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Executives

Nelson Squires - Director, Investor Relations

Paul E. Huck - Senior Vice President and Chief Financial Officer

Analysts

Jeffrey Zekauskas - J.P. Morgan

Prashant Juvekar - Citigroup

David Begleiter - Deutsche Bank

Sergey Vasnetsov - Barclays Capital

Michael Harrison - First Analysis

Michael Judd - Greenwich Consultants

Laurence Alexander - Jefferies

Kevin McCarthy - Banc of America

Michael Sison - KeyBanc

Robert Koort - Goldman Sachs

John Roberts - Buckingham Research

Mark Gulley - Soleil Securities

Edward Yang - Oppenheimer

Air Products & Chemicals Inc. (APD) F2Q09 (Qtr End 3/31/09) Earnings Call April 22, 2009 10:00 AM ET

Operator

Good morning and welcome to Air Products & Chemicals' Second Quarter 2009 Earnings Results Conference Call. Just a reminder that you will be in listen-only mode until the question-and-answer segment of today's call. Also, this telephone conference, presentation and the comments made on behalf of Air Products are subjected to copyright by Air Products and all rights are reserved. Air Products will be recording this teleconference and may publish all or a portion of the teleconference. No other recording or redistribution of this telephone conference by any other party are permitted without the express written permission of Air Products. Your participation indicates your agreement.

Beginning today's call is Mr. Nelson Squires, Director of Investor Relations. Mr. Squires you may begin.

Nelson Squires

Thank you, Jenny. Good morning and welcome to Air Products' quarterly earnings teleconference. This is Nelson Squires. Today, CFO Paul Huck and I will review our fiscal 2009 second quarter results and outlook.

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

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

Before we start, please note that today's comments on operating results will exclude last year's $26 million or $0.08 per share pension settlement charge. Details are included in the notes to the earnings release and our appendix slides.

Now, I will turn the call over to Paul.

Paul E. Huck

Thanks Nelson. Good morning, and thank you for joining us today. Now please turn to Slide Number three. As we indicated back in January, weak business conditions around the world have created a challenging business environment across our end-markets. As we expected, volumes were down significantly this quarter, as many customers ran at much lower operating rates. On a positive note, our volume trends did improve as the quarter progressed.

Sales at $2 billion declined 11% versus prior year, excluding currency and natural gas pass through impacts. Underlying business was off primarily due to lower volumes in our electronics and performance materials segment and, to a lesser extent our Tonnage Gases segment. Volumes are lower in Merchant Gases but this decline was mostly offset by higher pricing.

Sequentially, underlying business was down 4% on lower volumes across all segments except Equipment and Energy. Nelson will walk you through the details by segment momentarily.

Consolidated operating income declined by 31%, driven primarily by the lower volumes and unfavorable currency. Our operating margin declined a 140 basis points versus last year, primarily due to lower volumes, partially offset by higher prices and lower costs. Lower cost increased operating margin by 20 basis points sequentially even with the lower volumes. Despite lower than forecasted volumes, cost reductions moved earnings to the high side of the range and earnings beat expectations.

Our cost reduction actions are having an impact.

For the quarter versus prior year, our net income and diluted earnings per share decreased by 31% and 29% respectively. Return on capital employed fell to 11.7%.

Now, let me turn to slide four and review the factors that affected the quarter's performance in terms of earnings per share. There were two items of note. In discontinued operations, we recognized a tax benefit related to the previously recorded healthcare impairment charge. This tax benefit added $0.08 per share in discontinued operations. And we had a pension settlement charge in the prior year that Nelson mentioned earlier.

Excluding the discontinued operations and the prior year pension settlement charge, our adjusted EPS from continuing operations decreased $0.37 versus last year. Lower volumes accounted for $0.52 of the year-on-year decline. Pricing and Energy and raw materials together were favorable adding $0.13. Lower cost contributed an additional $0.12.

The unfavorable impact to operating income from currency translation and foreign exchange was $0.11. Accrued affiliated (ph) income declined $0.05 mainly due to reversal of a fine in the prior year results and unfavorable currency impacts.

In our Merchant segment joint ventures, volumes overall were about flat with a strength from lin injection (ph) in Mexico offset by weakness in other countries. Lower interest expense due mainly to lower rates and fewer shares outstanding, each contributed $0.03.

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

Nelson Squires

Thanks Paul. Please turn to Slide five, Merchant Gases. Merchant Gases posted sales of $870 million, down 14% versus prior year. Currency reduced sales by 12%. Underlying sales only declined 2% with volumes down 8% and pricing adding 6%. Sequentially, Merchant Gases of sales decreased 6%. Volumes were down 5% versus Q1. Pricing was up 1%, and currency reduced sales by 2%.

Volume declines versus prior year and prior quarter, reflected downturn in global manufacturing, a carry over of shutdowns from December and the Lunar New Year impact in Asia. Volumes were weakest in January with some improvement in both February and March.

