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Praxair, Inc. (NYSE:PX)

Q2 2009 Earnings Call Transcript

July 29, 2009 11:00 am ET

Executives

Jim Sawyer - EVP and CFO

Liz Hirsch - Director, IR

Analysts

Sergey Vasnetsov – Barclays

Mike Sison - KeyBanc

P.J. Juvekar - Citi

Jeff Zekauskas - JPMorgan

Donald Carson - UBS

John Roberts - Buckingham Research

Edward Yang - Oppenheimer

David Begleiter - Deutsche Bank

Laurence Alexander - Jefferies

Mark Gulley - Soleil Securities

Amy Zhang - Goldman Sachs

Kevin McCarthy - Banc of America-Merrill Lynch

John McNulty - Credit Suisse

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Praxair Incorporated earnings conference call. My name is Heather, and I will be your coordinator for today.

At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s conference, Mr. Jim Sawyer, Executive Vice President and Chief Financial Officer. Please proceed, sir.

Jim Sawyer

Thank you, Heather. Good morning and thank you all for attending our second quarter earnings call and webcast. Matt White, Vice President and Controller; and Liz Hirsch, Director of Investor Relations are with me this morning.

Today’s presentation materials are available on our website at www.praxair.com in the Investors section. Please read the forward-looking statement disclosure on page 2 and note that it applies to all statements made during this teleconference.

Our earnings per share this quarter was $0.96 towards the bottom end, but within our guidance range of $0.95 to $1. When we gave guidance at the beginning of the quarter, we assumed that the macroeconomic conditions would be about the same as the first quarter. However, the economy continued to slide further with US industrial production falling 13% in June and the bankruptcies of GM and Chrysler, which closed all of their assembly plants.

Additionally, we were impacted by very low natural gas prices. This impacted our top line, because these prices are a pass-through in our hydrogen prices, but it also impacted our bottom line due to the cessation of drilling activity. This caused a $20 million sales impact to our fracking business and reduced our operating profit by about $10 million. This will come back when gas prices move higher.

Let me also add that our operating profit was negatively impacted by $16 million in currency hedged losses or about $0.04 of earnings per share related to the Brazilian Reais and Euro, which strengthened right at the end of the quarter, requiring us to mark-to-market our hedges related to the third quarter.

Our currency management strategy has been to hedge our net income exposure one quarter forward. And in the fourth quarter of last year, we had a similar gain when the Reais and the Euro weakened suddenly.

Also included in operating profit is about $5 million in severance charges and $22 million of receivable write-offs. However, we will not review the special items, because either charges which will continue in the third and fourth quarters until we are finished reducing headcount and our customers financial profiles have stabilized.

Now having pointed out all the bad news in the quarter, let me say that I am much more optimistic about the economy than I was three months ago. First, the economy has clearly stabilized albeit at a low level. Second, the auto, steel and chemical industries have announced a significant number of plant startups in the second half. Third, China and India and Brazilian are already improving. And lastly, we have not seen our project backlog decline and we are currently studying a number of new very interesting large projects, primarily in the energy area. Consequently, we believe that our pipeline of new business will continue to be strong for at least the next five years.

Now let me turn the call over to Liz, who will review our second quarter results in more detail.

Liz Hirsch

Thanks Jim, and good morning everyone. Please turn to page 3 for a summary of our second quarter results. Given the overall environment Praxair had very solid results in the second quarter.

Sales and earnings were higher than the first quarter and well below the prior year. The macro environment continued to be very challenging with little change from the first quarter overall.

Volumes seemed to have stabilized and towards the end of the quarter, we began to see a few pockets of improvement which we will discuss. You can see in our results that our cost reductions and productivity have offset a significant portion of the impact from lower volumes.

Sales were 26% below last year’s second quarter, but net income declined only 14%. And our operating margin reached 20.9%. Sales this quarter were $2.1 billion versus $2.9 billion in the previous year quarter. More than half of this decrease came from currency and cost pass-through effects.

Negative currency translation primarily the Euro and the Brazilian Real reduced sales by $262 million or 9%. Secondly, lower cost pass-through reduced sales by $144 million or 5%. Cost pass-through includes the costs of natural gas purchased to make hydrogen and the cost of electricity for our onsite atmosphere customers. These costs are automatically pass-through by formulae in our contracts to our customers with the minimal impact on operating profit. The 5% negative effect on our top line this quarter was primarily due to significantly lower natural gas prices compared to last year.

Excluding these effects, underlying sales were 12% below prior year. Overall volumes were 14% lower and little changed from first quarter. Remember, that all our year-over-year volume comparison this quarter are against a very strong 2008 second quarter in which volumes rose 6%. Higher overall pricing partially offset the effect of lower volumes.

Operating profit was $447 million this quarter, 18% or $96 million below prior year. The impact of lower volumes reduced OP by about $207 million. We offset more than half of this with cost reduction and productivity.

We have streamlined our cost structure by reducing fixed cost and our gross margin this quarter increased to 44% from 39% from 2008. This should demonstrate to you the significant incremental earnings we will have when volumes recover.

Net income of $299 million was 14% of sales, a 190 basis point margin improvement from last year. In addition to lower cost, net income this quarter benefited from lower interest expense.

The rates we are paying on US commercial paper and short-term debt have continued to trend lower and in addition, we are paying lower rates on short-term debt overseas as governments have reduced rates to stimulate their economies.

Our effective tax rate this quarter was about 26%. This reflects a $7 million tax benefit, primarily in Italy, related to tax incentives. A third of this benefit was offset in the non-controlling interests line, since part of the benefit was attributable to our minority shareholders.

Earnings per share of $0.96 was 11% below last year, but $0.03 higher than last quarter. Cash flow generation was strong this quarter. Cash flow from operations was $563 million primarily from net income and depreciation. This funded $370 million of capital expenditures primarily for onsite projects under construction globally. We also repurchased $64 million of stock, net of issuances and paid a $123 million of dividends, leaving overall debt levels relatively unchanged.

