Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Praxair Inc. (NYSE:PX)

Q1 2010 Earnings Call

April 28, 2010 11:00 am ET

Executives

Jim Sawyer - EVP and CFO

Liz Hirsch - Director, IR

Analysts

Mark Gulley - Soleil Securities

John McNulty - Credit Suisse

Sergey Vasnetsov - Barclays Capital

PJ Juvekar - Citigroup

David Begleiter - Deutsche Bank

David Manthey - Robert W. Baird

Michael Harrison - First Analysis

Bob Koort - Goldman Sachs

Laurence Alexander - Jefferies

Mike Sison - KeyBanc

Edward Yang - Oppenheimer

Kevin McCarthy - Bank of America/Merrill Lynch

Don Carson - UBS

Jeff Zekauskas - JPMorgan

John Roberts - Buckingham Research

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter Praxair incorporated earnings conference call. My name is Jerry and I'll be your coordinator today. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

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

Jim Sawyer

Good morning and thank you for attending our first quarter webcast. Liz Hirsch, Director of Investor Relations and Matt White, Vice President and Controller are with me this morning. Liz will review our first quarter results. Afterwards, I'll discuss the current business environment, our outlook for the balance of 2010 and our earnings guidance. We'll then be available to answer questions. Liz?

Liz Hirsch

Thank you, Jim, and good morning. Today's presentation materials are available on our website at www.praxair.com in the Investors section. Please read the forward-looking statement disclosure on page two and note that it applies to all statements made during this teleconference.

Please turn to slide three in our presentation for a summary of our first quarter results. Please note that these results and the year-over-year earnings comparisons have been adjusted to exclude the impact of the Venezuelan currency devaluation, which was announced in January. This resulted in a one-time pre-tax charge to our earnings this quarter of $27 million, $26 million after-tax, and $0.08 of earnings per share.

As you will recall, the earnings guidance we gave you in January for the first quarter and for the full year of 2010 excluded this charge. A reconciliation of these results to our GAAP reported numbers appears in the appendices to this presentation and the press release.

Praxair's results in the first quarter reflect improving global business fundamentals, though the strength of the improvement we have seen varied considerably by geography. Volumes have picked up sequentially in all our regions led by Asia and South America. The modest overall sequential volume growth we reported was muted because March was kind of an inflection point following demand levels in January and February that were pretty much on a par with December. So this should position us well for incremental growth in the second quarter, given that the March trends are holding or slightly improving in April.

Sales in the quarter were $2.4 billion, 14% above the prior year. Higher volumes contributed 6% growth and foreign currency appreciation contributed 7%. Volume growth came primarily from higher sales to chemicals, metals and electronics customers whose production levels were very low a year ago as these three industries were working through significant inventory destocking. New plant startups in Asia also contributed to volume growth.

Operating profit was $506 million in the quarter, up 14% from the prior year in line with our sales growth and the operating margin was 20.8%, also in line with the prior-year quarter. Higher volumes of base business atmospheric gases contributed a high incremental margin in the 30% to 40% range. However, this is masked primarily because last year we were collecting take-or-pay revenue from a number of large onsite customers. The first quarter of 2009 was our volume trough and therefore, the quarter, when take-or-pay revenue was the highest.

Secondly, to-date, electronics has shown the fastest and strongest volume recovery and electronics process gases have lower margins than atmospherics. Higher cost pass-through also had a modest negative effect on the margin percentage.

So we do expect that the incremental margin contribution from the recovery of our base business volumes will be more evident as we go forward.

Net income was $340 million and 14% of sales. Net income grew 17% from 2009, a higher increase than the increase in operating profit due to lower interest expense. Interest expense this quarter was lower than we had forecasted due to strong cash flow generation in several of our countries with higher interest rate debt. We expected to trend upwards over the next few quarters and be in a range of $140 million to $150 million for the year.

Earnings per share were $1.09, 17% above prior year. We generated $483 million of operating cash flow this quarter, primarily from net income and depreciation. This cash flow is 20% of sales due to the fixed cost reductions we implemented last year and our ongoing tight control of working capital.

This cash flow funded $288 million of capital expenditures in the quarter, related primarily to construction spending on the large on-site projects in our backlog. Our free cash flow after CapEx of $195 million funded a $138 million of dividends and $68 million of stock repurchases, net of issuances.

The reason our total debt increased from year-end was because in January we took advantage of very attractive rates in the bond market and issued $500 million of three-year notes at a coupon of 2.125%. These proceeds will be used to pay off a note issue that matures in May. At the end of the quarter, this cash was sitting on our balance sheet because we have paid down essentially all our commercial paper and US short-term bank borrowings with the proceeds of the over $2 billion of note issues we executed over the past 12 months, locking in very attractive low cost financing.

Our after-tax return on capital this quarter was 13.6%. This number was impacted by the cash, which is temporarily on our balance sheet held for debt repayment, and also the significant amount of capital tied up on our balance sheet in construction in-progress. This capital doesn't generate revenue until projects are completed and start supplying products. The impact of construction in-progress on our reported return on capital is over two percentage points. However, these projects are high return projects, which will generate meaningful future sales and earnings growth.

