Good day, ladies and gentlemen and welcome to the third quarter 2009 Praxair Inc. earnings conference call. My name is Josh, and I’ll be your coordinator for today. At this time all participants are in listen-only mode. We’ll be facilitating a question-and-answer session towards the end of this conference. (Operator instructions)
I’d now like to turn the presentation over to your host for today’s call, Executive Vice President and CFO, Jim Sawyer. You may proceed.
Good morning and thank you all for attending our third 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 two and note that it applies to all statements made during this teleconference. I’m going to start of this morning by explaining a couple of special items we had this quarter, which are reflected in our GAAP reported results.
The reconciliation of our GAAP and non-GAAP results is included in the appendix to the slide presentation and is an attachment to this morning’s press release. Then I will describe for you the general business trends we saw in our major end markets in the quarter as compared to last quarter. Liz will then review in more detail our third quarter results excluding this specialty items. Afterwards, we will be available to answer questions.
Please turn to slide three in the presentation. In July, the Brazilian government instituted a new voluntarily Amnesty Program called the Refis Program, which allows Brazilian companies to settled certain Federal tax disputes at significantly reduced amounts. As we previously disclosed has numerous outstanding Federal tax disputes most of which date back to the 1980s and 1990s in our primarily related to non-income tax matters, which are reflected in operating profit, not in income tax expense.
The new program allows company to use existing net operating loss carry-forwards for part of the payment for settlement disputes. Praxair has significant existing income tax loss carry-forwards which have previously been unutilized we determine it is economic benefits of the participates in this program and settle disputes at substantial discounts.
The $306 million charge this quarter primarily reflects the settlement of a number of non-income tax disputes. In addition it includes reserves taking from Brazilian Government receivables, a state tax matter and a charge related to restructuring our natural gas cylinder business in Brazil. Offsetting this charged operating profits of $313million income tax benefit primarily coming from the participation in the Brazil, Refis Program and the use of our net operating loss carry-forwards which had previously been fully reserved.
These items together resulted in a $7 million benefit to net income and $0.02 of earnings per share this quarter. As you see in our press release and our slides we’ve excluded this net benefit from our non-GAAP earnings of $318 million for $1.02 of earnings per share. There was no cash impact in the third quarter from these items. However, we respect the settlement under the Refis Program to result in a one time cash payment by the company of up to $90 million, most likely in the fourth quarter.
Now, please turn to slide four which highlights our global end market trends. The slide shows both year-over-year and sequential trends in organic sales and excludes the affects of currency, acquisitions and feedstock pass through pricing changes. The year-over-year comparison is a good reference point to see how much volume we have lost since last year and how much upside we have when the volume comes back.
With the sequential trends give a better picture of what we are seeing right now, which end markets are slowing and which have stabilized and which are improving. You can see that the strongest sequential sales growth came from electronics, chemicals and metals customers. These are the three end market, which were hardest hit in the recession and the ones where we saw our volumes fall the most. These customers significantly cut back their production last fall, in order to reduce inventories in line with falling demand and falling commodity prices.
The production cut backs lasted until inventories were de pleated. Destocking in semiconductors ended in the first quarter. Chemicals that ended in the second quarter and in steel it ended in the third quarter. In each phase we saw a bump in production levels in Q3 as apparent demand met real demand, but because final end market demand is not growing fast, we expect sequential growth rates to decelerate next quarter rather than to accelerate next quarter.
Electronics reached its trough in about February and has since shown the most recovery. Our sales this quarter were up 16% from second quarter and are now 7% below last year. Our electronics sales recovered nicely in all regions with the highest growth in Asia. Sales to chemical customers grew 8% from the second quarter. We saw a growth in all geographic regions led by U.S. producers on the gulf coast, which currently have a feedstock advantage due o lower natural gas prices.
Our pipelines in Germany increased as well as our sales in China. Metals markets have been slower to recover. This is the first quarter since the downturn began that we have had any sequential improvement in oxygen volumes to steel customers. Volumes had picked up in North and South Germany and Spain and China and India. Demand was to some extent due to inventory restocking as service center inventories had reached historic lows.
In the U.S., we believe that auto plant restarts and the cash for clunkers program stimulated demand. So our volumes have improved, but it remains to be seen whether we will reach a plateau and at what level that will be. Since we’re generally forecasting a slow economic recovery, we’re not expecting our volumes in U.S. and Europe to return to early 2008 levels in the near term.
