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Airgas Co. (NYSE:ARG)

F3Q08 (Qtr End 12/31/08) Earnings Call

January 29, 2009 11:00 AM ET

Executives

Jay Worley - Vice President, Communications and Investor Relations

Peter McCausland - Chairman and Chief Executive Officer

Michael L. Molinini - Executive Vice President and Chief Operating Officer

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

Analysts

Robert Koort - Goldman Sachs

David Begleiter - Deutsche Bank

Mike Harrison - First Analysis

Laurence Alexander - Jefferies & Co.

Kevin McCarthy - Bank of America Securities

Michael Sison - KeyBanc Capital Markets

Mark Gulley - Soleil Securities/Gulley & Associates

John Roberts - Buckingham Research

Stephen Byrne - Bank of America

Operator

Good day and welcome to today's Airgas Third Quarter Earnings Teleconference. Today's call is being recorded. At this time, participants are in a listen-only mode.

I would like to turn the call over to Mr. Jay Worley, VP for Communications. Please go ahead.

Jay Worley

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

Our earnings press release was made public last evening and is available on our website, as are the slides that accompany this teleconference. To follow along, please go to www.airgas.com, click on the Investor shortcut at the top of the screen and then go to the Conference Calls & Webcasts page.

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

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

We will take questions after concluding our prepared remarks, and we plan to end the teleconference by noon Eastern Time.

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

Peter McCausland

Thank you, Jay. Good morning and thank you all for joining us.

As you know, economic activity in the third quarter was remarkable, as domestic and global markets deteriorated into a very challenging business environment. As recently as the first week of December, results have been largely in line with our expectation. But more significant slowing developed into excessively low holiday activity levels. We have seen some improvement in the last week, but it's too early at this point to say that it is a meaningful recovery.

Slowing was widespread, both geographically and across customer segments. Many customers extended their plant shutdowns; which is usually the case, but this holiday season it was inextraneous. And there seems to have been a broad wave of inventory destocking. Despite these conditions, we grew our net earnings to almost 63 million or $0.76 per share diluted share, which was at the top of our revised earnings guidance range for the third quarter.

Total sales in the quarter increased 7% to 1.1 billion, with acquisitions contributing 6% of the quarter's sales growth. Total same-store sales grew 1% with price up 6% and volume down 5%. Gas and rent same-store sales growth of 6% was largely offset by a 5% decline in hard goods same-store sales for the quarter.

Our operating margins held up relatively well, expanding by 40 basis points to 12.1% for the quarter, demonstrating our ability to react quickly in a downturn and reflecting the contribution of acquisition synergies. Some of the margin expansion was driven by sales mix as gas and rent exceeded 62% of sales, and some came from reduction in variable expenses related sales such as incentive compensation and overtime.

As we stated when we lowered our third quarter guidance, we have begun implementation of plans that will generate $35 million in annual cost savings. These savings are above and beyond the benefits achieved through our operating efficiency programs, which were undertaken independent of the current economic environment. We are prepared to initiate a second round of reductions, if necessary. Mike will talk about cost savings in more detail shortly.

Looking closely... closer at the quarterly results across our geographies, the East, Mid-America and Southwest regions posted the strongest sales gains, with Mid-America being the only region to realize positive hard goods same-store sales. The most pronounced slowing took place in the Great Lakes region and the Pacific Northwest. Slowing in the Great Lakes area was related to the uncertainty of the big three auto manufacturers, which seem to drive tier-1 and tier-2 suppliers to a defensive state of inactivity.

In the Pacific Northwest, slowing was broad-based and exaggerated by the Boeing strike and December blizzards. Nationwide customer segments that posted sales growth throughout the quarter were medical, analytical, and food and beverage. The most dramatic declines in December were in industrial manufacturing, petrochemicals and utilities. Manufacturing has been moderating for more than a year now, while petrochemical and utilities had here before been growing quite nicely.

Our construction customers also had a lackluster quarter, driven by project delays, deferrals and weather interruptions.

Cash flow continues to be one of the strengths of our business model. Year-to-date, we have generated free cash flow of 171 million, up 6% over the prior year, despite a rise in capital expenditures related to production facilities. We have now reported six straight free cash flow quarters in excess of 50 million, even while funding significant plant projects during that time.

Year-to-date operating cash flow excluding the impact of our accounts receivable securitization program has grown by more than 25% over last year. That's $327 million last year compared to $413 million for the nine months this year.

As of October 31st, we had spent all authorized funds available under our original share buyback program. In November, our Board of Directors elected not to authorize additional share repurchases. The Board will continue to evaluate repurchases periodically and may authorize an additional spend at a later date.

Slide three represents a recap of this year's acquisitions. Year-to-date, we've acquired 13 companies with more than $200 million in annual sales. Since October 1st, we have acquired seven companies with 58 million in annual sales, primarily in our core industrial gas distribution business.

These transactions have increased density in our distribution network in key geographies such as Ohio and Southern California in addition to expanding our presence in East Texas. We are continuing our integration of the Refron acquisition, which added significant refrigerants distribution to our infrastructure. We have already had some success in cross-selling refrigerants to our core customers and expect further benefit as we integrate our offering and capabilities into our distribution platform.