Please turn to page four for our results in North America. Sales in North America were $1.24 billion, 6% above prior year. Higher volumes contributed 4% growth and currency appreciation in Canada and Mexico 3%, offset slightly by 1% lower price mix. The strongest volume growth came from chemicals, steel and electronics customers.

Sales to the energy market ex-natural gas were lower due to continued weak oil well service activity. Last year's first quarter was the peak for our fracing volumes in Canada, so the year-over-year comparison is difficult. Oil well services revenues in Mexico are below 2009 levels due to lower spending by PEMEX, but we expect these volumes to increase over the balance of the year.

On-site volumes were 13% above the 2009 first quarter and grew 2% from the fourth quarter sequentially, driven primarily by higher pipeline oxygen and nitrogen volumes. Our oxygen pipeline volumes have rebounded significantly from the low point, but are still about 15% below 2008 levels. Demand for hydrogen from refiners has been steady and volumes are above last year.

Merchant liquid volumes were 2% above prior year. Excluding our fracing business, volume growth was 6%. Liquid oxygen and argon volumes increased year-over-year and sequentially due to higher demand from steel producers. We began to see a modest pickup in demand in March in the US and Canada. Liquid hydrogen and helium volumes were higher to electronics and solar customers. Liquid volumes in Mexico showed strong sequential growth of 5% from the fourth quarter. Total liquid volumes in North America were 5% higher sequentially.

Packaged gases in the US and Canada continued to be slow to recover. This is attributable to the fact that within the manufacturing sector, non-residential construction, infrastructure spending, equipment and welding activity are still weak. Higher auto production and appliance manufacturing should provide lift going forward.

Total North American packaged gases sales were 1% below prior year. In Mexico, packaged volumes were higher due to improving domestic manufacturing demand. In PDI, our business in the US and Canada, sales ex-currency were down 4% versus the prior year quarter. Sequentially, we have started to see some volume pickup, but it is stronger in hard goods and gases, which is typical in the very early stages of an economic recovery.

Operating profit in North America increased 8% to $277 million and the operating margin increased to 22.4%. The margin improvement is due to higher volumes and the substantial cost reduction actions in 2009, but is mitigated by the large customer take-or-pays we were receiving a year ago. New business activity is picking up and is increasingly broad-based in food, chemicals, metals, manufacturing, refining and environmental applications, so we expect a stronger second quarter in North America.

Please turn to slide five for our results in Europe. Sales in Europe were $338 million, up 12% from prior year. Higher volumes contributed 7% growth and currency 5%. Volume growth came primarily from higher on-site oxygen and nitrogen sales in Spain and Germany to steel and chemical customers. Liquid volumes are also up about 10% year-over-year. Liquid volumes are recovering across the region and volumes are higher than last year in Germany, Spain, and Italy versus a very weak quarter last year.

Auto production is increasing and exports are stronger in Germany. New business activity and contract signings are positive and above 2009 levels. Both on-site and merchant volumes grew sequentially from the fourth quarter. Packaged gases sales recovery is lagging on-site and merchant. Construction activity remains weak, especially in Spain.

Operating profit was $67 million, up 6% from the prior year. We expect to see continued recovery in Europe, but expect it to be slow. The strong volume increases this quarter reflect increased production by large customers who are making global commodities and exporting to the world market. After some restocking, sequential demand growth could slow in the second half. Merchant liquid and packaged gas volumes are more reliant on local consumption and an increase in manufacturing and construction activity and our expectation is that these will be slower to pull out of the downturn.

Please look at slide six for our South America results. Sales in South America were $458 million compared to $353 million in the prior-year quarter, an increase of 30%. Currency appreciation, primarily the Brazilian real, increased sales by 21%. Underlying sales grew 12% and 3% sequentially from higher volumes and higher price. Industrial production in Brazil has rebounded strongly from negative 15% in last year's first quarter to positive 12% in this year's first quarter.

Steel production in February was almost 50% above February 2009, but still 25% below peak production in 2008. Our on-site volumes are up strongly on a year-over-year basis and have continued to improve sequentially driven by oxygen demand.

Low interest rates in Brazil by historical standards and credit availability has provided economic stimulus and supported domestic consumer demand. Merchant volumes are higher versus prior year and last quarter. As in our other regions, packaged gases are recovering more slowly along with general manufacturing, but volumes are up 5% sequentially. Overall sales to manufacturing are up 10% from the fourth quarter.

We expect strong growth in South America to continue in the base business from new applications and new project startups. We have seven projects scheduled to start up over the balance of this year and we are looking at numerous new project opportunities. Our healthcare business in Brazil also continues to grow steadily.

Operating profit increased to $109 million from $75 million in the prior year and operating margin was 23.8%. The operating leverage came from strong incremental margins on higher volumes, higher pricing, productivity gains and cost reduction in 2009.

Page seven shows our results in Asia. Asia had a very strong quarter with sales of $258 million, up 43% from 2009, due primarily to 31% volume growth. This growth came from significant growth in on-site and liquid volumes in China, India and Korea due to broad-based demand across most end-markets.

Oxygen volumes are growing in China due to strong steel demand fuelled by auto production and infrastructure spending on roads, tunnels and rails. In March, China produced 1.7 million automobiles, more than US production.

Higher cost pass-through and currency appreciation added 14% to sales growth and price mix was down 2%. Electronic sales have completely recovered from last year's low point, up 88% excluding FX. The mix effect of such strong electronic sales is the primary reason that overall price is negative 2% and that our operating margin percentage declined.

