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Praxair (NYSE:PX)

Q2 2010 Earnings Call

July 28, 2010 11:00 am ET

Executives

James Sawyer - Chief Financial Officer and Executive Vice President

Elizabeth Hirsch - Director of Investor Relations

Analysts

Mark Gulley - Soleil Securities Group, Inc.

David Begleiter - Deutsche Bank AG

Michael Sison - KeyBanc Capital Markets Inc.

Michael Harrison - First Analysis Securities Corporation

Jeffrey Zekauskas - JP Morgan Chase & Co

Robert Koort - Goldman Sachs Group Inc.

Edward Yang - Oppenheimer & Co. Inc.

Christopher Shaw - UBS Investment Bank

John Roberts - Buckingham Research Associations

Kevin McCarthy

Laurence Alexander - Jefferies & Company, Inc.

David Manthey - Robert W. Baird & Co. Incorporated

P.J. Juvekar - Citigroup Inc

Operator

Good day, ladies and gentlemen, and welcome to the Praxair Inc. Second Quarter 2010 Earnings Conference Call. My name is Amisia, and I will be your Operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Mr. Jim Sawyer, Executive Vice President and CFO.

James Sawyer

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

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

Praxair had very strong second quarter relative to both last year and last quarter. Our results showed strong volume growth, margin improvement and strong cash flow generation. Overall volumes were significantly above the prior year in all geographic segments due to continuing improvements in the global economic environment and new project startups.

Sequentially, volume growth continued as we moved to the second quarter. South America and Asia have shown the strongest recovery from the downturn, but North America and Europe are steadily improving. Our earnings grew faster than sales, which increased our overall operating margin, reflecting the benefits of prior year cost reduction actions and ongoing productivity programs.

This morning, we announced a new $1.5 billion share repurchase program. This indicate the confidence we have in our continued ability to generate cash flow in excess of what is required to fund the large amount of capital opportunities we see before us. The previous share repurchase program was authorized in July 2008 and is now substantially complete. We expect to complete this program in 18 months by the end of 2011, depending on market conditions. Now Liz will review our quarterly results in more detail.

Elizabeth Hirsch

Thank you, Jim, and good morning. Please turn to Slide 3 in our presentation for a summary of our second quarter results.

Sales in the quarter were $2.5 billion, 18% above the prior year, primarily due to 12% volume growth. Sales were higher to all major end markets, with the strongest year-over-year comparisons in chemicals, metals and electronics, the industries where production was extremely low a year ago. Sales to overall manufacturing were also higher than a year ago and strengthened during the quarter. New project startups, primarily in Asia, also contributed to volume growth. Sequentially, sales were 4% above the first quarter due to higher volumes.

Operating profit grew to $547 million in the quarter, 22% above the prior year, and the operating margin increased to 21.6%. Higher volumes, productivity savings and currency effects were the largest contributors to the growth.

Net income of $371 million rose 24% from prior year, a higher increase than the increase in operating profit due to lower interest expense. Interest expense is below the prior year, primarily due to lower rates and lower debt overseas in higher-interest-rate countries due to strong cash flow generation. Earnings per share were a record $1.19, up 24% from prior year and up 9% from the first quarter.

Cash flow generation was very strong this quarter. Cash flow from operations was $536 million, including $106 million of pension plan contributions. Excluding these contributions, we generated cash flow equal to 25% of sales. We are keeping a tight control on working capital and carefully managing our fixed costs, despite some headwind from higher incentives and compensation accruals due to our improving business results.

Cash flow funded $325 million of capital expenditures, largely for construction of new on-site plants around the world. Cash flow after CapEx primarily funded $137 million of dividends. Total debt was reduced by $378 million. This decrease was due to the maturity of a floating-rate note issue in May, which we repaid with available cash from our most recent bond issue.

After-tax return on capital was 14.7%, up from 13.6% last quarter. The increase was due to higher earnings. Last quarter's number was low in part due to the cash temporarily sitting on our balance sheet. Our return on equity increased to 27.4%.

Please turn to Page 4 for our results in North America. Sales in North America were $1.28 billion, 14% above prior year. Higher volumes contributed 12% growth, and currency appreciation contributed 3%, with lower price mix offsetting 1%. Sales growth was driven by stronger demand from chemical and steel customers. Refinery hydrogen demand was strong.

Sequentially, overall volumes grew 5% from first quarter. Demand from chemicals and steel continued to increase, and demand from general manufacturing customers picked up.