Acquisition activity has slowed somewhat, but we are shaking the bushes. Our primary focus remains on core and product line adjacency acquisitions through fiscal 2009, but we will continue to evaluate international opportunities as they arise.

It is wildly accepted that the U.S. is in need of considerable infrastructure investments, ranging from energy infrastructure such as power grid, gas pipelines and petrochemical development to public works infrastructure such as bridges, highways and water works. A focused infrastructure build with support demand for industrial gases, welding goods and safety supplies; all of which are at the core of our product offering. While it remains to be seen, when and if such a stimulus package is passed to address infrastructure rebuild and the implementation will not be immediate, we do think the outcome will be incrementally positive for Airgas.

Further implementation of environmental regulations would similarly be beneficial for us. Looking forward, we intend to stay focus on our fundamental business strategies, and mine the growth opportunities that are available to us. Areas such as strategic accounts, specialty gases, bulk gases, energy and infrastructure construction, medical and food and beverage will continue to help us even in this difficult environment.

At the same time, we will pursue all available cost savings to protect our earnings and cash flow. As we exercise our competitive strength and balance our short-term and long-term strategies, I believe we will emerge from this downturn stronger than ever.

Mike will now give us a review of market strategy and operations.

Michael L. Molinini

Thank you, Peter and good morning to everyone. Peter just mentioned our strategy in today's challenging economy is to maximize value creation by pursing all available growth opportunities, while minimizing operating expense and capital expenditures.

Although we consider our approach to be judicious, we plan to stay on the offensive and avoid a bunker mentality. We'll maintain our focus on our competitive advantages such as strategic accounts, energy and infrastructure construction and strategic product offerings and at the same time, we'll manage our cost structure appropriately for today's environment.

Our strategic accounts business grew 9% for the quarter and has grown 14% year-to-date.

Our national infrastructure, technical expertise, and broad product offerings create real value for customers with multiple locations. Customers facing tougher times tend to renew their interest in supply chain savings, and we're seeing a heightened level of interest in our strategic accounts offering right now.

We are also seeing increased opportunities for our outlook supply chain management program, as high-volume cylinder customers turn to us as on-site experts in managing their supply chain.

Contractor customers, who struggled this quarter with shutdowns and weather, are still responding favorably to our strategic accounts program, which offers a full line of products along with management certification and safety consulting services.

In fact, one of our recently acquired standalone businesses, Oilind Safety turned in one of the best same-store sales performances of the quarter.

Of our overall construction offering, we currently have a small portion of the spend of the top 450 U.S. contractors. So even in a slowing economy, the opportunity for growth is significant. And as Peter mentioned, activity resulting from a federal stimulus plan would be incrementally positive.

Our strategic product categories of bulk, medical and specialty gases, CO2 and dry ice and safety products make up about 40% of our revenue. And in total, they posted 4% organic growth for the quarter. Strong growth in bulk, medical and specialty gases was off somewhat by weakness in safety products, CO2 and dry ice.

All of these products have good long-term growth profile, due to favorable customer exposure, application development, and regulatory acceleration, strong cross-sell opportunities or a combination thereof.

Bulk gas sales were up 13% for the quarter, as we continue to capitalize and enhance production capabilities, and a strong sales force. For us, bulk sales represent a great cross-sell opportunity, because prior to the Linde bulk acquisition, we were primarily a cylinder gas company with limited bulk capability.

With 16 air separation plants today, including the two new plants in Indiana and Kentucky, we have a competitive bulk offering for a large base of customers who have historically purchased their bulk gas elsewhere. Our ability to engineer solutions to customer needs has also been effective in winning new bulk accounts, as customers look for more efficient production methods in a tough economy.

Specialty gas sales grew 7% for the quarter, driven by demand from our expanding account base in biotech, life sciences research and environmental monitoring markets. In order to support further growth, in the last year, we have substantially increased the capacity of our national specialty gas production network, adding proprietary automation of both the filling and analytical process to all of our major specialty gas plants.

We also have a world class hydrocarbon mixture facility coming online soon in Texas. Complementing the growth in specialty gas sale, our related gas equipment and engineered gas management system sales continue to strengthen, including sales of our patented award-winning smart products, gas control devices, targeting the analytical markets.

Medical sales posted 8% growth for the quarter. Our hospital and doctor, dental segments continue to grow, as an ageing population drives increased demand for respiratory therapy. Both of these segments posted double-digit growth this quarter, while the homecare provider segment was modestly positive.

New business signings were strong across all medical segments, as our broad product offering in full range of supply modes makes vendor consolidation for hospitals evaluated proposition.

We're also experiencing solid growth in nursing homes, hyperbaric facilities, EMS and specialty clinics.

Safety product sales declined by 1% compared to the prior year quarter, driven by an extended plant shutdown and inventory destocking in the back half of the third quarter. The decline in safety product sales in the third quarter was also meaningfully impacted by the Boeing strike, without which safety product sales likely would have been flat year-over-year.

We are pleased to see the Boeing strike end shortly after we received a multi-year extension of our contract with them.

Finishing out our strategic products; CO2 and dry ice were down 3% compared to the prior year quarter. Dry ice demand in the airline service segment was down in the quarter. More significantly, in the prior year, there were large surcharges in our CO2 and dry ice sale, with two feedstock plants for our liquid CO2 production were shutdown simultaneously, forcing us to source product from other location.

