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Praxair, Inc. (NYSE:PX)

Goldman Sachs Basic Materials Conference

May 22, 2013 12:35 pm ET

Executives

Stephen F. Angel - Chairman, Chief Executive Officer and President

Analysts

Brian Maguire - Goldman Sachs Group Inc., Research Division

Brian Maguire - Goldman Sachs Group Inc., Research Division

Okay. Back from lunch. We're happy to get the afternoon session going. Really happy to have CEO of Praxair Steve Angel, here to give us an update on how things are going there. Steve?

Stephen F. Angel

Thank you, Brian. Good afternoon. I want to introduce Kelcey Hoyt sitting here in the front row who manages our Investor Relations department. I want to start -- well, first of all, I'll draw your attention to the forward-looking statement.

And I want to start with our unique revenue model. We build large on-site plants under long-term contracts with baseload customers that include high take-or-pay requirements which underpin our targeted internal rate of return. Our product represents a low percent of our customers' cost stack yet it's critical to their, operations. You can't run an oil refinery without hydrogen, a steel mill without oxygen or a semiconductor fab without ultra-high purity nitrogen. And as a supplier, this obviously translates into a favorable pricing environment.

You can see in the upper right that we enjoy a nice spread of our competitors in terms of the quality of our business as measured by operating profit as a percent of sales. There are many reasons for this, two of which are highlighted on the lower left side of this page. Our strategy is to be selective in the geographies we enter. We want to build out integrated supply systems on site, merchant packaged gas, think high-volume capital-intensive to lower-volume, less capital-intensive customers. We want to serve the full array of industrial gas customers within that targeted region and to take advantage of the coproduct synergies that exist between those modes of supply. And we want to build out density across each mode of supply. And I'll show you a few examples of this strategy in action later.

Productivity is very much in our DNA at Praxair. Every year, we target a 5% reduction in our cost stack. And we hold each business accountable for delivering that 5% out of their cost stack each year. That translates into about $400 million of savings per year.

Our integrated supply and density strategy, plus a relentless focus on productivity, has delivered solid growth, high profitability, high return on capital and strong cash flows. 12% growth per year since our inception in 1992, as you can see on the lower right side of the page.

We focus on 3 secular growth drivers at Praxair, which we refer to as the 3 Es: energy, environment and emerging economies. And emerging economies, we define as Brazil, Russia, India, China and Mexico. And I'll start with energy. Oil and gas services is primarily a North America play. Our activities range from nitrogen pressurization services for existing oilfields, say, in Mexico, to frac-ing various types of formations in the U.S. and Canada using liquid CO2 and nitrogen under high pressure to recover natural gas, natural gas liquids and oil.

To larger separation plants for enhanced oil recovery. Hydrogen for oil refining has been growing globally at about 7% per year due to increasing demand for transportation fuels in developing countries, the desire for more environmentally-friendly low-sulfur fuels, the demand for middle distillates: jet fuel, kerosene, diesel; and refiner's desire to have flexibility in their selection of crude feedstocks, and think sweet versus sour when I say that.

All of these increase the demand for hydrogen or hydrogen intensity per barrel of oil. Based on projects we have under contract and in the backlog today, we expect to grow our hydrogen business about 12% per year over the next 5 years.

Gasification is the technology that takes coal and petroleum coke feedstock and converts it into syngas for various end products such as methanol, ammonia, olefins, hydrogen which is then used for refining, and transportation fuels. The gasification process requires large oxygen plants which is where we participate.

Their principal market today is in China, which is focusing on gasification as a matter of energy security. They have a lot of coal but little in the way of natural gas and oil. We are operating 2 large oxygen plants for gasification trains today in China, and we have several other projects either in the backlog or expected to close this year.

The project that we announced recently in Alberta, Canada with North West Upgrading is an example of pet coke gasification to produce hydrogen, which is then used to upgrade the raw bitumen into synthetic crude.

Regarding environmental solutions, whether you're talking about the developed world or the developing world, everyone seems concerned about water quality, air quality and waste management. And most of the 50 or so applications we introduce each year address one of those environmental concerns.

Emerging economies are focused on building out their infrastructure and modernizing their economies, which creates demand for industrial gas. The chart on the right illustrates industrial gas consumption on a per capita basis for the U.S., China, Mexico, Brazil and India. And you can see that China, despite all their success in growing their economy, still has a long ways to go in terms of equaling the U.S. on an industrial gas consumed per capita basis. Much more so for Mexico, Brazil and India.

