Division

Okay. That's good color. And then second question on SAP. We've kind of have these higher costs kind of into the first half of 2014. I'm wondering if you can quantify the impact to the last 2 quarters of 2014 as those costs roll off. Is it meaningful? Is it something that the analysts should kind of have in their models? Or is that something you can't quantify for us right now?

Peter Mccausland

Bob?

Robert M. McLaughlin

Ryan, I don't think it's meaningful. We said that approximately $2 million was the shortfall, $0.02 this particular quarter. That's give you somewhat of a range. So, no, I don't think it's going to be a needle mover as we go into next year; in particular, in the time period that you referenced towards the end of the year.

Operator

We'll go next to Kevin McCarthy with Bank of America Merrill Lynch.

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Peter, I was wondering if you could provide an update on the Total Access program. I think you mentioned you have 80 representatives. How high could that go over the next year or 2? How many regions are live on Total Access? And what kind of sales uptick are you observing in the early days of that program?

Peter Mccausland

Well, Mike's closer to it than I am. I'll let him answer that.

Michael L. Molinini

It's about 3 or 4 months, or about say 3 months after a region converts to SAP, we typically begin that journey where they start to interface with those folks. So we've probably have, I'm not sure if it's 6 or it's 8, but it's in that order of magnitude of our businesses. We, obviously, we have to build the department and expand it before we can get the sales benefits, and that's one of the cost issues that came up earlier in this about the operating expense and the distribution group, the cost of building it. We're very, very pleased with it. The growth rates -- the customers that we already have that are in that range, that have been underserved, the growth rates have been very strong. In fact, they're stronger than we were expecting. We are continuing to move more and more of our existing customers into that area and we're spending more and more time targeting competitive customers in that range. But it's still early in the game. I don't think you'll see us go from 80 reps to 150 in the next year, but we might be 100-plus, low-100, 100 and change.

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Okay. That's helpful. And then as a follow-up, another component of your SAP benefits is strategic pricing. And I know it's still early there as well, but I was wondering if it's possible to parse out the incremental or strategic pricing that you're getting from SAP and separate that from the aggregate pricing that you're reporting as a company.

Michael L. Molinini

Well, they are interrelated and we choose not to try to carve that up because it's hazardous trying to be precise and we know it's having significant impact and you can see that in our gross profit.

Operator

We'll go next to Robert Koort from Goldman Sachs.

Neal Sangani - Goldman Sachs Group Inc., Research Division

This is actually Neal Sangani on for Bob. Just a follow-up question on the acquisitions. I know it takes a few quarters for the EPS benefit to usually ramp up. Has there been any benefit to the $75 million you did in '13? And if not, what's the tail-end going to look like for '14?

Michael L. Molinini

I don't think there's been any benefit, maybe $0.01, probably not. And I don't know what will $75 million in sales next year that we've done -- we've done almost $100 million, haven't we? What will that mean Bob?

Robert M. McLaughlin

I think it will -- for next year, for the full year, it's probably somewhere in the neighborhood of $0.04.

Michael L. Molinini

One follow-up to the question that Mike Harrison asked about expenses, and we talked in terms of relationships to gross margin and sales. The other thing is if you look at the distribution business, it's up about 7% year-over-year, and again, percentage-plus of that is acquisitions. A percentage-plus for that is expenses tied to SAP benefits, and Mike just made another reference to that, the build up at the telesales organizations and some of the costs associated with rolling out the strategic pricing program. So that leaves the base business growth in a more kind of normal 4% to 5% area. So we are watching expenses; they are not an issue. And tying it to the other question on margins going forward, pretty optimistic about the goals we put out for 2016 and the ability to leverage this platform.

Operator

We'll go next to Laurence Alexander with Jefferies.

Jeffrey Schnell - Jefferies & Company, Inc., Research Division

This is Jeff Schnell on for Laurence. In the Strategic Products, you've realized pretty solid organic growth in medical sales and also bulk and specialty gasses. Can you talk about what you're seeing in those markets? Is it mostly pricing or what's underlining this drive in growth?

Peter Mccausland

Well, at this stage, the big driver is pricing. I'm not sure what to say.

Michael L. Molinini

Yes, decent volumes in medical. Medical you have some volumes and maybe less price in medical. The other ones are primarily price.