System loadings for the quarter were in the low 70s. Despite this drop in loadings, pricing was flat sequentially and up versus prior year.

Merchant Gases operating income of $156 million was down 17% versus prior year.

Segment operating margin of 17.9% was down versus prior year and sequentially, due to lower volumes and reduced system loading. Margins benefited from improved cost performance.

Let me provide now a few comments by region.

Please turn to Slide six. In North America, sales fell 10% versus prior year driven by a very slow manufacturing climate. Volumes were down 15% versus prior year and price added 5%. Volumes were especially impacted by lower argon, Liquid Hydrogen and distributor sales. New business signings were slightly ahead of Q1, but below prior year.

In Europe, sales decreased 18% versus prior year mainly due to currency. Underlying sales only declined 1% with volumes down 7% and pricing adding 6%. Similar to North America, we saw weak demand across most end-markets and regions in Europe. Pricing remained solid in the quarter in both our liquid bulk and package gas businesses. Signings in Europe were below Q1 levels but remained ahead of plan.

In Asia, Merchant sales were down 17% versus last year with currency reducing sales by 10%. Underlying sales declined 7% with volumes down 12% and prices up 5%. Volumes were impacted by significantly lower demand from electronics customers as well as the overall manufacturing slowdown in Asia. Signings were lower than in Q1.

Please turn to slide seven, Tonnage Gases. Sales of $625 million decreased 28% compared to last year. Natural gas and raw material pass through decreased sales by 15%. Currency reduced sales by an additional 6% and volumes were up 7%. Aggregate volumes were up 6% versus prior year. Increased refinery hydrogen demand was partially offset by declines in sales to steel and chemical customers. Sequentially, sales were down 16%, mainly due to lower natural gas and raw material pass through, which reduced sales by 14%. Operating income of $98 million was down 12% compared to last year and 10% versus last quarter.

The year-on-year and sequential declines were due to lower steel and chemical customer operating rates and the stronger dollar. Operating margin of 15.7% increased versus last year and sequentially due to lower natural gas and raw material pass through.

We announced our hydrogen contract with Marathon Detroit last night and our key projects are proceeding inline with expectations.

Please turn to slide eight; Electronics and Performance Materials. Segment sales of $332 million were down 41% compared to last year. Volumes reduced sales by 38% and currency reduced sales by 3%. Electronics sales were down 47% compared to last year and 21% sequentially worst than forecast. This reflected the dramatic global downturn in semiconductor and flat panel capacity utilization that continued to decline this quarter.

Specialty materials sales were down 50%. Equipment sales were down 74% versus prior year. While costs in this business were significantly reduced, the collapse in electronics materials' demand was responsible for the overall segment losses in the quarter.

In Performance Materials, volumes declined 31% versus last year and 12% sequentially, reflecting weakened demand in our end-markets.

Asia continued to be the weakest region followed by Europe and North America. Despite this significant drop in volumes, Performance Materials was profitable this quarter and is forecasting steady improvement going forward. We now expect millions of square inches of silicon process to be down about 35% in our fiscal 2009 versus our January prediction of about 20%. TFT LCD production is expected to be down about 20% during the same period. And finally, industry CapEx is now expected to be down approximately 50% versus prior year.

While we believe the worst is behind us, we now anticipate a slower recovery in our Electronics business than we did last quarter based upon customers' projections. That being said, we are encouraged by the growing number of affordable take opportunities that we have signed over the last few quarters.

Please turn the Slide nine; Equipment and Energy. Sales of $128 million increased 22% compared to last year, due to increased large air separation unit activity. Operating income of $16 million increased due to improved cost performance. We did add one LNG heat exchanger order to our backlog this quarter. Our backlog in this segment now totals $281 million.

We are in the final stages of commissioning the first APX exchanger in the support of Carter gas 2 (ph) and we expect to see a new order for an LNG heat exchanger this year.

Now, I'll turn the call back over to Paul.

Paul E. Huck

Thanks Nelson. Now if you will please turn to Slide 10. I'd like to share our outlook for the second half of fiscal 2009.

We saw a significant deterioration in the economy during the first half of fiscal 2009. And our outlook for the second half of the year is now for a slower recovery than we have previously anticipated. We expect the global manufacturing contraction to persist through the end of our fiscal year in September. However, we are hopeful we have reached the bottom and that we'll see modest sequential gains in both the U.S. and Asia excluding Japan, in our second half.

Specifically for our businesses, we are forecasting slightly higher sequential volumes in Electronics and Performance Materials and in Merchant Gases. We expect that steel and chemical portions of the Tonnage Gasses segment will remain weak with the refinery hydrogen volumes remaining at current levels.

On the cost side, we should see additional benefits from our cost reduction actions. Our guidance for quarter three is for earnings per share of $0.93 to $1.02.

As we look at the balance of 2009, we continue to be faced with an uncertain economic environment. Here is our current view on the global economy and our key markets for fiscal 2009.

