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Airgas (NYSE:ARG)

Q3 2014 Earnings Call

January 30, 2014 10:00 am ET

Executives

J. Barrett Strzelec - Director of Investor Relations and Corporate Communications

Peter McCausland - Founder, Executive Chairman and Member of Executive Committee

Michael L. Molinini - Chief Executive Officer, President and Director

Robert M. McLaughlin - Chief Financial Officer and Senior Vice President

Analysts

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Vincent Andrews - Morgan Stanley, Research Division

David L. Begleiter - Deutsche Bank AG, Research Division

Ryan Merkel - William Blair & Company L.L.C., Research Division

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Laurence Alexander - Jefferies LLC, Research Division

Robert A. Koort - Goldman Sachs Group Inc., Research Division

Mark R. Gulley - BGC Partners, Inc., Research Division

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Operator

Good morning, everyone. Welcome to the Airgas Third Quarter 2014 Earnings Conference Call. Today's call is being recorded at the request of Airgas. [Operator Instructions] For opening remarks and introductions, I will now turn the call over to the Director of Investor Relations and Corporate Communications, Barry Strzelec. Please go ahead.

J. Barrett Strzelec

Thanks, Dana. Good morning, and thank you for attending our third quarter earnings call. Joining me today are Executive Chairman, Peter McCausland; President and CEO, Mike Molinini; and Senior Vice President and CFO, Bob McLaughlin.

Our earnings release was made public this morning, is available on our website, as are the teleconference slides. To follow along, please go to airgas.com, click the Investor Relations shortcut at the bottom of the screen, and go to the Earnings Calls & Events page.

During our presentation, we will make reference to certain non-GAAP financial measures. And unless otherwise noted, measures referenced in today's discussion will be adjusted for the unusual items identified in our earnings materials. Reconciliations to the most comparable GAAP measures can be found in the earnings release and in the slide presentation.

This teleconference will contain forward-looking statements based on current expectations regarding important risk factors, which are identified in the earnings release and in the 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 as time permits, and we plan to end the teleconference by 11:00 a.m. Eastern Time.

Now if you would please turn to Slide 2. I'll turn the call over to Peter to begin our review.

Peter McCausland

Thank you, Barry. Good morning, and thanks to everyone for joining us. I'd like to start by briefly recapping our third quarter results. And then I'll provide an overview of the current environment as we see it and our outlook for the fourth quarter.

Consistent with our expectations for continued sluggish business conditions during the third quarter, our adjusted earnings of $1.18 per share were at the midpoint of our guidance range, representing 13% growth year-over-year. Once again, we delivered on our SAP-related benefits for the quarter, managed expenses well and posted solid operating margin expansion. Mike will touch on SAP further in his remarks.

Cash flow remains very strong, with year-to-date free cash flow up 52% to $333 million, and adjusted cash flow from operations is up 28% to $576 million. Since the beginning of our fiscal year, we've acquired 9 businesses with aggregate annual sales of approximately $70 million, including The Encompass Gas Group, which we announced and closed in October. We're excited to have the loyal associates and customers of all of these businesses we've acquired as part of the Airgas family now.

As I said, business conditions were sluggish in the third quarter, and that continues to be the case in January, with the extremely cold weather across large parts of the country having an adverse impact on our sales. Current conditions are sluggish, and nonresidential construction moved lower in the quarter. Accordingly, our visibility with regard to the near-term economy is limited.

There are several bright spots that reinforce our optimism about U.S. industrial activity getting back on track more broadly, as we get deeper into calendar 2014. But there are also certain areas that are hard hit right now and are challenging our growth outlook for the fourth quarter. It's a difficult environment to read.

In the manufacturing sector, for example, railcar and oil and gas equipment production are bright spots, but mining equipment production continues to weaken. In construction, major projects we have highlighted in the past continue to move forward in various stages, which is good news, but new projects have been slower to gain traction, and the extremely cold weather prevents welding activity on general daily construction projects that make up a good portion of our construction segment.

Economic indicators are also giving mixed signals. The ISM has been above 55 for the past 6 months, which is encouraging, but fabricated metal new orders growth has decelerated in recent months. Non-tech IP has improved over the last several months, but private nonresidential construction spending has declined, with the most recent reading in November down 7% from last year.

We still expect the sequential seasonal uptick in volume levels in our fourth -- fiscal fourth quarter, as we did in our previous guidance, but our revised organic sales growth outlook has softened somewhat in light of the factors I just mentioned. Our revised fiscal 2014 EPS guidance in the range of $4.75 to $4.80, which still represents 9% to 10% earnings growth and strong execution on strategic initiatives in a challenging environment. We're doing all the right things by remaining nimble, continuing to invest in our businesses for the long term and sharing with you what we're seeing in the near term.

Recently, I've been visiting with our associates in the field, and I'm amazed at their level of enthusiasm around what they see in Airgas' future with the help of a stronger U.S. industrial economy. It's infectious and reinforces my excitement about the future. We remain very bullish on the long-term prospects for U.S. manufacturing and energy industries, as structural drivers like the abundant supply of low-cost energy, increasing shipping costs from overseas and the protection of intellectual property should favor the U.S. for years to come. We are still expecting significant increases in U.S. capital spending in calendar 2014, with a huge increase in the petrochemical sector. We also expect a significant increase in oil and gas production. Airgas is well positioned to leverage our unique value proposition and unrivaled platform as a leader in our industry to capitalize on the opportunities that lay ahead.