Operator

All right. We'll go next to Mark Gulley with BGC Partners.

Mark R. Gulley - BGC Partners, Inc., Research Division

First question is on acquisitions. It seems to me there's 3 parties out there looking for acquisitions -- not only yourself Peter, but one of your large competitors. But I wanted to ask about the role of some of the super regionals whether or not they are getting more aggressive, as you referenced earlier, maybe they're paying too much. So are there really 3 types of buyers out there now?

Peter Mccausland

Well, there is a private equity firm, there's MATHESON Tri-Gas, which is owned by TNS, there's Praxair and then there's super regionals, so there's -- and they've always been buying the smaller companies. It's probably a little more active in the last 5 years than it was in the 5 years before that, but that's always happened. And prices have moved up and they go up and down with cycles. And buyers have to run these companies. And when they end up -- when they see how difficult it is to run these businesses, sometimes they -- or often they either stop buying or they get less aggressive on the price. So we're just going to -- we're just in one of those cycles, and I'm sure it's going to cycle back the other way.

Mark R. Gulley - BGC Partners, Inc., Research Division

Just a really quick follow-up to that point, where are EBITDA multiples sitting right about now, do you think?

Peter Mccausland

I think for the really, really good ones, we've seen 8 to 10. And our average historical -- historically, has been around 6, 5.5 to 6 on average. And so that's a lot of money and that's a lot of goodwill. And now, I'm not saying we've never paid a big price, we have paid a big price for some that were really key to us. Fortunately, we have pretty good market share in most markets and we don't have to make acquisitions. And although we like to do it and it's easier than internal growth and we're good at integration and we bring a lot of, not only cost synergies, but we bring a lot of positive synergies in terms of the breadth of our product and service offering and our infrastructure and all the training and safety programs and things like that. So we like them, but there's a limit to how much we'll pay.

Mark R. Gulley - BGC Partners, Inc., Research Division

And then finally, tying that into competition for acquisitions and tying that into very low interest rates. Can we infer from that, that perhaps you're going to stay aggressive on the share repurchase front? After all, you're the best company out there when it comes to packaged gases.

Peter Mccausland

Yes. And certainly, when we look at an acquisition that's 65% hardgoods, and selling -- and we're -- it's offered to us for 11x EBITDA, and then we look at our stock price and we're 65% gas and rent or approximately 67%, whatever it is. And a proven and a solid, really good company, that certainly crosses our mind when we price acquisitions. Regarding share repurchases, we still have 2/3 of the last 1 to do. We do review it every time we have a board meeting, we review our dividends and share repurchases, and we balance. We want to grow our earnings and our dividends commensurate with the earnings. And we want to do share repurchases when appropriate and we balance that with our need for capital to grow by acquisition and capital expenditure.

Operator

We'll go next to Mike Sison from KeyBanc.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

In terms of the extra cost that you've taken to ensure the $75 million to $125 million in SAP benefits longer term, does that give you any more confidence that maybe you'll end up at the higher end?

Michael L. Molinini

Well, I think we've -- as we said in December, I think the -- we have a lot of levers to pull here on those benefits, not just the 3 that we've been talking about for the last couple of years. However, in order to realize all those things, we have -- our 8,000 people have to become very proficient in the use of the system. And all of this, this extra cost that we're talking about is really all about training and process improvement and getting those 8,000 people to become more comfortable and more talented in using all of the capabilities of a very complicated, powerful system. So taking the time -- now that we have the training team kind of winding down from just implementation after implementation -- taking the time, while it's still intact, to use those trainers, rather than disband the team, and -- rather than do that, to keep this training team intact, and now, let's go back and improve the proficiency of those employees, particularly those that need proficiency help, that's what we're going to do. In the long term, it's going to pay tremendous dividends to do that.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Great. And then just a quick follow-up on hardgoods. Is there any difference between the weakness in the heavier equipment side of that business versus the consumables?

Michael L. Molinini

Well, I mean at this stage, the weakness is affecting both. And we have the real big equipment which is still very active. But capital equipment and filler metals and even the smaller piece, the consumables and the safety products, have all been impacted in moderation in this quarter.

Operator

We'll go next to Edward Yang with Oppenheimer.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Most of my questions have been answered, but the strength in All Other Ops, the revenues were up 16%. And you mentioned the strength in dry ice and CO2 from the hurricanes. Do you expect to see any additional benefit in the fourth quarter?

