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Airgas, Inc. (NYSE:ARG)

F2Q10 (Qtr End 09/30/09) Earnings Call Transcript

October 29, 2009 2:00 pm ET

Executives

Jay Worley – VP, Communications and IR

Peter McCausland – Chairman and CEO

Michael Molinini – EVP and COO

Robert McLaughlin – SVP and CFO

Analysts

Tom Hayes – Piper Jaffray

Steve Schuman – Lafayette Research

Laurence Alexander – Jefferies & Co.

Holden Lewis – BB&T

Mike Sison – KeyBanc

David Manthey – Robert W Baird

Mike Harrison – First Analysis

Kevin McCarthy – Banc of America

John Roberts – Buckingham Research

Mark Gulley – Soleil Securities

Edward Yang – Oppenheimer

Operator

Good afternoon, and welcome to the Airgas second quarter 2010 earnings conference call. Today’s call is being recorded at the request of Airgas. All participants will be in a listen-only mode until the question-and-answer session of the call.

For opening remarks and introductions, I would now turn the call over to the Vice President of Communications and Investor Relations, Jay Worley. Please go ahead, sir.

Jay Worley

Good afternoon. Thank you for attending our second quarter earnings teleconference. Joining me today are Peter McCausland, Chairman and CEO; Mike Molinini, Executive Vice President and COO; and Bob McLaughlin, Senior Vice President and CFO.

Our earnings press release was made public this morning and is available on our Web site as are the teleconference slides. To follow along, please go to www.airgas.com, click on the Investor shortcut at the top of the screen, and then go to the Earnings Calls and Events page.

During the course of our presentation, we will make reference to certain non-GAAP financial measures. Please note that reconciliations to the most comparable GAAP measures can be found in our earnings release, in the slide presentation, and on our Web site.

This teleconference will contain forward-looking statements based on current expectations regarding important risk factors, which are identified in the earnings release and in our slide presentation. Actual results may differ materially from these statements so we ask that you please note our Safe Harbor language. We’ll take questions after concluding our prepared remarks and we plan to end the teleconference by 3’0 clock Eastern Time.

Now I’ll turn the call over to Peter to begin our review.

Peter McCausland

Thanks, Jay. Good afternoon and thank you all for joining us. It's just amazing to me that we're doing as well we are when you consider that this quarter marked the deepest same-store sales decline that we've experienced in our company’s history. And yet, we delivered sequential improvement in operating margin and adjusted diluted earnings per share while continuing our trend of very strong cash flow.

In addition to our financial performance this quarter, we were encouraged by the credit rating upgrades we received from both rating agencies. Our 400 million 4.5% senior notes offering that was heavily oversubscribed and our addition to the S&P 500 Index is clear that we are executing effectively on sound strategies that create long-term shareholder value.

As we recap the second quarter, it’s worth noting that last year’s sales and earnings results were the highest in company history. So this quarter represents our toughest year-over-year comparisons.

Net earnings for the second quarter were 54.5 million or $0.65 per diluted share. Excluding a $0.02 debt extinguishment charge and $0.01 multi-employer pension plan withdrawal charge adjusted earnings per diluted share were $0.68 compared to $0.86 per diluted share in the prior year quarter. Adjusted earnings per diluted share were near the top of our guided range in spite of low sales partially as a result of rapid implementation of cost reductions.

The total sales in the quarter declined 17% to 962 million driven by a total same-store sales decline of 19% with price down 1% and volume down 18%. Gas and Rent same-store sales declined 14% and Hardgoods declined 27%. Acquisitions contributed sales growth of 2%.

While second quarter sales finished stronger than they started, we’re still in a very challenging business climate. The soft demand we saw was broad-based across our geographies and customer segments.

Airgas National Welders, which covers the Carolinas and Southern Virginia, declined the least of our regional companies, followed by East and Pacific Northwest regions. The deepest declines took place in our Great Lakes and North Central regions still largely related to manufacturing, including the auto industry and in the Mountain West and Mid-South regions, where oil field service activity has slowed in recent quarters.

Consistent with recent quarters, our manufacturing customers suffered the deepest declines in excess of 25%. We did see some plant startup during the quarter, but operating rates remain low and company seems reluctant to build inventories.

Petrochemical and Utilities segments are also still pressured, but improving. Food and beverage customers as well as Analytical and Life Sciences are among the stronger segments and the Medical business is once again our strongest segment posting 1% growth.

We continue to benefit from our product mix shift towards Gas and Rent sales, which represented 65% of total sales in the quarter. Pricing is stable across most of our product lines including industrial gases and some specific product line including ammonia, fuel gases such as propane and propylene and Hardgoods silver metals, pricing contracted significantly this quarter as a direct result of sharp declines in cost of those products.

Our Hardgoods products are under the most volume pressure, led by steep declines in equipment, which is the only product line we sell that is a capital purchase for our customers. We expect equipments to drop deepest in a downturn, followed by silver metals used to manufacturing.

Fortunately, these tend to be the lower margin sales compared to the rest of our goods, as sales mix from Hardgoods to Gas and Rent drives gross margin expansion as Gas and Rent carry much higher gross margins than our goods. This gross margin expansion worked in conjunction with our cost reduction efforts to minimize operating margin erosion.

On a 19% decline in same-store sales, our operating margin only dropped 110 basis points to 11.4% from 12.5% last year and sequentially, it rose 40 basis points from 11% in the first quarter.

Cash flow continues to be one of the strengths of our business model. For the first half of the year, we generated free cash flow of $223 million. This is double the prior year and represents about 11% of our sales.

Adjusted cash flow from operations grew 22% from 287 million last year to 349 million this year and capital spending dropped 29% to $131 million this year.

We used our strong free cash flow to reduce debt this quarter. Acquisition activity has been slow as potential sellers assess their business in the wake of a downturn. However, our pipeline has been recovering recently as the anticipation of improving business conditions has stirred some interest.

Our acquisition activity has historically accelerated during the recovery phase of a business cycle and we hope that recent developments in the pipeline are signs of sustainable improvement.

