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Executives

Paul Huck - Senior Vice President & Chief Financial Officer

Nelson Squires - Director, Investor Relations

Analysts

John McNulty - Credit Suisse

Mike Harrison - First Analysis

David Begleiter - Deutsche

Kevin McCarthy - Banc of America/Merrill Lynch

Laurence Alexander - Jefferies

PJ Juvekar - Citi

Jeff Zekauskas - JP Morgan

Don Carson - UBS

Mark Gulley - Soleil Securities

Sergey Vasnetsov - Barclays Capital

Peter Butler - Glen Hill Investments

Edward Yang - Oppenheimer

Steve Schuman - Lafayette Research

Amy Zhang - Goldman Sachs

Air Products & Chemicals Inc. (APD) F3Q09 Earnings Call July 22, 2009 10:00 AM ET

Operator

Good morning and welcome to Air Products & Chemicals third 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 subject 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, Vicky. 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 third 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 www.airproducts.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 get started, I want to point out one major change that we are making this quarter to our variance analysis and reporting.

Energy and raw material cost pass-through will now include the cost of electric power pass-through contractually to Tonnage customers. This was previously included in our underlying sales variance, but we think that combining all cost pass-through will give better transparency on organic sales growth and margins.

Now I’ll turn the call over to Paul.

Paul Huck

Thanks Nelson. Good morning and thank you for joining us today. Now please turn to slide number three. I’d like to spend a few moments updating you on three items impacting this quarter’s results.

First, as we indicated to you on last quarter’s call, given the continued decline in global economic activity and an expected reduction in new plan orders, we recorded an additional restructuring charge this quarter of $124 million or $0.39 per share.

About three quarters of this charge is for severance costs targeted at improving productivity, by further reducing costs related to operations, overheads, business development, project execution and infrastructure costs. The rest of the restructuring charge is for asset impairments associated with restructuring manufacturing capacity.

Our expected benefit in fiscal 2010 will be about $30 million, and the annual benefit in fiscal 2011 and beyond is expected to be $15 million. The previously mentioned annual savings do not reflect about $20 million of project execution costs, which get capitalized into projects. This savings will be reflected in lower future project costs.

This quarter’s provision excludes an additional $20 million to $30 million of restructuring and accelerated depreciation charges to be incurred over the next several quarters associated with these actions. These costs cannot be accrued for in this quarter’s charge as that associated assets are still being used.

These costs are for accelerated depreciation, related to the closure of our air separation manufacturing plant in the U.K. and electronics asset consolidation. These costs will be included on our EPS guidance as we provide updates. Our guidance for the next quarter includes approximately $8 million of these costs.

Second, we recorded a supplemental pension plan settlement charge of $8 million or $0.02 per share for a number of our senior managers who retired recently. Third, we took a charge related to a large customer bankruptcy in the amount of $22 million during this past quarter. A bankruptcy court indicated that collection of certain receivables is unlikely. We also took other asset actions of $10 million for closure of several manufacturing facilities.

Turning to slide number four, I’d like to take a few minutes to update you on the electronics business review we undertook during this quarter. We are of course encouraged by the sequential improvement in Electronics Materials volumes as we indicated in today’s results.

Customer run rates have improved substantially from the lows we experienced in our fiscal Q2. While that is good news, demand is still significantly below last year. Our previous actions to improve this business and reduce its cyclicality did not do enough to shield us from the impact of this downturn.

From this review we concluded that the business is still attractive and that we can achieve our margin and return targets. It was clear however, that we had to take additional actions to further simplify the business and reduce the variability in our results.

Here are the actions we have taken as part of the restructuring charge announced today. Please note that, as I mentioned earlier, there will be some additional costs over the next year as we continue to execute this plan. The Electronics P&L will absorb a large portion of these additional costs.

We have further streamlined and consolidated the organization. Actions taken this year will reduce headcount by approximately 20%. We have re-segmented our customers to better match service levels to customer needs and what they are willing to pay for. We have refocused our technology spending away from long term development, to focus on closure and projects with an emphasis on working with customers and OEMs. We believe this reduces risk and provides a higher return and provides for more growth in the future.

We have ongoing opportunities for optimizing asset utilization by consolidating production capabilities and standardizing our packaging. The timing of these actions is asset specific, driven by both customer and supply chain considerations. Collectively, these actions have reduced our fixed costs and will further streamline our supply chain, while increasing our capabilities in Asia and our focus on emerging markets such as thin film solar that will deliver profitable growth in the future.

In summary, we remain confident in the long term growth opportunities and electronics. We believe we can achieve a low cost business model with increased ability to flex our costs. This will reduce the variability of our margins and returns. It is our goal to complete these changes in 2010 and achieve our 15% margin target in the business in 2011.

Moving onto our financial results for fiscal Q3, please turn to slide number five. Sales of $2 billion declined 11% versus prior year, excluding currency and energy pass-through impacts. Underlying business was all primarily due to lower volumes in our Electronics and Performance Materials and Merchant segments and to a lesser extent, our Tonnage Gas segment.

Sequentially, underlying business was modestly higher on volume recovery in our Electronics and Performance Materials segment. Nelson will walk you through the details by segment shortly.