Merchant pricing in atmospheric gases is stable and beginning to firm due to strong demand and tighter capacity. Merchant sales in China were at record levels in March from strong demand from glass, chemicals, electronics, and met fab customers.

In India, strong growth in merchant sales was driven by steel, pharma and auto. Carbon dioxide sales in Thailand for food freezing were also strong. In Korea, on-site and merchant volumes are sharply higher due to demand from electronics, as well as general industry.

This quarter we started up two plants in China. New business activity is robust in both China and India. There are many new large project opportunities. We are sticking to our strategy of selectively pursuing sale of gas, not sale of plant opportunities, where we can get good returns and can grow the merchant liquid business locally.

We have a strong project pipeline in Asia. Several projects in China will start up this year, but the larger projects we are working on, such as our second 3,000 ton oxygen plant to supply coal gasification and our large hydrogen plant for Indian Oil company start-up in 2011 and 2012. So, we are confident that our strong growth in Asia will continue.

Page eight shows Surface Technologies results. PST sales this quarter were $136 million compared to $123 million in 2009's first quarter. Sales increased 7% ex-currency effects due to the $20 million in sales from Sermatech, which we acquired last July. Overall, coating volumes, ex-Sermatech, were lower than the prior year.

Industrial gas turbine coatings are down due to weak IGT build by the major manufacturers resulting from the economic downturn and the credit crisis, but we are forecasting a pick up in these volumes in the second half of 2010 inline with the manufacturers increased forecast for new builds.

EBPVD jet engine coatings, which are used in the new GE GEnx engines and will power the 787 and 747-8 planes were strong and above prior year, but more conventional aerospace coatings declined. We are expecting EBPVD volumes to pick up in the second half as more planes are delivered and as spares for rebuild engines pick up, along with growth in passenger miles flown.

Operating profit of $19 million compares to $22 million in the prior year. The margin decline is due to lower volumes and Sermatech acquisition integration expenses, which has offset the profit contribution from Sermatech in the last two quarters. Our integration plan will be completed on schedule next quarter.

We will have closed five of 11 manufacturing sites, reduced headcount by a 150 people, and consolidated admin and back-office processes. The PST's operating margin should improve to the high teens range by the end of the year.

Now, I'm going to turn this over to Jim, who will give you more detail on our end market trends and discuss our earnings guidance.

Jim Sawyer

Thanks, Liz. Please look at page nine. We showed you this slide last quarter shows that sales trends we've seen from peak to trough in four of our key end markets. (Inaudible) sales for the third quarter of 2008, which was pretty close to the peak in these markets. We updated it this quarter to illustrate the sequential improvement we've seen from the fourth quarter of 2009 to the end of March. This also gives you a visual of where we are now relative to third quarter of 2008.

What you can see is that electronics was the most cyclical end market in the downturn. It felt the furthest, recovered the fastest and sales volumes are now above previous peak levels. Chemicals and metals continued to recover and showed positive sequential growth this quarter. Our global sales to both markets are still modestly below the 2008 third quarter. We expect continued growth in these markets and we are forecasting a slower sequential growth rate in the second half of the year as we believe that inventory restocking has been a part of the increased demand we are seeing today.

Manufacturing has been slow to recover. As Liz mentioned in the regional discussions, we began to see sub-sequential pick up in March and you can see that on this graph. However, we are still about 13% below the peak and so this end market represents a great source of upside to earnings as volumes continue to recover.

Page 10 gives you some more detail on our end market sales trends, both year-over-year and sequentially.

Let me make a few comments here on the energy market. This quarter our sales to energy market are a little lower, but this is not a long-term trend. We see this market as a solid source of revenue growth for us in the future. Largest piece of our energy sales is hydrogen sold to refiners. Hydrogen demand remained very steady through the downturn and our volumes in the quarter were above prior year.

We expect continued growth from new project opportunities to supply refiners outside of North America for expanding refining capacity and outsourcing some hydrogen supply. As an example, in November we announced a large contract for hydrogen and nitrogen supply to Indian Oil's new refinery being built on the East Coast of India.

New projects will be the principal driver of future hydrogen revenues, there is two large projects in our backlog in North America, the first of which is expected to start up in the back half of 2010 and the Indian Oil project is scheduled for 2012.

We'll be selective about the projects we've been on and disciplined about returns and we're interested only in built, own and operate, not large plant sales, but there are significant opportunities around the world and geographies where we have a very strong presence.

Our liquid nitrogen and carbon dioxide volumes for oil and gas for fracing in North America are well below prior year, as Liz mentioned and any significant will depend on the outlook for higher natural gas prices and drilling activity. Volumes declined over the course of 2009, and so after this quarter will not be as much of a negative comparison in our merchant volume. In addition, these lower volumes have had a negative mix effect on our North American merchant pricing.

In February, we announced a contract with Exxon Mobil to build the new plant to supply nitrogen for enhanced oil recovery in Hawkins, Texas. We're optimistic that over the long term, we will see more EOR project opportunities around the world as energy demand increases and producers look to increase production from existing reserves.