Our strategy is unchanged. We have the capacity to purchase and integrate quality businesses and we remain diligent in sourcing transactions. We will continue to evaluate international opportunities as they arise, but our primary focus remains on our domestic core products and service offering acquisitions.

Looking forward, with few signs of near-term recovery, we have a very cautious outlook. The low-end of our EPS guidance assumes a continuation of current conditions, while the high-end incorporates modest sales recovery.

We intend to stay focused on our fundamental business strategies, enhance our sales organization and performance and continue to train our sales associates and all associates as we position ourselves to emerge even stronger when the recovery does take shape.

Mike will now give us a review of our market strategy and operations.

Michael Molinini

Thank you, Peter, and good afternoon, everyone. As Peter mentioned, the business climate remains very challenging, but this quarter marked some stabilization in daily sales rates. While we do expect our same-store sales results to improve in coming quarters as a result of easing comps, we are also focused on strategies for growing daily sales in excess of market recovery.

Our Strategic Accounts offering and our strategic products focus were designed to capitalize on competitive advantages while diversifying and expanding our customer base. Not only have these strategies outperformed our core business in recent years, they are outperforming our core business now in this downturn.

For the second quarter, our Strategic Accounts business was down 10% from prior year as the benefit of new account signings across all customer segments continued to be outpaced by the year-over-year declines in our existing metal fabrication, construction and petrochemical base.

For customers with multiple locations our Strategic Accounts focus offer superior service and supply chain savings through our national infrastructure, breadth and depth of products and services and technical expertise.

Customers facing tougher times tend to renew their interest in supply chain savings and we have been busy responding to customer inquiries. We recently fine-tuned our organization focus, sharpening our focus on key accounts and customer segments. When the economy recovers, this part of our business is well positioned for strong growth.

Turning to slide #3, our strategic product categories of Bulk, Medical and Specialty Gases, CO and Dry Ice, and Safety Products, make up about 40% of our revenue and in total, they declined 9% for the quarter, comparing favorably to the overall same-store sales decline of 19%.

Sequentially, daily sales for total strategic products improved more than 2% in the quarter. Our strategic products as a group continued to have good long-term growth profile due to favorable customer exposure, application development, increasing environmental regulation and strong cross-sell opportunities.

Safety Products sales declined 15% in the quarter comparing favorably to the overall Hardgoods same-store decline of 27%. Although low operating rates and rising unemployment pressured sales during the quarter, Safety Products still represents a strong cross-sell opportunity for us as the value in vendor consolidation is greater for our customers in today’s economy.

Bulk Gas sales were down 9% for the quarter as increased sales of bulk nitrogen for food freezing applications only partially offset the impact of production slowdowns in the metal fabrication and steel segments and reduced activity by oilfield service customers.

Bulk sales also faced a tougher comparison against very strong sales posted in the second quarter of last year. Sequentially, daily sales for Bulk Gas is improved by almost 3% in the quarter.

Bulk sales continue to represent significant opportunity for us due to a combination of our extensive sales presence, full range of supply modes and ability to engineer solutions to customer needs.

Medical sales posted 1% growth for the quarter, while slowing in elective and non-critical procedures has reduced overall medical demand, we continue to have success with new business signings.

Our proprietary walkabout cylinders bulk capabilities and new medical gas piping and certification business combined with our core medical packaged gases offering have allowed us to cross-sell and expand business with existing customers and have proven to be successful in helping us win new key customers including some of the top hospitals in the country.

Specialty Gas sales declined 13% this quarter driven by general softening in overall demand in the chemicals processing industry and a very tough year-over-year comparison for sales of high value rare gases. However, core specialty gases were more resilient, posting only a 7% decline and we remain optimistic about our growth prospects given our expanding account base in the biotech life sciences research and environmental monitoring fields.

Our EPA Protocol business continues to drive as our recent signing of a five-year supply contract with NIST, the National Institute of Standards and Technology, not only validates our position as a premier specialty gas company in the U.S., but also has generated a significant level of leads for new business.

In addition, our investment in proprietary automated production and automated analytical technology now fully deployed at all of our major specialty gas cylinder production plants provides the quality and the capacity we will need to serve this future growth.

Finishing out our strategic products, CO2 and Dry Ice were down 8% from last year, while the slowing was broad-based; the pressure was greatest on Dry Ice sales in the airline services segment.

Higher sales of Dry Ice in the wake of major hurricanes in the second quarter of last year also made for a tough comparison this year. Food freezing segment held up relatively well.

We continue to seek new product opportunities in growth markets and we're pleased to announce two developments this quarter, both of which have a positive impact on the environment.

In August, we announced our partnership with Nuvera Fuel Cells to jointly provide hydrogen generators and fuel cell stations to the North American material handling market.

In September, we announced that our AiRx Diesel Exhaust Fluid had been certified by the American Petroleum Institute paving the way for us to supply truck stops and truck fleets with the fluid that will help diesel trucks comply with 2010 clean air regulations. While both opportunities may start small, they represent the kind of forward-thinking and innovation that led us to our Strategic Accounts and strategic products strategies.

As the construction industry works to recover from the strain of the credit crunch and decline in energy prices, our contractor business has trended in a manner similar to our core business. Our construction market strategy however remains intact including Red-D-Arc, rental welders and oil and safety and we are well poised for growth when contractor activity starts to recover.

Radnor private-label products were down 23% for the quarter, slightly less than the overall drop at Hardgoods volumes and essentially flat on a sequential basis. The long-term growth opportunity for our Radnor private-label remains strong. In addition to building brand loyalty within our customer base, Radnor products enhance our profitability because they carry higher gross margins that comparable OEM products.

In contrast with the rest of our gas business, ammonia, which is the main product at Airgas specialty products, posted a sales decline in excess of 30% for the quarter. More than two-thirds of the decline was pricing, driven by the impact of falling costs compared to very high levels in the ammonia industry last year. Volumes are also lower, driven primarily by low plant utilization rates. In spite of lower price and volume, gross margin and gross profit, both improved over last year.