Consolidated operating income declined by 22%, driven primarily by the lower volumes and unfavorable currency impacts, partially offset by lower operating and overhead costs. Our cost reduction actions continue to improve results.

Our operating margin of 15.6% improved 130 basis points versus last year, due to our cost management actions and energy cost pass-through impacts, despite the decreased volumes. We increased our operating margin by 230 basis points sequentially, mainly from higher Electronics and Performance Materials volumes and better cost performance.

For the quarter versus prior year, our income from continuing operations and diluted earnings per share decreased by 24% and 22%, respectively. Return on capital employed came in at 11%.

Now, turning to slide six for a review of the factors that affected the quarter’s performance in terms of earnings per share, excluding discontinued operations and the Q3 disclosed items, our adjusted earnings per share from continuing operations decreased $0.30 per share or 22% versus last year. Lower volumes accounted for $0.47 of the year-on-year decline.

Pricing and energy and raw materials together were favorable, adding $0.06 and lower costs contributed an additional $0.20. The unfavorable impact to operating income from currency translation in foreign exchange was $0.09. Equity affiliates were down $0.06. Several factors drove our equity income lower this quarter.

Last year’s results included some favorable US GAAP adjustments, which account for about a third of the decline, other factors including unfavorable currency impacts and lower volumes, particularly in Italy. Lower interest expense, due mainly to lower rates added $0.04. Fewer shares outstanding contributed $0.02 and the impact of a modestly higher tax rate was mostly offset by lower minority interest.

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

Nelson Squires

Thanks Paul. Please turn to slide seven, Merchant Gases. Merchant Gases posted sales of $883 million, down 19% versus prior year. Underlying sales declined 9% with volumes down 11% and pricing adding 2%. Currency reduced sales by 10%. Sequentially, Merchant Gases sales increased 1%, volumes were down 1%, pricing declined 2% and currency increased sales by 4%.

LOX, LIN system loadings for the quarter were in the low 70s, with North America and Europe essentially flat and Asia higher versus prior quarter. The sequential drop in pricing was primarily due to fuel surcharges imposed during last year’s surge in diesel prices that have run their course.

Merchant Gases operating income of $169 million was down 17% versus prior year and up 8% sequentially. Segment operating margin of 19.1% was up versus prior year and sequentially, due to continuing cost performance improvement. Let me now provide a few comments by region; please turn to slide eight.

In North America sales fell 16% versus prior year, driven by the slow manufacturing climate. Volumes were down 19% versus prior year, while price added 3%. We saw lower argon and distributor sales again in the quarter. We are encouraged by the amount of new business signings, which improved versus Q2 and represented our best performance this fiscal year.

In Europe sales decreased 21% versus prior year, primarily due to currency down 16%. Underlying sales declined 5%, with volumes down 8% and pricing adding 3%. Volumes were impacted by the weak manufacturing environment, but helped by stronger healthcare sales.

Signings in Europe improved over Q2 levels and continued to remain ahead of plan for the year. In Asia, Merchant sales were down 16% versus last year, with currency reducing sales by 7%, underlying sales declined 9%. Volumes improved off the Q2 lows, mainly due to improved electronics customer run rates. In addition, volumes in China increased 20% sequentially. Signings were in level with quarter two.

Please turn to slide nine, Tonnage Gases. Sales of $565 million decreased 42% compared to last year. Energy and raw material pass-through decreased sales by 32%. Currency reduced sales by an additional 4%, volumes were off 6%. Refinery hydrogen volumes continued to be up versus prior year.

Excluding refinery hydrogen, Tonnage volumes versus prior year continued to be impacted by the operating rates of our steel and chemical customers, but were flat versus prior quarter. Also, a significant PUI customer was down for a large portion of the quarter. Sequentially, sales were down 10%, mainly due to lower energy and raw material pass-through, which reduced sales by 11%.

Operating income of $88 million was down 30% versus prior year and 11% versus prior quarter. The year-on-year decline was due to strong overall volumes, spot sales and operating efficiencies in the prior year, while the sequential decline was due to the previously mentioned PUI customer outage and maintenance timing. Operating margin of 15.5% increased versus last year due to lower energy and raw material pass-through. Our key projects for fiscal 2010 continue to proceed inline with expectations.

Please turn to slide 10, Electronics and Performance Materials. Segment sales of $409 million were down 29% compared to last year. Volumes reduced sales by 24%; currency reduced sales by 3% and price was 2% lower. Electronic sales were down 35% compared to last year, but increased 21% sequentially, better than forecast due to improved customer run rates. The year-on-year decline reflects the significant downturn in semiconductor manufacturing.

Electronics specialty materials sales declined 36% versus prior year but increased 30% sequentially. Equipment sales declined 60% versus prior year. Performance Materials volumes declined 23% versus last year, but improved 26% sequentially, reflecting seasonal improvement and stronger Asian sales.

Operating income of $39 million was down 45% versus prior year, but recovered well sequentially due to higher customer operating rates and better than expected cost performance.