This month, we announced that we will be supplying CO2 under contract for enhanced oil recovery pilot project in Abu Dhabi with Abu Dhabi Future Energy Company or MASDAR. The Middle East has an abundance of energy-related projects going on but to-date has not been a region where Praxair has participated as many of the opportunities have just been equipment sales.

We've had business development people on the ground in Abu Dhabi for a while looking to see if there's an opportunity to develop an integrated industrial gas business in the region. Another energy opportunity is nitrogen dilution for LNG. We've recently announced a project with Chevron and Total to supply nitrogen at the Sabine Pass receiving terminal in Louisiana. This is not a large investment, but these projects are all examples of opportunities for industrial gasses in energy sector and why we feel bullish about this market over the long term.

Now, please turn to page 11 for earnings guidance. In the second quarter of 2010, our earnings guidance is for earnings per share in the range $1.10 to $1.15. This represents sequential improvement from the first quarter based on the trends we're seeing. We're raising our EPS guidance for the full year of 2010 to a range of $4.50 to $4.65, excluding the $0.08 negative impact in the first quarter resulting for the Venezuela currency's devaluation.

This represents year-over-year earnings growth of 13% to 17% and is well above Praxair's peak earnings in 2008 of $4.20. Our earnings guidance including the Venezuela charge is $4.42 to $4.57.

We expect full year sales to be in the area of $10 billion. The effective tax rate is expected to remain at 28%, and we still expect CapEx for the year to be about $1.4 billion.

Large project activity around the world is picking up from what we were seeing in 2009. The bulk of these projects are in South America and Mexico, India and China, where we have a very strong presence, a history of successful project execution, and integrated businesses, which allow us to get good returns on the capital we invest.

Our large project backlog at the end of the first quarter included 38 projects. This quarter, we started up six plants with a capital value of about $140 million. We added four new projects with a capital value of about $170 million. So the size of our backlog is holding up and start-up dates are now extending out into early (2013).

If you look at the chart on page 12, you could see how fast we're growing in Asia. Of 13% growth over six quarters, 8% was from project startups and 5% was organic growth from peak to trough.

Emerging markets represent about 34% of our global sales, which is at higher percentage than our competitors. I also believe we're winning more new business in China, India, South America and Mexico. This is a result of our reputation and demonstrated ability to execute in emerging economies. Additionally, our standard plant designs a key factor and our ability to win business at high returns due to a lower capital investment, better energy efficiency and greater reliability.

In addition, our base business in North and South America and Europe has a significant way to go to get back to pre-crisis operating levels. As you see them down 7% to 10% realize that we also had 3% to 5% contribution from new project startups, so the dip in the base business is actually lower than it appears and you will find more upside as the economy recovers.

In closing, I believe the outlook is clearly improving. Emerging markets are experiencing significant expansion which is being led by an internal demand and consumption while the mature markets are recovering from depths of 2009. And now I'll be happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of Mark Gulley with Soleil Securities. Please proceed.

Mark Gulley - Soleil Securities

First of all, excited about refinery hydrogen projects, but, Jim, would you be able to give us any kind of an update with respect to Chevron at Richmond?

Jim Sawyer

The Chevron Richmond story continues to unfold and drag on. They recently had a court decision which requires them to rewrite and resubmit the environmental impact report. And so, that's just going to be another delay as we see it in the project.

Mark Gulley - Soleil Securities

Secondly kind of a housekeeping question, can you give us the positive impact on PDI from currency, both the (inaudible) and I assume as well as the peso?

Jim Sawyer

I think it's about 3%.

Mark Gulley - Soleil Securities

And then finally on more of a secular long-term basis. I guess I'm a little surprised that there hasn't been more gaseous nitrogen plants built for EOR, either here in the US or Mexico or Middle East, any reasons why the industry hasn't taken advantage of that in terms of high oil prices and maybe what the outlook is for that particular application?

Jim Sawyer

I think that's a good question. I'm surprised that it hasn't picked up faster than that oil well, but I do believe that over time there will continue to be more EOR projects.

Operator

And your next question comes from the line of John McNulty with Credit Suisse. Please proceed

John McNulty - Credit Suisse

Just two quick questions. One tied actually a little bit to the last one, but with such a big push into kind of the shale gas plays and things like that. Why was your oil well services business weak in the quarter, because I would think it would be actually seeing pretty decent sequential growth?

Jim Sawyer

Well, what's actually happening is that the big push in the deeper shales, which is where everybody seeing activities around are so deep that you really can't use gases (in a strong) recovery, so they are using water for fracing and consequently we're really not going to participate in that market because the wells are so deep that you will have to inject so much nitrogen or CO2 down there that it just wouldn't be practical. And I think one of the reasons that they are down a little bit is because there is more activity going over to those shale reserves.

John McNulty - Credit Suisse

And then just with regard to Brazil, it sounds like you've got a lot of start-ups coming up over the next couple of quarters. Any impact on the margins there, or is it just a big enough business right now where even bringing up six or seven new plants isn't going to really move the needle in terms of start-up costs?

Jim Sawyer

Well basically, the start-ups are going to be on-site plants, okay. And on-site plants have a lower asset turnover, but a higher margin than the average of the business when you include merchant and packaged. So the start-ups once they get ramped up to expected capacity will increase the operating margin here.

Operator

And your next question comes from the line of Sergey Vasnetsov with Barclays Capital. Please proceed.