Excluding the impact of surcharges, our CO2 and dry ice sale yield a 1% growth rate for this year's third quarter.

Radnor private label products grew by 17% this quarter. In addition to building brand loyalty within our customer base, Radnor products enhance our profitability because they carry higher gross margin than comparable OEM products. Existing product lines continue to make strong contributions as do product line expansion and the addition of Radnor brand in acquired stores.

Airgas Specialty Products where our refrigerant business was managed prior to the Refron acquisition is now focused solely on ammonia and processed chemicals. We continue to gain new customers in the ammonia business as power and other large plants come online requiring ammonia for DeNOx applications. And we'll also benefit from the new requirement that utilities run their DeNOx units year around as opposed to only five months of the year.

Peter also mentioned that our integration of the Refron acquisition continues, and we believe our refrigerant strategy has us positioned for good long-term growth. Our operating efficiency programs which focus on fill (ph), maintenance and testing, distribution of fill plant logistics and freight and fuel management are on schedule to achieve the targeted $25 million in run rate savings by September 2010

UT cylinder test savings are the largest component of savings to date while distribution logistics initiatives are starting to take hold and produce meaningful results. In addition to our operating efficiency targets, we recently announced actions targeting 35 million in annual cost savings, including reductions in staffing and other personnel expense, such as overtime and temporary help as well as savings in discretionary categories, such as travel and entertainment.

In the December quarter, these actions amounted to a net savings of about $1 million. We expect to be at the full run rate on these savings by the end of March and anticipate about 7 million of savings in the March quarter net of about 1.5 million in severance. Given the challenging environment, we are preparing for another round of cost savings in case conditions do not improve.

We also intend to protect the infrastructure that we have built and maintain our operating momentum, and we'll continue to invest in training and our core strategy to enhance the Airgas customer experience so that we will emerge in this slowdown even stronger than we are today.

In addition to cost savings, we are optimizing our hardgoods inventory for the current business climate and expect to be able to reduce our investment there without compromising customer service. Similarly; we are scaling back our capital expenditures across the board and expect to complete most of our current major planned projects in the next couple of quarters.

Our new air separation plant in new Carlisle, Indiana was brought on stream on December 30th. The air separation plant under construction in Carrollton, Kentucky is on schedule for an early April commissioning. Our Deer Park, Texas CO2 plant is scheduled to begin a full production in early March 2009 and the Camilla, Georgia CO2 plant is slated for commissioning in November 2009.

In addition, most of our capital projects associated with the Linde acquisition are wrapping up in the near term and our need to purchase cylinders and bulk tanks is significantly lower today than it was early in the year. We expect to reduce our core capital spending meaningfully in the near term and we'll give further guidance on this subject when we issue our full year fiscal 2010 guidance in May.

We're also progressing with the design and configuration phase of our SAP implementation. We have selected the Deloitte Consulting as an integration partner and the project teams have begun their work. The long-term benefits of this project plays at the heart of our core strategies as the unification of our myriad, our back office and front office platforms will cement our capabilities in a single solid foundation.

We expect to spend the next year focus on design and testing followed by three to four years of phased implementation.

Now Bob will give our financial revenue of the quarter.

Robert M. McLaughlin

Thanks Mike. And good morning, everyone. To review our consolidated results, I'll start with slide number four. As I go through these results, please note that we have GAAP reconciliations for the various metrics on slide eight through 11.

Quarterly earnings per share grew 13% year-over-year, $0.76 in the quarter. Sales increased 7% to $1.1 billion with acquisitions contributing 6% of the growth. Same-store sales increased by 1% with 6% growth in gas and rent offset by a 5% decline in hardgoods.

Overall, price was up 6% and volume down 5%. Gas and rent represented 62% of our sales mix, comparing favorably with the prior year mix of 59. The sales mix shift is driven by the relative strength of gas and rent same-store sales, compared to hardgoods and by the mix of acquired revenues. The favorable gas and rent mix is also reflected in our 53.6 growth margin for the quarter, an increase of 130 basis points over the prior year.

Operating expense as a percent of sales was 36.4%, 60 basis points higher than the prior year, primarily driven by the significant decline in quarter-end sales and higher bad debt expense.

Operating income for the quarter was 131 million, up 10% over last year. While operating margins were negatively impacted by significant slowing in quarter-end sales, operating margin improved 40 basis points over the prior year, driven by gross margin expansion, acquisition synergies, operating efficiencies and the initial impact of cost reduction efforts in response to slowing sales. Sequentially, operating margin was down 40 basis points due to the quarter-end sales drop-off.

There were 82.7 million weighted average shares outstanding for the quarter, down about 2% both year-over-year and sequentially. Our return on capital was 13.5% for the quarter, a 40 basis-point improvement over the prior year, driven by the year-to-date 40 basis-point expansion in operating margins.

Our collection rates for the quarter on accounts receivable have remained relatively consistent both year-over-year and sequentially. So, we are effectively managing our collections in this challenging environment. As previously stated, we did experience an increase in bad debt expense in the quarter, and we expect it to be above normal levels in the near-term and are guarding our exposures accordingly.