Our Electronics business returned to profitability during the quarter and our Performance Materials results were also better than expected. We now expect millions of square inches of silicon process to be down about 40% in our fiscal 2009 versus our April prediction of about 35%. Industry CapEx is now expected to be down approximately 60% versus prior year.

The Electronics business has clearly bounced off the lows we experienced in our second quarter. That being said, our customers continue to take a conservative view towards their production and this is represented in our guidance.

Please turn to slide 11, Equipment and Energy. Sales of $119 million increased 12% compared to last year, due to increased large air separation unit activity. Operating income of $13 million increased due to improved cost performance. Our backlog in this segment now totals $253 million. We recently announced the successful startup of the first APEX exchanger, in support of Qatargas 2 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 Huck

Thanks Nelson. Now, if you will turn to slide 12, I’d like to share our outlook for Q4. We saw significant deterioration in the economy during the first half of fiscal 2009 and it would appear based upon the recent data and trends, that we found a bottom in fiscal Q2.

Looking to next quarter, specifically for each of our business segments, we expect our Merchant volumes to be inline with last quarter, with Europe continuing to deteriorate, partially due to summer holidays, but Asia continuing to improve. We don’t anticipate any significant change in the U.S. As one would expect, given capacity utilization rates in the low 70s, pricing on new business is proving to be more challenging, but we expect continued good cost performance.

In Tonnage, we expect volumes will improve as capacity utilization rates creep higher in the steel and chemicals portion of the Tonnage segment. We also expect refinery hydrogen volumes to improve modestly from current levels across most of our pipeline franchises, due to higher demand and fewer customer outages. Also we expect higher polyurethane intermediate volumes.

Higher operating bonuses and lower maintenance spending will help, and this segment should benefit from an asset sale next quarter. In Electronics and Performance Materials we expect that higher volumes will be offset by ongoing restructuring costs. In Equipment and Energy, we expect lower operating results due to ongoing restructuring costs.

Our guidance for quarter four is for earnings per share of $1.04 to $1.14, which for the full year is $3.95 to $4.05 per share. With regard to capital spending, we still expect that fiscal 2009 will be about equal to fiscal 2008 spending of $1.4 billion and as we look to fiscal 2010, our initial forecast would be for flat to modestly lower capital spending.

We are currently working on our budget for 2010. Let me share with you some factors that will impact next year’s results. We expect to bring on new plants where the volume is already sold. This should add $0.30 to $0.40 per share for 2010. Our cost reduction efforts, with the additional actions should now add approximately $0.35 per share.

Ongoing restructuring costs should reduce profits by about $0.05 in 2010 and we would expect, that given the overall decline we have seen in this fiscal year in the market that our pension expense should be about $0.10 higher. While we are not done with our plans and we’ll have more to share with you at year end, we believe we are well positioned for attractive earnings growth in 2010, without a significant recovery in the economy.

In closing, our actions this quarter demonstrate our commitment to improve our margins and returns. The cost actions we are taking are not only to preserve our near term profits, but more importantly they also position us with the right cost structure for achieving our 17% margin goals as volumes recover.

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

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from John McNulty - Credit Suisse.

John McNulty - Credit Suisse

On the Electronics business, with the actions that you are taking, can you give us some color as to how your past quarter, the second quarter, which really came under so much pressure, what that would look like with the cost cuts that you are looking to pull in? How would the profitability improve?

Paul Huck

You are talking about on quarter two?

John McNulty - Credit Suisse

Exactly.

Paul Huck

As far as quarter two is concerned, when we look at this, we are striving to take actions so that we do not drive ourselves into a loss and so that would be the thing that we think with the actions which we are taking here, that we could hopefully avoid a loss in this sharp downturn here; and also that we would be on average over this cycle, have returns which are well above our cost to capital.

John McNulty - Credit Suisse

Okay, great. Then just a question on your big on-site project, some of them had been delayed. Have you seen any comeback, now that the credit crisis doesn’t seem quite as severe?

Paul Huck

We have not seen anybody come back on the projects which people have put off, our current projects are proceeding well and we told you that, but as far as the ones which have not started, we haven’t seen anybody start to come back on that. I think that’s a little bit early.

I don’t think it’s a crisis of credit John, so much as people are looking, are they going to be able to sell the product. Manufacturing capacity operates at about 65% of global capacity today. So I think the push on new projects is going to be light over the next few years.

I think the places in which we’re going to see, we’ve told this to people before is we still see the hydrogen projects going forward for the refineries to make the refineries a lot more competitive, that’s a case of their economics and improving their economics.

In China we still expect that, and manufacturing is picking up faster in China than any place else in the world and so as they build a chemical industry in the inland of China based upon coal, we still expect to see the gasification projects proceed.

Operator

Your next question comes from Mike Harrison - First Analysis

Mike Harrison - First Analysis

I was wondering if you could give us a few more details about the 2% sequential decline in Merchant Gases pricing. It sounded like part of that was related to the diesel surcharge, but if you could maybe talk about how much of that is related to surcharges going away or a decline in pass-through’s and how much of it might be related to contracts rolling over or new business signings that are coming in at lower pricing.