Overall, we now expect manufacturing to decline globally by 9% to 10%, much greater than the 4% to 5% we spoke to you about last quarter.

Regionally, we are forecasting declines of 10% in the U.S., 11% in Europe and about 3% in Japan, excluding...it's about 3% in Asia excluding Japan.

Specifically, by market, we expect the following: Refinery hydrogen demand should hold up well even with the drop in demand for transportation fuels as the refineries that use large quantities of hydrogen had the best cash margins and will continue to operate.

In Electronics, we do expect that market recovery will be slower than previously anticipated, but fiscal quarter two should be the bottom for our volumes. As Nelson mentioned earlier, we forecast millions of square inches processed to decline about 35% in fiscal 2009. We expect that chemical markets will decline more than 20% in 2009, until key markets such autos, housing and consumer goods, start to pick up.

Overall, global steel operating rates remain depressed at about 50%. We don't expect this to improve until late in calendar 2009. We still expect the second quarter to be our low point with the cost reduction actions we are taking, some seasonal improvement in demand and new project start ups, our second half earnings should improve. We are now forecasting our fiscal 2009 earnings from continuing operations excluding charges related to cost reduction to be between $3.85 and $4.05 per share.

With regard to capital spending, we still expect that it'll be about equal the fiscal 2008 spending of 1.4 billion. While business inquiry activity is still active, awards for new projects have been slow as would be expected in this uncertain economic climate. It is still too early for us to give you a capital spending number for 2010 as it will depend upon the level of business that does get awarded over the rest of calendar 2009.

Turning to Electronics. We are disappointed by our current business performance. We have made significant changes in the business over the past two years. However, the recent downturn and our performance say, we need to do more. We are currently concluding a study of this entire business with the outcome intended to return Electronics to earning above its cost of capital.

Given our more negative economic outlook and our belief that the recovery will be slower, we are considering additional cost reduction actions in the company that could result in a charge in our fiscal third quarter. I will provide more details for you next quarter after we finalize our plans.

As we look beyond the current economic turmoil, we remain convinced that there are still solid fundamentals for driving industrial gas demand growth in the future.

Remember, that our products are used to save and efficiently use energy, to improve processes and environmental performance, to efficiently de-bottleneck processes to quickly and cheaply add capacity, and finally, to improve the quality of our customers' products.

Simply stated, industrial gases help our customers lower their cost and become more productive while producing better products and protecting the environment.

These continued opportunities to grow when coupled with our solid business model based on long-term contracts, provide us with a strong set of fundamentals that will help us continue to deliver value to our shareholders.

In closing, we remain committed to the necessary actions to improve our margins in return. The cost actions we are taking are not only to preserve our near-term profit but more importantly, they also position us with the right cost structure for achieving our 70% margin goal as volumes recover.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question comes from Jeff Zekauskas.

Jeffrey Zekauskas - J.P. Morgan

Hi, good morning.

Paul Huck

Hi Jeff.

Nelson Squires

Good morning Jeff.

Jeffrey Zekauskas - J.P. Morgan

I've got a couple of questions. The first is that your interest expense in the second quarter was 30 million, in the first it was 36.5. I know your rates are down, so is 30 a good number to use going forward? And secondly, you talked about Equipment and Energy having good cost cutting and on a sequential basis that also was an improvement where you went from seven million to 16.3. So basically, my question is, is the 16.3 quarterly number sustainable and is the 30 million quarterly number sustainable?

Paul Huck

Okay. On the interest Jeff, I think the...on the $30 million going forward, I think that's a god number. Regarding Equipment and Energy, I would not sustain that as the forecast some of that also comes through the profit coming through the projects here and workload continues to decline in those areas.

Jeffrey Zekauskas - J.P. Morgan

Okay. And then lastly, across your businesses, which are the areas where you feel that there is the most risk of price going down?

Nelson Squires

Well, certainly there is most risk which we have demonstrated consistently is Electronics. And that's the area in which I feel the most risk.

Jeffrey Zekauskas - J.P. Morgan

Is there a lot there or a little or sort of how do you see pricing in Electronics over the next several quarters?

Paul Huck

I think with the volumes coming down, there has been, as we've seen a price pressure, across Electronics and Performance Materials, Performance Materials prices have gone up, so we are roughly about have maintained ourselves about flat in that. I would not think that price at this point in time Jeff, for us as we look at that is a huge down factor for us. I think we...the thing which we have seen, which has driven our earnings down has been really two basic factors, one has been the currency declines, the strength of the U.S. dollar and the second has been the contraction in volumes.

And those are probably the risks for us.

Jeffrey Zekauskas - J.P. Morgan

Okay, thank you very much.

Nelson Squires

You're welcome.

Operator

And our next question comes from P.J. Juvekar with Citi.

Prashant Juvekar - Citigroup

Yes, good morning Paul.