In energy markets, we continue to see good growth in refinery and hydrogen from existing and new customers. This growth is offset to some extent by significantly lowerLiquid nitrogen and carbon dioxide for oil and gas well-fracturing in North America. This is primarily a result of low natural gas prices during the summer and these volumes recover with higher natural gas prices
Healthcare and food and beverage are steady, modest growers around the world and for the most part are non cyclical. Aerospace is largely related to our surface technology business. Our jet engine coatings have improved due to the global downturn in air traffic and the Boeing strike caused production delays and therefore a lower volume of parts.
We expect this business now to continue to improve. Manufacturing is our largest end market and it remains the weakest. You can see that overall sales to this market are still 20% below the prior year and declined 4% sequentially which is a normal seasonal pattern as factories especially in Europe take time off during the summer. Other than the seasonal pattern, it appears that manufacturing orders have stabilized currently at a level about 20% lower than a year ago.
These sales are primarily packaged gas and merchant liquid and where we have the most operating leverage changing volumes. This is because as volumes have fallen, we still have to drive trucks to almost all the same customers just delivering less product volume per trip.
Therefore, we’ve not been able to close facilities or take many trucks off the road. So when volumes come back, we will not need to add back much cost and will have strong earnings leverage. In Asia and Brazil, where economic recovery has been more robust due to stimulus program, sales increased sequentially.
Now I’ll turn this over to Liz to review our third quarter results in more detail.
Thank you, Jim. Please turn to slide five. We had solid results this quarter. Sales and earnings were above the second quarter primarily due to modest sequential volume growth. The comparisons to the prior year are difficult, because the third quarter of 2008 was a record quarter. Excluding the benefit to earnings from the special items which Jim described, earnings per share were $1.02, $0.06 above second quarter and $0.02 above the top end of our previous guidance range.
Sales were $2.3 billion, 20% below prior year. The combined affects of negative currency translation and lower cost pass through reduced sales by 11%. Underlying sales were 9% lower due to 11% lower volumes, partially offset by 2% higher pricing. Sales grew 7% from the second quarter, 3% of this increase came from currency translation resulting primarily from the strengthening of the Brazilian and the Euro relative to the US dollar.
Sales grew 3% from higher overall volumes and the Sermatech acquisition which we closed in July contributed 1% sales growth. Adjusted operating profit was $480 million, 12% below last year. The impact of lower volumes reduced operating profit by $147 million. We offset almost all of this impact with cross reduction and higher pricing, currency impacts reduced operating profit by $59 million or 11%.
Operating margin was 21% this quarter compared to 19% in the year ago period. The improvement was primarily due to lower costs and higher pricing. Interest expense in the quarter was $32 million as compared to $50 million in the prior year, despite slightly higher debt levels as a result of lower interest rates on commercial paper and bank borrowings. This quarter we did two long term debt issues which reduced our outstanding bank debt in commercial paper.
We secured very attractive long term interest rates of 4.5% and 3.25%, but as a result interest expense will increase by about $8 million per quarter going forward since we have been paying less than 1% in the commercial paper market. Adjusted net income of $318 million was 10% below the prior year. Primarily reflecting 11% lower volumes and 6% currency headwind partially offset by the benefit of cost reductions and pricing.
We generated strong cash flow from operations of $547 million, primarily from net income and depreciation. Operating cash flow includes a $114 million contribution we made to our US pension plan this quarter. Capital expenditures were 334 million, largely for construction of onsite plants around the world.
We invested $117 million in acquisitions which was primarily PST’s purchase of Sermatech international, which closed in July. We paid $122 million of dividends and repurchased about $30 million of stock net of issuances which resulted in a small increase in gas. Excluding the pension contribution from our operating cash flow we had free cash flow after CapEx of $327 million available to fund acquisitions, dividends and share buybacks.
Please look at slide six and seven for our results in North America. Sales in North America were $1.2 billion, 12% below prior year excluding currency affects and lower cost pass through primarily lower natural gas prices. Volumes were 13% lower and pricing was 1% higher. Sales were below prior year in all major end markets except energy.
As Jim mentioned earlier the growth in energy is due to refinery hydrogen mitigated by lower liquid volumes to oil all services. Sequentially overall sales rose 4% primarily due to higher onsite volumes. Sales in Mexico also rose 6% sequentially X currency as the manufacturing economy there is beginning to show slight signs of improvement.
Onsite sales were 35% below prior year X currency. Lower costs pass through primarily natural gas accounted for 32% of this decrease. Onsite volumes were 3% below prior year. However, last year’s quarter includes the impact of US Gulf Coast Hurricane making for an easier comparison. Excluding the hurricane impact onsite volumes are 6% below prior year due to lower demand for oxygen and nitrogen from steel and chemical customers.