Nelson Squires

The majority of this is the surcharges rolling off. If you recall where we were a year ago, we had just faced a 30% increase over the stretch of about three weeks in diesel costs when we did this call and we were basically chasing the price of diesel all through last year.

We put three surcharges into our customers and the whole purpose of the surcharge was we have to incur the difficulty or the problem before we can surcharge to, compensate for it and then the surcharges roll off as we basically have been compensated and have made up the difference and this is what has begun to happen.

So, it is mostly attributable to that. We have not really seen any significant changes in pricing contract roles, but as Paul mentioned in the prepared remarks, we have seen some pressure on new business, but frankly, that really hasn’t impacted overall price all that much.

Paul Huck

Mike, I think a point here is that we have not seen a tremendous amount of pressure on price come out here. There aren’t any cost pressures right now pushing price up, but as far as the pricing, I think everyone understands you’re signing a five year contract here. So, if you want to load something for a year or two, it doesn’t make a lot of sense.

If you’re short on loading for a year or two, it doesn’t make a lot of sense to go out and offer a five year contract at a low price for us. It’s just not a good economic deal for us, and that’s the way we’re functioning here. As you can see, the business is performing very well, giving a good margin and a good return at these pricing levels, so we’re happy with it.

Mike Harrison – First Analysis

In terms of Merchants volumes down 19% in North America, can you walk through what you’re seeing in individual markets in North America and now that we are a few weeks into July, are you seeing any signs of sequential improvement in any of those markets?

Nelson Squires

It’s pretty much an across-the-board decline. In that two-thirds of the business that’s focused on manufacturing, remember, about a third of the business is focused on things such as food, hospital oxygen, etc., markets that don’t really change that much. So it’s a general decline. It’s nothing probably any worse than anything else.

We continue to see lower argon volumes, and that’s putting a lot of pressure on the overall volume index and our third-party sales continue to be down, so our sales to distributors, etc. Obviously they’re in markets which are largely also manufacturing, have been hard hit.

As we look forward, our expectations for Merchant in North America are flattish to slightly up as we go forward. Europe, we are still seeing declines, but the steepness of the decline is more limited now. The issue we have in Europe, of course is the summer holidays, which always slowdown our sales in Europe. Asia though continues to look good as we roll into the quarter and continues a nice steady improvement.

Mike Harrison – First Analysis

Last question I had was on Electronics and Performance Materials pricing. I was wondering if you could breakout how much of that year-over-year decline was Electronics and how much was Performance Materials and also wondering if you could talk specifically about what you are seeing in pricing for fluorine-based gases like NF3.

Paul Huck

Mike, the decline was all Electronics on the pricing there year-over-year and we are still seeing pressure on prices on the fluorine-based gases. Realize though, that this is something which has been a long term trend for us and we have been able to counteract that by our cost reductions.

Operator

Your next question comes from David Begleiter – Deutsche

David Begleiter - Deutsche

Paul, on Electronics, how much smaller will the business be post the restructuring, and how much in sales did you find during the review that didn’t make much or any money?

Paul Huck

Yes Dave, I don’t think it’s going to be a lot smaller. I don’t think we found a lot of things and which would go out here as far as that is concerned. The main thing here is structured around the cost portion of the business for us and really taking advantage of the downturn to consolidate operations, consolidate production facilities, etc. the reductions in staff which we have put in. So we have a lot better cost base today to respond and we’ll improve upon that as we take the actions in 2010.

David Begleiter - Deutsche

Paul, on Q4 guidance, it was reduced by about $0.02 to $0.03 versus the last call. What were the main drivers of that reduction?

Paul Huck

That would be the top end of the guidance, when you actually look at that. If you are going to the top end of our guidance if you went there, I don’t think it’s really anything which gets at actually a reduction. It’s probably the variability in the third quarter isn’t as much there.

As far as the low end of our guidance, Dave as we look at this, the thing which we are concerned about is if the Electronics dips back down. We hope that isn’t true. Our volume trends through the first 20 days or so would say it’s not true in outward things and so as we continue to look, we think that we’re still pretty solid as far as the results are concerned.

The recovery is slow; realize that. I mean everyone should understand that we are not seeing a huge strong recovery anywhere. In the US, the package on the stimulus really isn’t having an impact for things, but overall I think we’re performing well and we think we’ve done a good job of matching costs and volume here going forward.

David Begleiter - Deutsche

Paul, lastly, what was the PUI impact in the quarter on Tonnage volume?

Paul Huck

Yes; the PUI impact of that customer being down was a couple of cents for us.

Operator

Your next question comes from Kevin McCarthy - Banc of America/Merrill Lynch.

Kevin McCarthy - Banc of America/Merrill Lynch

In the release this morning you reiterated your commitment to a 17% margin goal. I was wondering if you could walk us through how you get there, relative to the year-to-date average of 14% in last year’s 14%, number one. Then number two, comment on when you might be able to achieve that; would it be feasible in 2011, for example?

Paul Huck

Well Kevin, first I think the 17% margin goal and that is our goal for 2011, for us as we look at that. If you take a look at it, today we have done a lot to improve our margins and so, if we get to our margins of last year, we’ve already produced a point to a point-and-a-half of improvement.