Paul Huck

Morning, P.J.

Nelson Squires

Hi, P.J.

Prashant Juvekar - Citigroup

Yeah hi, Nelson. Can you give us some understanding on the project pipeline as you mentioned refinery steel chemical projects are getting delayed. Can you quantify the pipeline for us, how many projects do you have, how many are getting delayed?

Nelson Squires

Well yes, and we actually don't...I don't count the number of projects because as we've said before it always, you can count a $5 million project, you can have a $200 million project and they count the same in that. As we have looked at this, I think and we looked at 2010, as far as the things which we have said and the boost in earnings from 2010 of new projects, I think that is and that's good for us. I think we are going to see somewhere in the $0.30 to $0.40 a share boost in earnings from the projects coming on stream.

The next factor for us then comes out as to what's coming on stream in 2011, 2012? We do have some projects which we're currently booking and that's...and it would not be right now as big a boost in 2011 from those projects. Roughly stated, it's probably may be half to two thirds of that at this point in time as I look at it. But we still have time to take orders so that is somewhat of a normal view of it. I am really talking mainly about our on site projects here P.J.

Prashant Juvekar - Citigroup

Okay. So near-term you feel you are okay, but long-term some projects could slip?

Nelson Squires

Well certainly as we have said, I mean we are in... and you can see the capacity factors which were out there, which people are running at. And so, it's not a good environment now for people to expand capacity. And so, a lot of the new projects go around capacity expansion. All that said, we announced a project last night on Marathon for Detroit for their Detroit refinery.

So we are still seeing some activity. Its not...it is not like we... it is not like we have no activity. We are still seeing activity occur around the refinery hydrogen segment and we are also seeing activity principally in China as we mentioned before I think to you.

Prashant Juvekar - Citigroup

Okay. And quickly on Merchant Gases, Paul can you tell us what your average operating rates are in U.S., Europe and Asia?

Paul Huck

The average operating rates was in the low 70s across the regions.

Prashant Juvekar - Citigroup

If that's the case, then what do you think will happen to pricing sequentially? Can you really hold prices at 70% operating rates?

Paul Huck

Well for us and I can only speak for our products here. As far as the philosophy on pricing as we look at this, is that...it does not pay for us to go out and cut prices to load a plan for when I'm going to give a price for five years.

My operating rates are going to start to tick up. I think we've hit the low end of things here. We haven't seen a tremendous amount of customers go away from us. We've seen their takes decline. And so, as we look at this, it is something which for the future, you don't want to cut prices because you're going to live with the price for five years and it doesn't make sense that you're going to take something at a low margin to cure what could be a six to 12-month problem, let's say.

Prashant Juvekar - Citigroup

That's good thinking. Thank you.

Operator

(Operator Instructions). Next question comes from David Begleiter of Deutsche Bank.

David Begleiter - Deutsche Bank

Good morning, Paul and Nelson.

Paul Huck

Hi Dave.

Nelson Squires

Hey Dave.

David Begleiter - Deutsche Bank

Hey Paul, on the Electronics study, who is conducting it? Is it again some help from the outside and could it result in the sale or divestiture of portions or even larger portion of that business?

Paul Huck

As far as the study and we are using the people internally who we have to lead the study, we are also making... we are also consulting outside resources obviously on that and taking a look at given the sharp downturn in the industry, what is the outlook, what are the changes that are going to come in the industry and from the sharp downturn. What's sort of shake outs to that, what sort of changes in customer base et cetera, so we're taking a long hard look at that.

And Dave as far as any sale piece of business or things like that, I think the thing which we have always said about on the Air Products businesses, there aren't any secret costs here and so, if something is not right for us to hold it, we're not going to hold it.

David Begleiter - Deutsche Bank

How long will that study take to complete?

Paul Huck

I would expect that we will be talking to you about the results of that study at the end of quarter three.

David Begleiter - Deutsche Bank

And last question, your SG&A fell 26% in the quarter year-over-year, is that type of decline sustainable in the back half of the year?

Paul Huck

The factor is that I expect my SG&A to be about the same or a little bit lower coming forward here, going forward. One factor on the SG&A is currency. Its hurt earnings, but it's helped SG&A also. But the cost reduction has been a big factor in there.

David Begleiter - Deutsche Bank

Thank you very much.

Operator

And our next question comes from Sergey Vasnetsov with Barclays Capital.

Sergey Vasnetsov - Barclays Capital

Hi, good morning.

Paul Huck

Hi Sergey.

Nelson Squires

Good morning, Sergey.

Sergey Vasnetsov - Barclays Capital

Paul, in the past, you had a chance to buyout some of your joint ventures partners in Asia and I realized it's the timing like this is safe to a given family or given circumstances. Again, given the continuing global recession, in some case credit crisis, is there more likelihood now that you will be successful in some of the steps this year?