Please turn to pages 4 and 5 for our results in North America. Sales in North America were $1.1 billion, 15% below prior year, excluding currency effects and lower cost pass-through primarily natural gas. Volumes were 17% lower than prior year, partially offset by 2% higher pricing.

We saw lower sales in all end markets except energy, which was up 11%, excluding gas prices due to growth in refinery hydrogen and enhanced oil recovery. Overall volumes trended down slightly from the first quarter, but appear now to be stabilizing.

Onsite sales declined 38% ex-currency. Lower natural gas prices accounted for 27% of that decrease. Underlying volumes were down 11% as higher hydrogen volumes were offset by lower volumes to steel and chemical customers. The significant inventory destocking by our customers in these markets appears to be ending. And in June, our oxygen volumes began to pickup slightly.

Merchant liquid sales ex-currency were 13% below prior year at 18% lower volumes compared to a very strong second quarter last year, were partially offset by higher pricing. Merchant volumes trended lower compared to the first quarter as manufacturing in the US and Canada has continued to weaken.

Sales to oil well services are very low in line with the reduced drilling activity due to low gas prices. Overall pricing is above prior year and sequential trends continued to be stable.

We are signing a lot of new business for frozen budget foods as consumers are eating in home more due to the recession. We are also seeing new business opportunities for certain environment applications such as emission reductions and wastewater treatment.

North American packaged gas sales were 19% below prior year ex-currency due to lower volumes in the US, Canada and Mexico mitigated by higher price. In PDI, our US and Canada business, same-store sales declined 18% primarily due to a 34% decline in hard goods. Gas and rent same-store sales were down 7%. The large decline in hard goods reflects the sharp contraction in capital spending and production in construction and manufacturing markets.

PDI’s operating margin however increased 200 basis points from the prior year, due mostly to significant cost reduction and some effect from the mix of lower margin hard goods. PDI’s sales per day have been relatively flat since March and we believe we are seeing stabilization, but no visible upturn yet. Operating profit in North America was $264 million this year, up from last quarter due to our continued focus on cost reduction and productivity. Operating margin was 23.6%.

Our current outlook for North America for the second half of the year is for volumes to remain well below 2008 levels with a modest sequential recovery in the hardest hit end markets of chemicals, metals and electronics. Energy markets are a bright spot, except for oil well services which is down significantly.

We expect our hydrogen sales to continue to grow and we are looking at new projects for refining, oil recovery and sequestration. Food and healthcare markets are steady. We are very cautious about planning for higher volumes in manufacturing and industrial markets in the US and Canada, as we have yet to see a significant upturn.

Please turn to page 6, for our results in Europe. Sales in Europe were $306 million, down 11% from the prior year ex-currency due to 14% lower volume mitigated by 3% higher pricing. Sequentially, overall volumes were even with last quarter. This is a result of modest sequential improvement in sales to manufacturing, food and healthcare markets, offset by modestly lower sales to metals and chemicals.

Onsite and merchant volumes picked up in June versus May. By country, Italy is showing some improvement, while Spain is still weak due in large part to the steep downturn in construction. We are continuing to sign new liquid contracts for food and for environment applications, specifically wastewater treatment.

Operating profit was $61 million compared to $99 million in the prior year. We are stepping up our productivity programs and expect the margin to continue to improve over the balance of the year, even without a significant improvement in volumes.

Please turn to page 7, for our results in South America. Sales in South America were $395 million. Underlying sales were 5% below the prior year and higher than last quarter. Brazil’s economy is beginning to show some positive growth trends due to government fiscal and monetary stimulus. Interest rates have been reduced five times this year to a record low of 8.75%. Industrial production and consumer confidence are both picking up from the low point in January.

In Brazil, our pipeline and liquid volumes, excluding seasonal CO2 rose towards the end of the quarter as CO and chemicals picked up. Our LNG sales were also higher as were sales to food and beverage and healthcare. We are optimistic about Brazil’s earlier recovery from this recession and we expect sequential volume improvement in the second half of the year.

Operating profit was $70 million. Excluding currency effects, which included an $11 million net income hedge loss, operating margin was over 20%. Higher pricing and cost reduction have offset the impact of lower volumes and so volume increases will give a strong operating leverage. We also have a number of projects which will start up this year. The most will be in the fourth quarter, thereby contributing to sales and earnings in 2010.

Page 8, summarizes our Asia results. Sales of $199 million in Asia were 5% below prior year ex-currency. Sales were lower year-over-year primarily due to lower production at electronics and steel customers. Business conditions have improved in China, India and Thailand, and volumes rose to 13% sequentially. China is showing solid signs of recovery. Compared to first quarter, our onsite volumes and merchant volumes are up 16% and 28% respectively. Sales to electronics showed a strong rebound up 27% versus first quarter ex-currency. However, specialty gas pricing continues to decline.

Operating profit and operating margin were higher than last quarter due to higher volumes coupled with good cost control. We expect the growth will continue to pickup in China and India this year and in 2010. The Chinese Government is stimulating economic growth with infrastructure spending to create jobs and consumer demand. India has not seen as much of a downturn, but industrial production has resumed and we expect it to continue. We have a large number of projects under construction in both countries and are looking at numerous new projects.

Please turn to page 9, for surface technologies results. PST had sales of $118 million this quarter, down 14% versus 2008 ex-currency. Coatings for energy markets particularly industrial gas turbines were higher. Coatings for general manufacturing market like automotive, steel, printing and capital equipment were very weak particularly in Europe. Jet engine coatings were below prior year, but we expect them to increase in the second half. Operating profit was $19 million, 16% of sales.