The bulk of that actually has come from cost reductions. We’ve had a negative impact from volumes and we’ve had a positive impact from gas coming off, but roughly, if I were to walk you from today let’s say, it’s probably something which is an easier way to do it and let’s say we put gas at $6 or so, that probably puts us pretty close to a 15% margin as the company is concerned.

About half of the improvement comes from costs; that’s from today, improving my cost base, lowering my cost base by $80 million a year. So I’ve got those actions in place, with the cost reduction which we announced today and the continued and the impact of the rest of the cost reduction which we have going forward from quarter one, puts those actions in place and then a loading impact of about 1% as the volumes start to recover. That loading impact is about a 5% improvement in volume for us overall. So, it’s not a huge impact on volume and that quite simply is how we get there.

Kevin McCarthy - Banc of America/Merrill Lynch

A second question if I may on the Merchant business. Most companies are bemoaning the regional weakness in Europe. I think you’ve posted volume of negative eight there, much better than North America. The disparity seemed quite wide, even though I know you have healthcare in Europe. I was wondering if you could maybe update or elaborate on what you are seeing in merchants in Europe.

Nelson Squires

Healthcare in Europe did have a strong quarter and so that did mitigate a lot of the volume decline. I would also say probably that argon sales were not as weak as they were in North America, but most of the difference is attributable to a very good quarter in healthcare.

Operator

Your next question comes from Laurence Alexander - Jefferies.

Laurence Alexander - Jefferies

I guess the first question is on Electronics; could you walk through how you see the mix playing out over the next few years to get margins to 17%? That is, are you assuming a sustainable increase in equipment margins or what kind of levers.

Paul Huck

Lawrence, just thing, you said the thing which we are striving for is 15% in 2011; 17% I just answered and that was overall for the company, but as far as trying to get to the margins of 15% in Electronics, the things as we look at that is the mix of business, it’s probably not going to change a lot from today as far as we look at that.

We are about a quarter Tonnage; 15% or so Equipment; and 60% in the Specialty Materials for that. So with that mix, we can get there. What this does is that we will have some volume recovery. You’ve seen that and you’ve seen the nice impact of volume recovery. We are still well below the volumes of the prior year, but you’re seeing a very strong impact.

So, if we were at the prior year volumes, our margins and earnings would be above our 15% today for us. I do not have to get all the way back to the volumes of 2008 to get there, and so I can get there with some volume recovery and the cost actions which we have put in place here.

Laurence Alexander - Jefferies

Then in Tonnage, how much was the hit in the quarter from maintenance timing on your margins?

Paul Huck

On the maintenance, was small about $0.01 or so...

Laurence Alexander - Jefferies

And then lastly, for Merchant. Given the timing of the diesel surcharges rolling off and sort of the pushback from customers; is there a possibility that Merchant pricing could be negative in 2010?

Paul Huck

If we take a look at that certainly, if diesel would continue to climb we could see pricing there. You realize that this is a surcharge which goes through and so all we are doing is recovering our cost here with our customer. We are not in here trying to make money on our customers on this thing. It really plays out as diesel prices play out.

The other thing which we have, pressure coming up is that power prices continue to rise and we have the right to surcharge for power prices, too. We’ve seen power price increases in Europe. We’re likely to see some power price increases in the U.S., as states like Pennsylvania go out and deregulate those things, so would put some pressures on, longer term.

I think the bigger thing which you really need to focus on here is our improvement in margins in this business. We are going to get this business above a 20% margin in the near term here.

Operator

Your next question comes from PJ Juvekar - Citi.

PJ Juvekar – Citi

Quickly, on NF3; how low did the operating rates go? I know you shut down some Asian capacity for awhile. Can you update us on Asia as well as the hometown plant?

Paul Huck

Right now, the Asian plant is not up yet, so we still have that upside for us to happen as we will bring it back on stream sometime in the near future here, PJ.

PJ Juvekar – Citi

So are you supplying Asia from the U.S.?

Paul Huck

Yes, we are.

PJ Juvekar – Citi

So you are going back to your old supply chain, and is that costing you incrementally?

Paul Huck

Yes, and that does add some costs to us, but realize we continue to work on lowering those costs and also continue to work on lowering the cost of the production in the U.S. here too, so it’s a constant drive to that. We still have a decent amount of capacity here in the U.S. and plan to have that capacity in the U.S.

PJ Juvekar – Citi

Second; sort of a housekeeping question. Why was the pension charge put into one time charge for the quarter? Why did you call that out?

Paul Huck

Because it was an unusual charge, it was a similar cost to what we had last year. It wasn’t as large, but we thought as far as trying to do it, it’s not something which actually recurs, it’s a thing which you trip.

With all the divestitures which we have, we have had a significant cut in the number of senior people at the company. So what that does is it produces these one time charges and also, we can’t accrue these charges at the time they occur. It occurs when the payments actually come, so they are not matched to the cost reduction timing.

PJ Juvekar – Citi

Finally; just the big picture question, the margin goes right goes to half for Air Products, or would you rather have return on capital or some other goals? Because your margins are impacted by this natural gas pass-through.

Paul Huck

Yes; I missed the first portion of that.