Paul Huck

On the part of our JV partners and that always depends upon the partner and their desire to go out and sell. I can't make a comment on that for them. You'd have to ask them with that. We are very happy in our partnerships with them. They are fruitful. We believe they help us going forward. All that said, when it comes time for the partner if they want to exit, we are there and willing to buy it. We have the capital and the ability to execute those transactions.

Sergey Vasnetsov - Barclays Capital

Okay. And interestingly there some news stories about the current administration being classifying CO2 as potent (ph) and therefore, may be incrementally brings forwards the time when CO2 sequestration will become commercially visible, scalable option. What's your view? Has that news changed your time on the CO2, that profession?

Paul Huck

Sure. As far as us trying to take a view on CO2, we think it is a business opportunity for us and sequestering CO2, capturing it from power plants also making other fuels which could use industrial gases in the production of those fuels is possible for us. Just to give you a time line, the first thing which you need is a cap and trade system to pass or some sort of thing to get through Congress. So, if that happens 2009, 2010, it's probably going to take year or two to write the rigs then around it and then after the rigs are out, then people will start taking action.

So, as we've already said, we think that the market for projects on this would start somewhere may be for us around 2012 or so, which we have things on stream 2014, 2015.

Nelson Squires

Yeah and Sergey this is Nelson, just adding one more comment. Just in the past 30 days or so, we announced an effort with a vat in fall (ph) in Germany which is really a first large scale demonstration of clean coal. And they were excited about that is as the not only to supplier of oxygen but also the supplier of proprietary technology. And we also believe this is a critical step in getting things moving forward. So, I wanted to point that out as an opportunity for us.

Paul Huck

And that's a good add Nelson. That is a good add there.

Sergey Vasnetsov - Barclays Capital

Thank you, both.

Paul Huck

You're welcome.

Operator

And our next question comes from Mike Harrison with First Analysis.

Michael Harrison - First Analysis

Hi, good morning.

Nelson Squires

Hi, Mike.

Paul Huck

Hi Mike.

Michael Harrison - First Analysis

In terms of the equity affiliate income this quarter, quite a bit stronger than last quarter and you mentioned something in your remarks about the reversal of a fine in the prior year. Can you quantify what that fine was and maybe give us a little bit of guidance for what we might expect for that equity affiliates income number for next quarter?

Paul Huck

The fine in the prior year revolved around the reversal of the fine of a reserve which we talked for our accounting affiliate, when we got an unfavorable...when all the industrial gas companies in Italy got fined for on anti-trust. Those things were appealed, the Court reversed the decision of the Italian Government and we didn't have to pay it. And so that happened in quarter two of '08 for us. That was worth about $0.02 of share to us, Mike.

If we take a look going forward on equity affiliates we think equity affiliates will be about flat going down. We're also taking cost out in those areas. We are bringing some new projects on but overall, and there we are also seeing demand being cut as everyone is in business.

Michael Harrison - First Analysis

So, $0.02 a share so roughly

(Technical Difficulty).

Operator

One moment, sir.

Paul Huck

Yeah.

Operator

Your line is open Mr. Harrison.

Michael Harrison - First Analysis

I'll move on and maybe follow.

Paul Huck

Yeah Mike, and $0.02 a share is about $6 million source.

Michael Harrison - First Analysis

Okay, on the Merchant side, clearly the pricing's holding up on your existing contracts but I was wondering if you could talk about what you're seeing in terms of pricing trends for new customers, new installations. Are you seeing more competitive bids that are impacting the profitability of new business or are you still pretty happy with the margins on new business?

Paul Huck

Nelson, why don't you comment?

Nelson Squires

Yeah Mike, this is Nelson. Yeah, we really have not seen a significant change in bidding activity. Obviously, there are fewer opportunities right now but we are still seeing a fairer number of opportunities tied to new uses of industrial gases. And around environment around Energy, reducing reliance on carbon-based fuels et cetera, and in those types of deals we are able to bring applications technology to the point of sale and that is certainly helping us with the pricing.

So, it really hasn't been any significant change in behaviors in the last six to nine months.

Operator

And moving on, we have a question from Mike Judd with Greenwich Consultant.

Michael Judd - Greenwich Consultants

Yes Good morning. You guys benefited in the quarter from lower natural gas prices and your Tonnage Gases business, something that natural gas prices could go as low as $2.50. Could you just, I realized your volume issues and currency issues but maybe talk about that particular aspect going forward into the remaining part of your fiscal year, what kind of impact that could have on the margins?

Paul Huck

Yeah Mike, if you take a look at the natural gas prices, I think as we've commented before, is that they really...they helped the margin and they don't really do anything for profits for us. So, it's a sales impact because it's the past in that business. First, on your comment of 2.50, I don't think that's our forecast either going forward and so, but if they did go down, we would see a slight increase in our margins but once again, we are running this business for returns and not for margins on here. It's wide cap on the ground and if we constraint our margins, if gas is at ten or gas is at three, its how much cash we're taking out of the business versus how much capital.