DSO at the end of the quarter increased slightly from 48 days to just over 50 days. Our other primary working capital metric, inventory turns held consistent with recent trends at 4.5.

Year-to-date free cash flow was 171 million compared to 162 million last year, driven by earnings growth and strong operating cash flows, partially offset by elevated spending on planned construction projects and post-acquisition facility consolidations.

Adjusted debt at the end of the quarter was just under 2.2 billion. Our fixed to float ratio was 55% fixed and our adjusted debt to EBITDA ratio was under three comfortably in the middle of our range of 2.5 to 3.5. As of the end of December, more than 230 million was available under our long-term credit facility.

Please turn to slide five and we'll look at our segment results. Distribution sales were up 5% to 882 million for the quarter with fundamentally flat same-store sales. Pricing growth in the distribution segment was offset by volume declines. Distribution gas and rent same-store sales were up approximately 5% with negative 5% volumes offset by a positive 10% pricing impact.

Volume growth in bulk, medical and specialty gases was more than offset by the decline in industrial gas. Distribution hardgood same-store sales were down 5% with negative volumes of approximately 7%, offset by positive pricing of 2%.

Distribution gross margin was 51.8%, an increase of 180 basis points over the prior year, reflecting a favorable sales mix shift to gas and rent and price increases. Operating income in the distribution segment was 106 million, up 12% over the prior year. The related operating margin improved 80 basis points from 11.2% to 12%, driven by gross margin expansion, acquisition synergies, operating efficiency programs and the initial impact of cost reduction efforts in response to the slowing sales. The negative impact of the significant slowing sales at the quarter end was the primarily driver in a sequential operating margin decline of 50 basis points.

Sales for all other operations increased 19%, with same-store sales up 8%, driven in part by strong growth in ammonia sales. Overall, price contributed 9%, and volumes declined by 1%.

Operating income for all other operations was up 5% for the quarter. Operating margins decreased by 130 basis points, primarily by a mix shift towards refrigerants, including the impact of the Refron acquisition.

Please turn to slide six, capital expenditures. Year-to-date capital spending was 282 million versus 193 million last year. Spending on cylinders, bulk tanks and rental routers has moderated with sales growth, while the predominant growth in our spending has been on large projects in the construction and progress category. Excluding ASUs and another major construction projects, year-to-date capital spending as a percentage of total sales was about 5% inline with year-to-date same-store sales growth.

Please turn to slide seven to further discuss our free cash flow. The doted line represents our distribution same-store sales trend, measured on the right axis. The shaded area between the operating cash flow and CapEx lines represents our free cash flow, measured on the left axis.

We can use free cash flow to invest in acquisitions or growth CapEx, pay down debt or repurchase shares. During moderating or slower growth periods, we can dial back growth CapEx and working capital, generating incremental free cash.

As you can see from the trailing 12-month numbers as of December and March 2008, we've significantly grown our free cash flow, as same-store sales rates have moderated from the high rates of fiscal '05, '06 and the first part of fiscal '07. A similar expansion of free cash flow was realized in fiscal '02 and '03, when sales growth rates had moderated as well.

Also during this period, operating cash flow has grown from approximately 130 million in fiscal 2001 to 571 million for the 12 months ended December 2008. This represents a 24% compound annual growth rate, consistent with strong sales growth over this extended period.

Now, turning to guidance. Our earnings expectations for the fourth quarter of fiscal 2009 are 73 to $0.76 per diluted share, a range similar to our third quarter earnings. Accordingly, our expectations for the full year per diluted share are $3.16 to $3.19, an increase of 19 to 20% over the prior year.

We want to stress that today's economy provides very little visibility into future sales results. Our guidance assumes a slight acceleration of sales through the quarter from the slow start we've experienced in January, and overall modestly below third quarter sales level. It also incorporates the estimated $7 million benefit of expense reduction plan that Mike mentioned, and a slight reduction in our weighted average interest rate.

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

Jay Worley

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

Question-and-Answer Session

Operator

(Operator Instructions). We'll go first to Bob Koort, Goldman Sachs.

Robert Koort - Goldman Sachs

Thanks. Good morning. Maybe if you could talk a little bit... you mentioned the bulk business was up 13%. Is that all organic growth? And what are your expectations for that end market as we go through the third next couple of quarters?

Michael Molinini

Yes, it's primarily organic. With our additional production capabilities, the opportunities for us to supply customers with bulk that they have sourced elsewhere, where we already have the cylinder and all the supply business, that's a pretty target rich environment. And we will continue to mine that heavily, and we do expect to continue to see it grow.

Robert Koort - Goldman Sachs

And what's the value proposition to the customer? How is your opportunity there different than a competitor?

Michael Molinini

We are very... we are already very embedded. I mean, we have people embedded in these customers, almost on a daily basis. For other suppliers, it's again a simplification; it's the dealing with less suppliers, if somebody that's onsite, and can manage their entire supply chain from big bulk down through cylinders, down to safety supplies, and anything else they need.

Robert Koort - Goldman Sachs

Got it. And a follow-up, if I might. Peter, may be a history lesson, the last time we went through such horrific industrial end markets, can you talk a little bit about what happened on the pricing dynamic? And how it might be different the environment this go around, or will it be similar? Thanks.