On-site volumes were 20% above prior year and 7% above first quarter, driven by oxygen and hydrogen. Our oxygen pipeline volumes have significantly rebounded but are still about 10% below 2008 peak levels. Overall merchant volumes were 13% above prior year and 4% above the first quarter. Higher demand was broad-based for all liquid products, including oxygen, argon and liquid hydrogen. Carbon dioxide sales and nitrogen volumes were higher due to increased frac-ing activity in the U.S. and Canada. Sequentially, our frac volumes were lower due to the seasonal slowdown in Canada due to warmer weather. CO2 sales increased for seasonal food and beverage demand. Liquid volumes in Mexico are significantly above last year and continued to grow through the quarter.

Packaged gases volumes are improving as manufacturing activity has picked up in the U.S., Canada and Mexico. Overall volumes grew 6% sequentially versus the first quarter. Hardgoods in the U.S. and Canada are recovering at a faster pace than gases, which is typical in an economic recovery.

North American operating profit was $294 million, 11% above prior year. Compared to the first quarter, operating profit grew 6% on sales growth of 3%, showing solid operating leverage on improving volumes. This leverage was still masked in the year-over-year results due to take-or-pay revenue, which we were collecting in last year's quarter.

Looking forward, we expect volumes to continue to improve in the second half of the year, though the rate of growth may moderate somewhat. We are seeing new business opportunities for merchant liquids in food, energy and environmental applications. So our overall outlook is for steady growth in the second half of the year.

Please turn to Page 5 for our European results. Sales in Europe were $335 million, 9% above the 2009 quarter. Higher volumes and price contributed 11% growth, which was partially offset by currency depreciation. On-site volumes were up 16%, primarily due to higher pipeline oxygen demand in Spain and Germany. Merchant volumes across the region increased significantly from prior year. Packaged gases are showing sequential improvement, but have lagged the recovery in on-site and merchant due to weak local construction and metal fabrication markets, particularly in Spain. Demand from customers serving export-oriented industries like chemicals and steel and less cyclical industries like healthcare has improved. Sequentially, volumes grew 4% across Europe, but were offset at the sales line by currency devaluation.

Operating profit in the quarter was $73 million, 20% above the prior year and 9% above first quarter. OP included a $4 million currency hedge gain, which substantially offset the effect of the currency devaluation on operating profit. 2009’s second quarter included a similar-sized currency hedge loss.

For the third quarter, we expect sales to be lower than the second quarter, as a result of seasonally lower sales due to the August holidays and due to about a 5% negative impact from the weaker euro. But in terms of underlying growth, we are still expecting Europe to continue on a path of recovery.

Page 6 summarizes our South American results. Sales in South America were $490 million, up 24% from prior year. Currency appreciation increased sales by 12%. Sales grew 15% and 6% sequentially from higher volumes and price. Industrial production in Brazil has averaged about 17% through May and is forecasted to average about 12% for the full year.

Our on-site volumes have recovered strongly and are almost back to 2008 levels. Merchant liquid volumes are 13% above prior year and up 9% sequentially, excluding seasonal CO2. Packaged gases are also growing in line with increasing domestic consumption. By end market, growth is broad-based to steel, energy, food, health care and manufacturing. Other countries in Latin America are also growing nicely, with Chile, Argentina and Peru exhibiting strong year-over-year volume growth.

Operating profit in the second quarter was $114 million versus $70 million in the prior year quarter, which included an $11 million currency hedge loss. Operating profit margin was 23.3%.

Operating leverage came from strong volume gains, pricing and ongoing productivity and cost reduction. Our outlook for South America for the second half of the year is very positive. Brazil's currency is stable. Interest rates are low by historical standards, which has provided good economic stimulus, though they have inched up a little recently because the government is committed to keeping inflation in check.

The country has a growing consumption-oriented middle class which is driving growth. We started up three projects this quarter and are looking at numerous new project opportunities. The long-term outlook is especially bright, with numerous opportunities in the energy sector and expected infrastructure investment for the upcoming World Cup and Olympics.

Please look at Page 7 for our Asia results. Asia had another very strong quarter, with sales of $280 million, up 41% from prior year, driven by 27% volume growth. Currency effects increased sales by 5%. Cost pass-through, which is higher power and precious metal prices used in manufacturing our sputtering targets increased sales by 10%. Volume growth came from new projects and from significant growth in on-site and liquid volumes in China, India and Korea. By end market, sales to steel and chemicals are significantly higher. Electronics is still very strong. Sales rose 32% excluding cost pass-through. The mix effect of such a strong electronics sales caused the negative 1% impact from price.

Operating profit increased to $44 million this quarter from $33 million in 2009 and up from $34 million last quarter. We expect absolute growth in Asia to be strong for the balance of the year, but we anticipate that the growth rate may moderate in the second half from what we saw in the first half as the Chinese government tries to avoid an overheated economy.