Michael Judd - Greenwich Consultants

Fair enough. Thanks.

Operator

And our next question comes from Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies

Good morning. First on the Tonnage business, could you discuss what are you seeing any significant project cancellations or delays and if that's playing in too so that you were looking at the 2011 timeframe?

Paul Huck

Hi Laurence. As far as delays and yes we have, I think a comment which we made last quarter is we continue to see the oil sands push out in time for us. I mean that is not surprising given the price of oil and what sort of things are happening there. And as far as other projects, steel has been obviously slow in there, so we are seeing things push out in time.

As far as the projects which we have in-house, which we are bringing on stream in 2009-2010, we believe they're solid and they are in construction, they are in the field and that they are going to come on stream.

Laurence Alexander - Jefferies

And then if you look at the Merchant business where the contracts that are coming up for renewal, roughly how much do you think pricing for those contracts is below the average of the portfolio right now? And that is they were negotiated five years ago. Pricing has moved since then. How much do you have a chance as to mark up just to catch up to the marketplace?

Paul Huck

Laurence and the prices for a lot of these contracts have been taken up overtime for us. So as we have implemented price increases we've also gone into certain customers and changed that around. As I said before, as far as their product is concerned on pricing, we are... and we look at this as we make a dedication of a portion of our capacity for a long-term period of time. We are going to price it to get the return which we need to do to invest in this business.

Operator

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

Kevin McCarthy - Banc of America

Yes, good morning.

Paul Huck

Good morning, Kevin.

Nelson Squires

Good morning, Kevin.

Kevin McCarthy - Banc of America

If you go through the Tonnage business, just wondering if you could comment on how many customers, let's say in steel and in chemicals may be operating below they take or pay minimum requirements and to the extent that may have occurred what impact that has on your margins and segments?

Paul Huck

We certainly have a lot, a lot of our customers operating below the mid right now with steel operating rates at 50%. And so that and that does have an impact in some as this is for us. And, I think what you have to remember is in a lot of these projects, I don't even pay the power though. And so, it doesn't go through sales for me. And so, a lot of this is the capital cover and the operating and maintenance cost which I still have because I still maintain my plant ready to go.

Kevin McCarthy - Banc of America

Okay. So if I look at your margins in the segment and try to back out the very large effect from natural gas, it looks like Tonnage margins still would've been up, perhaps 50 basis points or so on an underlying basis?

Paul Huck

We also like good costs.

Nelson Squires

We also have very good costs there.

Kevin McCarthy - Banc of America

And so I guess

Paul Huck

A comment here of course, the company, as I said before, is we've had good...we had good cost across in all of our segments.

Kevin McCarthy - Banc of America

Okay.

Paul Huck

Cost performance is good.

Kevin McCarthy - Banc of America

Okay. Fair enough. I'll leave it at that. And then second on cash flow, I appreciate you providing the full cash flow statement. Just had a question relative to payables and accrued liabilities which look like it increased roughly $215 million versus the prior quarter, just wondering if you could elaborate on what might be driving that?

Paul Huck

Yeah, the payables and the accrued liabilities actually went down. And so, they were actually a use of cash there by us paying it down. The two big factors in there are pension and tax payments, which we made. And there is a timing aspect to those things. If I were just to look, and just take this opportunity on free cash flow and we were ...and free cash flow was down roughly about a 160, it was negative about $160 million in the first half of the year.

As we go forward and look at that because of those timing aspect, we think that there is about $300 million reversal of that as we go forward here. Capital spending is probably going to pick up as it normally does during the summer for us a little bit. But we're going probably be slightly free cash flow positive for the year overall.

Operator

And moving on, we have Don Carson with UBS.

Unidentified Analyst

Yes, thank you. A couple of questions, one...Nelson on Merchant Gas as you mentioned U.S. that you are seeing lower liquid argon and liquid helium sales. Is the lower liquid argon, is that a supply constraint because your steel customers are running so low you are having trouble getting liquid argon or is it reflect weak demand as well?

Paul Huck

It's weak demand. That was an issue probably through our first quarter. But demand has deteriorated enough that it's actually there is enough supply out there. And the other comment was lower on liquid hydrogen sales, helium is holding up fine. There is...there is just sales to the government are down substantially and liquid helium in the quarter. Liquid hydrogen, I'm sorry. Again liquid helium we are doing find there.

Operator

And our next question comes from Michael Sison with KeyBanc.

Michael Sison - KeyBanc

Hey guys.

Paul Huck

Hi Mike.

Michael Sison - KeyBanc

In terms of electronics you have lead out this three different areas in that business; gases, Tonnage, special materials were they all lets say in the red for the quarter or maybe as it's Tonnage at least on the profitable side?

Paul Huck

Tonnage business is making money on that.

Michael Sison - KeyBanc

Okay.