Similarly, refrigerants are down year-over-year as economic conditions and the mild summer weather experienced in the Eastern U.S. posted delays in maintenance of HVA system and elective refrigerant conversion projects during the second quarter.

Our operating efficiency programs, which focus on cylinder maintenance and testing, distribution and fill plant logistics, and freight and fuel management, are progressing according to schedule. We expect to achieve 10 million in annual run rate savings this fiscal year.

UT cylinder test benefits and common carrier freight reductions are the largest component of savings to-date, while distribution logistics initiatives are starting to play a larger role in generating savings.

By March of this year, we had fully implemented 45 million of annual expense reductions, which were at full run rate benefit in our first and second quarters. By September, we had implemented an additional 12 million of annual expense reductions, which will yield full run rate benefits starting in the third quarter.

At this point, we feel that our cost structure is appropriate for current demand levels. We are able to make additional reductions if conditions deteriorate further, but we intend to balance short-term profit protection with long-term strategy for creating shareholder value.

We’re also progressing with the design and configuration phase of our SAP implementation. The long-term benefits of this project play to the heart of our core strategies as the unification of our multiple IT platforms will cement our capabilities in a solid foundation

We have established a schedule for the first business unit to deploy in early fiscal 2011, followed by a base implementation over the course of two years to three years.

Now, Bob will give our financial review of the quarter.

Robert McLaughlin

Thanks, Mike, and good afternoon, everyone. To review our consolidated results, we’ll start with slide #4. As I go through these results, please note that we have GAAP reconciliations for various metrics on slide #8 through #10.

Adjusted earnings per diluted share of $0.68 in the second quarter was near to high end of our guided range of $0.64 to $0.69 and represents a decline of 21% year-over-year and an increase of 3% sequentially, including a $0.02 loss on the early extinguishment of debt and $0.01 charge for multi-employer pension plan withdrawal. GAAP earnings were $0.65 per diluted share.

Sales declined 17% to 962 million. Acquisition growth of 2% provided the slight offset to total same-store sales declines of 19%, comprised of a 14% decline in Gas and Rent, and a 27% decline in Hardgoods. Volume was down 18% and price was down 1%.

Although as Peter mentioned earlier, pricing for most products are stable and decline in cost and prices for ammonia, fuel gases and silver metals accounted for the negative pricing results.

Gas and Rent represent 65% of our sales mix comparing favorably with the prior year mix of just under 61%. The sales mix shift is driven by the relative strength of Gas and Rent same-store sales compared to Hardgoods and by the mix of acquired revenues. The favorable Gas-Rent mix is also reflected in our 55.7% gross margin for the quarter, an increase of 370 basis points over the prior year.

Operating expense as a percent of sales was 38.2, 340 basis points higher than the prior year, driven by the significant decline in year-over-year sales and by the mix shift to gas, which carries higher operating expense in relation to sales and corresponding higher gross margins as evidenced by the 370 basis improvement in total gross margins.

Operating income for the quarter was 110 million, down 24% from last year. While operating margins were negatively impacted by the significant decline in sales, the 57 million in annual expense reductions that we implemented between December 2008 and September 2009 in addition to our ongoing operating efficiency initiatives significantly mitigated the impact on our operating margins.

Our operating margins held up relatively well for the quarter at 11.4%, a decline of 110 basis points year-over-year and a 40 basis point improvement sequentially.

There were 83.5 million weighted average diluted shares outstanding for the quarter, down about 2% year-over-year and flat sequentially. Return on capital was 10.8%, a 280 point decline from the prior year, primarily driven by the slowing economy and related decline in operating income.

In light of the tough sales environment, we expect return on capital to be under pressure in the coming quarters, noting that this is a trailing 12-month calculation.

With respect to accounts receivable, our collection rates for the quarter have remained relatively consistent both year-over-year and sequentially and our quarterly DSO of 48 days was a slight improvement over the first quarter results.

Inventory turns held consistent with recent trends and inventory reductions have contributed more than $40 million to our cash flow this fiscal year. Year-to-date free cash flow was 223 million compared to 112 million last year, driven by strong adjusted cash from operations of 349 million, up from 287 million last year and by a 29% reduction in capital expenditures to 131 million this year.

During September, we issued 400 million of 4.5% senior subordinated notes due in 2014, which was significantly oversubscribed. By the end of September, we repurchased 58 million of our seven senior notes and eight senior notes due in 2018 and as a result incurred a loss on the early extinguishment of debt of $0.02 per share.

In October, we redeemed all of our 150 million, 6.25 notes due 2014, which will result in a $0.05 loss on the early extinguishment of debt during our upcoming third quarter.

Adjusted debt at September 30 was approximately 1.9 billion, representing $100 million reduction during the quarter and $716 million was available under our revolving credit facility.

Adjusted debt has been reduced by approximately $300 million since December 2008. Our fixed float ratio at the end of September was near to the high end of our target range of 40% to 60% fixed borrowing. And our adjusted debt to EBITDA ratio was 2.7, comfortably at the low end of our target range of 2.5 to 3.5.

Turning now to slide #5, we'll look at our segment results. Distribution sales were down 17% to 857 million for the quarter with same-store sales down 19%. Distribution in Gas and Rent same-store sales were down 12% with volumes down 11 and pricing down 1%. Without the impact of steep declines in cost and prices for fuel gases and some pricing pressure in rental orders, Gas and Rent pricing was stable as expected.

Distribution Hardgoods same-store sales were down 27%, with volumes down 26% and pricing down 1%. Distribution gross margin of 56.1% was an increase of 330 basis points over the prior year reflecting a favorable sales mix shift to Gas and Rent. Sequentially, distribution gross margin improved 30 basis points.

Operating income in the Distribution segment was 92 million, down 27% from the prior year. The related operating margin was 10.8%, a decline of 140 basis points year-over-year.

Consistent with my comments regarding consolidated margins, our distribution margins held up relatively well in light of the significant sales decline due to our quick and effective response in reducing operating expenses.

Sequentially, distribution operating margins improved 50 basis points. All other operations reflect our CO2, Dry Ice, refrigerants, ammonia and nitrous oxide business units.