On July 1st, PST acquired Sermatech International, a global supplier of coatings used on industrial and aviation turbines. PST’s business focus is to increase the proportion of turbine coatings, both jet engines and industrial and oil field service coatings, as these are faster growing markets and also require higher value-added technologies. It will reduce its focus on lower value-added industrial coatings from markets which are shrinking like printing, auto and textiles.

Over 80% of Sermtech’s sales are to the aerospace and energy markets. In addition, Sermatech expands PST’s coatings offerings and increases our business with key OEM customers like GE, Rolls Royce, Siemens and Alstom. We will realize significant synergies as we integrate the businesses from facility rationalization and manufacturing plant optimization.

The acquisition will add about $50 million of sales in the second half of this year, but integration cost will offset the operating profit contribution for the next few quarters. Our objective after integration is to drive the operating margins for all PST up to the 20% range.

Now I will turn this back to Jim, to discuss business conditions, our outlook, and our earnings guidance.

Jim Sawyer

Thanks Liz. As I mentioned earlier, business conditions in the second quarter turned out to be more difficult than we had hoped when we did our earnings call in April. At that time, we were cautiously optimistic that destocking in chemicals and steel will end soon. But in North America and Europe, volumes continued to decline further from the first quarter.

Page 10, shows our organic sales growth by end market both year-over-year and compared to last quarter. The sequential numbers show improvement in some markets, but it continued to fall off in sales to chemicals and metals. Electronics, chemicals, metals and manufacturing markets comparably, sales are down 15% to 20%. This shows you the opportunity we have to grow sales and earnings in the future as volumes recover, because we’ll not have to add any production capacity to support these sales.

Let me make a few comments about each of the major end markets. Energy has been very resilient with sales up 10% from last year. We expect steady growth in hydrogen for refining from existing customers and from new projects currently under constructions. We are also expecting to capture new opportunities outside of the US as refiners upgrade our facilities and move to over-the-fence supply systems. We believe enhanced oil recovery will continue to be a good opportunity globally for nitrogen enhanced CO2 supply. We signed a new project last quarter and are evaluating several others.

Current time, our fracking business is significantly below last year and last quarter due to weak drilling activity in the US and Canada. When natural gas prices get back to the $5 to $6 level, this business will pick up rapidly. Electronics has shown a significant rebound from its first quarter lows. The pickup is coming from the inventory restocking to meet Chinese demand for small notebook computers and saw an increase in production of flat panel displays. There is limited visibility on the longer-term outlook for growth in the semiconductor manufacturing. Consensus views are for a more moderate growth rates going forward.

Solar is an area which we expect will growth faster than semiconductor production supported by government incentives for technology development to drive cost down closer to great parity. We’ve signed a number of contracts to supply gases to poly silicon producers and solar cell manufacturers. They are also developing technology and increasing our production capacity for tubular targets for this market.

Demand levels of our chemical customers appear to be stabilizing and will probably grow next year. In metals, sales were down 23% from last year and were 5% below the first quarter. Significant destocking appears to be behind us. In the US, steel service center inventories are at historically low levels. Volumes have very recently begun to improve in North America as several customers have restarted blast furnaces. We have seen more of a pickup in volumes in South America and China and we expect those two regions to continue to see sequential improvement.

Our sales to manufacturing are down 14% year-over-year and about even with the first quarter. Overall, industrial markets continue to be very weak in the US, Canada, and Europe, primarily due to weak consumer demand for autos, housing and appliances and weak non-residential construction. At this point, it’s hard to call any specific upturn in industrial production in these regions and so we continue to align our cost structure for current demand levels. In South America and Asia, particularly China, we are beginning to see the effects inter volumes of government stimulus programs aimed at increasing economic activity. Sales for the healthcare and food and beverage markets continued to show steady and moderate growth.

Finally, a word on the aerospace market, which is largely related to surface technologies, our volumes of coatings for jet engines have been below our expectations this year for several reasons. First, Boeing’s union strike caused production delays and therefore delays in our coating orders. Secondly, the ongoing delays for the Dreamliner has pushed out our coatings work for the next generation’s more energy efficient engines slated for the new planes. These new engines require more coatings per part and more parts to be coated in the hot-section. Thirdly, the global downturn has obviously reduced air travel and thus our coatings volumes for repair and overhaul engines were softer. But we expect that business conditions will improve going forward.

Now please turn to page 11 for our earnings guidance. For the first quarter of 2009, we expect diluted earnings per quarter in the range of $0.95 to $1. This guidance does not assume a significant improvement in macroeconomic conditions. We expect diluted earnings per share for the full year of 2009 to be in the range of $3.85 to $4.05.

We’re bringing down the top end by $0.10 due to the fact that the second quarter came in at the bottom end of our range. We still expect that our CapEx will be about $1.4 billion for the year. We have 42 projects and a large project backlog. The supply systems are dedicated to specific customers and so our CapEx spend is directly correlated to future growth.

During this quarter, we started up a couple of plants and we signed contracts for several new projects in South America and Mexico. The plants we are building will come on stream as early as next quarter and through 2011. In spite of a significant decline in demand for semiconductor, steel and chemicals, we are currently starting a significant number of very interesting new projects, primarily in the energy industry and in the emerging market economies. Our strong positions in Mexico, Brazil, China and India should allow us to accelerate growth in these regions over the next five years or we believe the US and Europe will remain slow.

Let me end with some comments on future operating leverage. The 14% decline in volumes this quarter similar to last quarter on a year-over-year basis has reduced our operating profit by over $200 million or about $0.48 of EPS. We were able to reduce cost by over $100 million in the quarter, which substantially mitigated the impact of volume declines and our net income and earnings per share. We believe we have come to a new level of efficiency in this industry and are not planning on adding much of this cost back when volumes improve. Consequently, we will have a significant operating and financial leverage to any economic improvement.