Paul Huck

The issue for us in Electronics, as we've said before, is Specialty Materials and the related equipment business. The related equipment business is obviously is not going to have good sales in it given the state of capital spending. But that's really a business which enables on the spend specially gases and materials then.

Michael Sison - KeyBanc

Okay. And given the sequential improvement you're looking for in the third and fourth quarter for Electronics, do we get back in the black at that point?

Paul Huck

We will expect that the, in the third quarter that we're still going to loose money. But that we turn to profitability in the fourth quarter.

Operator

And our next question comes from Bob Koort with Goldman Sachs.

Robert Koort - Goldman Sachs

Thanks very much. Paul, I might have missed it but I wondered if gas in North America Merchant was off 10 in Asia up 7, that Europe was been only down 1%. Can you just remind me again why that was stronger and what the near-term outlook there would be?

Nelson Squires

Hi Bob, this is Nelson. That's really attributable to good results in the European homecare business. And so, that's really what drove the difference. In terms of industrial demand they were roughly similar with probably European a little worse.

Robert Koort - Goldman Sachs

Got it. And then, I guess I'm still trying to reconcile your more somber semiconductor expectations versus some of the data out of this i.e. another industry trade groups. I think barely the numbers they showed actually do the first quarter volumes were up. You know why it wouldn't jive with your units down 35% for the year?

Paul Huck

We have not seen an uptick on that Bob, on that data to be honest with you. And a lot of our stuff comes from our large customers as we've dealt with them. And our large customers as far as the forecast which they have for those who are actually going out and trying to make forecasts are pretty somber themselves.

Robert Koort - Goldman Sachs

Do you think maybe there is, can you gauge if there's been a dramatic inventory reduction so that there will be a restock on top of whatever demand growth or do you think?

Paul Huck

Yes Bob, yeah I think we can and there has been a drop in inventories and we've seen that. I mean, I think everybody's being quite cautious right now. I think this is a... but something which, which at least our view right now happens in Q4 and not in Q3 given the forecast.

Robert Koort - Goldman Sachs

Got it. Thank you.

Operator

And our next question comes form John Roberts with Buckingham Research.

John Roberts - Buckingham Research

Morning guys.

Nelson Squires

How are you doing?

Paul Huck

Morning John.

John Roberts - Buckingham Research

How do the captive gas operations behave in this environment? I assume refineries produce as much hydrogen as they were all processing, but how about the captive oxygen units at emerging markets, steel guys and chemical guys? Do they shutdown and for whatever minimum they need they take it from the merchant market or are they protecting their own operations and continuing to operate and maybe hurting the merchant mark a little that way?

Paul Huck

If a person operates in their own plant, what you will typically see is that they will take from their own plant themselves before they would business it from an industrial gas company.

John Roberts - Buckingham Research

So they probably higher operating rates on average than the independent producers like yourself.

Paul Huck

Well all the captive guys, I mean they and those guys are really not out there producing any and not going out and selling against us. They are making it for their own usage.

John Roberts - Buckingham Research

That's right that they protect their own volume for first.

Paul Huck

Sure I mean, but that only makes sense. Now that doesn't happen in a lot places. Okay, there is some obviously, there is some business where we go in and top off a customer who has captive plans but it's not a big factor in our volumes.

John Roberts - Buckingham Research

Thank you.

Paul Huck

Yes.

Operator

And moving on, we have a question from Steve Schumann (ph) with Lafayette Research.

Unidentified Analyst

Good morning guys.

Nelson Squires

Hi Steve.

Paul Huck

Good morning, Steve.

Unidentified Analyst

Because gas is really our inventory, can you talk about any uptick in demand in any of your businesses may be late in the quarter? Where we are struggling right now what's the underlying end demand versus an inventory re-stocking at the customer's side? Could you talk to that?

Paul Huck

If we look at the operating rates, one of the things which we have seen, is we did see operating rates of in a number of areas start to pick up from January and February in to March. It wasn't large. It was not huge, as far as things are concerned. And it was expected by us. And so, have steel operating rates picked up a little bit? Yes they have. On the chemical side, yes, they have. Across Asia to be honest, the economic activity was down far in January and in the beginning of February it started to pick up a little bit in February and March.

And also we have seen some, we have seen some things there. But those are inline with the expectations. What we have not seen here is any anything which is solid from an economic standpoint which would say heavy economies overall are starting to move back. There is a lot of volatility out there and the consumer is still very concerned. And until those things start to get solved, I don't think we're going to see a lot of good momentum build in the economy.

Unidentified Analyst

So would you say there is upticks are really just a seasonal affect as opposed to potential higher end demand?

Paul Huck

Yes and the other thing is that I think what...the other factor which we have to consider that is that on the inventories. I mean people have been dragging down inventories. Inventories are low, and they have been dragged down a lot. I don't think they have a lot more to go right now. And so, people are taking up production to meet demand.

Unidentified Analyst

So basically while they can inventory gas they de-stock their end products...