Sales for all operations were down 17% year-over-year with a 24% decline in same-store sales offset modestly by a 7% contribution from acquisitions. This decline was largely driven by lower pricing in ammonia products related to a corresponding drop in raw materials; and lower refrigerant volumes reflecting mild summer weather in the Eastern U.S. and deferral of maintenance and conversion projects related to the economic conditions.

Operating income for all other operations was down 9% for the quarter. Operating margin increased to 140 basis points, driven by expansion of our ammonia business from declining product costs in the current year, compared to rising costs in the prior year. Carbonic and Dry Ice production efficiencies also contributed to the overall operating margin expansion.

Please turn to slide 6, Capital Expenditures. Capital spending was 131 million fiscal year-to-date versus 185 million last year. Spending on cylinders, bulk tanks and welders declined as sales have slowed and overall capital spending was down 29% compared to the prior year.

Excluding the impact of major capital projects, year-to-date capital spending is about 3.7% of sales. We are still in pace to realize a $100 million reduction in capital expenditures for the full fiscal year 2010.

Slide #7 presents our guidance. Given the continued challenging sales environments and few signs of any significant near-term recovery, we remain cautious in our outlook for fiscal 2010.

We expect adjusted earnings per diluted share to be in the range of $0.67 to $0.70 for the third quarter, a decline of 12% to 8% from last year. This excludes the previously mentioned $0.05 loss on the early extinguishment of debt related to the October redemption of our 150 million 6.25 notes. Including this charge, we expect earnings per diluted share of $0.62 to $0.65.

The guidance range assumes little to modest recovery from current sales levels with same-store sales declining in the low-to-mid-teens compared to the prior year. It also incorporates sequential headwinds from the loss of the selling day, seasonality in our Dry Ice and refrigerants businesses and the normal impact of the holiday season.

For the full year, we expect adjusted earnings per diluted share between $2.70 and $2.80 per diluted share, a decline of 13% to 10% from last year. This excludes $0.03 of charges in the second quarter and a $0.05 charge in the third quarter. Including these charges, we expect earnings per diluted share in the range of $2.62 and $2.72 per diluted share.

This guidance assumes full year same-store sales with a decline in the low double-digits. The range implied by the fourth quarter we will return to positive year-over-year growth with the midpoint being about a 6% increase over the prior year.

Please note that the third quarter and fiscal 2010 full year guidance does not incorporate the impact of future multi-employer pension plan withdrawals. We will continue our efforts to withdraw from such plans. Charges for withdrawal from plans under contract that expire during the remainder of fiscal 2010 could be approximately $0.04 per diluted share.

And now I’ll turn it back to Jay to begin the Q&A portion of the call.

Jay Worley

That concludes our prepared remarks. As we begin the Q&A portion of the call, we ask that you limit yourself to two questions and one follow-up, and then get back in the queue if you have further inquiries. The operator will now give instructions for asking questions.

Question-and-Answer Session

Operator

(Operator instructions). We’ll take our first question from Tom Hayes with Piper Jaffray.

Tom Hayes – Piper Jaffray

You indicated second quarter finished better than it started. I was just wondering if you could provide any color. And then third quarter last year had a lot of plant shutdowns and across the manufacturing base and your thoughts on going into the third quarter.

Robert McLaughlin

Well, sales turned up in August nicely on a daily basis. They were up for September, I mean, they were up about 5% over the level that we had benefited in the prior two months. And so that's why I was referring to by saying it was a better end. And we’re seeing some factory closings, but not as many as we saw last year and not as many as we saw in that 1998 to 2000 period. It’s amazing how many businesses are hanging in there with their revenues of 30%, 40%, 50%. It's just incredible what’s going on so I take that as a good sign.

Tom Hayes – Piper Jaffray

Okay. I guess and then secondly on the Gas and Rent side. Mike gave some good color, just wondering if there is any more specific industry color or more commentary you could provide us as far as where you saw the weakness?

Michael Molinini

Manufacturing pretty much across the board was the weakest and continues to be the weakest.

Tom Hayes – Piper Jaffray

Okay. I guess just lastly then on the machine sales. Are you seeing any additional enquiries into your rental business as fabricators who may see a small spike in activity, look towards rental as an alternative to buying?

Peter McCausland

Yeah, we see a little bit of that one during every downturn. We also know that some of these deferred shutdowns are going to be taking place in the next couple of quarters. So we’re looking forward to that a little bit. Just a supplement, what Mike said, I would also say another weak area has been the oil service area. And we have very tough comps in oil service. And that’s starting to come back during the quarter a little bit. So that’s a positive sign.

Michael Molinini

One of the more encouraging pieces about manufacturing long-term. In the 1998 to 2002 period plants, there were many plants that were closing and moving offshore. And the sales activity and inquiry activity for investment in automated equipment and operating efficiency improvement type equipment died for probably four years in a row. Four straight years in the 98 to 2002 period. What’s really surprising this time is that manufacturers are the enquiries and projects on the table for new investment of large cost reduction automated quality improvement manufacturing systems. It’s actually pretty robust considering the current state of manufacture.

Tom Hayes – Piper Jaffray

Okay. I guess just one more if I could. Maybe if you talk any success you may be having with substituting the Radnor line for more traditional brands in competitive situations or to hold the margins.

Michael Molinini

Well, that’s been the history, that’s still the history. We continue to do that. It’s our brand. It’s well received by our customers, it’s well received by our employees. We’re expanding the breadth all the time of adding new products to it. So I mean that strategy hasn’t changed and even in the decline of Radnor has not been as deep as the decline in the core products and that applies to silver metals or it applies to the accessories.

Tom Hayes – Piper Jaffray

Okay. Thank you for the insight.

Operator

We’ll take our next question from Steve Schuman with Lafayette Research.

Steve Schuman – Lafayette Research

Good morning. Your same-store sales typically lag the broader economic indicator like durable goods by a quarter or two. So it’s a matter of hanging on as those have turned up a little bit or at least they are less negative. Is it a matter of just waiting for that to turn the corner? Or do you see the sort of increase in your cost control and push your margins a bit?