Sergey Vasnetsov - Barclays Capital

In China, there seemed to be mad rush of coal related projects, coal to methanol, coal to olefins, basically coal for anything. How significant is this opportunity for the on-site produce business that you would like to participate in?

Jim Sawyer

We're looking at quite a few of those projects, and they basically all require large volumes of oxygen, and we're negotiating a couple. As you know, we're building two right now. We are in the process of negotiating a handful more and I think ultimately that'll probably be the biggest end market for industrial gases in China.

Sergey Vasnetsov - Barclays Capital

And so, on slide four, you commented that your packaged gas sales (inaudible) down 4% in the US and Canada, what has been your historical expectation, by how much this business will lag the pace of the general economic recovery?

Jim Sawyer

Well, I think basically the packaged gas business is really about 50% metal fabrication and welding, so some part of that business is just steady day-in and day-out, maintenance and repair work, things that have to be done. Other parts of the business are tied to the physical capital investment cycle, such as non-residential construction, equipment and machinery, things like wheel cars and so forth. And I think that part will recover when the rest of the manufacturing and the process economies gets back to full capacity utilization. So I think there is going to a longer ramp up in packaged gases.

Operator

And your next question comes from the line of PJ Juvekar with Citigroup. Please proceed.

PJ Juvekar - Citigroup

I think based on what Liz said, you're seeing good incremental margins, but it's not apparent in the numbers yet. So is it fair to say that your margins will improve with the lag of couple of quarters, and would you say that maybe your second half margins would be better than first half?

Jim Sawyer

They should be, and basically when you look at our underlying business, where volume is coming back. We are getting 30% to 40% margin on that. But a couple of mitigating factors particularly in this quarter, which should basically not be important going more. But part of those is that a year ago, we had a number of on site contracts where we were operating take or pay, and so we were receiving the payment, but we weren't producing the volume and so as that volume went up, we're not making any more money for that. So that's a damper on margin expansion.

At this point in time, we've moved through the threshold level of almost every take or pay contract, so we should get more leverage going forward.

PJ Juvekar - Citigroup

Okay.

Jim Sawyer

On top of that, we've got some higher expense from pension expense and incentive comp and so forth, which are just some inflation is up year-over-year. And then lastly, the areas where we had the greatest sales growth like in electronics are the areas we have the lowest margin. So we have some kind of negative mix effect under whole thing. And then lastly, the areas where we're going to get the biggest operating margin leverage are going to be in liquid volume and packaged gas volume, and those are the areas that still haven't recovered as much.

PJ Juvekar - Citigroup

Jim, I have a second question about margins and returns. Several times in the past, you've talked about hydrogen business having lower margins than LOX and LIN. So can you compare capital investment for a hydrogen plant versus an ASU and compare return on capital on similarly sized projects?

Jim Sawyer

Yeah. The common denominator is the cash flow internal rate of return on capital investment, okay? Atmospheric plants, you don't have to pay for anything except the electricity. You don't have to pay for your raw material. So, atmospheric plants tend to have low asset turnover and not a lot of sales for the capital investment, but very high margins.

In hydrogen, you have to buy natural gas and pass that on to the customer. So depending on the way the contract is structured, if we're buying the gas and selling it to the customer, then we're going to have a lot more sales growth for the capital investment. But it's going to be at a cosmetically lower margin.

PJ Juvekar - Citigroup

Correct.

Jim Sawyer

Now going back to the (inaudible), the internal rate of return, they should be about the same except for the fact that atmospheric gases has more opportunity for a co product economics and more opportunity for vertical integration between the on site to both in the packaged business. And so, as a whole, I think what we would see is that, atmospheric gases is a higher return on capital business than hydrogen, not to say that hydrogen is bad, it just doesn't have as much co product economics.

Operator

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

David Begleiter - Deutsche Bank

Jim could you comment on pricing in large projects in Asia? Is it becoming more competitive?

Jim Sawyer

I don't think so. Theirs is floor an abundance of projects, which are on the drawing boards in China and India and so forth. And I think we're winning more than our fair share of those projects based on our reputations in those countries, based on our ability to execute, build the plant on budget, on schedule, and based on the fact that we have probably more liquid products than our competitors in there. Now, there's another contributing factor which I think is helping us win this business of high returns is our standard plant designs. We are making most of our plants according to cookie cutter standard plant designs, and when we do that, each time we make another one, we bring the capital cost down, we bring the reliability up, and we reduce the amount of spare parts and maintenance that's required.

But just to give you an example, we've built over 15 of our TL4 size-plants. The project that we are just announced in India is a T13 and we're building five of those. So the standard plant design really is working out very well for us and enabling us on the one hand to win the business and on the other hand to get a good return.

David Begleiter - Deutsche Bank

And Jim, you also mentioned that merchant pricing was getting firmer in Asia. Does that include China as well?

Jim Sawyer

Yes. The only place merchant pricing has been weak was China and merchant pricing is going up in China.

Operator

And your next question comes from the line of David Manthey with Robert W. Baird. Please proceed.

David Manthey - Robert W. Baird

As far as the price increases that went through last year, I think you put your bulk pricing increases in late October in PDI in November. In this quarter, did you actually realized some positive pricing that was offset by mix or was there some slippage to those price increases?