Paul Huck

Yes and that's right. It's the end product, right. For us it's the end product which we look at and not the inventory gas.

Unidentified Analyst

And then real quick, the dollars been a bit strong here, I guess you guys have an outlook going forward?

Paul Huck

We don't gamble along those lines. No, we don't. I mean as far as which way, and we try to operate and set up our cash flows so that we have, so we don't have a lot exposure. We try to match everything as much as possible because we think that that's a hard thing for us to do to go out and predict the currency.

Unidentified Analyst

Could you remind me what your number of your contracts, your longer term contracts are independent of foreign exchange due to contractual terms?

Paul Huck

The bulk of our contracts don't have any real exposure here because I match my revenues and my costs up. And so I don't have any...I've not matched. I'm not an exporter of a huge amount of stuff where I don't sell in dollars. As an example a lot of my electronic sales even into Asia go in dollars because of the production of some of those products here in the U.S., so I try to keep myself well matched in that area.

Unidentified Analyst

Alright, thank you.

Paul Huck

You're welcome.

Operator

(Operator Instructions) Our next question comes from Mark Gulley with Soleil Securities.

Mark Gulley - Soleil Securities

Hey, good morning guys.

Paul Huck

Hey Mark.

Mark Gulley - Soleil Securities

Got a question for you on margins. It looks like operating margins may have troughed here at 13.3 if I'm doing my math right, here in the March quarter. If I remember your remarks Paul you talked about 17 being the goal. Can you give us an idea of how long you think it's going to take to meet that 17 goal given where you are now?

Paul Huck

Yeah Mark, if I were to take a look at our operating margins, and just walk you forward from there. As we look at the cost reductions, we think our cost reductions overall probably, overtime, are going to raise the operating margins from the things in which we put in motion right now, about a point and a half or so. We think the volume from our new projects probably also contributes about half of percent. And then the remaining comes from the recovery of volume in the economy here. And as that happens and so is that 2010, I don't think so. It could be 2011, if we start to get some good momentum in the economy towards the end of 2009.

Mark Gulley - Soleil Securities

Hey, that's pretty helpful. Can you give us an idea of what the volume, negative volume variance has hit your margins by thus far, to you can give us some idea, for example, how far do actually have to go to see when your volumes...

Paul Huck

On the volume impact and roughly the volume impact is probably about, today about 2% or so.

Mark Gulley - Soleil Securities

And a housekeeping question. Note for you talk a little bit about the bankrupt customer. Have you already reserved for that, or is that a reserve that's still coming?

Paul Huck

No, we had not taken. We have not taken any reserve on that customer.

Mark Gulley - Soleil Securities

Is there a reason why you haven't yet?

Paul Huck

Because we...as we look at we still think there is a good chance to us being able to go out and recover that.

Mark Gulley - Soleil Securities

Thanks Paul.

Operator

(Operator Instructions). And moving on, we have a question from Edward Yang with Oppenheimer.

Edward Yang - Oppenheimer

Hi, good morning.

Paul Huck

Hi Ed.

Nelson Squires

Hi Ed.

Edward Yang - Oppenheimer

In Electronics, how much further can you get margins up if revenues stay flat? How many more, how much more cost can you take out of that business?

Paul Huck

As far as that is concerned, we can cut some cost but this whole thing is going to have to involve complete look at the business. Our goal still get this thing back to a 15% plus margin for us and we are not going to get and we can't get there with just going out and cutting cost is our view, we got do other things that could include pricing, it include other actions.

Edward Yang - Oppenheimer

So Paul when you talk about the potential for third quarter charge related to additional cost cutting, which businesses would that cost cutting focus on?

Paul Huck

We are looking across the whole company and trying to make our plans there. And so we are in the process of doing that right now and so it's too early for me to single anything out. But we're going to look across the company and say, how do we size the business for the opportunity going forward here.

Edward Yang - Oppenheimer

And when you think about your European exposure, what percentage of that is Central Europe and Poland right now? And of the 7% volume decline you had this quarter, can you segment that by Western Europe and Central Europe please?

Paul Huck

If we look at on the European business, we are roughly Central and Eastern Europe is roughly about maybe 15% of that total for us. As far as on the volumes declines, I don't do that across there but I will tell you that volumes did decline in those countries. We actually managed across product lines there. But the volumes and they did decline there, so I would not say it was extremely and better or worse there.

Edward Yang - Oppenheimer

Thank you very much.

Operator

It appears there are no further questions at this time. Mr. Squires, I'd like to turn the conference back over to you for any additional or closing remarks.

Nelson Squires

Thanks Jenny. Please go to our website to access a replay of this call beginning at 2:00 PM today.

Thanks for joining us and have a nice day.

Operator

That does conclude today's conference, ladies and gentlemen. Thank you for your participation.

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Source: Air Products & Chemicals F2Q09 (Qtr End 3/31/09) Earnings Call Transcript
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