Project proposal activity continues to be robust in the region. We have a large number of projects under construction which will start up in 2011 and 2012, supporting strong future growth.

Surface Technologies results are on Page 8. PST sales this quarter were $141 million compared to $118 million in the 2009 quarter. Excluding currency effects, sales increased due to the Sermatech acquisition, which contributed sales of $21 million this quarter. We closed this acquisition last July, and so there will no longer be an acquisition impact next quarter.

Aviation coatings were above prior year due to strong EBPVD jet engine coatings. These are the coatings used in the new GE GEnx engines powering the 787 and 747-8 planes. We expect these volumes to increase in the second half of the year. Coatings for the aftermarket are expected to pick up slowly, in line with increases in passenger miles flown.

Lower coatings for industrial gas turbines offset some of this growth. IGT builds by the major manufacturers turned down in the economic crisis. We do expect to see this business start to pick up, but this is long-lead-time equipment, so we are not forecasting a meaningful increase in our coatings volumes to this market until 2011.

We completed the acquisition integration July 1, and so PST's margins should continue to improve in the second half due to the lack of integration expenses. Our goal is to move PST's operating margin to the high teens area over the next six to nine months with reasonable volume improvement.

Now I'm going to turn this back to Jim to discuss our global end market trends and our earnings guidance.

James Sawyer

Thanks, Liz. Please turn to Page 9. In this slide, you do some detail in our end market sales trends, both year-over-year and compared to last quarter. We're showing you our organic sales growth excluding currency, cost pass-through and acquisition effects. Sales to the energy market are above prior year and up 9% sequentially. Hydrogen sales to refiners represent about 2/3 of our sales to the energy sector. Demand has been very steady from existing customers, and this quarter we began to find [ph 0:28:30] a new customer from our Gulf Coast pipeline system. The balance of the segment is primarily enhanced oil recovery and natural gas well frac-ing. Frac-ing volumes were above prior year and seasonally lower on a sequential basis. Our long-term outlook for energy is very bullish given many hydrogen project opportunities in Brazil, Mexico and Asia. These new projects are large and will drive significant future growth for us. And we're positive that EOR will also continue to gain traction around the world as energy demand increases.

Electronics sales have continued to be robust, up 22% from a year ago due to strong demand in Asia from semiconductor and LCD manufacturers. Sales to the photovoltaic industry and polysilicon producers also continued to grow, and we have won a number of new contracts. We expect a strong second half of the year due to industry forecast of continued strong demand for consumer electronics and a pickup in business IT spending.

Sales to chemicals and metals markets have recovered significantly from the low levels in 2009. Sales to both markets were up 7% from last quarter from strong base business demand and new projects on stream in Asia. Demand for steel and chemicals is being fueled by infrastructure investment and growing consumer demand in the emerging markets, particularly China, India and South America. Customer demand has also picked up in the U.S. and Europe at a more moderate pace.

Sales to manufacturing this quarter grew 6% sequentially, primarily due to continued strong growth in South America and Asia. In addition, we began to see more strength in the U.S., Canada and Europe, where merchant and packaged gases volumes improved. However, we're still about 10% below peak levels, which represent significant future upside in sales and operating leverage as volumes continue to recover.

Please turn to Page 10 for our earnings guidance. For the third quarter of 2010, our earnings guidance is for earnings per share to be in the range of $1.15 to $1.20. We expect to see our overall volumes continue to trend up sequentially. Our third quarter is typically on a par with the second quarter because it includes the slowdown in Europe due to the summer holidays. In addition, as Liz mentioned, this guidance includes a sequential headwind due to the depreciation of the euro currency, which will reduce sales by $15 million to $20 million in the third quarter versus the second quarter.

We are raising our EPS guidance for the full year 2010 to a range of $4.60 to $4.70, excluding the $0.08 negative impact in the first quarter resulting from the Venezuela currency devaluation. This represents year-over-year earnings growth of 15% to 18% and is well above our peak earnings in 2008 of $4.20. Our earnings guidance including the Venezuela charge is $4.52 to $4.62. We expect full year sales to be the area of $10 billion and the effective tax rate to remain at about 28%. CapEx for the year is still forecasted to be about $1.4 billion. Our long-term outlook continues to improve. Our base business is clearly recovering, and there's more upside to come. In addition, large project activity around the world is strong. We are working on a host of opportunities in South America, China and India as well as the Middle East and Russia, which we believe will sustain our product backlog, and therefore, growth, in years to come.