Now this chart is directional. I don't know if these countries will ever consume as much industrial gas on a per capita basis as, say, the U.S. or Europe. But as their economies develop and the standards of living rise, they will want more things like higher-quality welding, stainless steel, carbonated beverages, food freezing, cleaner air and water, better health care, et cetera, all of which consume industrial gases.

I believe you can see our density strategy at work in China. We are focused on concentrating assets in 3 key industrial zones along the east coast, and we'll be starting up 8 plants from our backlog, and you will note the yellow triangles there, in those regions. You will also note a new region more inland, Chongqing, a small city of 32 million people, where we will be starting up 2 large oxygen plants with a capacity of 5,000 tons per day to supply BASF and other customers in what will be our third large chemical enclave after Daya Bay and Chongqing.

Now this map also illustrates what we are not doing in China, which is participating in the coal triangle in inner Mongolia, where there are quite a few gasification projects underway. There are many reasons for Praxair avoiding this area, including, in many cases, poor customer quality, questionable asset longevity -- customer asset longevity, difficult project execution and the fact that many of these projects are sell of equipment versus sell of gas, and that's the side of the industrial gas business that we don't participate in.

But the most significant issue we see is the inability in the coal triangle to build out an integrated supply system and density due to the lack of a merchant liquid market.

North America is our largest region at nearly $6 billion in revenues. We operate 500 production plants, 3,000 distribution vehicles and have an unrivaled integrated supply system where we are the largest on-site and merchant liquid industrial gas player, and have a strong #2 position in the packaged gas business.

We are a strong player in all 3 countries: The U.S., Canada and Mexico as you can see on the chart, and we are well-positioned to take advantage of growth opportunities in metals, both ferrous and nonferrous, manufacturing, and I don't know whether or not we're in the precipice of a manufacturing renaissance, but the fundamentals for positive growth going forward are certainly in place.

Energy opportunities, as I described earlier, and chemical project opportunities fueled by an abundance of low-cost natural gas. That picture of Texas in the middle of the page depicts the successful execution of our strategy over the years. The yellow dot indicates our presence before 2005. Since then, we've added quite a few assets, largely through packaged gas acquisitions and scratch starts, which positions us to take advantage of strong industrial growth across Texas, including petrochemical complexes, the Eagle Ford Shale and manufacturing growth along the Texas-Mexican border.

We acquired NuCO2 on March 1 of this year, and I'm pleased to say the business is performing to expectations and we're certainly on track from an integration standpoint. I think you will agree looking at the supply chain on the left side of this page that this looks very much like a core industrial gas business. The 162,000 customer tanks you see are all owned and maintained by NuCO2. The revenue is tied to the service and not to the volume of CO2 consumed by the customer.

NuCO2 bills a monthly rental fee under 5-year contracts with inflation escalation formulas, just like our industrial merchant liquid businesses. We expect this business to continue to grow top line in the high single-digit range through new store openings; cylinder-to-bulk conversions; cylinder pull-through from PDI, which is our existing packaged gas business in the United States; the growth of the craft to beer segment and price realization where NuCO2 has averaged 3% per year.

And when combined with the synergies we have identified, we expect to leverage this top line into mid-teens operating profit growth going forward.

I didn't intend to go through this chart in any detail. What we wanted to convey is that we continue to see plenty of productivity opportunities. You can basically group these opportunities into the following buckets existing plant upgrades; distribution and network optimization; reliability improvements; low-cost sourcing; and business process improvements using Lean, Six Sigma and value-mapping tools. I say we have historically delivered about 5% of our cost stack in productivity, and we are confident we can continue to deliver that level of productivity going forward.

Now for the growth outlook. This is our outlook over the next 3 to 5 years. We expect high single-digit annual growth rates from a combination of base industrial production growth in the countries we operate in; the secular growth drivers, the 3 Es I described earlier; and the growing intensity of industrial gas usage, particularly in developing countries. And of course, pricing, where we had historically realized about 2% per year, and that would be our expectation going forward.

The combination of pricing and productivity and excess of inflation, we'll lever that growth into higher levels of operating profit. And through financial leverage in the form of share repurchases, we are confident that we can deliver at least low double-digit earnings per share growth.

You will also note we are targeting a return of 15% return on capital over this time frame. And today as a result of high construction in progress, which basically means we spent the money but have yet to enjoy the benefits and our NuCO2 purchase, we are around 13% return on capital and could get slightly lower in the coming quarters. As these projects start up and the global economy recovers, we expect to get back to a 15% return on capital level over this time frame.