Jim Sawyer

Basically, the way our business works is, everybody has a different contract and everybody's contract has a different price, and you have an on-site 15-year contracts and in merchant, usually five-year contracts. And when the contracts come up for renewal is where you just talk about pricing. So when announce a price increase, generally what we mean by that is we're just giving our sales people some backbone when they go back to a customer whose contract is being renewed after five years.

And so there are a number of customers that are below market that we are increasing price on. The place that we lost to slippage was that our highest priced products in the merchant business, where the CO2 and nitrogen for fracing, and the reason the price is higher is because of a long transportation costs to get there. So as that business is going down and other business is going up, it's kind of been a neutral overall pricing environment.

David Manthey - Robert W. Baird

And in terms of the uptick at the end of March, I think you mentioned North America, maybe specifically merchant gas, but did you concentrated in certain areas or was it just a broad-based uptick at the end of March?

Jim Sawyer

It's broad-based and it's consistent with what I think other companies are seeing, it's that March manufacturing and also production activity picked up pretty significantly across the board and April is holding and getting stronger from March.

Operator

And your next question comes from the line of Mike Harrison with First Analysis. Please proceed.

Michael Harrison - First Analysis

I was hoping I could just piggyback on the last question. You didn't really address the PDI pricing environment. And my question related to PDI pricing is, was your December price increase in hindsight maybe a little bit premature and are you seeing the pricing environment improving now?

Jim Sawyer

No, we're getting traction on the December price increases. It was focused on some specific areas and some specific product lines, and so forth. And specifically at gases, okay. And so we're getting traction on the gas price increase. Hard goods, on the other hand, which is about 40% of the sales, prices are naturally uncompetitive and potentially coming down because you have wire and stuff as your raw material, and so the cost of making hard goods is coming down and the realized pricing is coming down also.

Michael Harrison - First Analysis

And just so I understand correctly the PDI same-store sales number, was that negative 4% or negative 7%?

Jim Sawyer

Negative 4%.

Michael Harrison - First Analysis

And last question I want to ask you is on the Asia margin. Can you just give us some more detail on the mix issues there? What are some of the differences between margin level in atmospherics, process gases and sputtering targets and what is the mix looking like right now as compared to historical norms?

Jim Sawyer

Well, I think that there are two factors. One of them is that we're really in a growth mode in Asia and we got lot of engineers on the ground and a lot of business development people on the ground, and therefore, overhead structure, which is supporting a business that will be well over a $1 billion in the couple of years. And so, that's a little bit of downward pressure on the margin here. But more specifically, the electronic sales represent roughly a third of our total sales in Asia, okay.

And the atmospheric gases sales and hydrogen sales have about a 20% operating margin. In other words, if I carved out the electronics business from our business in Asia, it'd be running at a 20% operating margin, but electronics business is running closer to 10% operating margin and it's up 88% year-on-year. So that's why the mix caused the margin to go down relative to the prior quarter.

Also, in there we've got the sputtering targets, which have a lot of precious metals in them and we had cost pass-through in the targets, representing 9% of our total sales there, probably about 27% cost pass through targets themselves. So I know it always looks like a disappointing thing in the low margins in Asia, but the fact is that electronics is just a bigger part of Asia. We're not investing very much in electronics in Asia. So as we start up more oxygen plants and hydrogen plants, you will see that operating margin go up.

Operator

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

Bob Koort - Goldman Sachs

A little surprised you guys haven't seen a little bit more active volume pickup based on what we're hearing at some of your customers. So I'm just curious, slide 12, you gave us your volumes geographically. What do you think that curve looks like as we go through the next few quarters, does it sort of stay at that same rate of change, is there a potential for acceleration?

Jim Sawyer

That's a good question. And I think when you look at our customers they've got improvements going on both in volume and in price, okay, and I can't, you understand that better than I do. Our price is constant. So we're only looking at improvements in volume. And in the chemical sector and the steel sector, we've got very significant volume pick up just quarter-over-quarter from the fourth quarter. The other sector is more general manufacturing. We just don't have that much volume pick up. So what we need to see is overall manufacturing get better and we need to see the production levels of chemicals and steel stay up at the levels that they are at right now. Does that answer your question, sort of?

Robert Koort - Goldman Sachs

It does. I guess I didn't consider the part that a lot of the revenue growth we're seeing of your customers had the price component, but it would still seem like their volume component was maybe stronger. And I don't sense there is any inventory build through many of those end markets, so I guess I'm expecting maybe a bit of a hockey stick for your volume development.

Jim Sawyer

There's no inventory of gases, okay? So we've got to see more pickup in the manufacturing and so forth. If you look at slide 10, you'll see our metals volume is up 19% year-on-year and chemicals up 12% year-on-year. Now, they may not be as much as the commodity chemical producer and the commodity metal producers, but remember, we're selling to a whole broad array of customers there.

Operator

And your next question comes from the line of Laurence Alexander with Jefferies. Please proceed.

Laurence Alexander - Jefferies

Just a couple of questions. One is, in your European business, could you revisit the current geographic mix both in terms of how much is in Germany as opposed to the Mediterranean countries and then also the difference in the end market mix?