Page 11 is the slide which indicates the confidence we have in this regard. We will be starting up about 10 projects in the second half of the year, but we're forecasting that the capital value of our backlog will rise to about $2.5 billion by year end, which will be a record for us. These projects are all under long-term contract and have at least made returns [ph 0:32:48] well in excess of our cost of capital and which should therefore drive high-quality revenue and earnings growth through 2012 and beyond.

Our new share repurchase program and our track record of dividend increases is an indication of our commitment to returning excess cash to shareholders. It does not suggest a lack of growth opportunities in our core business. Instead, it's a result of our financial discipline, which has delivered a much higher return on capital than our peers. This has resulted in operating cash flow of nearly 25% of sales, capital spending on new projects of about 15% of sales and free cash flow of about 10% of sales. This allows us to increase dividends each year and repurchase stock without increasing leverage.

And now I'm happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And the first question comes from the line of P.J. Juvekar with Citi.

P.J. Juvekar - Citigroup Inc

Jim, you gave this interesting slide on the project backlog. If you were to slice this by the bar chart by geographies, how would it look like?

James Sawyer

Well, it's shifting to the emerging markets. We still have two very large refinery projects in the backlog in North America. But almost all of the new major projects are coming in China, which would be more coal gasification projects. Then we’re negotiating in Brazil, which would be hydrogen projects. We’re negotiating in Mexico in EOR projects. Potentially other projects in India, in both steel and manufacturing, and potential projects in Russia in steel and the Middle East. So it really will be shifting so that probably by the end of 2011, 2/3 of the backlog will be in the emerging markets countries.

Operator

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

David Manthey - Robert W. Baird & Co. Incorporated

I was wondering if you could talk about the competitive landscape within PDI. I know you implemented pricing actions late in 2009. Could you discuss the realization you're seeing this quarter?

James Sawyer

Right. I would basically say that we’re working on additional price increases. We are thinking through the need to increase price in both packaged gas and merchant gas in the coming couple of months, primarily as a result of higher capacity utilization and also to cover distribution costs. So we’re generally very positive on pricing. We're seeing pricing hold and increase in some areas.

David Manthey - Robert W. Baird & Co. Incorporated

Okay. And just quickly on the take-or-pay contracts, I think in the third quarter last year, you said there was about a $2 million impact to revenues in EBIT. Could you discuss what that was in the second quarter of last year just for comparison?

James Sawyer

Yes, that’s a good question. I would say probably in the second quarter, we probably had about $20 million impact from take-or-pay contracts, the positive impact in revenue and operating profit above and beyond what we’re receiving in revenue from actual product shipments. And basically, we’re through the threshold now of all the minimum take-or-pay requirements around the world.

David Manthey - Robert W. Baird & Co. Incorporated

Okay.

Operator

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

Michael Sison - KeyBanc Capital Markets Inc.

In terms of your new project bidding backlog or the projects that you're seeing now, can you give us a little bit of color of which end markets continue to drive that? Does it continue to be energy, metals or electronics? Can you give us a little bit of insight there?

James Sawyer

Right. It's basically a continuation of energy, and I mean energy from a little bit broader perspective, that we've been seeing over the last five years or so. The largest projects in Asia, our goal gasification projects, you can call that energy, you can call it chemicals, because the end syngas goes as a chemical feed stock there. Additional electronics projects in China and Korea, we expect them to be; additional hydrogen projects in Brazil and other countries in South America; more Enhanced Oil Recovery with PEMEX in Mexico. And India is pretty much across the board in terms of end markets. The Indian economy is really the strongest it’s been in my lifetime, with a huge amount of demand pull in many, many end markets, from glass to steel to refined products and so forth.

Michael Sison - KeyBanc Capital Markets Inc.

Okay. And just one quick follow-up on the refinery hydrogen, that business looked like it strengthened a bit in the second quarter. Are you back at higher peak levels there? Or is that going to get there at some point this year?

James Sawyer

We're back at pretty much full capacity utilization from the projects that we have online. On top of that, we're going to be ramping up the BP Whiting project beginning this quarter and going on for about 12 months. And then probably in 2012, we'll see the Chevron project come on stream.

Michael Sison - KeyBanc Capital Markets Inc.

Great.

Operator

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

David Begleiter - Deutsche Bank AG

Jim, can you give us on the backlog how many projects were added this quarter? How many were started up?

James Sawyer

Right. We basically started up seven projects, three in South America, two in Asia and two in North America. And we added four projects, one in Asia, one in South America, one in Mexico and one in Russia. What we added was about $100 million higher in total capital spend than what we started up.

David Begleiter - Deutsche Bank AG

And on the $2.5 billion backlog for year end of this year, what's the backlog number today, as of June 30?

James Sawyer

It's $2.3 billion, up from $2.2 billion in last quarter.