This quarter volumes did begin to recover from the low levels we experienced due to the significant inventory destocking in these end markets as well as in electronics total onsite volumes increased 10% from second quarter. Merchant liquid sales were 13% from the below the prior year ex-currency and 16% lower volumes were partially offset by higher pricing.
Overall volumes increased moderately from the second quarter. Sequential pricing trends are stable. We are seeing some new business activity in food, wastewater and combustion. However, customers are still very cautious about making purchase and capital commitments.
Packaged gas volumes are stable sequentially, but have yet to turn up reflecting the continuing weak manufacturing environment. Overall sales were 18% below prior year excluding currency affects due to lower volumes. In PDI, our U.S. and Canadian business same store sales were 20% below prior year driven by 35% lower hard goods.
Gas rent same store sales were off 10%. These year-over-year numbers look a bit worse than in the second quarter, but this is due to the comparison with last year, when sales grew from the second to the third quarter. Our sales per day have been relatively flat with second quarter. Due to significant cost reduction, PDI’s operating margin has increased to 16% despite the low level of demand from customers. So we expect to see positive operating leverage when volumes start to pick up.
Overall operating profit in North America was $263 million and operating margin was almost 23% compared to about 18% in the prior year. This is due mostly to the significant cost reduction. OP is about flat with the second quarter despite the volume improvement. This is largely because we are climbing our way above minimum take or pay thresholds with some of our large customers.
When volumes increase and take or pay revenue decreases it is dilutive to margins because volumes come with variable costs. However, this quarter we received only a minimal amount of take or pay revenue. So we expect that future volume increases will come with good OP leverage.
Please turn to slide eight for our results in Europe. Sales in Europe were $323 million, down 8% ex-currency compared to prior year primarily due to lower volumes. Overall volumes stabilized sequentially. Higher volumes to chemicals, metals and healthcare customers offset continued sequential sales declines to manufacturing customers.
Compared to second quarter, on-site and merchant liquid volumes improved slightly and packaged gases weakened further. By country pipeline and merchant volumes in Germany are picking up. We are seeing some improvement in Spain, but Italy remains very weak. Operating profit of $68 million compared to $96 million last year, but last year’s OP included a $9 million net FX hedge gain. Sequentially OP improved slightly reflecting cost reductions and productivity gains.
Please turn to slide nine for South America. Sales in South America were $436 million. Underlying sales were 7% below the 2008 quarter from 12% lower volumes partially offset by 5% higher pricing. Sequentially sales grew 10% largely due to currency depreciation, but our base business volumes also grew from the second quarter.
On-site volumes showed the strongest growth up 22% mostly due to increased production by chemicals and metals customers. This is an impressive increase, but off a low base as volumes are still below 15% from prior year. Merchant and packaged gas volumes were about even with the second quarter. We expect these to pick up in conjunction with the continuing recovery in industrial production in Brazil.
Offsetting overall gases volumes to some extent was lower sales of the cylinders we manufacturer in Brazil for conversion of automobiles to natural gas fuel. There are currently structural disincentives in the market due to more conversions due to more attractively priced alternative fuels like ethanol.
Therefore demand has returned down and we have decided to close one of our cylinder manufacturing plants. This is equipment manufacturing and so it has lower manufacturing impact than gases. Operating profit of $94 million was 12% below the prior year and was 16% above last year excluding the impact of net impact hedges. Ex-currency effects operating profit increased sequentially from higher volumes, higher pricing and cost reduction.
Slide 10 shows our Asia results. Our results in Asia reflect broad based growth across the region in most industry end markets and in electronics. China is showing solid signs of recovery and India’s growth continues to improve. Sales of $232 million were 3% above prior year ex-currency and 15% above second quarter ex-currency.
Sequential volume growth was driven by higher onside volumes in China, India and Korea from existing customers and plant start ups. Merchant volumes are also higher compared to last year and last quarter from new business and improving demand from current customers.
Pricing in the region is a bit of a mix. Generally merchant liquid merchant pricing is stable, however, our reported average price is way down by lower electronic specialty gas pricing. Operating profit of $37 million was relatively flat with the year ago quarter as was our operating margin of 15.9%. Operating profit grew versus second quarter, but the margin fell slightly this reflects higher depreciation due to new plant starts at the end of the quarter, lower average pricing and higher cost pass through in the quarter.
We expect sequential growth to continue in China and India next quarter and in 2010. These emerging economies are benefiting from government stimulus to create jobs and fuel consumer demand. Infrastructure spending, the construction of new manufacturing facilities by our customers and refinery expansions will all create demand for industrial gases. About a third of the 42 projects in our backlog are in Asia and we are continuing to evaluate a number of new proposals.