Jim Sawyer

Do you want me to talk about the PIGS? The PIGS refer to Portugal, Italy, Greece and Spain, right? And Spain and Portugal got their credit downgraded yesterday and have some pretty significant macroeconomic issues, and we don't do any business in Greece. So we'll start out with that. Then about 40% of our business in Europe may be 35%, 40% in Spain and 35%, 40% in Germany, with the rest in Italy and France.

But the only real impact that we could have on the negative side from this credit crisis in Europe will be seen as the dollar-euro exchange rate. In other words, we don't have credit issues with customers. So if there is a bigger crisis that emerges in Spain and what not, maybe they'll slow the economy down some, maybe it'll weaken the euro some, but that's going to be the extent of any impact on us.

Laurence Alexander - Jefferies

When you look at pricing, how is merchant (inaudible) pricing in North America?

Jim Sawyer

Merchant (inaudible) pricing, it's flat overall. You've got some downward pressure, as I mentioned before, from the mix from selling less fraced gases, and those are the highest priced gases because of the long transportation cost. But if you exclude that to the average customer, pricing is holding very nicely.

Laurence Alexander - Jefferies

Then lastly quickly, from the peak, how much has the frac business declined in terms of dollars of revenue as opposed to a percentage?

Jim Sawyer

I'm going to guess that's 50%. I don't know exactly, but I'm going to guess it's around that area and a lot of profitability alone those sides.

Operator

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

Mike Sison - KeyBanc

Jim, just wanted to gauge your sentiment a little bit given your sales guidance stayed the same. Are you feeling a little better about the industrial road now versus January, about the same, a little bit worse?

Jim Sawyer

I'm feeling much better about it. This January, the third quarter, we saw a fair amount of pickup from the depths of the second quarter. Fourth quarter was kind of flattish. We came through the Christmas season okay. But really I think, across the board, you're seeing the economy ramp up in March and April, and so I'm a lot more optimistic about it.

Mike Sison - KeyBanc

Then in terms of Asia, the 30 plus percent growth in volumes, is that run rate sustainable? Is that primarily new projects?

Jim Sawyer

There are two things there. One is that electronics is about a third of Asia, and electronics was up the fastest, okay? Well, I'm looking at chart 12, you see the 13% pickup in Asia, about 8% of that is from new startups and about 5% of that is organic growth. That's over the six-quarter period. If you look year-on-year, it's a mix between electronics and start-ups.

Mike Sison - KeyBanc

And last question, if you had to guess, when you look at PDI same store sales, when would you think it would stabilize and maybe see a positive inflection point this year?

Jim Sawyer

Well, they've definitely stabilized. The year-over-year comparison of all four is, it doesn't look that great, but it definitely stabilized. They really kind of bottomed out in the third quarter, which is the summer quarter and typically a weaker quarter for packaged gases, but we're seeing a solid but gradual increase in same store sales volumes.

Operator

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

Edward Yang - Oppenheimer

My question is just on M&A, on packaged gases, are you still looking at independent distributors or anything larger? And also geographic expansion opportunities, you mentioned the Middle East. I think when you have expanded geographies, would you be looking at larger-sized acquisitions to get a large footprint right away?

Jim Sawyer

Right. In packaged gases, we continue to look at acquisitions where we can bolt-on small acquisitions and cut cost in half and get a very high operating margin contribution from them. Other places around the world where there are privately owned industrial gas companies, there are a number of family-owned companies, and at some point in time, the family will decide to sell and we stay in conversation with those folks and every once and while you'll see one of those come up for sale.

Now, the other two geographies that we're looking at and been looking out for a while but been slow to move is the Middle East and Russia, and both of those geographies come with a bit more risk than some other places and you really need to know how to operate locally. But our strategy for building shareholder value is to build integrated industrial gas networks, if you will, for we've got on-site merchant and packaged gases.

So that's where we're looking to see if there's a way we can enter those markets with the fairly low level of risk and build an integrated business there, because both in the Middle East and Russia what they are trying to do is take the oil dollars they've got and diversify the economies into other industries, and that's kind of where we're going to be looking to build an integrated business.

Operator

And your next question comes from the line of Kevin McCarthy with Bank of America/Merrill Lynch. Please proceed.

Kevin McCarthy - Bank of America/Merrill Lynch

In packaged gases, what are the leading indicators telling you such as large ticket equipment items as you look at the recent trends, let's say through March and April?

Jim Sawyer

The leading indicators, in fact are really these hard goods. Hard goods move faster up and down than the gases do, and particularly the equipment sales, okay. So for example, if you have a job shop and it's not full, he doesn't need to buy any equipment. But when volume goes to the point where he needs to buy equipment; you'll see him come in and buy welding machines and laser cutting machines and that type of stuff. So what we are tracking is inquiries and orders for that type of equipment and we're starting to see a few of them, but I don't think it's broad-based.

Kevin McCarthy - Bank of America/Merrill Lynch

And then second question Jim, if I look at slide five, in Europe you had an operating margin decline of 190 basis points sequentially. Often when you see that kind of volatility, I guess it relates to energy pass-through, but in this case it looks like that was flat sequentially and volumes actually picked up slightly. So, can you help understand what is creating the margin pressure there in the quarter?