Peter McCausland

I would say that the last one was started... the last downturn started in '98. And as you'll recall, we had a very strong dollar, and companies were closing facilities left and right. And it was a very, very serious industrial recession, and somewhat different, whereas this one started in housing and consumer sectors, and the financial sectors. That one started in industry, and really devastated the industry. And I don't think this one is going to be as bad for industry.

Also, the capacity utilization on the air separation plant was pretty low going into that recession, because Messer and some others had really overbuilt their air separation networks. And I think they started out like in the high 70s, and at the beginning of recession, and of course they went really, really low. I think they even got as low as the high 60s at one point.

And so, I would say that that's another difference between now and the last recession. The capacity is still pretty tight. We're running at pretty high levels right now. And we think that most of the players in the industry are, and there hasn't been that many new additions over the last four or five years. So, there's been a lot more discipline.

And then I would say, the last thing is that we, in the last recession, we had spend a lot of money on infrastructure and repositioning, and so that... those two things drove down our operating margins much more than they otherwise would have been impacted. And we're a very different company today. Our infrastructure is fully utilized, and we are realizing the economies of scale, because we're bigger, we're a much better operating company. So I would draw that distinction too.

And then, in terms of pricing, specifically I mentioned that capacity utilization differences, and on the air separation plants. And I think that will be the biggest thing.

Another thing is there are still power cost increases going through the grid. And customers understand that, because they get power bills as well. So, we expect pricing to hold up better than it certainly did back in '98.

Robert Koort - Goldman Sachs

Great. Thanks, Peter.

Peter McCausland

Sure.

Operator

We'll take our next question from David Begleiter, Deutsche Bank.

David Begleiter - Deutsche Bank

Thank you. Peter, you mentioned you've seen some improvement in January. Can you detail where and how much?

Peter McCausland

I'm just looking at our daily sales and they've gradually improved throughout the month. They started at dead like it was late December. And they always do start slow in January but everything has been magnified 100 times this year. And so in the last week, we've seen a steady sort of pickup in the daily sales. But as I said, it's too early to say that this is a meaningful recovery.

David Begleiter - Deutsche Bank

I think you also mentioned your guidance assumes an acceleration. Is that off of the December base or off of a different base?

Peter McCausland

It's off the December sales. We expect some modest improvement and certainly if this trend were to continue and sustain, that would give us the modest improvement. But we're not sure it's going to. There is a lot of crazy stuff going on out there and now the least of which is the turmoil in the auto manufacturing area.

David Begleiter - Deutsche Bank

And can you also update us on the new ASUs both Indiana and Kentucky in terms of being sold out and potential earnings contribution for 2010?

Peter McCausland

Well the first plant just got turned on, and we have been debugging it and knock on wood. As of a couple days ago it's making all the products to spec and running very well. Our pipeline customer Mittal Steel is actually taking quite a bit of nitrogen. So up toward the upper end of our expectations and we've sold a lot of that product and I'll let Mike tell you what percentage.

And then the Carrollton plant which is an identical plant, we are building next to Dow Corning with the pipeline to them in Carrollton, Kentucky is under construction. And we're looking at an April start date, and we're busy selling out that plant. And Mike will give you the exact figures but remember, we still purchased over 70% of the products that we sell, gas products that we sell. So there will be a significant transfer of product from our suppliers' production plants to our plants when they are finished. Mike?

Michael Molinini

Yeah. I think the initially the Indiana plant is probably going to be about 70%, in that order of magnitude utilized. And I'm not sure exactly what the number is in Kentucky when we turn it on, but it's probably in that... it's in that range. And they're probably worth $0.02, $0.01 to $0.02 a year.

David Begleiter - Deutsche Bank

Is that each or combined?

Michael Molinini

Each.

David Begleiter - Deutsche Bank

Thank you very much.

Operator

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

Mike Harrison - First Analysis

Hi, good morning.

Peter McCausland

Good morning, Mike.

Mike Harrison - First Analysis

Just maybe a follow-up question on the ASUs with only 70% of the volumes sold, I mean is there a risk that those ASUs could struggle with profitability? And as you look at the $0.01 to $0.02 a year of contribution in EPS, how would that change as you start to approach 90 to 100% utilization?

Peter McCausland

Well, first of all when we built, when we decided to built them, that's exactly the kind of loading that we put in the plant. We expect to load them probably three years or so after we built them. So the downside is, there's not a lot of downside for us. There is a lot of upside and they get very profitable. The faster you load them the better it's going to be. So the faster we grow our bulk business in those areas and we can reload them, the better it's going to be.

Robert McLaughlin

And they're immediately profit... they're accretive. They will... one of them is accretive already, it's started and the other one will be, that's our expectation and that accretion will increase as the loading factor goes up.

Mike Harrison - First Analysis

All right. And then I was wondering, Peter or maybe Mike, if you can talk about argon, given the steel operating rates being so low, how has argon availability been? Is there a need to go out and get pricing higher there? What are you seeing in terms of customers switching shielding gases to something with maybe a lower argon mix and how does that end up affecting you from a margin standpoint?