Please turn to slide 11 for surface technologies. PST had sales of $135 million this quarter. Organic sales excluding currency and acquisition affects were down 17% from prior year and down 8% from second quarter. Jet engine coatings improved from last quarter, but this was off set by a decline in coatings for industrial gas turbines and oil field gate valve of components.
We closed the acquisition of Sermatech in July. Sermatech is a global supplier of coatings used on aviation and jet engine turbines. The acquisition contributed $22 million in sales this quarter with minimal operating profit net of integration cost. The consolidation of the acquisition therefore reduced overall operating margin by almost 200 basis points, which we expected.
We will continue to incur and expense integration and business restructure costs for the next several quarters, which will off set any meaningful profit contribution from the acquisition, but there are substantial synergies from the businesses and as we told you last quarter our objective is to drive operating margins for PST up to the 20% range.
Now, I will turn this back over to Jim to discuss our fourth quarter earnings guidance.
Thanks, Liz. For the fourth quarter, we expect diluted earnings per share to be in the range of $1.05 to $1.10, this guidance as modest should give us some operating leverage on our lower cost structure. It also reflects some currency benefits from the stronger Brazilian real and euro. It that’s 5% to 10% above what we earned in the prior fourth quarter on an adjusted basis, so we expect next quarter to be lapping the negative affects of the recession.
This therefore brings our EPS guidance for the full year of 2009, on an adjusted basis to a range of $3.96 to $4.01 as compared to the$ 4.20 we earned in 2008, it’s only a 5% to 6% decline in earnings year-over-year when the severe global recession in currency impact reduced our sales by about 17%. This demonstrates the value of our business model and the discipline we have showed in quick and decisive cost reduction.
We’re still expecting 2009 full year sales to be about $9 billion and full year CapEx to be about $1.4 billion. Looking ahead we’ll be giving specific earnings guidance for 2010 in January in conjunction with our fourth quarter results. We don’t know how strong an economic recovery we will see in 2010, but we’re assuming it will be relatively modest in the U.S. and Europe.
However, we expect that we’ll be able to deliver organic sales growth, 5% to 8% above the growth in industrial production and double digit earnings growth over the long term. This will come from starting our new projects that are currently in our strong project backlog and from numerous application technologies many of which are focused on producing environmental or energy efficiency benefits from our customers.
We currently our 42 projects in our large project backlog towards the end of the third quarter we started up three plants and added three new plants to the backlog. We expect our current backlog of new plant start ups will add about 5% earnings growth for each of the next two years.
In addition to this, we expect to realize positive operating leverage as our base business volumes recovery. As we do not plan to add back a lot of the costs we have taken out and because we are currently operating many large plants at in efficient levels. Our incremental margins on base business volume increases should be in the 30% to 40% range.
In any case while we are not giving specific guidance for 2010 right now, it is certain to be a record year for Praxair, because our earnings fell by only 5% in 2009 in spite of significant volume declines, it will take us less than a year to grow our earnings out of the recession and begin delivering record quarters again in early 2010.
Now I would like to open the call to questions.
Your first question comes from Pj Juvekar - Citi
Pj Juvekar - Citi
The reality appreciated significantly against the dollar recently. That should be a benefit on the translation impact but maybe Brazilian export growth slows down. Can you talk about those pluses and minuses and how are you hedged against the real.
It is pretty much back to where it was in its high a roughly year ago and that has given us some boost on translation this quarter and if it stays at this level will give us some boost next quarter and in 2010, but so far we haven’t seen that has heard the competitiveness of the REI in terms of its domestic business or export business and in fact what we’re really seeing in Brazil right now is a very significant increase in GDP economic activity which is pretty much consumer led.
The auto production in Brazil reached an all time high a couple of months ago. So, it is very different than what we are seeing in the United States. Secondly there is an election coming up at the end of 2010 and the administration has got an accelerating growth initiative underway to stimulate the economy and, also they have lowered interest rates from about 18% to 8% and now they have won the 2016 Olympics. I think there will be a lot of domestic enthusiasm going on in Brazil and domestic growth in Brazil. Therefore, the strength of the REI right now I don’t see as impacting the economy negatively.
Pj Juvekar - Citi
Just quickly, you mentioned Jim that some of your onsite customers are still on taker pay. Can you tell us what percent of your customers are on taker pay? Thank you.
There are very little that are left that are on taker pay. Right now just about $2 million of revenue and operating profit in this quarter are coming from taker pay and that is actually coming in Germany.
Your next question comes from Don Carson - UBS.
Don Carson - UBS
Jim, can you talk a bit about the quality of the backlog. I know initially you thought it might fall off because of reduced energy activity, but you have seen to would maintained it at a fairly constant level. Are they return in the backlog as attractive as a year ago? How would you characterize them especially with the new hydrogen projects?