Cash flow. This page looks at our average cash flow over the last 3 years versus our competitors and how we have spent our cash flow versus our competitors. And based on the relatively slow global growth we expect going forward, I personally believe our CapEx spend will flatten out from its current rate at about $1.8 billion annual spend, plus or minus. That will mean a sub-15% to sales CapEx spend, which is lower than what we've experienced over the past 3 years, which peaked in 2012 at about 20% CapEx spend to sales.

We will continue to increase dividends in line with net income growth while targeting a 2% dividend yield. And we will continue to repurchase shares at the rate of 1% to 2% per year, likely at the high end of that range as our CapEx spend flattens out at around $1.8 billion per year, plus or minus.

Well, that concludes my remarks and now I'll open the floor for questions. Brian, do you get to go first? How does that work?

Question-and-Answer Session

Brian Maguire - Goldman Sachs Group Inc., Research Division

I'll take the privilege. I was hoping you could give an update on what kind of customer demand trends you're seeing, given you're pretty global? Some specific end-market but pretty broad in chemicals and refining in general industrial activity, and you keep a lot of inventory, so it should be reflective of what's really going on out there.

Stephen F. Angel

Is that more of a U.S. question or...

Brian Maguire - Goldman Sachs Group Inc., Research Division

Globally, [indiscernible], let me just...

Stephen F. Angel

I'll just start with the U.S. And of course, we talk about March trends during the investor call and, obviously, I have April's results in hand as well now. So I would say steel demand remains very strong in the U.S., and our oxygen demand to the steel industry is very strong. Now part of that is driven by the fact that they are using more natural gas in the blast furnace as a coke substitute, and again this is one of the positive effects of Praxair low-cost natural gas. And that means that our oxygen intensity per ton of steel produced is 25% higher today than it was, say, 1 year, 1.5 years ago, which is a very good thing for us. But it means we're operating, like, 90% capacity utilization on the steel pipeline along the Great Lakes where our customers may be 75% capacity utilization. So that's a positive, certainly a positive trend going forward for us. The chemical industry, looking at those volumes, looks relatively flat to me, steady but flat. And I can only expect that's had more to kind of slowing growth that everybody's seen in the U.S. economy and perhaps from an export standpoint too. If I look at refinery hydrogen, we're expecting a very strong quarter in refinery hydrogen. Part of that's coming out of the turnarounds, but also we're expecting very high volume from BP Texas City, which now is Marathon, Valero and Motiva. And of course, we're starting up 2 large hydrogen projects, one as we speak, another one following a month from now, that will contribute in part of that. So I'm pretty bullish on what we're seeing on the hydrogen side. Merchant liquid volumes have kind of been going sideways in the United States. And I think that's very much tied to a lot of the uncertainty that you're hearing, a lot of companies talk about. Packaged gas volumes, we said in March, or we said in the Q1 investor conference, we're negative in hard goods, kind of weaker in gas. I would say that trend is continuing. So our gas -- our packaged gas volumes for gas and hard goods, again, hard goods is weaker, is more aligned with what we're seeing in merchant liquid volume. So kind of a lot going on in that mix in the United States. Now Mexico continues to perform at a pretty nice pace. They have grown at a rate faster than what we've seen in the rest of North America. I don't think that they can continue that pace going forward, particularly with respect to packaged gas and the merchant liquid volumes. There's just too much integrated in North America to be able to sustain the pace that we have. But on the flip side of that, oil well services is very strong in Mexico. PEMEX needs oil. They've had declining production for years, and they're using a lot of our nitrogen pressurization services to get that oil. Talking about natural gas and oil for a second, in the United States, frac-ing for dry gas, which we participate in, has been weak, as you would expect. Price of natural gas is too low. And we will need natural gas probably get back up to the $5 to $6 range for that activity to become strong again. And on the other side of this, there's always, on the other hand, frac-ing for natural gas liquids and frac-ing for oil using our products is pretty strong. So let me just shift to South America. I know a lot of people in this room are interested in what we're seeing in Brazil. March was a good month, April was a good month. So I'm very encouraged by the trends I've seen -- I'm seeing in Brazil today. And I'm encouraged by the breadth of the volume growth that I'm seeing. It's much -- coming much more so from packaged gases, which means it's broad-based manufacturing recovery and there's some construction component to that too. Merchant liquid volumes are doing well also. Steel, which had struggled, they've got -- still got fairly strong re I [ph] and the markets they would normally export to have been weak, grew sequentially pretty nicely coming out of the first quarter. So that's an encouraging sign as well. But the most encouraging of what I've seen really is in the packaged gas as we operate a very large packaged gas business in Brazil. Brazil, as you've heard us talk about before, was a big drag for us in 2012. And the numbers we basically delivered at the high level globally were on the strength of North America. This year, I think North America will be okay. Certainly won't grow at the rate it did in 2012, but I'm expecting South America -- again, when I say South America, 80-20 Brazil, to do well in 2013, they're on track to do that. I doubt I can tell you anything about Europe you don't already know. It's flat. I don't expect it to get much better. Our Scandinavian business is performing the best. Our southern Europe's performing the worst, Western Europe is somewhere in between, Germany's stable. Our focus has been on productivity. Now with 60% -- near 60% -- 60% capacity utilization, you would think that pricing would be weak. We are able to get pricing, not as much as we'd be able to get, say, if it was 80%, 85% capacity utilization, but we are able to get some positive pricing. But we really have to focus on productivity in a place where you have a lot of mandated inflation through electricity prices, through high higher labor rates that are controlled by the government. Productivity is the way you survive. Now a lot of people talk about -- it almost sounds as if I'm really pessimistic about Europe, and I probably am compared to the rest of the world, but it's still a 20% operating profit sales business for us. Good cash flow, we don't put much back in and don't intend to. So let me come to Asia. China volumes in April look pretty good. And again, where did it originate? Metals and we're very much exposed to the metal industry there through our oxygen pipelines but also in the merchant liquid business. And general industry, manufacturing. So the growth looks to me like it's kind of returned to where it has been in the past, maybe not as robust a rate. But I think 8% -- 7%, 8%, you pick the number. High single-digit industrial production growth going forward is certainly in the cards for China. And I believe that we will grow at a rate twice that. And the reason I say that is we continue to migrate new application technologies into China, go back to that industrial gas consumption per capita chart that I showed you, secular drivers such as gasification. That's not tied to industrial production output. That's tied to the desire to switch feedstocks, lower-cost feedstocks. And we've done some de-captivations, which is kind of fancy word just to say that we've taken over customer-operated air separation units because they're operated very inefficiently. And with surging electricity cost in many cases, there's more of a desire on our customers' part to have industrial gas companies come in, take over the asset, run it for them. And of course when we do that, we take our merchant liquids and so forth and that's our value creation. India, I don't expect a lot out it going forward. We have some projects we're starting up which will certainly contribute probably to double-digit kind of growth rate this year and maybe next year. But industrial production, I think, will be certainly much weaker than China. And they've got other issues to grapple with like inflation. South Korea, growing at a pretty decent pace, not at the pace of China again but a very good business for us, and I'm pretty encouraged by what I'm seeing. Of course, a lot of what we do in Samsung -- excuse me, in South Korea is tied to Samsung, which is doing very well in a market space in electronics that probably is not doing that well globally, they certainly are an exception. So I'll stop right there, Brian. I probably gave you a very long answer to your question.