David Begleiter - Deutsche Bank AG

Okay. And, Jim, lastly, the question was asked about competitive intensity in packaged gases. Has it increased since the beginning of the year?

James Sawyer

No. I mean, it's always been a competitive industry. Every industry is competitive. But I see some good improvement coming along in volume. Packaged gases was sort of the last distribution method to come down, as we went into the recession, and it will also be the last distribution method to fully recover. And that's because a lot of packaged gas goes into non-residential construction and equipment and so forth. And what we're seeing is that it takes a little longer for people to decide to make capital investments, and so it's a little longer for the construction cycle to come around. But we've been positive about -- we saw sequentially from the first quarter to the second quarter of about 6% volume growth. So we're feeling a lot better about that. But there is still a significant amount of upside in packaged gas, not only in North America, but also in Europe and South America, where it's still the lagging segment to come back.

Operator

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

Laurence Alexander - Jefferies & Company, Inc.

Jim, could you give some color on what's driving the pipeline oxygen growth in Spain?

James Sawyer

Sorry, what's driving…

Laurence Alexander - Jefferies & Company, Inc.

The pipeline.

James Sawyer

The pipeline oxygen in Spain. Yes, that would be steel production in Spain. A lot of steel production around the world was curtailed 12 months ago. In fact, the second quarter of 2009 was the weakest quarter. And overall, steel is up about 35%, and Spain is part of that.

Laurence Alexander - Jefferies & Company, Inc.

And as you look across the different regions in the products mix in each region, are there going to be any shifts in the patterns of incremental margins as we go into the back half of the year?

James Sawyer

I don't see any major shift in the mix effect on incremental margins. The packaged gas and merchant distribution segments, which are still way off from the high in 2008, have a lot of incremental margin impact, because most of the customers are still operating; they’re just consuming less gas. And so this is really a distribution business, and as those customers consume more gas, it doesn't increase the distribution cost all that much.

Operator

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

Kevin McCarthy

Nice to see the 6% sequential increase in packaged gases. Jim, I was wondering if you could just elaborate a little bit on how much faster hardgoods might be growing versus gas and rent at this point in the cycle? And then, what the leading indicators are pointing to within hardgoods?

James Sawyer

Right. Well, hardgoods is growing faster. You may recall that hardgoods actually were off about 35% at the bottom of the recession. Hardgoods is about is up about 10% now, so maybe a third of the way back. And that tends to be the leading indicator versus the gases, because welders tend to buy capital equipment when they need that equipment and they see their own volume improving. So that's a very positive indicator.

Kevin McCarthy

Okay. And then I wanted to ask about Europe. The operating margin improved 200 basis points sequentially after declining a similar amount sequentially last quarter. Can you talk about what is driving that kind of volatility when pass-through effects seem to be flat? Is it the customers ascending above the take-or-pay threshold?

James Sawyer

No, actually, in Europe, European currency devalued, and we hedge our earnings forward about one quarter. It's been [ph 0:45:13] about a $4 million hedge gain in Europe. Meanwhile, sales were going down because the European currency was getting weaker. And then that’s compared to last year, which exactly the reverse. The currency was getting stronger, and so sales were going up faster than operating profit.

Kevin McCarthy

Got it.

Operator

And the next question comes from the line of Jeff Zekauskas with JP Morgan.

Jeffrey Zekauskas - JP Morgan Chase & Co

Why was your minority interest line down year-over-year, from a $12 million loss last year to $10 million this year?

James Sawyer

It's basically effect in Italy and the effect of the tax rate in Italy, that we have a minority interest in Italy, which we had a tax benefit in the prior year quarter which we don't have this year.

Jeffrey Zekauskas - JP Morgan Chase & Co

Okay. And secondly, what was in the $8 million other income that's on the consolidated income statement?

James Sawyer

Right. As I mentioned before, there's a $4 million FX hedge gain. The remaining $4 million is the usual net income or other income, which is, some items are positive, some items are negative. But we generally expect to get back into the area of other income being about $15 million to $20 million a year. But that's really where you find -- like last year, we had negative other income, because we did a lot of restructuring expense last year, which we ran through the income statement instead of taking a special charge on. And we also had receivable write-downs and so forth. So that's where that kind of stuff goes. And as the economy's getting better, we're not going to be seeing those negative charges in other income anymore.

Jeffrey Zekauskas - JP Morgan Chase & Co

Okay. And then lastly, the gross profit margin, even adjusting for the take-or-pay effects, was down year-over-year, but only by a little bit. What is it that's really pushing up cost of goods sold, given that you have such strong volumes?