The backlog is essentially unchanged versus the last couple quarters and the year ago. We are seeing some delays caused by our customers in starting up new projects. The rate of start ups hasn’t been as fast as it normally would be.
So we expect about a half a dozen startups in the fourth quarter, most of them being in Asia and then secondly we have a delay in the single largest project, which is the Chevron refinery project and that delay is caused by some environmental issues at Chevron is facing. So that project would have be starting upright about now, but it looks like it won’t startup until about a year from now. So that’s the negative side of it.
On the other side, we are winning new projects. We’ve recently won store recovery project in the United States, a gasification project in China and another copper mining project in South America, a refinery modernization project in North America and a couple other projects in China.
So we are winning the new projects and I’m quite optimistic that while the total number of projects in the backlog will probably go down. The level of construction spending and therefore the level of earnings, which will come out of it, will stay about the same and that is about $2 billion of construction in the backlog. So if we continue to win some of these more interesting oil and gas projects, I think we will be able to keep the backlog about the same level it is right now.
Now, as you mentioned on the quality of earnings in the backlog, that will be going down some and not so much because the world is more competitive, but generally speaking the smallest projects will get the highest internal rate of return on, because they’re usually projects where we are connecting a new customer to an existing pipeline or something like that.
So the smallest projects have the higher ROR. The larger projects like the big Chevron and BP hydrogen projects tend to have a lower ROR and so as the mix changes more as the larger projects, we will see a little bit of reduction in the total ROR and we’re now looking at a number like 14% of the average project in the backlog in terms of its ROR.
Your next question comes from Mike Harrison - First Analysis.
Mike Harrison - First Analysis
Jim, I was wondering if you could comment on what kind of visibility you are seeing on Q4 shutdowns from your customers in the metals and chemicals businesses in particular, but really any areas, manufacturing as well.
People have been talking about that in general as a risk to the fourth quarter. Clearly there will be some shutdowns around the Christmas time period and so forth. I think that’s one of the things that people didn’t get about last year. We were warning people that there would be shutdowns in the fourth quarter and that would hurt the fourth quarter.
So I think there’s an increased sensitivity to it, but my expectation is that steel production levels overall will stay pretty much flat with where they are right now and the same thing with chemical production and then probably some decline in the fourth quarter in semiconductor production, which is typically a seasonal affect on the semis, but the part that we’re looking for is really where we have the most leverage is the overall manufacturing bulk gases and packaged gases and so forth.
I don’t have any real visibility over any real shutdowns. I think that just going to continue to rise, but on a gradual basis.
Mike Harrison - First Analysis
Also hoping you could talk about the pricing environment in PDI and maybe comment on, whether pricing was positive in the quarter on the gas rent component of same store sales?
Pricing in PDI continues to be positive both on a year-over-year basis and a sequential basis and we’re all going to be looking at some price increases in the near future. So I don’t think that’s anything for anybody to be concerned about.
Your next question comes from David Manthey - Robert W. Baird.
David Manthey - Robert W. Baird
Jim, when you mentioned earlier that sequential growth rates will decelerate not accelerate, were you referring to overall or was that relative to specific end markets?
Yes, I thought that comment might be a little bit confusing. I was really referring to the chemical and steel and semiconductor sequential growth rates, which were 16%, 8% and 12%. I think we’ll continue to see sequential growth rates in those end markets, but I think not at a 12%, 8%, 16% type rate.
David Manthey - Robert W. Baird
As it relates to the backlog, you talked about the tone of it right now. Could you compare the pace that it is filling or the activity level today versus maybe three or six months ago? Would you say that has improved?
It’s definitely improved versus three to six months ago. I think six months ago, when we were at the beginning of this depression and there was a lot of uncertainty out there and very little credit out there, people were really unwilling to commit to new projects and to new taker pay contracts. I think the general mood is a lot more stability and so the signings on new contracts is definitely increasing versus what it was six months ago.
Your next question comes from Mike Sison - Key Bank.
Mike Sison - Key Bank
Jim, could you comment on hydrogen, sort of the base business here? It seems like it is holding up very well given where refinery margins are these days. Do you think that growth is or sort of the performance is sustainable here at these levels for the next couple quarters?
I do and in fact I think it will continue to go up. Hydrogen consumption in the refinery is really not a function of either the refinery output per se, refinery output is 5% or 10% below what it was a year ago, nor is it a function of refinery margins. In a lot of cases they are actually using more hydrogen to get better margins in the refineries. So it’s really a function of the way they run the refineries and once they get the refineries stabilized on a certain level of crude feed stock and certain types of end use products, that’s what really determines the hydrogen demand. I think that will keep growing.