While I do not believe we will see overall demand in the US, Canada, and Europe recover to 2008 levels for a number of years, but if we do see a few percentage points of recovery, it will produce significant earnings upside. Absent any volume recovery, we still expect to deliver 5% growth each year from our new project startups and new business we are winning today. If you assume a couple of percentage points of economic growth each year albeit coming off this year’s very low base, we will still be on track for long-term sales growth in the 10% area and double-digit EPS growth.

Now, let me turn this call over for questions.

Question-and-Answer Session

Operator

(Operator instructions). And your first question is from the line of Sergey Vasnetsov with Praxair. Please proceed.

Sergey Vasnetsov - Barclays

I wish it was Praxair, I’m with Barclays. Good morning.

Jim Sawyer

Good morning, Sergey.

Sergey Vasnetsov - Barclays

I wanted to ask you about your outlook for the second part of the year. Obviously, the recovery is debatable. But your guidance suggests that the fourth quarter would be quite a bit better than the first quarter. So what’s your medium term indicator suggest to you, what do you see in the fourth quarter?

Jim Sawyer

Well, so far in July, we still haven’t seen much pickup and that’s a third of the – the third quarter is already over. The fourth quarter is really where we have some range in the guidance. And should we see some pickup in onsite volumes? We get some significant leverage in earnings in the fourth quarter.

Sergey Vasnetsov - Barclays

In terms of business activity for new projects, can you comment on the projects that you have completed, that you have signed up recently, how do you see prospect for the next year?

Jim Sawyer

It’s going to be a changing mix. I don’t believe that there is going to be a lot of new projects going forward in metals, mining and chemicals sectors, because generally, there is overcapacity in those industries right now and I don’t see that overcapacity going away. So while those companies will continue to finish the projects that are under construction, I don’t see signing a whole lot of new projects in those areas.

However in the energy sector, both in the refining area and in the upstream area, we are in talks with a quite a few big customers who are looking at some pretty interesting projects involving enhanced oil recovery, refinery hydrogen, and CO2 sequestration and so forth. And they’re pretty interesting projects. I think they’re good projects for the customer on a standalone basis and they’re fairly large as well. And so, I am a little more optimistic that we are not going to see a big fall off in new project activity as a result of the turndown.

Sergey Vasnetsov - Barclays

Okay. And last question on price mix, your price has held up quite well as expected to. What are your thoughts for the rest of the year?

Jim Sawyer

Right. Well, let me just say a couple of things on that. And actually our price that we are showing here and the way you calculate it and the way we calculate it which is same every time is up 2% year-on-year and flat sequentially.

But when you kill back on that, it actually I think understates the improvement in price that we’re continuing to get and that’s where the mix comes in, because for example, the fracking business, the price that we sell CO2 and nitrogen in the fracking business is more than twice as high as the price that we sell those products to other customers. And that’s because of the substantial amount of transportation and equipment that we have to bring with that.

But if you do the variance analysis, that’s sort of dragging down the price. And otherwise, we are still seeing some pretty good price increases. And so I am pretty optimistic about pricing going forward.

Sergey Vasnetsov - Barclays

Thank you.

Operator

And your next question is from the line of Mike Sison with KeyBanc. Please proceed.

Mike Sison - KeyBanc

Hi, good morning. Jim, in terms of leverage you sort of commented that the $200 million hit in volume in the quarter for operating income had sort of an impact of $0.48. If you get that $200 million back let’s say going forward, the earnings leverage contributes something like $0.75, $0.80, just want to get a feel for what the degree of the improvement could be with all the cost savings you’ve generated.

Jim Sawyer

Right. On a quarterly basis, it was $200 million. And if you just divide that after – take that after-tax divide it by earnings per share that works out to about $0.48 of earnings per share in each quarter.

Mike Sison - KeyBanc

Right. So if you – if you get that back, does that $0.48 improve with all the cost savings that you have generated?

Jim Sawyer

We don’t have right now, that we would have, if we got it back.

Mike Sison - KeyBanc

Okay. Then in terms of the automotive, chemical, steel markets, can you give us a sense what the degree of the improvement would be going forward?

Jim Sawyer

Well, I am not actually sure and that’s the crystal ball question. But I think that while we don’t have that much exposure directly to the auto industry, it’s my sense that the bankruptcies of GM and Chrysler took a pretty big toll on the industrial economy in the second quarter, it was secondary and triple down effects on people doing machining and car dealers and car dealers getting shutdown, mechanics getting laid off and so on and so forth. So I think those strikes took a bigger toll in the second quarter.

And now they’re beginning to announce that they are going to start up some auto assembly plants. And consequently some of the steel customers are beginning to announce that they are startup some blast furnaces and you are also seeing some announcements in the chemical sector and in the fertilizer sector of companies that they are going to restart production.

And based on what’s been announced so far, it’s not a huge increase, but it certainly looks like we’ve picked up the bottom and it certainly looks like destocking is over. So I do think we will see a bump. I don’t think we will see a return back to the levels we saw in 2008 for probably five years. But I do think we will see a bump as destocking comes to an end.

Mike Sison - KeyBanc

Okay. And last question, in terms of delays of major onsite projects, have you seen less of that this time around. Are you seeing some of the delays maybe come back faster with general improvement in the economic environment?

Jim Sawyer

We have seen one change which is a couple of weeks – last week actually which is an unexpected delay in the Chevron refinery expansion in Richmond, California which is well under construction and we have a – two world steel hydrogen plants under constructions to feed that.

Unfortunately, a judge ruled based on the complaint from an environmental group to halt construction at the site. And while I think that will end, they will get that resolved, because it’s a small environment group who contended that the city didn’t evaluate the environmental statement correctly. There is a huge amount of effort to get that resolved and back under construction.

So that’s really not related to the economy, that’s just an environmental harassment issue and I think that will get resolved pretty quickly. And then that hydrogen plant will be coming on stream probably in the second half of 2010. Otherwise, there really hasn’t been any change in what we said in the first quarter has been deferred.