PJ Juvekar – Citi

Are these margin goals, the right goals to have?

Paul Huck

Yes, they are, and the thing which I will tell you is that I do my margin goals. As I set these up, I put gas at $6. If you take a look at the segment of Tonnage Gases, that’s a hard one to get a margin goal in here, but when you look at this in the end, the margin goal is really being driven by our desire to improve our returns.

Everyone focuses; the investor community has a lot of focus on margin. So, our focus, as you know here is very much on return and our goal in improving our margins really is to improve our returns. So, if I get to my margin goal, I should get my return on capital employed up to 15% at that point in time.

Operator

Your next question comes from Jeff Zekauskas – JP Morgan.

Jeff Zekauskas – JP Morgan

What’s the size of the gain that you intend to book in the fiscal fourth quarter on an EPS basis?

Paul Huck

Are you talking on the sale of assets?

Jeff Zekauskas – JP Morgan

Yes, please.

Paul Huck

Yes, it’s about $0.02 or so, and so the reason we called those out is we have the ongoing cost of the restructuring, plus we have this one time gain. They are going to about offset, if we get the assets sold.

Jeff Zekauskas – JP Morgan

Secondly, in response to some of the other questions about your sequential pricing, you’ve talked about how it’s really an answer to changes in diesel fuel prices. So, should diesel fuel prices stay relatively stable, then what we should expect for Air Products sequential pricing going forward, is that it remains flat. Is that correct?

Paul Huck

Yes.

Jeff Zekauskas – JP Morgan

Lastly, if you look at the Merchant volumes in the United States for the last three quarters, the Merchant volumes have stepped down globally from 6 to 8 to 11. What do you make of that in general, Paul? That is, why should there be an acceleration in the decrease for an industrial gas company? Whereas it seems that on a relative basis the economy is more stabilized over that period of time.

Paul Huck

Yes, Jeff. That’s a good question. I think what you have to realize is that we were having growth during these periods. So, the first three quarters we had growth from year-to-year. So, it’s actually the comparison period. As we go into quarter four and as we go into next year, you are going to see a better comp which is an easier-to-beat number there for us. So, it’s just and lapping the growth here is what we are getting.

Operator

Your next question comes from Don Carson - UBS.

Don Carson – UBS

Just to follow up on merchant pricing, what impact does liquid argon have on the volume index? I’m trying to wonder what would that index be if you are just looking at LOX, LIN. Would that be somewhat muted and, Paul just wondering if you could clarify the comment again on pressure on new signings. How does the pricing on new signings in Merchant in the U.S. compare to your existing book?

Paul Huck

If you take a look at the impact on pricing, whether its volume or price index in which we are looking at is LOX, LIN and so that’s going to be the one which has the biggest impact. LAR is going to be next and then followed by hydrogen and helium for us, but LOX, LIN is well above 50% of most of our sales there. So, that’s going to be the one which is going to dominate.

Regarding the comment on pricing is that, as one would expect the business is a lot more competitive for things and so you are seeing more people show up to these things. People are taking their pencils out and trying to win business.

I will tell you, I’ll say this for ourselves here, we are being very careful because we like our prices today, we like our business today, we like the performance of our business. We are very happy, even with the performance, even given the fact that the loadings are in the low 70s.

I do not have an urgent desire to take business at a low price to increase my loadings. I don’t need to do that and I think the bulk of my competitors, as they’re reacting at that, haven’t shown a great desire to do that, either, for us. So, I do not think that there’s a huge issue here on pricing, it’s just that people should understand that pricing is still competitive at these rates.

Don Carson - UBS

You gave some comments on the 2010 outlook, more just looking at new plants and cost impacts. What would be the impact if global industrial production recovers? You’ve got some pretty low operating rates.

What kind of incremental operating margins would you see in both your Tonnage and Merchant business on a volume recovery next year?

Paul Huck

A good rule of thumb for us is anywhere from 35% to 45%. When I do large calculations, I use about 40%. The big impact on which we are going to see is Electronics, actually, I think, year-to-year right now. We went through a very low period in quarter two. So we are set up for a good comp here next year in quarter two of fiscal year for us, I think with the volume recovery which need, that sustained.

Operator

Your next question comes from Mark Gulley - Soleil Securities.

Mark Gulley - Soleil Securities

Paul, as you talked about all the restructuring actions that you’ve taken, one of the things you mentioned very quickly, was I think reflecting lower growth prospects going forward in Tonnage. I think you talked about reducing your project execution team and stuff like that.

Can you elaborate on that a bit? Can you talk about whether or not you think the Tonnage business is going to face significantly lower growth prospects going forward, and that’s why you’ve taken these actions there?

Paul Huck

Certainly, as we’ve said, Mark there is lots of new bidding activity still out there, there’s lots of development activity still out there. The awards of orders have slowed down.

I made a comment earlier about refinery hydrogen and in China the oxygen for gasification of coal to chemicals; those things are still proceeding, all-be-it not at the same rates as what they were, but activity is slower for things.

We think, in the longer term, the growth drivers are still the same. Improved energy performance, improved environmental performances are still there for us to keep going. As production shifts to Asia, we see that as an opportunity for us to go and take advantage of that.