Unknown Analyst

As you look at the acquisition you can potentially do, and NuCO2 is an example where you had -- where you're producing the CO2 already and then you had this other distributor that was actually marketing it to customers. Are there any other product lines or areas where you can see similar opportunities to do bolt-ons?

Stephen F. Angel

You mean kind of forward-integrate from the business that we're in?

Brian Maguire - Goldman Sachs Group Inc., Research Division

Right.

Stephen F. Angel

No. Let me just kind of come back a second. I do not see an opportunity to do that kind of thing. Regarding acquisitions and what you should expect out of us going forward, NuCO2 is kind of a one-off thing for us. $1.1 billion acquisition, we're very pleased with what we're seeing. I think it's going to be -- it'll certainly deliver on that mid-teens internal rate of return that the talked about when we announced this acquisition. So we could be sitting here 10 years from now, and we would not have done anything like that over the next 10 years. So one-off. That's not an indication that we're on some acquisition binge or that we no longer believe capital projects pay off, nothing could be further from the truth. We will continue to do packaged gas acquisitions. There's an opportunity to roll up the industry, consolidate the industry. Obviously, there's a lot of benefits that accrue when you're able to do that, to go back to the density that I talked about, lower cost to serve, more market leverage, think pricing leverage when I say that. But I think there's opportunities to continue to roll up packaged gas industry in the United States, and we actually benefit whether we do it or our competitors do it. And that's what you'll see out of us with respect to acquisitions over the coming years. Maybe $100 million or so a year kind of number. Any other questions?

Brian Maguire - Goldman Sachs Group Inc., Research Division

Okay, if there's no more, I'd just give my thanks to you, Steve. Thanks very much.

Stephen F. Angel

Thank you.

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