We’re continuing to sign new customers that we can supply from our existing production capacity and I think we’ll continue to see incremental growth in hydrogen without any new projects coming on stream and then when we see bigger projects on stream coming on screen, there will be more step change in growth.
Mike Sison - Key Bank
Switching gears in terms of merchant, could you give us sort an update on where your operating rates are and there are, one of your major competitors raised prices recently in anticipation of higher costs. Do you see the need to raise costs going forward?
First of all, I’ll tell, our overall operating rates in the United States are in the mid-70s and that’s up from the low 70s as an average. Part of what has hit the operating rates is the significant decline we had in the oil tracking business, when natural gas went down to $2, the people doing oil fracking in the United States and Canada, pretty much just virtually shutdown.
That oil fracking was using primarily merchant nitrogen and merchant CO2, so hurt not only the volume in the merchant business, but it also hurt the margin in the merchant business, because some of that was t expensive merchant product that we sold because of the need to be able to deliver it to remote location in a rapid period of time we could get some very nice pricing for that. I think the merchant market is certain segments of it are still ripe for price increases.
There is still a lot of customers who are below reinvestment economics. In other words, their contract might be five years old and still below current pricing. So, I’m optimistic that we will be seeing positive pricing in the merchant market.
Your next question comes from Edward Yang - Oppenheimer
Edward Yang - Oppenheimer
Interest expense, did I hear you right, it is going to be up $8 million per quarter to around $40 million or so?
Right, I think some people have been confused about interest expense. Basically we went into this year and our debt hasn’t gone up that much or down that much, but we had a number of bond maturities 12 months ago, with coupons of 5%, 6%, 7% and when we got into the sort of financial crisis the cost of going out and refinancing those, replacing a five year note with another five year note would have been a 400 spread over treasury over something like that.
So we elected to stay sure and for most of this year we have been issuing commercial paper for less than a quarter of a percent. Well below the bank’s cost of commercial paper. That has benefited our interest expense tremendously this year. What you try to do when interest rates come down is to stay short for a while and take advantage of the short rates and your pocket the money you can save on the short rates.
You start to state short for a while and take advantage of that but then before rates go up, you want to go ahead and issue some long term bonds so that you can lock in the low rate environment before it goes up. So, in the third quarter, we found some great opportunities where we issued ten year note at four in a quarter and a six year note at three in a quarter, over the full life of history, those are going to be great locked in interest rates, but those two issues alone will increase interest expense by about $8 to $10 million a quarter.
Edward Yang - Oppenheimer
In your volume disclosure for South America, volumes were down 12% year-over-year and that was actually worse than the second quarter when volumes were down 10%. So I would like to understand that?
Right, that relates to the business that we had in cylinder manufacturing and we have had a business down there where we make our own high pressure cylinders and also about eight years ago got into the business of making high pressure cylinders that we’re used in automobiles so they automobiles can convert from burning either gasoline or ethanol to burning compressed natural gas.
The sales in that business had gotten up to about $100 million a year, but two things happened over the past several years which have made it now unprofitable. One of them is when the Bolivian Government changed both the natural gas in Brazil is piped down from Bolivia and then new Bolivian Government reneged on the contract and Brazil end up renegotiating to pay significantly more for natural gas from Bolivia, so that meant the cost of natural gas was higher and that meant that the compressed natural gas at the pump was no longer competitive with gasoline.
At the same time there is almost a like ethanol in South America because there is a huge amount of cane produced ethanol production and the US has a huge tariff preventing the entry of ethanol until into the US. So, at this point in time ethanol is the choice of fuel for burning in cars and therefore we are not making as many of these cylinders. That alone caused our actual volume to decline significantly but our gas volumes are actually up.
Your next question comes from Mark Gulley - Soleil Securities
Mark Gulley - Soleil Securities
On the tax issue, Jim, historically one of the sources of your low tax rate overall was the tax advantage you had in Brazil. So should we look for an increase in our tax rate going forward now that you settled and it seems like good things are more normalized there?
No. In fact, there are two kinds of taxes and Brazil raises more money from transactional taxes, where it is accounted for aspirating profit like VAT taxes and taxes on bank transactions and so forth. They have always done that because it was easier for them to collect tax on a transaction rather than go out to someone and say “Give me your tax return and give me some taxes.”
So it has very high reliance on transactional taxes. The tax cases that we settled go way, way back in time and have more disputes over what the inflation rate and imputed interest rate would be on those taxes going forward. So consequentially what we’re doing is wiping out some pretty significant potential exposures on the operating profit line and I’ll not going to have any impact on the net income tax ROI.