I like to go back from time to time and look at what I said earlier. And recently, I was reviewing our annual report that was printed last July. The theme of that report was "positioned for growth." Well, we were positioned last July, and we're even much better positioned today. We hope we are seeing signs of growth returning to the U.S. economy after more than a year of uncertainty fueled by budget impasses, a slowdown in China and emerging market turmoil, all of which seemed to contribute to a lack of confidence and conviction for U.S. businesses despite large cash balances on those businesses' balance sheets and historically low borrowing rates.

I'm looking forward to the day when the economy is supportive of volume growth, because I think Airgas is really going to shine. In the meantime, we're doing a good job executing on our strategic initiatives.

Now I'll turn it over to Mike to discuss the business in greater detail.

Michael L. Molinini

Thank you, Peter, and good morning to everyone. I'm very happy to tell you that we have achieved our long-standing target of reaching a run rate of more than $75 million in SAP-enabled operating income benefits by the end of calendar year 2013.

I think it bears remembering that we put that target out more than 3 years ago in August of 2010, at a time when the U.S. economy was recovering nicely from the recession and at a time when we did not foresee the manufacturing slowdown and delay in the non-res construction upturn, which have been the realities of the last 18 months. Delivering on that commitment to our shareholders is a remarkable achievement that has required incredibly hard work on the part of our 15,000 associates. So I want to take this moment to thank them for their effort that they've put forth and the sacrifices they made along the way in not only implementing the system successfully but also deriving the early benefits. We continue to find ways to leverage SAP's capabilities and the benefits of having a unified platform across our distribution operations to improve the way we manage our business on both the top and bottom line, and we expect to realize benefits for many years to come.

Now please turn to Slide 3. Moving on from SAP, we continue to tailor our value proposition to the unique needs of each major customer segment. Our Strategic Accounts program, which leverages this segment-driven approach, presents us with tremendous cross-sell opportunities in terms of product lines, services and locations and represents approximately 25% of total sales.

In the third quarter, our Strategic Accounts sales were up 2% from the prior year, with new account signings, expansion of locations served and product lines sold to existing accounts and positive pricing more than offsetting the lower levels of activity in several areas, including mining and related heavy equipment manufacturing, defense contractors, as well as some pressure in home care. Strategic Products increased 3% over the prior year, with safety products and bulk and specialty gases outperforming the category overall.

Now I'll provide you with a brief update on refrigerants. As you know by now, the EPA's unexpected ruling in late March to allow for an increase in the production of R-22 this year has caused some real challenges for us this year. R-22 prices continue to be pressured despite some stabilization in volumes. Our previous expectation was that year-over-year headwind related to this issue would be at about $0.15.

Our current forecasts indicate that the year-over-year headwind is likely to be closer to $0.17, which is what we have incorporated into the revised fiscal 2014 guidance that Bob will review shortly. We've said all along that this is a challenging and unpredictable situation, and I expect it will continue to be challenging and unpredictable for the next few quarters. We'll continue to keep you informed as it develops.

The rollout of our expanded telesales channel, Airgas Total Access, is progressing well and very much in line with our expectations. We have a full complement of full-time Total Access telesales representatives trained and deployed across all our distribution regions, calling on customers in the target size spend range, selling gas and welding-related hardgoods in addition to our traditional telesales offering of safety products.

While we are frustrated with the sluggish environment, we will continue to focus on the growth drivers that we can control and are ready to capitalize when sustained growth in the industrial economy resumes. The heavy lifting associated with the SAP implementation is behind us, and most of the distraction is now in the rearview mirror.

We're focused on gas' growth and fine-tuning our organizational structure. All of our associates are now focused on doing what they do best, servicing our more than 1 million customers. Overall, I share Peter's optimism about our future, and I'm confident we have the right people working on the right things.

Thank you. And now Bob will review our financial results for the quarter and discuss the outlook.

Robert M. McLaughlin

Thank you, Mike, and good morning, everyone. Please turn to Slide 4. Total sales were up 3% year-over-year to $1.24 billion. Organic sales, up 1% over the prior year, with gas and rent and hardgoods each up 1%. Acquisitions contributed year-over-year sales growth of 2% in the quarter. In aggregate, volumes were down 1%, and pricing was up 2% year-over-year.

On a sequential basis, total sales in the quarter included approximately 3% headwind from the impact of 2 less selling days, partially offset by a 1% contribution from acquisitions. Gas and rent represented 63.6% of our sales mix in the quarter, down 40 basis points from the prior year and down 60 basis points from the second quarter.

Gross margin for the quarter was 56.7%, an increase of 60 basis points from the prior year, reflecting margin expansion on price increases; a mix shift away from lower-margin refrigerants, partially offset by supplier and internal production cost increases; and significant margin pressure on our refrigerants business.

Selling, distribution and administrative expenses increased by about 3% over the prior year, with costs associated with acquired businesses representing about 2% of the increase. The favorable impact in the reduction in SAP implementation costs compared to the prior year was substantially offset by expenses associated with the expansion of our telesales business through Total Access, our strategic pricing initiative and enhancing our eBusiness platform, as well as by rising health care costs.

Operating income of $155 million was up 6% over last year's adjusted operating income, which excluded restructuring and other special charges. Operating margin of 12.5% was up 40 basis points over the prior year's operating margin of 12.1%. The combination of a reduction in SAP implementation costs and the achievement of SAP-related benefits contributed favorably to the net increase in operating margin this quarter compared to the prior year.

Low organic sales growth challenged our operating margin this quarter, as did R-22 volume and pricing on our refrigerants business, following the EPA's unexpected ruling in late March 2013 to allow for an increase in the production of R-22 during calendar 2013.