Mike Sison - KeyBanc

Great. Thank you.

Jim Sawyer

Okay.

Operator

Your next question comes from line of P.J. Juvekar with Citi. Please proceed.

P.J. Juvekar - Citi

Hi, good morning, gentlemen.

Jim Sawyer

Hi P.J.

P.J. Juvekar - Citi

Can you divide your project pipeline into different buckets like energy, metals, manufacturing? Can you just give us some idea where these projects are going?

Jim Sawyer

Yes. We actually put that up on a slide in the January earnings conference call, so that you can go back and take a look at that. But geographically, about 40% of it is in the emerging markets, which is really just South America, India and China. Then the two biggest projects which account for close to $500 million are the two refinery projects for Chevron and BP in Chicago.

And I mentioned $500 million, I guess I also want to mention that the total of the backlog is about $2 billion. And then the next two biggest projects are two coal gasification projects in China. So energy is about half of that. The rest of it is pretty well distributed into various end markets, some chemicals, some semiconductors, some metals and mining and so forth.

P.J. Juvekar - Citi

Thank you. That’s helpful. And secondly on the refinery hydrogen when business was up, but you probably had some new project startups in the last 12 months. What are your same-store growth, or, what’s your same-store growth in refinery hydrogen?

Jim Sawyer

That’s up about 5% on the same store. There were no project startups with the past 12 months. But it’s just more demand from the capacity that we’ve already got.

P.J. Juvekar - Citi

Are you seeing the refiners are processing less sour crude, or, you haven’t seen that at all?

Jim Sawyer

Yes, definitely. I mean they’re processing sour crude, number one. And number two, they are processing more – they’re producing more of low sulfur diesel fuel and less gasoline. And low sulfur diesel fuel requires more hydrogen per gallon of fuel produced. So that’s another area where they’re increasing the demand. So what’s happening in refining is, even though the volume of the refined products is down probably close to 10%, the demand for hydrogen is up probably 5%.

P.J. Juvekar - Citi

Okay. Just, did you say that they’re refining less sour crude or more sour crude?

Jim Sawyer

No, I am not sure. I know they’re still doing sour crude, but I don’t have any numbers to compare this year with last year.

P.J. Juvekar - Citi

Okay. Thank you very much.

Jim Sawyer

Okay.

Operator

Your next question comes from the line of Jeff Zekauskas with JPMorgan. Please proceed.

Jeff Zekauskas - JPMorgan

Hi, good morning, Jim. One of the themes of your commentary has been your very high incremental margins. And in the first half, your revenues were about $4.25 billion and you’re forecasting about $9 billion in revenues for the year, which means in that second half, your revenues or your volumes would go up by about $500 million. And so if your incremental margins or call it 50%, you know what that would do was that on an annualized basis or would add about $0.54 in earnings per share and push your guidance way above your $3.85 to $4.05 range. So is that – so which is correct or the $9 billion in revenues or the earnings guidance, because they seem inconsistent at first sight?

Jim Sawyer

The $9 billion in revenues is on the high side. And what we are forecasting is closer to $9 billion and $8.5 billion. But $9 billion is on the high side.

Jeff Zekauskas - JPMorgan

Okay. And then secondly just as a, I guess clarification. If you exclude the hedge losses, would the operating profit in Brazil or in South America have been more like $86 million. And by geography, where would that $20 million in receivables write-downs?

Jim Sawyer

Okay. Yes, I think you have the numbers right for South America would be $81 million in OP and Brazil and Europe would be up by 4 and Asia up by a couple of as well because we had hedges on the Korean line. So that’s kind of where those are located if you want to adjust those segments. The receivables are all over the place. There is fair amount of receivables. We have some receivable policies that we follow for write-downs, there’s no single big receivable in there.

But given the economic environment, we’ve gone through the balance sheets of all of our subsidiaries around the world and checked to see if we have adequate – received adequate reserves, and in many cases, we’ve increased the reserves. So that’s pretty well distributed about 8 in Brazil, about 6 in Europe, about 8 or 10 in North America and kind of range of 2 to 5 in Asia.

But with customers getting weaker, I think receivables are going to continue to be an issue. These aren’t really receivables where we have given up trying to collect them. We’ve just decided at some point in time, because of the weakness of our customer base, that we are going to collect less than we would have before, so we have increased our receivable reserves.

Jeff Zekauskas - JPMorgan

Thank you. That’s very helpful.

Jim Sawyer

Yes.

Operator

And your next question is from the line of Don Carson with UBS. Please proceed.

Don Carson - UBS

Thank you. Jim, just wondering about price competition in the US merchant market, I mean we have got rates in the low 70s here. Are you – how was your new business signings? How was pricing and that comparing to your existing portfolio and was there any evidence of competitors going through price to load up their plants?

Jim Sawyer

When we started out, well, there hasn’t been a lot of new business in the last six months, because people are delaying – people are delaying plants to increase capacity and so on and so forth.

But most of the places where there are businesses is a result of applications technology such as in the food industry and in the oxy fuel combustion for making cement and glass and so forth and pretty much in those areas where we have new sales. We are bringing the technology as well. And so pricing has not – it sounded like they are going out and bidding the price of the gas. So we haven’t seen any change really in pricing and because of the long-term five-year merchant contracts, it would be awhile before we would see any.

Don Carson - UBS

And then could you also comment on your electricity price trends in merchant, I know you have passed through an onsite, but what’s – are you seeing pretty reduction in your electricity costs?

Jim Sawyer

Well, there is a big reduction in electricity cost, because our production is down a lot, okay? Price of electricity, it’s started to come down in some areas, it’s definitely lower in Canada, because of the natural gas in Canada and Mexico. The US is a mix, it’s just pretty much flat in the US. And actually in Europe, I think electricity pricing is up.