Mark Gulley - Soleil Securities
So could you boil that down into a tax rate outlook for next year?
I expect it to be around the same, about 28%.
Mark Gulley - Soleil Securities
Secondly with respect to the delay in the hydrogen plant out there in California, I also remember in whiting for BP there were a lot of environmental concerns, any chance that the environmental lists may possibly go after that refinery upgrade in your hydrogen plant, just like they did in California?
They have and that went through and got finally resolved and going forward. The particular case that Chevron faces in California is a very desire case, it was judged by a small counter judge in Contra Costa County and it doesn’t really make any sense. So any of these projects could be challenged with environmental delays, but I don’t think that one leads to the other.
Mark Gulley - Soleil Securities
Then can you list for us some key plant startups for next year either geographically or industry, it just on your backlogs on a decrease with the six startups in the fourth quarter?
The key startups are the two hydrogen projects, one, about six months from now, that will be Chicago, then the next one about a year from now, which will be the Chevron project. Then we have the coal gasification project, which is starting up next month and we call gasification project, which will startup about a year later.
Then we’ve some steel startups and actually more copper mining startups going on in South America. Next year is a startup for Samsung, which is taking place next quarter and it’s pretty well diversified by end market and also pretty well diversified by geography, but the thing I would say generally, directionally with the exception of the U.S. hydrogen projects, we’re going to be investing more in emerging market countries in approximate Mexico and South America and China and India, because that’s where the demand growth is.
There’s just not that much demand growth going on in North America and Europe and then also directionally to the extent that there is demand growth in North America and Europe, it’s going to tend to be more environmental related so forth. So for example, working on some off take fuel gas projects and so forth to save some of our customers some air emissions.
Your next question comes from Kevin McCarthy - Banc of America/Merrill Lynch.
Kevin McCarthy - Banc of America/Merrill Lynch
In your closing remarks you mentioned that you would anticipate incremental margins of 30% to 40%. Given the cost reduction actions you have undertaken, I was wondering if you can compare that level to what Praxair would have experienced emerging from prior recessions, say following the 2001 recession, for example?
We never had volumes down thus far before. In the on-site business, the incremental margin, as volume starts to tick up, you don’t really get much incremental margin until you break through the threshold level of take or pay contract and then you’ll get some buyer incremental margins. In the merchant and package businesses, that’s typically where you see the same kind of operating leverage when volumes declines, but you can’t shut the plant down.
So we have to still get all the same plants and, not quite all were same number of trucks. It’s mostly the same number of trucks. As those volumes pickup, I think we’ll be getting 30% to 40% incremental margin on them, but the only thing I would say about that is probably at the same time we’re going to see natural gas prices go up and that on a margin percentage basis.
I’m not talking about earnings basis, but a margin percentage basis that will probably tend to push down the operating margin percentage and when we get higher sales from higher natural gas prices, but the same amount of operating profit.
Kevin McCarthy - Banc of America/Merrill Lynch
Then shifting gears to packaged gases. As you look at the monthly volume results for September and October, do you see any nascent signs of an early cyclical pick up here or would it be pre-mature to say that at this juncture?
There’s definitely some momentum in the right direction in packaged gas volumes, but it’s not extraordinary or remarkable. It’s definitely bottomed and stabilized and it’s definitely picking up, but if I don’t have a leading indicator in that business, your hard good sales and particularly sales or laser cutters and welding equipment, which is job shops have to buy those things when they run out of capacity in their job shop and they are not buying those things right now.
I think for the most part those shops have more than enough excess capacity given the volume that they’re seeing that it will be sort of a slow March up in volume in package gases.
Your next question comes from James Sheehan - Deutsche Bank.
James Sheehan - Deutsche Bank
You commented earlier on pricing in PDI and you’ve also mentioned a particular pricing issue in Asia with the increase in electronics mix. Can you give us a little more color on pricing in the other geographic regions, please?
Pricing is stable pretty much across the board. It’s certainly stable in Europe. It’s certainly going up and Mexico and South America and to some extent in the U.S. India and China, if you look at the traditional gases, the merchant oxygen, merchant liquid and argon and so forth. It’s stable.
It’s just that a year ago, we had really premium prices in argon, certain electronic gases and helium and because there’s no longer a supply squeeze in those products, those product prices have come down a little bit, but I don’t think that is indicative of anything else in the industry.
James Sheehan - Deutsche Bank
Also with respect you have pretty strong margins in South America now. To what extent is that sustainable and you mentioned you have this compressed gas issue going on t here. Is that playing a part in it and what can we expect on that in the next few quarters?
South America margin is definitely sustainable and could be climbing higher. That equipment business that we had was a very low margin business. So we are shutting one of those plants down and sort of phasing that south.