Adjusted earnings per diluted share increased 13% to $1.18, which excludes the previously announced $0.08 loss on the early extinguishment of debt. We delivered significant SAP benefits consistent with our guidance, and the current quarter includes net SAP benefits of $0.14 compared to $0.13 of net expense in the prior year quarter.

Return on capital, which is a trailing 4-quarter calculation, was 12.4%, flat both year-over-year and sequentially. Year-to-date, free cash flow was $333 million, up 52% over the prior year. And adjusted cash from operations was $576 million, up 28% over the prior year. The increase in cash flows was primarily driven by the lower required investment in working capital year-to-date compared to the prior year-to-date period.

Total debt increased by approximately $252 million year-over-year to $2.5 billion at December 31, driven primarily by the fiscal 2013 share repurchase program and acquisitions, partially offset by strong operating cash flow during the past 12 months. Our fixed/float debt ratio at the end of September was approximately 69% fixed. And our debt-to-EBITDA ratio was 2.7, within our target range of 2 to 3.

Turning now to Slide 5, we'll look at our segment results. SAP implementation costs, which are included in our consolidated adjusted operating results, have not been allocated to our business segments. Distribution sales for the quarter were up 5% versus the prior year to $1.1 billion. Organic sales for the distribution segment were up 2%, with pricing up 3% and volume down 1%.

Gas and rent organic sales were up 3%, with pricing up 4% and volume down 1%. Distribution organic hardgoods sales were up 1%, with pricing up 1% and volumes flat. Gas and rent as a percentage of distribution sales was approximately 60%, consistent with both the prior year and second quarter. Distribution gross margin of 57%, an increase of 20 basis points over the prior year, reflects margin expansion on price increases, partially offset by supplier price and internal production cost increases and a mix shift within gas to lower-margin fuel gases.

Operating expenses in the distribution segment increased by about 5% over the prior year, with operating costs associated with acquired businesses, rising health insurance costs and expenses associated with the expansion of our telesales platform, our strategic pricing initiative and eBusiness platform, together representing more than 3% of that 5% increase. The benefit of lower year-over-year implementation costs did not flow through the distribution segments but are reflected in our consolidated results.

Operating income in the distribution segment increased 3% year-over-year to $143 million, and operating margin decreased by 30 basis points to 12.7%. The year-over-year decrease in our operating margin reflects the achievement of SAP-related benefits as planned during the quarter but was more than offset by margin pressure from low organic sales growth relative to our fixed cost base and rising health care costs.

All Other Operations reflect our CO2, dry ice, refrigerants, ammonia and nitrous oxide business units. Sales for All Other Operations were down 11% from the prior year on lower price and volume in our refrigerants and ammonia businesses, and difficult comps in our CO2 business due to prior year hurricane-related sales and outage-related surcharges. Sequentially, sales in All Other Operations segment decreased by 17%, reflecting the normal seasonality in those businesses and 2 fewer selling days.

Gross margin for All Other Operations was 51.1%, an increase of 380 basis points from the prior year, primarily driven by the impact of higher margins in our ammonia business due to lower feedstock costs and a mix away from lower-margin refrigerants, offset in part by continued margin compression in our refrigerants business. Sequentially, gross margin in All Other Operations expanded by 380 basis points, primarily due to higher margins in our ammonia business and the seasonal sales mix shift away from lower-margin refrigerants.

Operating income for All Other Operations was $13 million, a decrease of $2 million compared to the prior year, driven primarily by the decline in refrigerants, in part offset by higher margins in our ammonia business. All Other Operations' operating margin of 10.7% increased 30 basis points year-over-year, driven primarily by higher margins in our ammonia business, partially offset by margin pressure in refrigerants.

Please turn to Slide 6, capital expenditures. Year-to-date, CapEx represented 6.8% of sales, consistent with the prior year. Excluding major projects, CapEx as a percentage of sales was approximately 4%.

Now I'd like to discuss our guidance for the remainder of the fiscal year. Slide 7 presents walks through the primary elements of our fourth quarter and revised full year guidance. The first column shows a sequential walk for the first quarter, using third quarter adjusted EPS of $1.18 as the starting point. SAP benefits, net of costs, and the remaining elements of our base business are expected to contribute $0.00 to $0.05 in aggregate, resulting in EPS of between $1.18 and $1.23 or flat to up 4% sequentially.

While it is difficult to quantify the full impact of adverse weather conditions in January, it seems clear to us that we have lost the equivalent of at least 1 day and likely more. As such, we do not expect to see the otherwise favorable impact of having 1 additional selling day in the fourth quarter compared to the third quarter, and therefore, it is excluded from this walk. The sequential improvement underpinning this range, excluding the impact of acquisitions closed, is approximately 1% to 2%, with some of the sales growth impact reflected in SAP benefits.

The second column of this slide shows the year-over-year walk for the fourth quarter, using fiscal 2013 fourth quarter adjusted EPS of $1.14 as the starting point. SAP benefits, net of costs, variable compensation reset and the remaining elements of our base business are expected to contribute $0.04 to $0.09 in aggregate, while the tailwinds from acquisitions closed in share count will be offset by the negative impact of the EPA's March 2013 ruling on our refrigerants business, resulting in EPS of between $1.18 and $1.23 or 4% to 8% growth year-over-year. This range assumes organic sales growth in the low single digits.

The right-hand column of this slide shows the year-over-year walk for our revised fiscal 2014 EPS guidance range. We're expecting SAP benefits, net of costs, to contribute $0.65 to the year-over-year earnings growth, which represents the difference between the $0.18 of net expense in fiscal 2013 and the expected $0.47 of net benefits in fiscal 2014.