James Sawyer

Mainly it's power cost. And it's because the recovery’s been faster in the on-site business than in merchant and packaged. And on-site has a higher proportional amount of power. And actually, our power costs were up about 20% year-on-year. That's in the variable cost line. Then both in the fixed costs line, in period costs and SG&A, we had a fairly significant increase of about 14%. But inside the 14%, SG&A is about 4% FX and about 6% higher accruals for incentive compensation. So the remaining SG&A is still very tightly under control.

Jeffrey Zekauskas - JP Morgan Chase & Co

Okay. That’s very clear.

Operator

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

Robert Koort - Goldman Sachs Group Inc.

Jim, can you talk a little bit about the health care trends? I guess I always assumed that was a more stable base business, but it seems like the growth is pretty muted there. Is there something specific to elective procedures? Or some other more economically sensitive impact that I didn't appreciate?

James Sawyer

Our largest markets in healthcare are in North America and Europe and Brazil. And we're getting strong growth in Europe in home care, and we're also getting fairly strong growth in the hospital side of the business as well.

Robert Koort - Goldman Sachs Group Inc.

So I guess I'm curious, on year-over-year you show 1% improvement or 4% sequentially. That doesn't sound like strong…

James Sawyer

You got to explain a little bit more of that. The year-over-year U.S. healthcare was down because of the cuts in Medicare reimbursement. Plus, in order to improve the quality of our U.S. home care business, we divested almost all of the durable medical equipment business so that we're just selling gases now. So if you want to look at the year-over-year comparison, it would've been up 5% to 10% except for the cut in homecare reimbursement and the divestiture of our durable medical equipment.

Robert Koort - Goldman Sachs Group Inc.

Okay. And then on a conference about early June, you’d made the comment that you felt more confident in the environment than you'd felt in a while, but you also had some -- I don’t know if “cautious” is too strong a word, but words about slowing growth in the U.S. and China. Has much changed from where you sit in the last two months?

James Sawyer

No, I think actually we've been seeing fairly dramatic recovery over the last six months or so. And if you just kind of take our volume growth, 4% sequentially, if you annualize that, that would be 16% annualized. And that's a pretty fast rate of volume growth. What we're expecting to see is that the quarter-on-quarter volume growth’s probably going to slow down to something like 2% rather than the 4% we've seen over the past couple of quarters. And that’s just because, I think, a lot of the recovery has come back. Asia has come back to 100% of where it was before the slowdown. South America has come back to about 3/4 of where it was before the slowdown. And the U.S. and Europe are about halfway back, with packaged gas really only coming back about a quarter of the way from the peak to the trough. So we've seen good sequential growth as steel volumes, chemical volumes have been up. I think that sequential growth will slow down more to like 2% a quarter than the 4% a quarter.

Robert Koort - Goldman Sachs Group Inc.

Great. Thanks for the clarification.

Operator

And the next question comes from the line of Mark Gulley with Soleil Securities.

Mark Gulley - Soleil Securities Group, Inc.

Jim, one of the hallmarks of your geographic strategy has been your selectivity. And today, this morning, you talked about opportunities in the Middle East and Russia. My impression was that perhaps only recently have they kind of come back into the fold in terms of your target markets. Can you talk about that a little bit?

James Sawyer

Right. Yes, they really hadn't been target markets for us in the past. But we are exploring those areas, and I think we have a very good ability to execute signed contracts, build projects on budget and on schedule in emerging countries, mainly from our experiences in India and South America. But we do see good growth opportunities at very attractive pricing in Russia and the Middle East, and we have been approaching them very cautiously because of sovereign risk and so forth. So it's been a very cautious approach of making sure we've dotted the i's and crossed the t’s before we do anything in those countries. But we do see some very good project opportunities with good pricing.

Mark Gulley - Soleil Securities Group, Inc.

Now, safe to say you have no current on-site projects in those countries today. Correct?

James Sawyer

Well, we actually do have some. We've got one on-site project underway in Russia, probably another one to come. And one on-site project underway in the Middle East with probably more to come.

Mark Gulley - Soleil Securities Group, Inc.

Secondly, when your competitors talk about CapEx plans on a go-forward basis, would you anticipate the $1.4-ish billion CapEx continuing for another two years beyond this year? Can you kind of frame that for us?

James Sawyer

Yes, I think we'll probably see an increase in capital spending in 2011 as the stack-log [ph 0:54:09] goes up. And some of these projects we're working on have fairly long completion schedules, so I'm expecting a significant increase in capital spending in 2012.

Mark Gulley - Soleil Securities Group, Inc.

And then finally, your share repurchase announcement this morning. Is that a signal that perhaps you're a little bit less interested in M&A than, perhaps, you would have been three months ago?