Peter McCausland

Well, we haven’t been sitting on our hands for the last year. We’ve taken 57 million in cost out and we haven’t sacrificed any of our growth programs or our efficiency programs, which have also made us more profitable and have really preserved our operating margins in this tough environment. We have the same graph you have on durable goods and you're right about our business lags, an indicator by a quarter or two. And it’s pointing in the right direction and we continue to be hopeful that business is getting better.

And in the last couple of months, we’re seeing some improvement, but we're very active in trying to win new business on the basis of our broad products and service offering. Solutions for customers would be the applications or cost savings, process improvement and so we’re really focused on customer acquisition during this period of time, so that when the tide does come in, we’re going to price higher.

Steve Schuman – Lafayette Research

Thanks. Second, real quick on acquisitions. Sounds like multiples had to come down and you talked and some of your competitors talked about, it’s specific what the acquisition target may be transfer and family ownership or something. But with that, you’ve got plenty of cash and acquisitions really have tapered off. Is there any particular reason, if you’re willing to pay a reasonable multiple or a consistent multiple that you sort of pull back?

Peter McCausland

No. But what happens is, actually we’ve a slide that we have in our road shows that shows the number of acquisitions in each year and the sales acquired and then there are some economic durable goods or GDP or some sort of economic indicator that runs across the graph. And you can see every time there is a downturn, the acquisition activity is dried up. And this time it’s no different. These are good businesses that generates very good cash flow and usually there is no rush to sell. So, people wait and try to sell off higher numbers.

Regarding the multiples, they are pretty inelastic in our business compared to manufacturing companies. The ones that do happen though when the economies are down it might be a good multiple, but it’s off lower numbers. These businesses have always gone for a fairly decent multiple compared to manufacturing.

Steve Schuman – Lafayette Research

And would you be willing to pay for companies say at similar price that you may have been selling for last year?

Peter McCausland

You mean with 25% lower sales?

Steve Schuman – Lafayette Research

Yes, exactly. But with expectation that comes up and it’s a 20-year investment?

Peter McCausland

Generally not. We generally don’t buy expectations. We are more of hearing now people.

Steve Schuman – Lafayette Research

Great. Thank you.

Operator

We’ll take our next question from Laurence Alexander with Jefferies & Co.

Laurence Alexander – Jefferies & Co.

Good afternoon. I guess, first of all, just a follow-up on the acquisition pipeline. As regulations have tightened from the FDA, the DHS and the DOT are you seeing the smaller competitors become more motivated to sell earlier in this cycle or do you expect that to happen. Do you expect the surge in M&A activity to be a little bit more front end loaded at this time?

Peter McCausland

It could be. I know the small companies are having a very, very hard time. And because we talked to some of them and we’re hearing that from people in the industry, they tend to have a higher Hardgoods sales mix than we do. Our mix is skewed to our Gas and Rent. And Hardgoods are suffering worse than gas. So it could very well be and of course you’re right we have the FDA and EPA have stepped up homeland security. That’s stepped up or fairly highly regulated and all the agencies are stepping up their scrutiny and increasing the number of regulations with which we have to comply.

So it could be. I think the industry has been consolidating now for some time and I think the combination of the bad economy and increased regulation and maybe taxes as well will cause an acceleration in acquisitions has become out of this cycle. But again, I’m just speculating, we’ve never predicted acquisition numbers before and we’re not going to start now.

Laurence Alexander – Jefferies & Co.

And then just a follow-up on one of the points you made about this pressure on small competitors. To the extent that you have any visibility, can you tell if there Gas and Rent volumes are down more than Airgas? Or is that you in this environment able to pick up some share as well?

Peter McCausland

Well, we’re always after share and we're out there trying to sell solutions and to offer our broad product and service offering and to improve our general customer service through our core strategy to program. And we think we’re picking up some business. We haven’t measured the market share or anything like that. All I know is that our entire sales force is very active and we have a lot of good things going on. So I do think that in special areas where we’ve been able to deploy special expertise and technology, we’ve definitely taken share but not necessarily from small companies. It could be from large companies and small companies like in spec gases and life sciences and we feel we have the best product and service offering in the business in those areas. And we’ve been doing relatively well.

Laurence Alexander – Jefferies & Co.

Thank you.

Peter McCausland

Sure.

Operator

We’ll go next to Holden Lewis with BB&T.

Holden Lewis – BB&T

Good afternoon, thank you. Can you talk a little bit about the pricing environment? Obviously, it has continued to trend down. And I think you sort of isolated specific areas, but I mean the trend is what it is. Can you sort of comment on whether you expect that pricing to continue to sort of slip down? And then comment on kind of the price and cost relationship? Are you able to cut pricing, because you’re also getting concessions from your vendors on the Gas and the Hardgoods side or is that sort of a negative to the gross margin?

Peter McCausland

Our pricing isn’t down. Our pricing is holding up very well. The only place that’s down is where in connection with products that had severe inflation because of cost push inflation last year like ammonia, like silver metals that has a very large steel content and steel went through the roof. And also the fuel gases like propane, because they’re driven by oil prices that went through the road. So as our costs have come down dramatically in those product lines and so have the prices. In the case of ammonia, our margins are actually up and our profits are up, even though prices were down.

So if you exclude those product lines, our prices have held up very well during this economic downturn. And quite frankly much better than I would expect and I think this isn’t the time we don’t think to have an across the board price increase given how weak the economy is, but we continue to try to eliminate discounts. We focus on our lowest priced customers and try to move them up through negotiation and we’ve made some progress in local areas. And it’s all that and of course there is some gift back when contracts renew or customers go ask the multiple bidders. There is some good gift back. But net-net, we’re ahead of slightly even or slightly ahead and we feel pretty good about it.

Holden Lewis – BB&T

It’s all across from a price cost sort of standpoint, you feel, that’s what you’re referring to in terms of even or ahead?

Peter McCausland

Well, I'm talking about just price. On cost, we are way ahead. Our gross margin on gases was up 370 basis points over last year.