The contribution from SAP benefits, net of costs, combined with variable compensation reset and the remaining elements of our base business are expected to contribute $0.39 to $0.44 or 9% to 10% growth over the prior year. Again, the otherwise favorable impact of having 1 additional selling day in fiscal 2014 was more than offset by the impact of the adverse weather conditions in January.

The tailwinds from acquisitions, net of divestitures closed to date, and the reduction in share count, net of projected share creep and the related interest costs to fund the share repurchases, will largely be offset by an estimated $0.17 headwind related to refrigerants.

In aggregate, we now expect adjusted EPS for our fiscal 2014 to be in the range of $4.75 to $4.80, which represents year-over-year growth of 9% to 10%, reflecting organic sales growth in the low single-digits and the other items noted above.

Our previous fiscal 2014 guidance range for both earnings diluted share and adjusted earnings per diluted share was $4.85 to $5, an increase of 11% to 15% over the prior year. The guidance revision primarily reflects a reduction in our year-over-year organic sales growth rate of roughly 2% to 3% below our previous assumptions for the fourth quarter.

Now I'd like to touch briefly on our 2016 midterm financial goals. The U.S. industrial economy has not improved in the past year to the extent that we and many others had expected when we introduced our fiscal 2016 goals at our Investor Day in December 2012. As a result, and combined with the slow pace of acquisitions, it will take longer than expected to reach the goal of $6.5 billion in annual sales.

If the long-awaited resurgence in the U.S. industrial economy were to gain real strength in the near term, however, we could make up some of the lost ground. At this time, we are optimistic that the 15% low end of our fiscal 2016 operating margin goal is still within reach. We hope to be able to provide a more formal update on our 2016 goals after we close out this fiscal year and have more visibility on business conditions but wanted to share with you our current thinking around these goals.

And with that, I'll turn it back to Barry to begin our question-and-answer session.

J. Barrett Strzelec

Thanks, Bob. [Operator Instructions] And Dana will now give instructions for asking questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to Kevin McCarthy with Bank of America Merrill Lynch.

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

In the distribution segment, your operating margins declined about 30 basis points year-over-year. And I think you cited in the commentary some fixed costs there. Do we need to see acceleration of volume to get operating margin moving north again? Or are there other levers you might be able to pull to achieve that?

Robert M. McLaughlin

I think we will need to see some improvement relative to the same-store sales, but that said, as we've mentioned, we still have additional levers to pull as it relates to our SAP system. But in that low organic sales growth environment, that puts a lot of pressure on our fixed costs.

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Okay. And as a follow-up, you remarked the refrigerant headwind at, I guess, $0.17 versus $0.15. Can you talk a little bit about where R-22 prices are, and how much residual downside, if any, there is there? And what you think the future looks like in terms of trajectory?

Michael L. Molinini

I'll try that one. Prices have declined pretty dramatically. I think in the last few months, they've been relatively stable at this lower rate. There is plenty of available product right now in the marketplace. The EPA held a hearing last week on -- for industry people in various groups to comment about the future. The general consensus of that -- of those comments were that the marketplace is flush with product and that the EPA should aggressively be reducing the allocation amounts. The EPA listened -- and one of the other big themes at that meeting was -- consistently, from everyone, no matter what their position was, was to the EPA to -- whatever you're going to decide to do, please do it as quickly as possible, because the whole industry, whether you're a manufacturer, a user or distributor, is directionless, and please make your ruling as rapidly as possible. So we're in a 60-day comment period. After that, we will await the EPA's ruling on the future. And then they threw out proposals that ranged anywhere from modest reductions compared to this year to very dramatic reductions compared to what was allocated this year. And we really don't know at this moment what they're going to say.

Operator

We'll go next to Vincent Andrews with Morgan Stanley.

Vincent Andrews - Morgan Stanley, Research Division

Mike, in the past, we've talked about sort of in terms of the next step in SAP that you wanted to get your sort of competency and transaction accuracy together. Where does that stand now? And how far away might we be from sort of moving to the next step of SAP opportunity?

Michael L. Molinini

Well, we are making very good progress. We track metrics that would indicate -- or track error rates and mistake rates and things like that. We've shown consistent improvement. We are, and have been, and in fact, are moving quickly into other areas that -- related to SAP benefits, the -- whether it related to pricing, additional pricing actions, whether it related to the rollout of our new eBusiness platform, which will -- which is going to happen shortly. And we'll use data that is contained in SAP to allow customers to self-serve many more things than they've ever been able to do before. So there's a lot in the hopper, and it's moving quickly.

Vincent Andrews - Morgan Stanley, Research Division

But do you think it were -- presumably, you're not going to give as explicit an outlook on the next set of SAP benefits, but do you think in the next couple of quarters or...

Michael L. Molinini

Yes, let me comment about that, because that's a -- and I don't want to -- I mean, I want to be kind of very transparent on this. In -- up until now, SAP for us has been a project, okay? Put it in and learn how to use it effectively. And for the past month or most of the month of January, I spent with few others traversing the field organization, talking with all of our senior managers. And the discussion was really about that we are at a time now where SAP at Airgas is no longer a project. The project is officially over, okay. Now SAP is a tool that we will use to continue to run our business better. And it's going to be a tool that will help us run our business better in many areas that are not conducive to reporting the progress as if it was a project. And as a result, we probably will not be as transparent on specific pieces as we have been in the past.

Operator

And we'll go next to David Begleiter with Deutsche Bank.

David L. Begleiter - Deutsche Bank AG, Research Division

Mike, looking at your operating margin target for 2016, should the path to that 15% be more back-end weighted to '16 versus '15 or perhaps be more linear?