Jim Sawyer

Specifically, it is some on-site contracts where the plant was operating below minimum take-or-pay, but we were receiving the take-or-pay payment, okay. And so that translates into heavy dollars of drop right to the bottom line without much revenue. When you increase the volume in the plant, you move through the take-or-pay threshold and your revenues go up, but your operating profit doesn't go up quite as much. So that's really the explanation of the lower margin in the first quarter.

Kevin McCarthy - Bank of America/Merrill Lynch

Understood and at this point Jim are all of those customers above the threshold?

Jim Sawyer

I believe so, yes.

Operator

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

Don Carson - UBS

Two questions on North American merchant. The first one was what operating rates you did sequentially? You had a 5% volume increase from Q4 to Q1. What did that do to operating rate? And it's another way of getting back to that, why didn't we see more margin on a 5% volume improvement?

Jim Sawyer

Yeah, probably the round numbers on that is moving from mid-70s to about 75% operating rates. Well below the 85%, 90% operating rate, we'd like to be at.

Don Carson - UBS

So when you say mid-70s and 75%, it sounds about the same, so you really only have a point improvement?

Jim Sawyer

Oh, I'm sorry. I didn't mean mid-70s. I meant about 70% to 75%.

Don Carson - UBS

So on a 5 percentage point operating rate change in merchant you should see some pretty good incremental volumes, though, right? You're talking about incremental volumes in the 40% range. Wouldn't that translate into a better operating margin?

Jim Sawyer

Yeah. We are definitely seeing that. The merchant business is up. Margins are up in the merchant business. That's still way below where it was at the top of the cycle. Okay? And really when we look at our total North American business, we've got a mix in there of packaged gases, home healthcare merchant, on-site and electronics. So we're a little bit getting masked here where we're getting that leverage in the industrial gases business, but electronic sales were up significantly and they are lower margins. So you're just not seeing it at all come through the financials right now.

Don Carson - UBS

So if you were just looking at merchant, what would have been the incremental margin sequentially then?

Jim Sawyer

New volume coming on or you mean quarter-to-quarter?

Don Carson - UBS

I mean quarter-to-quarter.

Jim Sawyer

That 2% growth would be around 40% margin. Overall net sales are about $200 million, so you do the math on that.

Don Carson - UBS

Then just one follow-up. How is pricing on new business signings? When you go out and get new business, how do pricings compare to your existing book of business, the same, lower or higher?

Jim Sawyer

Pretty much in the centre, in other words what I mean by that is that when we look at our existing merchant customers, there's a band, there are some customers that are above the average, some that are below the average. And new customers are coming in pretty much around the average right now.

Operator

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

Jeff Zekauskas - JPMorgan

In your Asian business, is there a seasonal margin progression where the first quarter for various reasons is the lower margined than the other quarters?

Jim Sawyer

Yeah absolutely. In any business, when you have a shorter operating period, you're going to have the same fixed costs, but you're going to have lower sales, okay? What I mean by that is that even in months when you go from 30 days to 31 days or whatever, you see that happen. But in Asia, you have a lunar holiday when things are shutdown for a week, sometimes two weeks and that translates into lower sales and even lower operating profit your lower sales are still distributed over the same amount of fixed cost. So you're going to see first quarter being below the fourth quarter, both in dollars and in operating margin percentage.

Jeff Zekauskas - JPMorgan

Then lastly, to keep your options open, have you filed Hart-Scott-Rodino on Airgas?

Jim Sawyer

(Inaudible) but we wouldn't until we decide to take some activity there, okay? Basically what we said about Airgas is that we're monitoring the situation, watching it closely. We're keeping our options open as to whether we'll do anything, we can't tell you definitively right now what we might do, but I think what I've said before is that we would have more synergies than anyone else in buying Airgas, because we run the second largest US packaged gas business already. And you should not assume that that would preclude us from an FTC standpoint. And I will also say if Air Products is successful in buying Airgas and we don't participate, it will still I think be a net positive for us in several ways.

Operator

And your next question comes from the line of John Roberts with Buckingham Research. Please proceed.

John Roberts - Buckingham Research

I just wanted to follow up on your earlier comment on metals and chemicals, because you sound upbeat about it, but I thought you hedged your comments by saying you thought it would slow later this year because of inventory issues that your customers have. Do you have any data that maybe support how much restocking may have occurred or whether you think inventories are normal or not normal downstream?

Jim Sawyer

Well, we do watch inventories. I don't have the numbers on the top of my head. But the way I see it is that inventories went to practically zero level. So, inventories have definitely been moving up. I think they are still well below what they would have been historically and could move higher. But if inventory has been moving up fast, then that means the production is faster with consumption. So if inventory sort of hold in this area, you'll probably see a tempering off of the growth rate. That's just my guess, but I really don't have any data to support that.

John Roberts - Buckingham Research

But still growth, you don't see…

Jim Sawyer

But still growth, yes. I don't see it double-dip or anything like that going on.

Operator

This concludes the time that we have for the question-and-answer session today. I would now like to turn the call over to Mr. Jim Sawyer for closing remarks. Please proceed, sir.

Jim Sawyer

Yes. Thank you all for participating in the call. And anybody who has follow-up questions, you can call Liz Hirsch or myself and we'll try to help you out of those questions. So thank you and have a good afternoon. Bye, bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Praxair Inc. Q1 2010 Earnings Call Transcript
This Transcript
All Transcripts