Robert McLaughlin

Yes, lot of that was mix, but underneath the mix, our margins have held up well and a slight expansion. So we’ve held them well and as you are aware, we lapped the price increase, which kind of sequentially makes it look like it was more the comps than it was actually a price contraction.

Michael Molinini

For those products that are very volatile, our folks have done a very, very good job of having our prices come down much slower than the cost have come down. We aided going up. So we deserve it now, but some of our costs are coming down too. We purchased about 70% of our molecules and we have energy indexes in them and utility electric charges where there is natural gas generating electricity are down. Our utility costs are down at our own production plants. So our costs have come down too and that has helped our operating margins, but when I’m talking about price, our prices are overall steady.

Holden Lewis – BB&T

Okay. And so, yes, your operating margins have actually benefited from that price-cost relationship at this point?

Michael Molinini

Right.

Holden Lewis – BB&T

You don’t anticipate any changes to that at this point?

Michael Molinini

No, we don’t. And we hope the worse is over for the economy and we could use some price increases sometime in the future and we will be looking for when the economy is sufficiently healed so that we can have a successful one.

Holden Lewis – BB&T

Okay. Along those lines, obviously, you did sort of the high end of your expectations in the quarter; it looks like relative to where you’ve given guidance over the prior two quarters, the environment does appear to be getting better. And yet really just sort of tightens the range around the same sort of mid point. Is there any reason why given what seems to be sort of some rolling improvement and better than expected performance in reality that we didn’t move the range upwards? Is there some offset to that?

Robert McLaughlin

No. I think obviously it was a very broad range as we began the year. And if you look at the back half of our guidance, we’re increasing excluding the charges from the $1.34 and the high-end would imply $1.46 on the back end. So that’s a $0.12 increase with too less business days in the back half of the year, one less in the third quarter and the fourth quarter, and the seasonality with respect to our Dry Ice, CO2 and refrigerant. So it’s actually a fairly good performance of the basic underlying core distribution business, if you look underneath the covers of the guidance.

Holden Lewis – BB&T

Okay. And then trying to maybe on October since that’s largely packed, you said that in September you would see increases in the DSR. Sounds like that was greater than sort of the normal seasonal increases. Are you seeing sort of normal seasonal increases in October or better than seasonal increases in October so far?

Michael Molinini

Well it’s flat to slightly lower daily sales rates than September. But usually the daily sales rate is a little bit lower in October than September. But if October tends to benefit because usually there is more billing days. So I don’t know what there is this year. But I’d say it’s basically flat, maybe slightly lower than September, nothing to. These levels of activity we think it’s pretty much flat.

Holden Lewis – BB&T

Okay. Fair enough thank you.

Michael Molinini

Sure.

Operator

(Operator instructions). We will go next to Mike Sison with KeyBanc.

Mike Sison – KeyBanc

Hey, guys.

Michael Molinini

Hi, Mike.

Mike Sison – KeyBanc

If I think about the volume declines that you have seen potentially through your fiscal year and may be adding up a little bit of last year, your volumes are going to be down. Somewhere in the neighborhood of 700 million or so. Is most of that recoupable? I mean, is that business that over time you can get back in total? And given all the cost savings that you guys have been able to sort of you generate this year. Does the incremental margins improve?

Peter McCausland

Well, yeah. We think the high definitely coming back. And our customers do, they are hanging in there. We’re adding to our customer roles, there is no question about it. But we have many, many customers, and as Mike pointed out, in the manufacturing sector there are 25% to 50%. And their usage of our products is correspondingly all 25% to 50%. But they are still there and I'll just give you an example. I was reading a report of one of our regional companies and they said in the last quarter, they added something like 280 new accounts. Everything from very small to large, $5 million new additional annual business. But that $5 million represented only half of the total decline that they suffered in their 100 largest accounts.

So the total decline in their 100 largest accounts was $10 million. And they haven’t lost the business. Now I’m not saying that there hasn’t been any closures, there has been some closures. But for the most part it’s just much, much lower volumes and we expect to do well. And regarding our profitability, I think, our fall through should be better coming out of this recession than the last one, because what we’ve done is, become a hell of a lot more efficient through our efficiency programs. And we’ve taken this opportunity to take all excess cost that we could find out of our system without cutting any programs. So we’re ready, we’re just waiting for it to come.

Mike Sison – KeyBanc

I got you. Then in terms of acquisitions, do you think that or maybe give us historic perspective, do acquisitions really accelerate at the early parts of recovery? Are there sort of a surge there where you might be above your normal 3% per year and that part of the equation could actually be a little bit stronger in the first couple of years?

Peter McCausland

Generally, that’s what happens. They get a couple of quarters a decent numbers and then they hope that the potential buyers will analyze them, which generally people do; we do it as well, if we are confident in the economic recovery. And if you look at that slide, I know you’ve seen it before, Mike; you’ll see that exactly that trend. And after a couple of nice quarters of recovery, the activity tends to be then front end loaded. But let’s say over the next three-year period you tend to have more in the beginning than you do towards the end.

Mike Sison – KeyBanc

Great. And last question, in terms of your strategic products area, historically sort to thought that business or those groupings would grow high single digit to low double-digits. Any thoughts or any change in that going forward? Is it going to be a little bit less strong in terms of growth or could it be even be stronger as you’ve gained, maybe a little bit more share on tractions in some those areas?

Michael Molinini

The medical business will be strong. I think the specialty gas business will be strong. The food and beverage business will be strong. CO2 and Dry Ice, food and beverages and dry should be strong. Safety products will recover, but there’ll be some impact on the speed of the safety products with employment, which would probably be slower than medical. But our opportunity for continue to cross-selling and growing our safety business is very strong. And Bulk would be very strong, I believe, because again, as we take our new capabilities in Bulk to our existing customers, who buy Bulk, we’re having some very, very good success in adding that product line to the other products and services to sell them.