Peter McCausland

Mike, first of all we buy more argon than we make. So we're a big purchaser of argon from a number of suppliers. And depending on who the supplier is and depending on who the big plant is that he is supplying and making argon, the availability of argon today would... could vary dramatically. We are fine with supply, we have passed on an occasion surcharges for argon in certain areas for our products that we get from suppliers that they have a big steel mill that's gone down where they have the windmill plant and to make the argon.

And so far customers are not happy about it. They understand that what's going on and then they need the supply. And no, we have not seen any material migration to some other shielding gas, don't expect one either.

Mike Harrison - First Analysis

All right. Last questions for Bob, in terms of the SG&A costs with the end of the fiscal year coming up any kind of accruals or bonuses or anything else that we could see reverse in the fourth quarter and maybe give you a one time reduction in SG&A costs?

Robert McLaughlin

Come on, give us a break, we had a good year. Yeah. Depending upon where we end up, we true up our bonus and other accruals every quarter. So, relative to as we kind of project out we've made some adjustments. So there certainly could be some more adjustment which we baked into the forecast, but I don't think there are going to be needle movers.

Mike Harrison - First Analysis

All right. Thanks very much.

Operator

We'll go next to Laurence Alexander, Jefferies.

Laurence Alexander - Jefferies & Co.

Good morning.

Peter McCausland

Good morning.

Laurence Alexander - Jefferies & Co.

I guess, first, to follow-up on that last question, was the truing up of your accruals this quarter and the impacts of more than $0.01?

Robert McLaughlin

No.

Laurence Alexander - Jefferies & Co.

Okay. Now I guess question on the M&A front. I mean as you are looking at M&A front, I mean as you are looking assets for potential acquisitions, how do you look at... how confident are you in the EBITDA when you're valuing the assets that you're acquiring? Or and how has this volatility in the market changed your acquisition strategy?

Peter McCausland

Well, we project companies out eight years and we assume flat sales. So, and then we try not to buy them on the downside. I mean when we see a company's sliding, we... it's reflected in our offer. But companies in this business do pretty well even in a bad environment. So, and the sellers tend to know that. So, I think the flat sales for eight years and the caution that we exercise in tough environment like this, pretty much takes into account, and that kind of swing and it works out.

Laurence Alexander - Jefferies & Co.

Then lastly on the pricing. Can you give us a little bit more detail on which product areas you've seen the most pricing in particular are you see... are you managing to get any price change on your cylinder rental fee?

Peter McCausland

We did get increases in the late summer which was very effective. And at this point we are not planning anything right now.

Laurence Alexander - Jefferies & Co.

Thank you.

Operator

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

Kevin McCarthy - Bank of America Securities

Yes. Good morning.

Peter McCausland

Good morning.

Kevin McCarthy - Bank of America Securities

I've few questions on hardgoods, one of your competitors yesterday posted same-store sales down 10% or roughly twice as much yours. I wonder if you could address why you feel you might be a little bit better than the industry in terms of maybe geographic mix differences, product mix differences or other factors? And my second question, would you comment on where you're seeing same-store sales in equipment versus consumables, presumably equipment is under more pressure and how bad is that getting in the December, January timeframe? Thank you.

Robert McLaughlin

I will take the one on same... our same-store sales. I am not sure I haven't looked at that competitor same-store sales yet. I do have an email about it, and I will take a look at it. But I think that our strategic products emphasis and our strategic account activity are accounting for some good growth, more modest than it has been. But certainly descent growth that's offsetting sort of the industrial customer weakness, and I think that's helping us a lot. And I expect that to continue.

I feel like we have a lot of momentum in bulk gases and specialty gases, in medical gases and I think that and we have some new plants coming on that give us new capabilities in the atmospheric gases and in CO2. So I expect that to continue and I think that's been a real help over the last couple of years. And it becomes more evident in a downturn.

I'd let Mike address the mix of the hard goods, because he's very close to it right now. But it's not surprising in an environment like this that we see a big decline in hard goods.

Michael Molinini

Something I have been saying for a long time and will continue to say that the indicator in the hard goods business is the equipment, which is the capital purchases by that customer. And we, our equipment sales in the quarter were down north of negative 15%. And we're the single biggest piece by far, because our small... because our lowest margin sale in the entire portfolio, which is one of the reasons that the impact on the sales line that really doesn't carry a lot of weight. But it was... they were way, way off and then in fact we had a couple of pre-scheduled very large equipment sales that did go through, which maybe makes it even a little worse than that... than what I said. So, we expect equipment to continue to be very, very soft and no other segment in the hard goods was off to near the extent that the equipment was off.

And we sell equipment, we sell filler metals and then we sell all of the consumables and supply products and safety. The safety and the general consumable stuff was down the least and then the filler metals were down much less than the equipment, but they were down and then the equipment was way off. Okay?

Operator

And we go next to Mike Sison, KeyBanc.

Michael Sison - KeyBanc Capital Markets

Hey, good morning guys.

Michael Molinini

Hi.

Michael Sison - KeyBanc Capital Markets

Nice quarter. Underlining the assumption that fourth quarter is going to be a little bit less than the third quarter, is that more driven on volume being little bit weaker year-over-year that what you saw on the third quarter?

Peter McCausland

Yes. I mean that's the assumption and we're talking primarily sequentially.

Michael Sison - KeyBanc Capital Markets

Okay.