Peter Mccausland

Well, we get into the cyclical...

Michael L. Molinini

Yes, seasonality. We have -- it's not a strong period for our dry ice business, but it's a strong period for our refrigerants business. So every quarter in that -- that's a group of business that is much more related to seasonal trends than probably the rest of our business. So depending on the quarter, one could be very strong and one could be in an off quarter.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Well, outside of seasonality, do you expect to see any additional hurricane benefit?

Michael L. Molinini

Oh, no. No, no.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Okay. And going back to the share repurchase and the -- I guess you were surprised by the level of options exercises. The cash that you received from those options exercises, is that all reflected in the balance sheet at this point? And how much was it? And do you expect to redeploy that in share repurchases?

Robert M. McLaughlin

Yes, it was all in the balance sheet. I think it was in the $70 million-plus neighborhood relative to the proceeds. What's not in the balance sheet yet is the tax benefit that we'll realize. And we will certainly redeploy it into the business.

Operator

We'll take our final question from Holden Lewis from BB&T.

Holden Lewis - BB&T Capital Markets, Research Division

A couple of things. First, again, I just wanted to maybe beat this SAP thing a little bit. In the past, you've given sort of annual net expense and net benefit to sort of get what the swing is. You've obviously had some moving pieces here, but I think the last time you gave guidance, it was kind of fiscal '13, it was a net expense of $0.12 to $0.16 and fiscal '14 was a net benefit of $0.45 to $0.55. Do either of those numbers, have they changed either the '13 net expense, the '14 net benefit, given all the moving pieces? Or are those numbers, and therefore the annual swing, the same?

Robert M. McLaughlin

I think the composition, relative to, as we talk about next year, and Mike reiterated, that we're going to be at the run rate of the $75 million to $125 million by the fourth calendar quarter of 2013 and reaffirmed our $0.45 to $0.55 EPS contribution. And the components, there's never been a degree of level of precision throughout this journey, but we think that we'll have a little bit more expense than we had anticipated, which we talked about a number of times throughout this conference. But that we're confident that we'll have a little bit higher benefits that will more than offset the increase in expenses. So it's shifted a little bit more to benefits and hanging onto expenses a little bit longer. So more expense, more benefit and kind of so net, falling out in the same range.

Holden Lewis - BB&T Capital Markets, Research Division

For those 2 years?

Robert M. McLaughlin

Yes.

Holden Lewis - BB&T Capital Markets, Research Division

Okay. And then, so the follow-up is on the pricing. Obviously, you stepped up in terms of your overall prices this quarter, up into that 500-basis points range from 400 the past few. Would you expect to see further increases in that because of the SAP rollout continuing? And you've been getting price every 9 months or so, or that's sort of been sort of the unofficial objective. Do you see the environment still supporting that? Or has that sort of impetus maybe leveled off here?

Peter Mccausland

Well, we expect to get improved SAP pricing as a result of SAP as our program rolls out. There's no question about it and that's how we're going to get to the high end -- one reason we're going to get to the high end of the benefit range. But when you have soft volumes, it has a offsetting impact. So we need business to stay steady and not to decline further. But yes, the SAP pricing benefits and also the sales benefits from Total Access should be increasing, and we expect them to increase over the next several quarters into next year. And eventually, we're going to get the operating expense savings, which was the third bucket and -- but that's going to be delayed probably another couple of quarters as we spend money to make sure that we do the retraining and everything else that's necessary to make sure we have a fantastic conversion.

Robert M. McLaughlin

Holden, in your question, you asked on the SAP net. I mean, obviously, from the material that we sent out and discussed, we have brought down the net benefit and net expense number this current year. Unchanged next year of $0.45 to $0.55, but we are going to have net expense of $0.16 to $0.18 this year where, originally, we were at $0.12 to $0.16 range. And the driver of that is that is the $0.02 in this quarter and the roughly $0.02 of additional expense in the fourth quarter, just to be clear.

Operator

Thank you. I'll now turn the call back over to our moderator, Barry Strzelec, for any additional comments or closing remarks.

J. Barrett Strzelec

Well, again, we thank everyone for joining us today. And I will be available for follow-up questions today. Thank you.

Operator

That does conclude today's conference. Thank you for your participation.

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