So, we do think that there’s a longer growth in the very near term, let’s say that’s the 2010, 2011, we think there could be some pressure on capital spending downward for us. If that happens, that’s cash for the shareholders, which is the nice thing about the industrial gas model.

The other factor here, Mark, and we continue to go out and look at it, I didn’t make a comment as we went through our results, but we continue to work on project acquisitions, and we think we have some real prospects here which would add very nicely and would give growth instantaneously.

They would involve a cash outflow right away, and it wouldn’t be over two years, it would be a lumpy type of capital spends, but it would also put earnings right to the P&L pretty quick here.

Mark Gulley - Soleil Securities

Can you elaborate on the kind of acquisitions you are looking at?

Paul Huck

Well, there is acquisitions of plants which we have sold or other people have sold in the industrial gas space; of captive plants which people operate for themselves, oxygen, nitrogen, hydrogen plants, which these people operate for themselves and we would buy and put them on our pipeline systems in many instances or go in and take that position for them.

Mark Gulley - Soleil Securities

If I may in housekeeping; tax rate cosmetically was low this quarter. What is the underlying tax rate for the quarter for this year and for next year?

Paul Huck

The underlying rate for this year is 26%. We’re not ready to give any guidance really for next year, but I don’t think it’s not going to change a remarkable amount, I don’t think, unless the laws change.

Operator

Your next question comes from Sergey Vasnetsov - Barclays Capital.

Sergey Vasnetsov - Barclays Capital

You mentioned a couple of times your Merchant Gases capacity utilization is at about 70%. Any comments regionally U.S., Europe, Asia and also some changes in the freight?

Nelson Squires

Yes. You are saying capacity or system loadings by region, Sergey? Yes, this is Nelson. In North America they’ve probably ticked up a point or so, but still are in the low 70s and I’m really talking LOX, LIN here. As Paul said earlier, that really drives the system.

In Europe they probably ticked down a point or so, but remained in the low 70s and in Asia they’re up a fair amount; they’re probably up 10 points over where we were in the second quarter and so that takes again from the low 80s or the low 70s and probably to around 80% loading.

Sergey Vasnetsov - Barclays Capital

Also, your fiscal year is earlier than for most other peers by quarter, which means that you must be doing your strategic plan review and budgets for next year early as well. Today may not be the time for them to seek formal 2010 outlook, but maybe you can offer some quantitative comments on the pace of improvements you expect in your end markets and also your overall results?

Paul Huck

Yes, one of the things which I gave is, I gave an outlook on the budget here, which is about what we are comfortable at this point in time in sharing here for us, as far as the impact to the company, and we are set up for some good growth going forward here. We have the projects coming on stream with the full year impact of the cost reduction out there, which are going to drive the growth going forward, and so we think we’re positioned well.

Overall, as far as the economy is concerned, I’m starting to feel a little bit better about the economy, certainly in Asia, and the U.S. seems to have bottomed here. Europe we think will probably bottom in the fourth quarter, but in the end, the thing which we’re planning for is a slow recovery. So we’re going to set our costs and all our plans based upon a slow recovery, to be conservative on here, because it’s a lot easier for us to adjust up than it is to adjust down.

Operator

Your next question comes from Peter Butler - Glen Hill Investments.

Peter Butler - Glen Hill Investments

Your comments on Merchant pricing were primarily describing what’s gone on here. I’m wondering whether in Europe, with the economy worse and the operating rates lower, could they be the lead indicator running into competitive pressures there?

Paul Huck

No, I don’t think. In fact, the prices in Europe are actually moving up here based upon power costs and things like that for us. So we have not seen issues in Europe as far as pricing is concerned here.

Peter Butler - Glen Hill Investments

Okay. On your pension fund costs, in your presentation, did you say that you expect about a $0.10 headwind next year from pension charges?

Paul Huck

Yes, and that’s with where the markets are today and it’s a rough estimate at this point in time. We’ll see how it actually comes out and based upon that, because you do the valuation on 30 September year end, so it’s always a guess here. The things which Air Products didn’t have the last year is that in the markets were higher at the end of our fiscal year than the calendar year companies, so we could run into some of that headwind in this coming year.

Peter Butler - Glen Hill Investments

Is it possible that you might have to make a contribution, and how would that impact your balance sheet by the end of next year and possible disposition of some of that cash flow, is it your own?

Paul Huck

Yes, Peter that’s certainly something which would be voluntary on our part, the contribution. We always look at the ability to make a contribution with tax benefits. We’ve talked a lot about that in past calls, as far as we manage it.

We would not be forced to make a contribution. Let’s say from a government standpoint of regulations and we are fine with that. So if we chose to make the contribution, it would be based upon it’s the right thing to do from managing the cash for the company as a whole for us going forward here.

Operator

Your next question comes from Edward Yang - Oppenheimer.

Edward Yang - Oppenheimer

A quick question, your net debt was up sequentially and the interest expense was actually down. I was wondering what was behind that and what you expect for the next quarter in terms of interest expense?