So you kind of evened out that all around the world, we really haven’t seen much change and it’s hard to predict as well, because on the one hand with the soft economy and lower raw material prices for power, the rates have come down. On the other hand as people start requiring utilities to do things, to reduce emissions and CO2 and all that kind of stuff, that’s going to dry rigs up.

Don Carson - UBS

Then, finally on the new project front, are you looking at any opportunities to buy existing customer?

Jim Sawyer

We actually did one in the second quarter. We had sold a – I think a 900-ton per day plant to Inco at the Sudbury nickel mine. And at that point in time, this was three year, four years ago, they wanted to buy the plant. They didn’t want an over-the-fence supply.

And while we are not normally in the plant sale business, we needed the liquid out from that plant, and so we sold them that plant at cost and we took back liquid which comes down to our Toronto market. And so we are looking at that one and also a couple of plants that Dow owns that they owned since they were part of Union Carbide and so we bought back one the Dow plants and signed a long-term take for pay contract. And they’re going to be others and it really has to do more with a financial condition of those customers that they de-cash flow. But I consider them to very low risk projects, because we built the plants, we know the plants, we’re operating the plants for them right now, so we know exactly what we are buying.

And from a credit point of view, as you probably know, Sudbury nickel mine is always going to be producing and Dow is always going to be producing or the Dow joint venture is always going to be producing ethylene glycol, ethylene oxide up in Prentiss which is where we bought the Dow plant.

Don Carson - UBS

Okay. Thank you.

Jim Sawyer

Yes.

Operator

Your next question is from the line of John Roberts with Buckingham Research. Please proceed.

John Roberts - Buckingham Research

Good morning.

Jim Sawyer

Good morning, John.

John Roberts - Buckingham Research

You think in the third quarter will have sequentially flattening out or increases in the chemicals, metals and energy area, are they exiting at least the second quarter stable. Kind of sounded like they were, but I wasn’t sure.

Jim Sawyer

I think they will be flat to slightly up. I don’t see much risk of going down.

John Roberts - Buckingham Research

In the third quarter, you wouldn’t have any sequential declines in any regions or any businesses.

Jim Sawyer

Well, I can’t promise that, because if I would have promised that in the second quarter, I was wrong. But I think we are starting to see some startups in some of the industries. I think the area is the weakest and saw a potential decline is in the package gas which we have seen no signs of uptick, because basically a lot of that goes into welding and when you have industries operating well below their production capacity, people don’t need to buy mining equipment, they don’t need to buy Caterpillar equipment.

And so a lot of the tick up over the last five years in package gases which were welding and related to the capital cycle, people building new capital equipment and that’s what’s really has slowed down. And I am fairly pessimistic because I just don’t think, I think the economy has over capacity in almost every quarter of it and so I just don’t see at least in the North America, people buying that much more capital equipment.

John Roberts - Buckingham Research

Do you track OEM weldings separately from maintenance and service welding?

Jim Sawyer

We might, but I don’t know what it is.

John Roberts - Buckingham Research

Okay. All right thank you.

Jim Sawyer

Yes.

Operator

Your next question comes from the line of Edward Yang with Oppenheimer. Please proceed.

Edward Yang – Oppenheimer

Hi Jim. Good morning.

Jim Sawyer

Hi Ed.

Edward Yang - Oppenheimer

You mentioned natural gas fracking being weak. How large is that business for you?

Jim Sawyer

The total business in terms of fracking and oil services is about $150 million business, okay, on an annual basis. And we lost $20 million sales this quarter, so on an annualized basis, we went from sort of $150 million down to $80 million or cut in half. But if you look at the gas futures strip, the market expects gas to be back up to $5 and $6 January, February, March. And if that is correct, then I think the fracking will pick back up again.

Edward Yang - Oppenheimer

Is that a higher margin business for you relative to your overall mix?

Jim Sawyer

It’s a much higher price and it’s a strong margin. And the reason the price is much higher is because, for example, we will have to drive 10 CO2 trucks to a site in the middle of nowhere and we bring in a pumper equipment and a lot of other equipment to actually do the frac job. So the revenue we get per $1 of gas is a lot higher than our typical revenue. And so that’s why when you look at merchant pricing, there is a mix effect that there is just less of that in the total mix.

Edward Yang - Oppenheimer

Okay. And you mentioned being a bit more conservative with your assumptions on receivables. But it looks like you’ve built quite a cushion already, because allowance for doubtful accounts, as a percentage of gross receivables it’s up to I think 7.9% at the end of 2008 and that’s up from about 5.8% in 2007 and so on and your bad debt expense as a percentage of revenue has gone up as well. So are you being overly conservative or do you need to change or do you foresee any other changes in your assumptions in terms of how you treat bad debt and doubtful receivables.

Jim Sawyer

Well, you never get exactly right. But I do believe that they’re going to be a lot of small businesses which are still heading into bankruptcy, number one. And then number two, you have some occasional large companies that are in bankruptcy. And one other things our guys in Europe were focused on is that August is when they close the plants down for summer holiday and the guys were saying, well, there is a possibility that some of those plants will never be restarted yet.

Edward Yang - Oppenheimer

Thank you.

Jim Sawyer

Yes.

Operator

Your next question comes from the line of David Begleiter with Deutsche Bank. Please proceed.

David Begleiter - Deutsche Bank

Thank you, good morning.

Jim Sawyer

Hi David.

David Begleiter - Deutsche Bank

Jim, on your FX hedging, are you thinking about any changes in the program to limit the volatility on quarterly basis?

Jim Sawyer

That’s a good question. Basically we have been doing a quarter forward with the idea that that would be dampening and that with a plus or minus 10% move in the currency, it might have a $5 million dollar impact. But we’ve looked at that on a currency by currency basis rather than all the currencies together. So we are going to take a look at that and see whether it will make sense if you keep doing that.