James Sawyer

No, we have buyback stock in the first place to offset dilution. We’re generating very strong cash flow. And for the last couple of years before the recession, we basically had about a $1 billion-a-year stock repurchase program going on each year, and we’re really just expecting to return to that.

Mark Gulley - Soleil Securities Group, Inc.

Okay.

Operator

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

Edward Yang - Oppenheimer & Co. Inc.

In the last quarter, you provided a very helpful slide showing global end market trends and was wondering if you could provide an update there, in terms of where electronics, chemicals, metals and manufacturing are relative to prior to the start of the recession?

James Sawyer

Right. Yes, and that chart we showed also because it was our volume trends included startups of new projects. So it was a bit more than the base business. But electronics has fully recovered, and steel and chemicals are probably still about 10% off the top.

Edward Yang - Oppenheimer & Co. Inc.

Okay. And manufacturing, about 10% off as well?

James Sawyer

Yes, manufacturing, probably about 10% off globally.

Edward Yang - Oppenheimer & Co. Inc.

Okay. And you sounded relatively sanguine about Europe, and it's not a very big business for you. But when you think about the pull and tug between a cheaper currency helping exports and budget cuts perhaps hurting the domestic economies in Europe, where is most of your exposure? Is it geared toward serving domestic European consumption or exports for steel and so on?

James Sawyer

It's probably balanced in some respects, because people now are considering Germany to be the beneficiary because it's an exporter. We have a large business in Germany. And then Spain, we also have a large business, which is probably more affected by domestic consumption. And so a weak spot is in construction, just like it is in the United States. But I'm not pessimistic about Europe. My personal view is that this whole reaction to fiscal conservativism in Europe has kind of been overdone in the marketplace and that underlying business is not being affected by that unless you're a contractor or something to the government.

Edward Yang - Oppenheimer & Co. Inc.

Okay.

Operator

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

Michael Harrison - First Analysis Securities Corporation

Looking at the pricing activity in North America, you posted a negative 1% year-over-year. Your competitors had a similar impact, and they play in [ph 0:57:43] liquid hydrogen. I assume that is a relatively smaller business for you. So can you may be comment on what's been driving that lower pricing in your case? And, I guess, what are your expectations on pricing in North America for the second half of the year?

James Sawyer

Actually, we're the #1 liquid hydrogen producer in North America, so I want to set that fact…

Michael Harrison - First Analysis Securities Corporation

I stand corrected. I apologize.

James Sawyer

But that's not actually been an issue. The negative pricing is more of a mix issue in a couple of areas. In packaged gases, the hardgoods have been recovering faster than the gas and rent. And they’re at a lower margin, so that's kind of a negative mix effect, whereas if you just looked at pricing of hardgoods, it's fine. If you just looked at pricing of gases, it's fine. And then, the other places, some of it is in the frac-ing business. The frac-ing business has come way off, and that business used to be a very, very high-margin business. It's not as high a margin anymore. But I think if you look at the underlying pricing, and we do our price comparisons in many different ways, but if you look at pricing by customer or pricing by continuous customer, it is not down. And as I said before, we’re seeing some increases in power cost and distribution costs, and we're also seeing a tightening of capacity utilization, which will give us more ability to announce some price increases in the near future.

Michael Harrison - First Analysis Securities Corporation

All right. And then, looking at the PST business, if I back out the growth that you saw from Sermatech, sales were pretty flat even though the comp in the prior year was pretty weak. Is PST a business where you'd expect to see a lag in recovery? Or can you point to something maybe more temporary that was hurting this quarter? And maybe what's your outlook for organic growth in PST for the second half?

James Sawyer

Yes. Well, PST, it’s more of a function of what's going on in its key end markets. And our strategy when we made the acquisition of Sermatech and our strategy going forward is really to be the #1 provider of high-temperature and performance coatings to turbines. And there are really two kinds of turbines. There are aircraft turbine engines and there are industrial gas turbine engines. And so in the aircraft side, there's always a very cyclical increase and decrease as the airlines decide how many planes to buy, as the plane makers figure out how fast they can make those planes and then as the engine makers figure out how much inventory that they have. So it kind of cycles from quarter to quarter. And on the industrial gas turbines side, same thing. And so our customers in industrial gas turbines are in a big inventory-correction mode right now. And our industrial gas turbine business is way off this quarter from 12 months ago. But if you take the long run, the amount of coatings we’ll provide to jet engines is, over time, is just going to be a linear function of how many air miles are flown. Either they buy new engines or they recoat the old engines. So over the long run, it's going be a function of how many air passenger miles are flown. And air passenger miles are really growing significantly in emerging markets. And then the same thing is true in the turbines. If you take the position that natural gas is going to continue to be a key fuel in the future, there will be more industrial gas turbines, both new turbines as well as recoating of existing turbines after a certain number of hours. So while we have these bumps up and down quarter to quarter, and this quarter was really impacted by industrial gas turbines, we do think that our strategy of being the #1 provider of coatings to turbines should pay off in the long run.