So, I mean, I’m really optimistic and I also think on that group of product lines, but I’m especially optimistic on the Strategic Accounts segment. Because when you combine our footprint with all the products and all the services we sell, given an opportunity to explain to the customers what we can do for them, it’s tremendously compelling. And we’ve been able to talk with customers during this downturn that we’ve never been able to get an appointment with before. So very, very, very, that’s very, very encouraging.

Mike Sison – KeyBanc

Great, thank you.

Operator

We’ll take our next question from Steve Schuman with Lafayette Research.

Steve Schuman – Lafayette Research

Thanks for taking the second question. Some of the other companies in this space had talked about the accountable end markets picking up pretty significantly. It seems like you guys saw some declines. Is there any particular reason for that or is it just the part of the market you serve?

Peter McCausland

Declined? Why would you say we saw continued declines in chemicals?

Steve Schuman – Lafayette Research

I think, in one of your notes on your specialty gases, broad-based slowing including chemical processing.

Peter McCausland

Yeah. I mean I wouldn’t have anything sequential.

Robert McLaughlin

That’s not sequential.

Peter McCausland

Sequential was up, year-over-year it was down. I mean, we’ve seen some improvement; it may be again depending on which company you’re talking to. It could be also partially related to the kinds of products that they’re selling those customers versus the kind of products we're selling to those customers.

Steve Schuman – Lafayette Research

Okay, thanks.

Robert McLaughlin

Sure.

Operator

Moving on, we’ll take our next question from David Manthey with Robert W Baird.

David Manthey – Robert W Baird

Hi, good afternoon and thanks. Last cycle, your incremental or contribution margin was somewhat massed by acquisitions. Could you quantify what you think early cycle contribution margin should be on incremental volume in Hardgoods and Gas and Rent this time around?

Peter McCausland

I guess, you mean, fall through, right. You’re talking about fall through relative to incremental sales coming out of the recovery?

David Manthey – Robert W Baird

Yes, I am thinking forward, if you get an incremental, your first incremental dollar of Gas and Rent, does it fall through at $0.65 at the bottom line or what should that read to be from here?

Peter McCausland

Well, generally where we talk about in the upper 20s to 30% fall through type. Blended, Hardgoods and Gas and Rent and it would be higher than that on Gas and Rent.

David Manthey – Robert W Baird

Okay.

Peter McCausland

So in the 30 plus area.

David Manthey – Robert W Baird

Okay. So by category, by each segment, is the read through from gross margin to operating profit, is it 70% to 80%, or how do you think of that. Just because we don’t know what kind of mix you’re assuming with that 30% number?

Peter McCausland

Well, Hardgoods will come back a little bit faster than gas. It went down faster and I don’t really separate at the two in terms of the fall through.

Michael Molinini

We can take a look at that.

Peter McCausland

We’ll give you a call back on that.

Operator

We’ll take our next question from Mike Harrison with First Analysis.

Mike Harrison – First Analysis

Hi, good afternoon.

Peter McCausland

Good afternoon.

Mike Harrison – First Analysis

I was wondering, Mike, if you could talk about what your cylinder utilization rate has looked like during this downturn and whether you’re seeing any customers working with less cylinders or if they just reduce the turnaround of the number of cylinders they have.

Michael Molinini

The utilization of cylinders in the hands of customers has declined about 2%.

Mike Harrison – First Analysis

And what kind of rate are you at now then?

Michael Molinini

I’m not sure; I can tell you the rate of at the top of my head.

Mike Harrison – First Analysis

Okay.

Michael Molinini

But if you take a look at the cylinders on hand at customers, a year ago, and you look at what’s on hand today, it’s probably about 98% of what was there at the peak.

Mike Harrison – First Analysis

All right. And you noted that Airline Services was a source of weakness for the CO2, Dry Ice business. How much of that business goes into Airline Services? Is it like 15% piece?

Michael Molinini

It’s about 15% to 20% of the Dry Ice business.

Mike Harrison – First Analysis

Okay. Got it.

Michael Molinini

And Dry Ice and CO2 combine where the numbers that we gave you. So I’m not sure exactly what percentage it could be.

Mike Harrison – First Analysis

All right. Now that’s helpful. And then the last question I had was for, Bob. Any guidance with the new debt structure, any guidance on interest expense for next quarter and going forward?

Robert McLaughlin

Interest rates will be – the average interest rates will be fairly comparable to the quarter we just ended. We had some slots that came up and with the calling at the 6.25 notes. So no material change with respect to interest.

Mike Harrison – First Analysis

All right. Thanks very much.

Operator

We’ll take our next question from Kevin McCarthy with Banc of America.

Kevin McCarthy – Banc of America

Yes, good afternoon. I just had two questions on pricing. First, if we were to aggregate the deflation across ammonia, the fuel gases and the silver metals. Can you give us a sense of how large that would have been in the quarter?

Robert McLaughlin

I think on a combined basis related to the total revenues it was a little over 1%. So it’s a reason for the decline.

Kevin McCarthy – Banc of America

And that would be year-over-year 1%?

Robert McLaughlin

Yes.

Kevin McCarthy – Banc of America

Okay. Great. And then, Peter, in terms of prospective increases, one of your competitors yesterday I thought have some fairly constructive comments on the potential for price increases and packaged gases. It sounds to me like from your earlier comments you might be a little bit more cautious in that. I was wondering if you could elaborate on what you think that potential is, let’s say, over the next quarter or two, and what kind of metrics or factors you would be watching to assess whether or not it would be wise to raise prices?

Peter McCausland

Well. You have to look at the total landscape, and on the one hand people on our business need price increases especially the smaller competitors, and I don’t know anybody specific. I’m not talking about anyone specific circumstance. On the other hand a lot of customers are suffering out there, and we think it’s not the right time to come out within across the board price increase. There will be a time though as the economy recovers and I’m fairly positive in terms of pricing. This especially if we have energy increased price increasing. So I don’t know what was said by any competitor, and our pricing decisions are made independently, but we feel like when the economy recovers, we will be able to get price as we have shown in the past.

Kevin McCarthy – Banc of America

Understood. Thank you very much.

Peter McCausland

Sure.