Peter McCausland

October was very good.

Michael Sison - KeyBanc Capital Markets

I got you. So the volumes will be tracking more of what November and December were looking like in the first quarter than what you saw in October?

Peter McCausland

With some rebound as we get into March, almost the inverse of the October to December.

Michael Sison - KeyBanc Capital Markets

Okay. Then if you think about pricing, pricing holds, it should anniversary sometime in 2010. But if does hold, what type of pricing sort of lay over occurs in 2010 versus 2009?

Peter McCausland

Probably somewhere in the neighborhood of 3%, on the gas side.

Michael Sison - KeyBanc Capital Markets

On the gas side, okay.

Peter McCausland

And the pricing outlook, as I said, we don't expect to be giving back pricing, but we also don't expect to be out there with major initiatives. However, we'll continue to increase pricing where customers have been enjoying large discounts and we try to eliminate some of them and so we have a different pricing strategy in an environment like this than you did let's say, year and a half ago. And we'll continue to pursue that and then there are special situation shortages and like Argon and things like that where we're going to have to get some additional pricing because we have significant additional expense.

Michael Sison - KeyBanc Capital Markets

Right. And last question, in terms of strategic growth platforms in total, you've been tracking at 10% plus 4% sort of came in the quarter, still they are pretty good in difficult environment. How do you think that whole area performs heading into next couple of months and into 2010?

Peter McCausland

Well, it's going to outperform the core industrial business, there is no question about it. And some of the... like bulk products, they grow twice GDP, and spec gases grow maybe 1.5 times GDP, probably under this administration at least, twice GDP, because of more regulation. And medical gases have been growing at 1.5 times GDP.

So, it's going to be a function of the economy to some degree. They will outperform the core products. I expect them to get back into double-digits as the economy recovers.

Michael Sison - KeyBanc Capital Markets

All right. Thank you.

Operator

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

Mark Gulley - Soleil Securities/Gulley & Associates

Hey, good morning guys. Yesterday one of your competitors said that a lot of industrial customers would shut down plants, because of the low demand, are taking the time to do a lot of MRO, maintenance, repair and overhaul. Are you seeing the same thing, and if you are, is it simply pulled forward MRO activity that would have been done anyway now in the future?

Peter McCausland

We are seeing just a normal MRO activity. We didn't... I heard about that comment. And it... they must be talking about something other than what we're seeing. We're just seeing the routine activity, and sometimes there are a few additional turnaround things people take care off, when their shutdown gets extended from one week to three or four weeks. But I really haven't heard of anything really meaningful to us. Have you, Mike?

Michael Molinini

No, what we've seen though is holiday shutdowns that were normally a week, and it became four weeks. And probably overall, the number of shutdowns of industries for extended holiday periods, was up by probably four times higher than we've even seen before.

But not any dramatic increase of... we're going to take our maintenance or pull maintenance forward real quick, and try to ram it in over this holiday. Nothing material there for us, lot of shutdowns over a long period of time.

Mark Gulley - Soleil Securities/Gulley & Associates

Yeah, that's helpful. And then on the free cash flow slide, the so-called yellow slide, CapEx comes down next year as you've already indicated. Is that free cash flow going to expand meaningfully on that slide?

Robert McLaughlin

Well, certainly CapEx will be a contributor, and we think that there is going to be a meaningful reduction in CapEx. So a lot then will depend on how this economy plays out, and the strength of our sales and operating cash flow. But we're optimistic about a strong cash flow performance.

Mark Gulley - Soleil Securities/Gulley & Associates

And finally, one on the M&A environment. It was addressed earlier, but I am trying to determine to what extent are sellers simply sitting on the sidelines, not allowing the sell-off of depressed numbers, or are your M&A discussions there come on normal level?

Peter McCausland

No, I'd say it's a little sluggish. And we're talking to people, we have deals in the pipeline. But it's not as full as it normally is. And I would... I think your characterization of the sellers is probably right on.

They know that this is a pretty good business. It holds up well in a soft economic environment, and they will... some of them are waiting it out. And, the industry... there is a fair amount of optimism in the industry long-term, once we get past this cycle. I mean people do feel like there is going to be a lot of infrastructure construction, maybe not in the President's care package. But there is a lot of infrastructure in this country that needs to be replaced and renewed. And that was starting before this economic tsunami hit.

So, I think people are optimistic about that, and optimistic about greater environmental regulation, and other things. So, we are not seeing any desperation among the sellers, and they're sitting out. And as I said in my remarks, we're beating the bushes.

Mark Gulley - Soleil Securities/Gulley & Associates

Thanks, Peter.

Peter McCausland

Sure.

Operator

We'll go next to John Roberts, Buckingham Research.

John Roberts - Buckingham Research

Good morning, guys.

Peter McCausland

Good morning, John.

John Roberts - Buckingham Research

Everyone's feeling the indirect effect of the credit crunch on overall economic activity. Any direct effects showing up, either among your customers, your competitors that either thinking it for sale, not for sale or business has been bought because of specific credit issues that you know of.