Robert M. McLaughlin

Well, a lot of that will be driven by the timing and the pace of the recovery. So I would say it'd probably be more back-end weighted between the 2 fiscal years.

David L. Begleiter - Deutsche Bank AG, Research Division

Very good. And just on pricing versus your power fuel and purchased product costs, where do you stand on recapture? Are you lagging, or even, or...

Robert M. McLaughlin

On the passing on the increase in production costs and electricity costs as it relates to our ASUs?

David L. Begleiter - Deutsche Bank AG, Research Division

Yes.

Robert M. McLaughlin

There's typically a lag, but not a long one.

Michael L. Molinini

Right this very minute, that's a longer -- in the normal course, we are attempting to anticipate those course -- costs and get ahead of those costs. However, at any specific time, there could be things that are going on where we have to surcharge, and we could be lagging. And at this very moment, with all of the high -- low temperatures that are out there, it's causing power costs to spike. So in some parts of the country, we are -- in January, we are absorbing additional power costs. We are -- we have or are beginning to implement surcharges to recover those costs, but they will not be directly aligned. There is -- it is not uncommon for your surcharges to run longer than the power cost increases until you recover the full impact.

Operator

We'll go next to Ryan Merkel with William Blair.

Ryan Merkel - William Blair & Company L.L.C., Research Division

I'm hoping you can give us a sense for how January ended up in the context of fourth quarter organic sales guidance in the low single digits. I guess what I'm asking is do we have to assume that February and March pick up quite a bit?

Robert M. McLaughlin

It came in low, and we -- for the low end, it picks up around 2% and in the high end 4%. But seasonally, that's normally what it does. So it will take some to make up the ground for January.

Michael L. Molinini

And January is not over yet, but it's almost over. And this particular -- we have not yet processed the full impact of all of the events across the Gulf Coast and the South this week as to what that's going to translate into. But prior to that, January has been very soft.

Ryan Merkel - William Blair & Company L.L.C., Research Division

And then as my follow-up, is the slowness in January, is that more weighted to the construction weakness due to weather? Or would you say that manufacturing is equally as soft?

Michael L. Molinini

Well, construction for sure, that's part of the problem with the visibility into what exactly is happening because in some cases, manufacturing may be off because places were closed or no deliveries could be made or employees -- their employees couldn't get to work. But trying to gauge that in some of these heavy manufacturing areas, where for several days, not only could you not make delivery, you couldn't even start the trucks. It's -- the visibility is extremely difficult.

Operator

We'll go next to Mike Sison with KeyBanc.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Encouraging that you still can hit your margin targets by 2016. Where are you making up the profit improvement given that sales might be a little bit less than you thought?

Robert M. McLaughlin

Yes. I mean, it's the percentage -- you're talking about the margin percentage, Mike?

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Right.

Peter McCausland

15%.

Robert M. McLaughlin

Yes, the 15%?

Michael L. Molinini

Yes.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Yes, the 15%.

Robert M. McLaughlin

Yes, well, there was a 100 basis points gap between the high and the low. And we still -- there was incredible amount of leverage relative to sales dollars in terms of what we've already accomplished with respect to implementing SAP. So it's generally going to be delivering on the 3 parts of the SAP benefits that we've already put out there, which we haven't delivered on any piece of the administrative savings yet, so that's going to come, as well as we've made reference over the past year to other areas that we're targeting around eBusiness and logistics, et cetera. And also, to the extent that acquisitions pace pick up, we have an incredible amount of synergies relative to our footprint as it relates to adding additional businesses through acquisitions.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Okay, great. And then, either Peter or Mike, when you set your outlook at the beginning of May last year, there was sort of the potential for the base business to give you as high as $0.30 in incremental EPS or sort of down to, let's say, a minus $0.20. Can you maybe help us bridge the gap how much volume you need to -- that represents? And it might give us a better idea of how to maybe time some of that earnings leverage over the next year or so.

Peter McCausland

Well, I don't know about your exact numbers. I'll -- I won't address them. But in general, we expected a volume pickup during last year because we thought the industrial economy was continuing a steady -- slow but steady increase, and we expected nonresidential construction to catch fire a little earlier. What actually happened is the industrial economy, net-net overall, declined, and nonresidential construction, the jobs that were under way wound down, and very few new ones started. So we continued to see weakness even into the last quarter. So there's a tremendous -- I mean, the kinds of numbers that you're citing shows how much leverage we have in our platform. And if we get the same-store sales growth, we're going to have tremendous leverage and much more earnings gains than we've had declines here because we are able to rein in expenses. And we've -- we controlled pretty -- our expenses pretty well during the course of this year, even though we never had a defined expense reduction program under way during the year because we've got so many things going, finishing up on SAP, e-commerce, sales force segmentation projects, building air separation plants. We've had a lot going on. So -- and we felt like growth was coming. And so we didn't maybe pull the belt in as tight as we could have during the year because we didn't want to kill our growth opportunities. And we still think the growth is coming, and our customers are telling us it's coming. But right now, looking at the fourth quarter with almost -- with January almost gone, it's going to be hard. We decided it would be very, very tough to make the prior guidance, and we should lower it to something that's realistic given what's going on. And no one hates to miss the -- to lower the guidance more than I do, and everyone else around this table and in this company is the same way. And it kills us. We -- but look, we've got -- if you look our 3-, 5-, and 7-year CAGR growth rates on earnings per share in some of those periods, including the great recession, they're very, very strong and compare very favorably to our peers', and we always find a way to grow. And so I'm pretty optimistic about the future even though I'm disappointed that we're lowering the guidance for the fourth quarter.