Operator

We will take our next question from John Roberts with Buckingham Research.

John Roberts – Buckingham Research

Good afternoon, guys.

Peter McCausland

Hi.

John Roberts – Buckingham Research

Would you still consider Hardgoods growth, a leading indicator of the FY09 [ph] growth or is it such an unusual cycle here that maybe that doesn’t apply anymore?

Peter McCausland

It probably does apply. I’m not a good economist I guess, because I didn’t predict the downturn was either severe. But I think we’ve got a year out, and we look back if there is a recovery, I think there will be. We’ll see machine sales pick up just like they have before and be the leading indicator for us. That’s about 10% of our sales and 80% is coincident with the economy and then the last 10% is Bulk, which is a lagging indicator. And so I think it will be there, just like it always has been.

And as Mike pointed out that this recovery is different, and then we are still getting a lot of interest in large automation systems, that we didn’t even see in the last recession, and I tend to think that’s going to accelerate, and there are factories that are being announced here, and some of them are for stuff like alternative energy, which is mandated. But there are steel mills and automobile plants, and uranium enrichment plants, and plants for the solar polycrystal manufacturing and the dollar has been weak until just very recently, and it’s come down. And that bodes well for exports, and exports drive a lot of our metal fabrication business, the heavy equipment that we manufacture here, that’s the best in the world that are comparable and in that a lot of that is direct. So, I think when we get out there and look back, we’ll see a trend like we’ve seen in the past recessions expansion.

John Roberts – Buckingham Research

And you said earlier that the quarter ended a little better than it began. Did Hardgoods have a more significant better end into the quarter or bounce back a little bit better?

Peter McCausland

Hardgoods were definitely improving and showing improvement, and last several months now, from the bottom sequentially.

John Roberts – Buckingham Research

Okay. Thank you.

Operator

We’ll go next to Mark Gulley with Soleil Securities.

Mark Gulley – Soleil Securities

Hey, guys.

Peter McCausland

Hi, Mark.

Mark Gulley – Soleil Securities

Can you comment a little bit on your LOX/LIN operating rates, particularly now that you’ve had it, I think the two new ASUs in Kentucky and Indiana?

Peter McCausland

Mid 70s.

Mark Gulley – Soleil Securities

Are you (inaudible) pressure in LOX/LIN given the fact that operating rates across the industry seem to be in that 70% to 75% area.

Peter McCausland

Well, here and there, but pricing is held up overall very well. And mid 70s is a lot better than low to mid 60s like we had in the last downturn. And with the lot of the big steel mills down and the big oxygen columns down, some of the argon production is down, so that’s a little tighter than one would expect at this stage in the cycle. And there just hasn’t been that much new capacity added. So I think it’s remarkable that we’re in the mid-70s given the debt of this downturn and pricing is holding up fairly well.

Mark Gulley – Soleil Securities

Okay. Secondly, Mike talked a little bit about strategic accounts and how you are being invited to bid on piece of the business now that those customers are looking for efficiencies. But do those efficiencies extend to price cuts; are you having to lower your prices there to win those piece of business?

Peter McCausland

I’m not saying we never lower our price, but that’s certainly not the goal. We want to help our customers with process, cost and improvement in supply chain, cost improvement. And what Mike was talking about is that few customers where we’ve made presentations recently, where they’ve taken seven different product lines or product and service lines that we can offer across all their facilities. And finally some of these barriers within corporate purchasing and procurement departments of customers are breaking down and customers are starting to think outside the box and say, hey, if I can eliminate 250 vendors by going to Airgas, with seven different products and services across 32 plants this is something that we have to think about it because our sales our down 30% and that was the kind of opportunity that Mike was referring to I think. Do you want to add to that?

Michael Molinini

No, I think that is the case. I don’t these are not customers we have, okay, these are customers where so I can’t speak to what the pricing is before. I know what we may have quoted, I also know that what the customer is looking for is not necessarily what he is paying for when he starts he is looking for continued ongoing cost reductions overtime through operating efficiencies, product substitutions, you name it. And that’s the kind of additional value we can bring to them, which is what so compelling.

Mark Gulley – Soleil Securities

Okay. And lastly, given that the tough times you are going through now, is there any thought been given to pushing out the SAP implementation or you are going to hang in there with respect your current timetable?

Michael Molinini

No, on plan, on schedule.

Mark Gulley – Soleil Securities

Thank you.

Operator

We’ll go to Edward Yang with Oppenheimer.

Edward Yang – Oppenheimer

Hi, good afternoon.

Peter McCausland

Hi.

Edward Yang – Oppenheimer

One of the break points during this downturn has been your free cash flow generation and that was up substantially year-to-date. Part of that was CapEx. Just curious how CapEx should look like in 2011? And I know you had construction in process spending this year, which kept CapEx spending above maintenance levels. So what would be an appropriate level going into a rebound?

Peter McCausland

Well, we think that if we have a gradual improvement in the economy for the balance of this year and into next year we're probably going to be around 5%, 5.5% CapEx as a percentage of sales next year. But the caveat would be if we got involved in some sort of major projects or something that could change, but we don’t have anything like that. Right now, booked and so it’s probably a good number to start in the 5%, 5.5% range.

Edward Yang – Oppenheimer

Okay.

Peter McCausland

There is some slack in the system, there is our realized cylinders are down 2% from the peak, but we are still buying cylinders in some category. So that’s probably a good number.

Edward Yang – Oppenheimer

Okay. And just quickly on gross margins for silver metals. What would that be?

Michael Molinini

That's in the mid-20s, mid-to-upper 20s.

Edward Yang – Oppenheimer

Okay. Thank you very much.

Operator

And there are no further questions at this time. Mr. Worley, I’ll hand it back over to you for any additional or closing remarks.

Jay Worley

Well, again, we thank you all for joining us today. I will be available this afternoon and tomorrow for follow-up questions. Have a nice day.

Operator

And that does conclude today’s conference. We thank you all for your participation.

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Source: Airgas, Inc. F2Q10 (Qtr End 09/30/09) Earnings Call Transcript
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