David Begleiter - Deutsche Bank

And Jim just on the discussion about variable margins, incremental margins, in your merchant business what do you think now that your variable margins are opposed these cost reductions?

Jim Sawyer

Merchant variable margins, I don’t have merchant variable margins showing out separately. And actually the reason we don’t have it shown out separately is that, the merchant product primarily comes from the onsite product and it all depends on how much of your electricity cost you attribute to the merchant production versus the onsite production. But together, it’s generally about a 50% variable margin.

David Begleiter - Deutsche Bank

Thank you very much.

Jim Sawyer

Yes.

Operator

Your next question is from the line of Laurence Alexander with Jefferies. Please proceed.

Laurence Alexander - Jefferies

Good morning. With respect to the $27 million in severance and receivables that was a drag this quarter, how much of a drag are you looking at for the back half of the year as we can think about year-over-year comparisons into next year?

Jim Sawyer

Well, I think until – I think about the same kind of numbers.

Laurence Alexander - Jefferies

So just as the run rate –

Jim Sawyer

These are higher numbers than we normally we would have a year ago, substantially higher than we would have had a year ago. But we are still looking at cost reductions referring through the accrual that we took a year ago for severance, we pretty much burned through that six months ago. So now the severance that we are taking is coming through the income statement, but it will be about $5 million a quarter for – until we start rolling again.

And we’re also making some shifts of focusing more and more of our resources in the markets where we see more growth and more people resources in China and India and Brazil. So that’s kind of an overhead drag if you will. Then the receivables, once the – once you get through the wave of bankruptcies you will get a better feel for what those numbers ought to be.

Laurence Alexander - Jefferies

And then when you look at the projects you have in the pipeline for the next couple of years, is there any lumpiness in how they’re going to be coming on strong or is it going to be fairly evenly distributed over the next eight quarters?

Jim Sawyer

There will be lumpiness because the two hydrogen projects worth account for a third, almost half of our capital, are going to come in the third and fourth quarter of 2010.

Laurence Alexander - Jefferies

Okay. Thank you.

Jim Sawyer

Yes.

Operator

Your next question comes from line of Mark Gulley with Soleil Securities. Please proceed.

Mark Gulley - Soleil Securities

Hi, good morning, guys. A couple of questions, one, you have already addressed this just now Jim, but I want to make sure I understand. Roughly speaking let’s say next year and in 2011, how much capital, how much sales are going to come on in tonnage?

Jim Sawyer

Right.

Mark Gulley - Soleil Securities

I am trying to get a bite here.

Jim Sawyer

Well I have to talk about that on an annual run rate basis, because it comes on in different parts of the quarter. But basically, we are looking at bringing on the sales in the order of $400 million a year. A lot of that is very high margin sales and because it’s onsite business, number one. And number two, because the – one of the big contracts that we have were hydrogen, we don’t pay for natural gas, so natural gas is not going to show up in the sales number, but our profit from that capital will show up at operating profit. So consequently, some are in the area of $100 million and $150 million of operating profit contribution.

Mark Gulley - Soleil Securities

So $150 million against each of those $400 million, I guess is what you are saying, right?

Jim Sawyer

Yes, the high percentage of the $400 million, but that’s the way the numbers work out.

Mark Gulley - Soleil Securities

Secondly, Liz mentioned some statistics on that acquisition at PST and I think I missed the sales and OI contribution and will that acquisition be accretive and if so by how much?

Jim Sawyer

The acquisition will not be accretive until probably the second quarter of 2000 – and because we have got a lot of cleanup work to do. And the main reason this is an opportunity is very poorly run business before. There is a lot of cleanup to do. We are going to close two or three of the seven plants that they operate. So we are going to have the severance cost with that and we are going to have the facility write-offs with that.

And so kind of as a general rule of thumb, what we are saying is that the added operating profit for the next six months will be wiped out by the restructuring cost. But then after that, I think once we get through with fixing that business and really the goal is to transform PST into a company that is 80% focused or 90% focused purely on turbine coatings, jet turbine coatings and IGT coatings. That’s where we have an unique technology that’s not replaceable or not that is not competitive with other people. And those markets are going to keep growing. So once we get to that point, I think I will be able to operate PST at 20% operating margin.

Mark Gulley - Soleil Securities

Now the severance and facility shutdowns you just referred to on this acquisition, are they in the numbers referred to earlier or is that on top of?

Jim Sawyer

They’re – when I said that the costs will offset the added operating profit, they’re in that.

Mark Gulley - Soleil Securities

But in terms of the $27 million, in an earlier question, you said that that will continue into the second half of this year. Does that $27 million include or exclude this PST transaction?

Jim Sawyer

That excludes. That was the second quarter and we didn’t buy this until the third quarter.

Mark Gulley - Soleil Securities

Great. And finally if I may, Jim, we saw pricing declines in Asia. Asia is often times in the past year has been a concern in terms of price competition. Should we be concerned about further price erosion in Asia or is there some other one-off thing?

Jim Sawyer

Well, the primary price erosion in Asia was in electronic, gases and specialty gases. And since they have very margins and especially some of the inert gases, they is price erosion there. I don’t think you will see it continuing that rapidly. There is a little bit of a price erosion going on in the merchant market in China. And that’s largely attributable to the proportion of merchant sales which are major distributors rather than to end market customers where we have a long-term contract and we own the tank and so forth.

And we’re really in the process of – and it’s a big effort of changing the business dynamics in China, where historically a lot of merchant gas were sold through distributors, I thought it was made by these state-owned chemical plant or whatever and they had byproduct nitrogen or oxygen and they sold that to distributors who sold that on to customer. Our focus is that that’s not really a very good business model and so our focus really is on selling merchant liquid directly to end use customers with the – I guess supported by if you want to call that’s supported by applications technology.

Mark Gulley - Soleil Securities

Thanks Jim.