So the mix effect should move to higher margins there and as you know we try to operate our business model with a high density of production plants, distribution vehicles and customers and the more density of that we have the higher operating margin we can get. Consequently South America where we have that very high density, we should be earning a low 20s operating margin percentage.
Your next question comes from Lawrence Alexander - Jeffries.
Lawrence Alexander - Jeffries
Just wanted to get your impression on whether acquisition has started to comedown and either directly in the regional players in the packaged gas and merchant gas markets around the world or on the adjacent markets for PST?
In the packaged gases, I haven’t seen acquisition multiples comedown. I think it all has to do specifically with what the sellers are. For the most part the sellers are independently wealthy family own businesses and they’re not in any hurry to sell their businesses. In the PST business we were able to take advantage of a business that was owned by a distressed financial buyer, who absolutely had to sell that business and get it at a very good price, but I don’t see much change really in the marketplace there.
Lawrence Alexander - Jeffries
Can you give an update on the mix that you have in Brazil in terms of distribution channels and ancillary businesses and how that to evolve over the next two to three years given how strong the economy is there?
The mix we have in Brazil is not dissimilar from the mix that we have on a consolidated basis, roughly 25% on-site and about a third and a third of cylinder gases and merchant business. The capital investments going into the on-site, so that’s where all the capital growth is going, but the other two distribution segments really I use talk from the on-site. So I don’t see the mix between on-site, bulk and packaging changing very much.
As far as the end market mix, we have a stronger end market mix in food and beverage and healthcare in South America. They represent almost 40% of our total sales in South America, but the growth is really taking place more in the mining and metals and industrial production. So you might see that shift a little bit, but not very much.
Your next question comes from Jeff Zekauskas - JP Morgan.
Jeff Zekauskas - JP Morgan
Sort of just one nested question. Of the $90 million in cash outflows stemming from the pretax charge you took, how much of the $90 million is for restructuring charge and what is for other matters?
None of the $90 million is restructuring charge. When we do the settlements with the government, we’ll be paying the majority of what we owe on a discounted basis out of the net operating losses. So we’ll be getting credit for net operating loss that is we couldn’t use anyway.
We will also be paying some with some deposits that we put down on those cases and the net difference will be up to $90 million depending on how much of the deposits we have on those cases we actually get back. In terms of the restructuring, we basically just have the cylinder manufacturing plant, which we stopped operating a year ago and expected we would start it up again and we still haven’t started it up again. We are just impairing that asset.
Jeff Zekauskas - JP Morgan
In your footnotes in the K, you estimated the liability in Brazil at 380 and in the K it also says that you would reserve 210. So in general, why wasn’t the charge something like 170 rather than 306?
First of all, we added more cases than we had in the liabilities in the first place and then secondly, the NOL was used to satisfy a bigger piece of it. I can explain that to you on the phone a little more directly.
Your final question comes from Chris Shaw - Ticonderoga Securities.
Chris Shaw - Ticonderoga Securities
Just quickly, I think you alluded to the answer on this question about South America just if you look at the sequential profit growth versus sequential sales growth, suggested the incremental margins were like 60% is that just mostly because you are exiting that business and that was lower margin and that’s the difference or is there a lot of currency in there as well?
There are two things in there. If you look at the second quarter, 2009 segment operating profit is shown as $70 million. We actually had if you may recall in the second quarter $11 million currency hedging loss and that’s footnoted down on the right side here so X that we would have had $81 million of operating profit in the second quarter and so you are seeing $81 million go to $94 million which is pretty consistent in terms of margin. It actually goes from $20.6 to $21.6.
Chris Shaw - Ticonderoga Securities
Was there hedging loss in 3Q?
Yes, there is about $2 million hedging loss in 3Q.
I’ll now pass the call back to Jim Sawyer. You may proceed.
Again, thank you all for attending the call and there is really just one last point that I would like to make which I think some people will be interested in focusing on which is really free cash flow. We are now expecting that we will be able to continue our project backlog in the range of $2 billion of new projects going forward.
That obviously depends six months, a year, two years from now on which of the projects that we are focusing on end up materializing, but even at that level, we do expect that we will soon grow into generating about $1 billion a year of free cash flow and I define that as net income plus depreciation minus capital spending but before dividends and share buybacks and acquisitions.
So, I think when you look at the cash flow of this business, we are investing a lot of cash flow in new growth, but we are still throwing off a lot of free cash flow for our shareholders. So, with that I’d like to thank you for attending the call and look forward to talking with you soon.
Thank you for your participation on today’s conference. This concludes the presentation. You may now disconnect. Have a great day.
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