Paul Huck

Yes, the debt was up a little bit. I mean there is the impact of currency, rates are a little bit higher and that produced the bulk of the impact on debt. As far as the interest rates, the rates continue to be low in the short term here for us, so our CP is low here.

Edward Yang - Oppenheimer

Paul, on Electronics and the 15% margin target, I think you had some restatements in the past, so we don’t have a lot of historical data on this, but when was the last time that segment, if ever had margins in that 15% range? I would like some historical perspective.

Paul Huck

Certainly in the 90s and the early portion of the 2000 decade we saw margins there above the 15% range. We got close in 2008, in that time period, to 15%, but a lot of things have changed in the business. We have changed a lot of things. We have made a lot of changes and substantial reductions in our staffing, substantial changes in our plants, in our product lines and how we do business here. So we’ve made a lot of changes to this business, and we feel confident that we can go forward here and achieve our margin target.

Edward Yang – Oppenheimer

Can you talk about the competitive landscape within that segment? You’re taking constructive steps with your cost basis. I would think that your competitors are probably doing the same as well. So are the lower margins in that Electronics segment just a function that it’s just much more competitive?

Paul Huck

Certainly there have been pressures on price, but realize that there’s been a lot of volume which has been pushed through this segment too, and so what that does, that changes the dynamics of it, of the business here. What that gives you is an opportunity and your customers expect that opportunity to take advantage of economies of scale.

That’s what we’re doing and we’ll continue to do, as we go forward here and realize that the positions which Air Products has in this business are very good. We are a leading supplier, if not the number one supplier in the bulk of the products in which we offer here.

Operator

Your next question comes from Steve Schuman - Lafayette Research.

Steve Schuman - Lafayette Research

One thing I’ve noticed with yourself and some of the other competitors is that the fall in income has been less than I would expect considering the fall in sales. Of course there are some put and takes with currency and pass-through, but is the bulk of that cost savings or are you still finding products that are at either zero or negative margin you’re able to remove from your sales picture?

Paul Huck

I think the bulk is actually going out in saving costs here, and continuing to reduce costs is something which we do on a constant basis. We do it in good times and in bad times.

Steve Schuman - Lafayette Research

So I guess, couple of years ago, you went through a product review on Electronics in particular, where you did remove a lot of the low or negative margin cost products. So that you say is pretty much done at this point?

Paul Huck

Yes, but I think the thing which people ought to realize, it wasn’t a huge amount of sales. It was probably $100 million a year in sales. So, when you put that over the size of Air Products, it’s not a huge impact. It helps, but it’s not a huge impact.

Operator

Your next question comes from Bob Koort - Goldman Sachs.

Amy Zhang – Goldman Sachs

Good morning, this is Amy Zhang sitting in for Bob. I have two quick follow up questions. The first one, on the Electronics side, Paul or Nelson, can you give us a little bit more color on the magnitude of rebound across each of the three divisions there; Specialty Gases, Bulk Gases and Equipment. Also, what the quarter-to-date trends look like?

Paul Huck

Yes Amy, the bulk of the change here and the rebound occurred on the Spec Gas and Chemicals side of this business. The Equipment business is still down and is going to remain down until capital spending comes back. Tonnage Gases is a stable business and we don’t see that moving a whole lot.

Amy Zhang – Goldman Sachs

Then the trend, the quarter to date, I guess rather consistent with whatever you saw in the June quarter right?

Paul Huck

Yes.

Amy Zhang – Goldman Sachs

Then second question on the cost of savings, you mentioned $0.35 per share in FY 2010 and then at the same time as you assume a modest economic recovery. I’m wondering, what’s the mix for this cost saving benefit between the variables and fixed?

If this global economy rebounds stronger or much stronger than you guys expected, what shall we expect as the cost of saving at the end of the day? Would that be reduced or how we should think about; how much of the savings is sticky?

Paul Huck

Amy, the cost savings which we talk about on the $0.35 a share is all fixed cost savings for us, that’s what we’ve been talking at. We continue to work on our variable costs, trying to drive that out by improving the efficiency of our plants, etc and the yields of our plants, but that’s a separate topic for us as we go forward here.

I think, as far as a large rebound in the economy, it could require us to do something, but for right now I just don’t see that requiring us to be a lot, given our loadings on the system and things like that I would have to add a lot of fixed cost, even under a scenario where we got growth of 10%, let’s say.

You can see the loadings on the plant, so I don’t have to add manufacturing capacity, etc to respond to this. I’ve got about $2 billion in sales which is sitting unloaded at this point in time which we can grow back into. So that’s a good thing to have and a great opportunity for us.

Amy Zhang - Goldman Sachs

So the bottom line here is that $0.35 per share savings is safe and that’s regardless of the underlying economic environment?

Paul Huck

We should have that, right.

Operator

That is all the time that we have for questions today. At this time, I’ll turn things back over to Mr. Squires for any additional or closing remarks.

Nelson Squires

Thanks Vicky. Please go to our website to access a replay of this call beginning at 2:00pm today. Thank you for joining us and have a nice day.

Operator

That does conclude today’s teleconference. Thank you all for joining.

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Source: Air Products & Chemicals Inc. F3Q09 (Qtr End 06/30/09) Earnings Call Transcript
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