Robert M. McLaughlin

Yes, Mike, this is Bob. I think that, that dovetails to the other question in terms of what do we think we need. So in your numbers, if you think of that $0.50, the number you threw out relative to our prior year's EPS, in a mid-single-digit growth environment that we were expecting, that's generating EPS growth in the low to mid-teens. And so we'll see when we get there and when the pace picks up, but that's the way to think about it.

Operator

We'll go next to Luke Young [ph] with Robert W. Baird.

Unknown Analyst

Mike, maybe if you could talk first about investments in Total Access. Obviously, the step-up in spending there has been one of the areas pressuring the operating leverage in the business this year. Can you maybe just talk about how you feel about staffing levels today and plans for 2015 preliminarily in that business?

Michael L. Molinini

Yes, we are -- that's a program -- actually, that's a development of a sales channel, okay, is really what that is, a new sales channel, one that has been very, very successful for us in other parts of our business. And with any development of a new sales channel, you need to build it before you can load it. And at this point, we are staffed and we are stable for the most part. We have some other things we want to do in some other areas. But for right now, the bulk of the cost build is over, they -- and we are rapidly working on transitioning business and customers and targets to that channel. So we will be in a loading phase here for the next 12 to 24 months.

Unknown Analyst

Okay, great. And then just a follow-up. As it relates to the Red-D-Arc business, heard some seemingly positive comments around the spring turnaround season. You optimistic that it's going to be a good one for that business? Any thoughts there?

Michael L. Molinini

It's -- just as recent as yesterday, we were working with those guys to review the Q4 forecast, which is really through March, which is not really the entire spring turnaround system. But again, they've experienced a very, very weak January but are confident, with the things that they have in the hopper, that they're going to be able to deliver their component of the fourth quarter forecast.

Operator

We'll go next to Mike Harrison with First Analysis.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

I was wondering if you could comment -- give a little bit of color on the hardgoods sales outlook. Obviously, we're at a point now where volumes have stopped going down. That's a positive. But can you talk a little bit about what you're seeing in terms of sales trends of automation equipment and some of the bigger-ticket items that would suggest people are starting to add capital and invest for future production growth?

Michael L. Molinini

Well, just speaking strictly around what I would call large, complex solutions, whether it be automated welding or cutting or whatever, interest level is high, and we're winning our -- at least our fair share of those systems. And I would have to say the outlook for that is good, very good. Overall, hardgoods may not -- is not quite as exciting.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Got it. And then in terms of helium, it's been a little while since we've talked about it, and I understand the pricing is up even though the volumes are down. But are you expecting availability to improve with the new plant in Qatar coming onstream? And could helium be a tailwind as we look out to fiscal '15?

Michael L. Molinini

Availability, we have -- we get it from multiple sources, okay? And 2 primarily. And one of our sources in this quarter is expected to -- actually, besides being -- allowing us to get back to 100% of historical demand, is actually making available some product in excess of historical demand. So on one side of it, we're starting to get quite a bit more product. On the other hand, our other supplier continues to struggle and is at well below a 50% allocation and, from what I hear, is likely to remain at that level for the foreseeable future. So on balance, we're getting more product, but it's still going to be some constraints here for the foreseeable future.

Operator

And we'll go next to Don Carson with Susquehanna Financial.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Yes, 2 questions. I want to go back to the telesales. The -- one of the big SAP benefits was supposed to be how it helps you expand your telesales effort. So I'm wondering why these expansions that you're doing there are considered an offset to the SAP benefit. Was this expansion in Total Access not envisioned as part of the whole program?

Robert M. McLaughlin

Now Don, it's Bob. Let me take that. Now what we pointed out is the -- you got growth in sales and gross margins that are being delivered by the Total Access program. And then you have the operating expenses associated with the employees and the distribution of those goods are down in SG&A expenses. So it's not reducing our operating margins, it's actually been a positive contributor to our operating and our growth. We merely pointed out that one of the drivers of expenses was the fact that we had to invest in people to drive the Total Access program. So net-net, it's a positive contributor. It's just geographically, it's in our expense line as well as in our sales and gross margin line. And so what we called out was trying to explain why expenses -- its contribution to the increase in expenses, and -- but that's not in isolation. It also contributed very positively to sales and gross margins.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Okay. And then the second question is just on your growth in gases and rent. One of your competitors talked about high single-digit growth in gases and rent, and most of that coming from the U.S. Is -- are you penalized by not having as much energy exposure or more non-res exposure than your peer?

Michael L. Molinini

I have no visibility into this -- really the segments that they participate in. I think last year in Q4, the data was kind of opposite of what just came out. So I don't know.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Okay. And then finally, Mike, you mentioned that the acquisition activity is going a little slower than expected or at least between now and your 2016 top line target. Can you talk about the balance of the year? You're halfway to your $150 million annual goal. What's the acquisition pipeline look like?

Peter McCausland

Don, this is Peter. We have a bunch of small deals that we hope to close by the end of the year. The chances of getting to $150 million are probably 30% maybe. It doesn't look like we'll get there. But we'll add several before the end of the year. Activity has kind of increased in the last few months, so we're talking to a bunch of people. And acquisitions are acquisitions. They come when they come. And I think the slowdown in the industrial economy this year kind of put a damper on what was beginning to accelerate. And -- but in the last few months, we've seen a pickup. So we're optimistic that it's going to get back on track and it will be a contributor going forward. But I can't tell you what the timing might be.