Michael Harrison - First Analysis Securities Corporation

All right. Then, just very quickly if I could, can you talk about what you're seeing in locks lin [ph 1:02:35] pricing in China?

James Sawyer

Locksmith [ph 1:02:38] pricing in China is actually up. It had been under pressure for a couple of years, but the excess capacity is being consumed and pricing is up.

Operator

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

John Roberts - Buckingham Research Associations

When you look at Slide 9 with the organic sales growth trends, they seem to average higher than the 4% sequential sales growth that you showed in the quarter?

James Sawyer

Yes, it does. And actually there's two different numbers here. The 4% was specifically volume, and the organic sales growth includes [ph 1:03:25] volume and price and pass-through. Yes, so if you look at that, it looks like it should be higher than the 4%. But it's also the weightings of which end markets were in as well.

John Roberts - Buckingham Research Associations

But the energy number of 9% sequential growth would have pass-through in it, wouldn’t it? In that Slide 9?

Elizabeth Hirsch

No, it doesn't, John. We take that out.

James Sawyer

Pass-through, John. I’m sorry about that. Pass-through’s not included.

John Roberts - Buckingham Research Associations

Okay. And then secondly, when I look at that $2.5 billion 2010 backlog and compare it to the 2008, that's a 12% compounded growth rate across those two years. And the economic environment was strong in 2008 compared to today, so would you call that kind of a conservative trend-line growth? And should we be thinking about, actually, an acceleration going forward from the 12% trend between those two years?

James Sawyer

Well, I don't know. Thinking of a trend-out of what happened in 2008 and then 2009 and 2010 with a big recession in the middle, it's kind of hard to do. But…

John Roberts - Buckingham Research Associations

But the starting point is high. The end of 2008, the backlog was high.

James Sawyer

The starting point was high, and we expect to be back signing a lot of new projects over the next couple of quarters. And the trend growth rate could be higher than that 12% I'm talking about over time.

John Roberts - Buckingham Research Associations

Great. Okay.

Operator

And the next question comes from the line of Chris Shaw with Monness Crespi.

Christopher Shaw - UBS Investment Bank

I was just looking at the sequential organic sales growth in electronics, 2%. I know other people in the space, electronics, have been sort of reporting better sequential numbers. Is that something specific to you, or is there some pricing in that, that makes it look like a little lower than I would have thought?

James Sawyer

Couple things in electronics, and I might not be close as I should be, but the 2% sequential is a sales growth number. There's actually negative price in electronics. And so volume would be a bit higher than that. But electronics is also very cyclical, and really, they had a very strong first quarter. And they normally would expect, actually, a weak first and second quarter and a strong third quarter. So I think just staying at the level we're at is fairly strong for electronics. And the industry's forecasting continued sequential growth in the third and fourth quarters, and we’ll expect to realize some of that also.

Christopher Shaw - UBS Investment Bank

Okay.

Operator

And the final question is a follow-up question from the line of P.J. Juvekar with Citi.

P.J. Juvekar - Citigroup Inc

I think Liz mentioned that China is trying to slow the economy. And so far, that's mostly in the housing sector. Do you expect that to have an impact on the industrial economy down the road?

James Sawyer

Yes. Actually, beginning in June, we started to see that the rate of growth in China was definitely slowing. Because it was a double-digit industrial production growth rate. And I think they put the brakes in a lot of areas, mainly construction. And so the volume growth in steel has really slowed down, although it's not decreasing. But we still expect strong volume growth in chemicals going forward and also new projects in coal gasification and so forth.

P.J. Juvekar - Citigroup Inc

So would you say that your organic growth in second half in China would be lower than first half?

James Sawyer

Yes, definitely. I mean, I think that you have a very strong first half from recovery from the recession plus a lot of organic new business growth on top of that. And I think we’ve pretty much run our course in China in recovery from the recession, and the steps they've been taking over the last year or so just start to begin to slow down the economy. It’s starting to take a little bit of an effect.

Operator

Ladies and gentlemen, this concludes the question-and-answer session for today's call. I would now like turn the call over to Mr. Jim Sawyer for closing remarks.

James Sawyer

Thank you very much, and I thank everyone for attending the conference call. If you have any follow-up questions, please give Liz or myself a call. We try to be available as much as possible. Have a good August. Bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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Source: Praxair Q2 2010 Earnings Call Transcript

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