Jim Sawyer

Yes.

Operator

Your next question comes from the line of Bob Koort with Goldman Sachs. Please proceed.

Amy Zhang - Goldman Sachs

This is Amy Zhang sitting for Bob. Good morning. I have two questions and the first one is South America. If we look at the margins on the sequential basis, the second quarter margins are around 18%, the first quarter is slightly above 21%. But on your slide number 7, on the sequential basis actually they trend either flatter or slightly up. I am just wondering what’s the – can you just provide a little bit more color why we see this margin contractions on a sequentially basis in South America?

Jim Sawyer

Okay. So I think the question is what’s happening with margins in South America and why? And the margin percentage – okay, if you take what we are showing as a segment operating profit to South America that includes $11 million of negative hit and operating profit. Excluding that it would be $81 million or about 20.6% margin. Now we also took on extra $5 million of receivable write-off in South America as well. So the underlying business is actually we are getting margin expansion, we are getting more cushion in our cost structure. As you can see at the bottom of page 7, we are getting a significant amount of price increases both year-over-year and sequentially.

Liz Hirsch

Amy, $11 million here is the net income hedge we talked about.

Amy Zhang - Goldman Sachs

Got you. So essentially on a sequentially basis, we should see the South American margins to expand in the second quarter – second half.

Jim Sawyer

Yes.

Liz Hirsch

Yes.

Amy Zhang - Goldman Sachs

And then I think a similar question in North America, margins and obviously you guys have been doing a very great job, driving the margins actually expansion on a year-over-year basis for the first quarter and second quarter. And I think the average for the two quarters margin is about 22%, 23% that kind of range and is above your normalized level of 20%. I am just wondering, going forward, how we should think about the margin progression for North American business.

Jim Sawyer

Well, I think we will be able to keep the margin in that area and particularly as if activity picks up, the margin could go higher. But that margin also is affected by the natural gas pass-through, which natural gas prices a year ago were about $10 in the quarter and this year they were $3 to $4. So there was a significant amount of lower natural gas pass-through.

And if you want to look up that number, it’s in the earnings press release tables and the footnotes to the segment page that shows how much the natural gas pass-through was. So that added 1.5 percentage points or so to the margin which is really a cosmetics and rather than real. But what we are really focused on now is that we are operating the business in different way in North America and really focused on generating cash flow and applications technology.

Amy Zhang - Goldman Sachs

Great. Thank you so much.

Jim Sawyer

Thank you.

Operator

Your next question is from the line of Kevin McCarthy with Banc of America-Merrill Lynch. Please proceed.

Kevin McCarthy - Banc of America-Merrill Lynch

Yes, thank you. Jim, you have done a great job on cost cutting. I was wondering if you could comment how much in the way of incremental costs you feel you might be able to extract in the back half of the year.

Jim Sawyer

We’re pretty much done with the cost cutting. We’re always looking at where we can find some more efficiency and so forth and I am not going to say that we are not going to do more cost cutting. We’ve got some more on the way in the area of a couple of hundred people, but no way near the 2,000 people kind of number that we did a year ago. And so we’re pretty much where we’ll going to be.

Kevin McCarthy - Banc of America-Merrill Lynch

The second question on use of free cash flow, you bought back some shares in the quarter, but we also saw the Sermatech deal. I was wondering if you could comment on your expected direction of cash deployments over the next year or so between repurchases, acquisitions and debt reduction.

Jim Sawyer

Yes. And I think I mentioned this on the last conference call, which is that we are trying to take advantage of the fact that we still got strong earnings. Our earnings have not declined very much. We’ve got a very strong balance sheet and there are companies around the world that we can use as acquisitions as well as assets around the world (inaudible) which we’re going to be taking advantage of the weakness in the economy and our strength of our balance sheet to buy them. So I would expect to see a continued pickup in the acquisition activity as we go through the second half.

Kevin McCarthy - Banc of America-Merrill Lynch

And then finally, if I may, what tax rate would you anticipate for the third quarter?

Jim Sawyer

Okay. The tax rate was 28%. We had a one-time – we had a change in the official tax rate in Italy last quarter and the way you view tax accounting is if you have a change in the tax rate, you have to bring it all and book it all at once. And so that brought the tax rate down to 26% or probably 26%.

Now, because we operate Italy as a 50-50 joint venture, the part of those earnings which go to our partner is shown in what used to be called minority interest. I can’t remember what it’s called now. But – so the tax, that benefiting tax is we only really got to keep half of that. And so that was just purely a second quarter thing. And we will be back with 20% for the rest of the year.

Kevin McCarthy - Banc of America-Merrill Lynch

Very helpful. Thank you.

Jim Sawyer

And your final question is from the line of John McNulty with Credit Suisse. Please proceed.

John McNulty - Credit Suisse

Yes, good morning.

Jim Sawyer

John.

John McNulty - Credit Suisse

Jim, you had talked a little bit earlier about in terms of where you thought the new projects would be coming from and it sounds like the bulk of the energy with chemicals and metals and basically general industrial down and looking like there is no need for capacity anytime soon. Do you have any concern with the four big players, kind of all focusing on the same industry and now they’re being basically one big end market just to focus on that that you may see either enhanced competition or a lapse in discipline from some of the players in the industry?

Jim Sawyer

I don’t really and a lot of respects we are focusing on different projects and that’s one of the reasons I hate to be any more specific about what we are focusing on than we are. But I don’t have a concern of people taking over returns on projects, because there aren’t enough to go around in that type. I just don’t have any concern about that.

John McNulty - Credit Suisse

Okay, great. Thanks for the update.

Operator

As there are no further questions in queue at this point, I would like to turn the call back over to Jim Sawyer, for closing remarks.

Jim Sawyer

Thank you all for joining the call. And we look forward to speaking with you in the future. Bye-bye.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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