Operator

We'll go next to Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies LLC, Research Division

I guess a question about if we do end up with a choppy environment for several more quarters, is there room for belt tightening that would not imply a trade-off with operating leverage or future sales growth?

Robert M. McLaughlin

There's always room for that. And we have been tightly controlling some controllable expenses and following them and there's opportunities there. There's always things we can do. The question is going to be how much do we do, how deep do we do -- do we cut and what are the longer-term implications. And at this point, until this picture gets a little clearer, we're tightening the things that will not harm us longer term. That can always change as the picture clears or the fog lifts. But I want to be very careful that we don't overreact to something short term that hurts us in the longer term.

Laurence Alexander - Jefferies LLC, Research Division

And then there was a comment about the customers giving feedback that the growth is coming. But can you give a little bit more color as to who or which types of customers are most optimistic or feel they have the most visibility and who is running -- who has the thickest fog, so to speak?

Peter McCausland

Well, in the construction -- this is Peter, Laurence. In the construction area, we have a very, very favorable outlook. There are a lot of big jobs, particularly in power and petrochemical and energy infrastructure, that we're told are going to begin momentarily. They've been permitted, and they're ready to go. So we have a pretty good outlook on that. We have a lot of the top construction companies we'd count as our customers. And then in the metal fab business, we have a mixed bag. If you're making tanks or railcars, the outlook's pretty good. If you're making mining equipment, continues to decline. Defense continues to decline. So net-net, metal fab is kind of not doing much because the bright spots are offset by weak spots. In the noncyclical areas like universities, research, medical, health care, food and beverage, we're starting to see signs of health, very slow but steady improvement in those areas. And that's a good thing, and I think that's connected to the restoration of grants and healthier government spending and things like that. It's not to say that every single one of those sectors is perfect because, like in health care, whereas hospitals are pretty good and nursing homes are pretty good, home care is -- has been tougher for us because of the reimbursement pressure on our customers. So -- but overall, I would say those noncyclical areas are growing pretty well. Then energy, of course, is really pretty strong and was strong all year in oil and gas, frac-ing and energy infrastructure. However, we have a huge exposure to the coal business in Virginia and Eastern Kentucky, and that's not doing very well, so that's been somewhat of an offset. So in general, I think the surveys we've done with our -- in each of our customer segments indicate that calendar 2014 is going to be a year of rising industrial production and pretty significant growth in nonresidential construction. That's the feedback we've gotten.

Laurence Alexander - Jefferies LLC, Research Division

And then just lastly on the telesales, so if you roll it out a couple of years, say, 2, 3 years, do you think the program -- I mean, now that you've been investing in it for a while, do you think the program's going to be viewed as a margin expansion lever or a noticeable change to your top line growth relative to industrial production?

Michael L. Molinini

Well, it's definitely going to be a top line growth engine. And seeing as how the channel is way more cost effective than some of the other sales channels we have, I think the combination of the telesales channel and the eBusiness investments we are going to make are going to have significant margin expansion capabilities, either through reduction of costs or through the clearing of additional capacity in the infrastructure we have built that we will be able to service without additional expense.

Operator

We'll go next to Robert Koort with Goldman Sachs.

Robert A. Koort - Goldman Sachs Group Inc., Research Division

Mike, can you help me out on the R-22 issue? I guess I foresee that you guys would buy it and then resell it and make a markup. So is the big earnings hit because you're not selling another product that's far more profitable? Or are there inventory hits? Or what causes the level of earnings pain from that?

Michael L. Molinini

Well, when R-22 -- it's a supply and demand -- look, it's partially a supply and demand issue that as -- with lots of additional supply, pricing comes down. When supply is limited, pricing goes up. And one of the keys to supply when supply is tight is the -- is driving of the reclamation, recovery and re-purification of used refrigerant into a form that can be either sold as new or blended with some virgin product to sell as new. To the more reclaimed -- and in that case, you pay somebody to buy back their old refrigerant. You clean it up, and then you mix it with new product and you sell it again. The -- to the extent that availability is tight, that drives additional reclamation and recycling. To the extent that more and more of the product in the market goes through reclamation and recycling, people like us improve our margins because we have a cost base that is not just buying it all-new product from some manufacturer and packaging it and selling it, but we're blending it with product that has a net lower cost than what it costs to buy the new product. So it's -- as the availability of product tightens, which it's going to do, there's no question it's going to do that, tightness of product gets more people interested in reclamation because the only way they get more product is by participating in reclamation programs, improves our margin. Now to our case, we have the filling, we have the packaging, we have all the investment for reclamation. We have all the pieces necessary to play out this model for many, many years to come, and it's really now a matter of when will the supply and demand lines cross.

Robert A. Koort - Goldman Sachs Group Inc., Research Division

Okay. And then the comments about telesales, upping your efforts there, is that primarily a headcount cost? Or what else are you doing around that?

Michael L. Molinini

No, it's a headcount issue primarily.

Robert A. Koort - Goldman Sachs Group Inc., Research Division

Okay, okay.

Robert M. McLaughlin

It's not an issue. It's just a component [indiscernible]...

Michael L. Molinini

Yes, it's not an issue. To build out the sales channel, the 90, I don't know, very high percentage of the expense is a person that has to be hired, trained and then deployed before you can generate the sales that, that channel can generate.

Robert M. McLaughlin

But even in this early part of the game, they're generating enough profit to cover the costs, and it's been a net positive [indiscernible].

Michael L. Molinini

Oh, yes, yes, absolutely. Yes, if you just look at OpEx, though, it is an increase to our -- if you just look at the one line called OpEx, it's an increase.

Robert M. McLaughlin

Right.