Peter McCausland

Well Bob mentioned the AR. We had a couple of big customers, file for bankruptcy. One of them we got preferred supplier status which was very helpful. So we got paid most of our pre-declaration receivable. And we continue to supply. But we got... and then there is a third one with a window manufacturer that where we took ahead. We are looking at it very carefully and doing a good job managing it. And in terms of our competitors we've heard of cutbacks at several of our competitors. And there is a lot of resumes falling our way these days.

But, I don't know how... only our competitors know how deep they cut and why they cut and where they are soft. But they are the two things, resumes and a couple of bad debt that kind of stung us. And of course normally (ph), we've got to manage that closely that I am saying. And say maybe also the third thing, now I think about is there has been some slowdowns of major construction projects. There is a couple of used refineries where we have the work and the supply to the contractors and they went from three shifts to one shift. And I don't know if this is just to get through the credit.

Once we get through the credit crisis, it's going to pick up or whether it's going to be somewhat permanent or what. But I can imagine it's going to... there is going to... that costs a lot of money to the slowdown in construction project like that. So I can imagine it's going last too long. They are the three things I'm seeing.

John Roberts - Buckingham Research

And secondly, the strategic products growth of 4% was less than the same-store gas and rent growth of 6%. And so wouldn't you've expected the strategic products to be ahead of the overall gas and same stores sales number?

Michael Molinini

Well, safety products was a drag on that. And the safety products drag was... a big impact on the safety products drag was the Boeing strike.

John Roberts - Buckingham Research

Okay, thank you.

Michael Molinini

Sure.

Operator

We'll go next to Luke Yankee (ph), Robert W. Baird.

Unidentified Analyst

Good morning.

Peter McCausland

Good morning.

Unidentified Analyst

Can you maybe just talk little bit about new changes and how you're thinking about uses of cash going forward, whether your focus is on acquisition still or maybe just sitting on the cash or even looking at paying down the revolver a little bit?

Robert McLaughlin

Well, the orders been given. Our guys are out there generating as much cash as they can. And through receivables management, through conservative, being conservative on CapEx through expense reduction round one, and if we need to, we can go it around two and three as Mike described. And we are still looking for core acquisitions and but we're being cautious in our evaluations. And we are very cautious about adjacency acquisitions where we are not already in that adjacency.

We probably won't be doing any of them until the new ones, until the smoke clears and we're cautiously looking at international opportunities. But I think the emphasis is on a word cautiously. These kinds of businesses can generate a lot of cash in a downturn and we are determined to do that and it would go towards debt reduction.

Unidentified Analyst

And then second just slightly related that you mentioned how much have you neared on the revolver. I am just wondering how much is LME Airgas exhibition (ph) as of third quarter.

Michael Molinini

It's been a consistent amount at $360 million.

Unidentified Analyst

Okay, thanks guys.

Peter McCausland

Sure.

Operator

We'll go next to Steve Byrne, Bank of America.

Stephen Byrne - Bank of America

Hi, I just wanted to ask you a little bit of your ammonia business, the wholesale ammonia prices out there have just been massively volatile over the last year. And I wanted to ask you how do you protect yourself or how do you price that product in the face of such a volatility and can you hold on to some of those higher prices that were around six months ago?.

Michael Molinini

It was probably the single most volatile area that we have, and we did... our guys in the ammonia group did a really nice job of not having very much of our customer pricing locked-in. And we were able to raise prices ahead and at the same time that those increases... we were getting the increases. They also did a really nice job and of course when that comes down, customer prices will come down in ammonia.

We've also done, and they also have done a really nice job of managing inventories. So that we were not burdened with lots of the high price inventory. We were able to remain very nimble. And so they did a great job of managing it up and down. I think the price and the revenue in ammonia will come down. But the margins will remain strong.

Peter McCausland

And it may go up.

Michael Molinini

It will go up because of the applications just in volume will grow.

Stephen Byrne - Bank of America

Now let's pass through of that raw material costs, so your margin should go up. Right?

Robert McLaughlin

Margin dollars.

Michael Molinini

Dollars, yes.

Stephen Byrne - Bank of America

I mean your margin as a percentage, right. And then on that, in that business what is the typical volume that a customer requires for their compressors and do you fulfill this business all out of your hundreds of facilities or out of relatively few?

Michael Molinini

Yes, we run that as a national business on to itself. And it's probably managed out of... now I'm going to guess, on the order of a dozen terminals, ammonia terminals where we would receive bulk ammonia, typically in railcar and then we would repackage it from tank trucks, on down through ton containers and cylinders and distributed. There is some that goes through our branch based businesses, but the majority of the volume is sold direct to customers by the ammonia guys in bulk tanks.

Below railcar quantities typically are sweet spots.

Peter McCausland

We're in the packaged ammonia business.

Michael Molinini

Yes.

Stephen Byrne - Bank of America

Okay. Thank you.

Peter McCausland

Sure.

Operator

Due to time constraint, that concludes the question and answer session today. At this time Mr. Worley, I will turn the conference back over to you for any additional or closing remarks.

Jay Worley

We would like to thank everybody for joining us. We know that there were still some callers left in the queue, and I will be able all afternoon today for follow-up questions. Have a nice day.

Operator

This concludes today's conference. We thank you for your participation. You may now disconnect. Have a wonderful day.

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Source: Airgas F3Q08 (Qtr End 12/31/08) Earnings Call Transcript
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