Michael L. Molinini

But net-net, it's doing wonderful.

Operator

We'll go next to Mark Gulley with BGC Financial.

Mark R. Gulley - BGC Partners, Inc., Research Division

Two questions, if I may. Mike, you took a moment to praise the associate base for their efforts on SAP. I'm wondering if the back story there was all the effort that they've put into SAP might have been a contributor to weakness in volume growth. Is that maybe how we should read between the lines? Or am I reading too much into that?

Michael L. Molinini

No, I mean, to -- look, I'll give you another stat. Here it comes, okay? To think that we did this and that there was no distraction, you'd be lying to yourself, okay? I was asking the other day how many hours of training did we provide to our associates over the last 2 years when we were doing this conversion. And this would be training that was primarily done in a classroom, done in -- sitting in front of a computer terminal. And it's 1,025,000 hours of training that we provided. Now during those 1,025,000 hours, okay, so who was taking care of the customers? So, I mean, we're talking about people covering for each other and backfilling. And, I mean, it's a mammoth, mammoth, absolutely mammoth project. And to think there was no distraction is not realistic. Now to be able to say, well, it accounted for x or y, I don't know what that is.

Mark R. Gulley - BGC Partners, Inc., Research Division

Well, I'll take that as a positive because it sounds like it was a distraction, and the absence of that distraction, it seems to me, would be an incremental positive going forward.

Michael L. Molinini

Well, I mean, I said earlier I've spent the last month in the field talking with people, and I would have to say that although it's maybe not completely gone as a distraction, the energy level that is now being used to grow our business and all that is amazing, it's exciting.

Mark R. Gulley - BGC Partners, Inc., Research Division

Yes. Switching gears to financial side, I guess the share count, guys, is down about 5% year-over-year. Peter, you've expressed a little bit of frustration with respect to the ability to hit the goals on acquisitions. So could an updated -- an increased pace of share repurchases fill the breach at least for a while?

Peter McCausland

Well, it's something, as I've said before, we -- the board looks at, at least a -- at every meeting actually and will continue to look at it. Our strong -- very, very strong cash flow from operations would support that. And what we try to do is balance things, and we do have some very interesting acquisition opportunities that we're looking at. I hesitate to get all -- everyone all jacked up about them because they don't always work out. We don't always win or we decide it's not the right thing for us. But were those opportunities to come to fruition, that could -- that would have to be taken into the mix, that we would consider on the share repurchases. But we're committed to growing our dividend, along with our earnings, and buying back shares at appropriate times. And that basically means when we have very strong cash flow and we don't need the monies for capital expenditures or acquisitions.

Operator

We'll go next to Edward Yang with Oppenheimer.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

A question for Peter or Mike, I guess, on acquisitions. What's your current thinking on international acquisitions? I seem to recall many years ago you had some assets in Thailand and India and so on. And given the currency situation in those countries, you're seeing some double-digit currency declines over last year, levels we haven't seen in the last 5 years or so. Does that create any opportunities for you? And then I guess balancing against that, are there very different markets versus North America in terms of being much more consolidated and integrated? Do you have those opportunities in those markets?

Peter McCausland

Well, on the one hand, they are more consolidated. They tend to be. But that's good, too, because prices tend to be higher. We continue to look. We -- most of our opportunities are domestic, and that's really our priority. But we're looking at a couple now overseas, and we'll continue to do that. And I would agree with you, weak currencies could create opportunities. But in terms of running those businesses, we ran businesses successfully in Poland and India, Thailand. We were just a passive investor in an ASU in Indonesia. And this business is pretty much the same all around the world, and so we're not afraid of that. Our Red-D-Arc rental -- welder rental company is the largest in the world, and it has expanded throughout Western Europe and the Middle East. It's in Mexico. Of course, it started in Canada. And it's done very nicely in foreign markets because it's just a great company. So we have that presence. We'll continue to look. I can't put a percentage on whether we'll do one or not, though.

Operator

And we'll take our final question from Sibanji Titnus [ph] with Global Hunter Securities.

Unknown Analyst

Just a couple of questions. Can you quantify the acquired sales in quarter 3?

Michael L. Molinini

What were acquired sales for quarter 3?

Peter McCausland

Acquired sales in quarter 3.

Unknown Analyst

Right.

Robert M. McLaughlin

Yes, acquired sales during the quarter?

Michael L. Molinini

During the quarter? Yes, about $60 million.

Unknown Analyst

[indiscernible]

Michael L. Molinini

$60 million. $60 million.

Unknown Analyst

Okay. Okay, and...

Michael L. Molinini

That's the annual acquired revenues.

Unknown Analyst

Okay, yes, that's what I was wondering. So okay, I can just do the math. Okay. And do you expect like any of the annual -- sorry, unusual items like the other debt extinguishment charges during the first quarter of 2014?

Peter McCausland

Any unusual?

Michael L. Molinini

No.

Unknown Analyst

No? Okay. And just as a last quick question. In case the EPA does not cut the allocation amount of the required expectations or maybe just modestly, what would be your quick strategic initiative? Or it's just modest allocations?

Michael L. Molinini

We'll figure that out when we see what they say. I mean, eventually, it's going to be 0. We know that. It's just that we need to see what that is and then we'll adjust accordingly.

Operator

And at this time, I'd like to turn the conference back over to Mr. Barry Strzelec for any additional or closing remarks.

J. Barrett Strzelec

Thanks, Dana. Again, we thank you all for joining us today. And Joe and I are available for follow-up questions. Thank you.

Operator

Again, that does conclude today's presentation. We thank you for your participation.

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