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Praxair (NYSE:PX)

Q3 2010 Earnings Call

October 27, 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.

Jeffrey Zekauskas - JP Morgan Chase & Co

Robert Koort - Goldman Sachs Group Inc.

Michael Harrison - First Analysis

David Manthey - Robert W. Baird & Co. Incorporated

Laurence Alexander - Jefferies & Company, Inc.

Kevin McCarthy

P.J. Juvekar - Citigroup Inc

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2010 Praxair Earnings Conference Call. My name is Katie, and I'll be your coordinator for today. [Operator Instructions] I would like to now hand the call over to your host for today, Mr. Jim Sawyer, Executive Vice President and CFO. Mr. Sawyer, over to you.

James Sawyer

Thank you. Good morning, and thank you all for attending our third quarter earnings call and webcast. Liz Hirsch, Director of Investor Relations; and Mark Murphy, Vice President and Controller, are with me this morning. Liz and I will review our third quarter results. Afterward, I will discuss our earnings guidance for the fourth quarter and our business outlook. We will then be available to answer questions.

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 2 and note that it applies to all statements made during this teleconference and website.

Praxair had a strong third quarter with overall business trends in line with our expectations. Our results showed strong volume growth in all geographies as compared to last year. Volume growth was particularly strong in South America and Asia. As we anticipated, sequential growth in the second quarter was at a more modest pace from what we were seeing in the first half of this year. We grew operating profit and net income faster than sales from productivity and cost reduction and operating leverage from higher volumes.

We reported record net income and earnings per share despite the fact that in developed markets like the U.S., Canada and Europe, our volumes are still below pre-recession levels. We generated very strong operating cash flow, started up four new plants, signed a number of new customer contracts and acquired an investment in a leading industrial gas business in the Middle East, a region, which we believe offers significant opportunity, all of which positions us well for continued future profitable growth. Liz is going to 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 third quarter results. Please note that the results for the prior year quarter and the year-over-year comparisons have been adjusted to exclude the impact of the Brazil tax amnesty program and other charges last year. Sales in the quarter were $2.5 billion, 11% above the prior year, primarily due to 9% volume growth. Sales were higher in all our major end markets. Chemicals, metals, electronics and manufacturing have the strongest growth versus prior year. New plant start-ups in Asia and in the U.S. contributed to overall growth. Sequentially, sales were similar to the second quarter as organic volume growth was somewhat offset by summer vacation seasonality in Europe, combined with a number of customer plant outages in Europe, the U.S. and China.

Operating profit of $551 million grew 15% from the prior year and the operating margin increased to 21.7%. Excluding the effect of higher cost pass-through, operating margin was 22.1%, which is a record. The contribution of higher volumes on a lower cost structure from ongoing productivity initiatives drove this improvement.

Net income of $377 million grew 19% from 2009, aided by lower interest expense and higher income from equity investments. Interest expense is lower due to lower rates and lower international borrowings. Equity income is higher due to higher earnings in our affiliates in Italy and Norway, and our recently acquired investment in the Middle East, the ROC Group. Earnings per share were a record $1.21, also up 19% from prior year.

We generated strong cash flow from operations of $596 million, which is 23% of sales. This cash flow funded $324 million of capital expenditures, largely related to the construction of large on-site plants in our project backlog and acquisitions of $114 million. Acquisition expenditures relate primarily to our recently announced acquisition of a 49% interest in the ROC Group, which is the leading industrial gas company in Kuwait and the United Arab Emirates, and which also has a growing business in Qatar. Cash flow also funded dividends of $139 million and $54 million of net stock repurchases.

After-tax return on capital was 14.7%, and return on equity was 26.4% for the quarter.

Please turn to Page 4 for our results in North America. Sales in North America were $1.3 billion, 10% above prior year, due primarily to 7% volume growth. Higher cost pass-through, primarily higher natural gas prices, contractually passed through to our customers in hydrogen prices, increased sales by 3%. Sales to chemicals and metals customers were well above prior year and manufacturing showed nice improvement. Sequentially, sales volumes were flat with second quarter due to the mix. Merchant volumes were higher and packaged gases volumes were lower due to normal seasonality related to summer holidays. On-site volumes were modestly lower due to several seal [ph] and refining customer turnarounds.

On-site volumes were 7% above prior year driven by higher oxygen and nitrogen. Towards the end of the quarter, we started up the first hydrogen plant at BP's Whiting Refinery. Our hydrogen supply at this location will ramp up throughout 2011. This supply agreement is different than other hydrogen contract in that the natural gas feedstock is being supplied by the customer and not running through our income statement. Therefore, this contract will not add as much to our top line, but its very high margin sales.

Merchant volumes have continued to grow. Overall volumes grew 12% from prior year and 3% sequentially. Growth was broad based across all major products. Carbon dioxide was strong for seasonal food and beverage demand. Liquid sales were higher for gas well frac-ing activity related to a number of specific projects and technology testing sites. Merchant pricing trends are relatively flat year-over-year and sequentially, with some tailwind from recent price increase actions and some headwind from lower liquid hydrogen prices tied to natural gas.

Packaged gases volumes are improving more slowly. Volumes were 6% above prior year with growth led by hardgoods and some equipment sales, which is typical at the start of an economic recovery. Sequentially, packaged volumes are slightly lower as is customary in the third quarter due to summer holidays.

Our business in Mexico is performing well, with volumes up 6% from prior year and continuing to improve sequentially. New project activity is increasing in the energy, steel and petrochem sectors, which bodes well for future growth. Pemex will continue to invest in energy production, and multinational corporations and local companies are investing in new production capacity for both domestic consumption and export.

Operating profit in North America was $314 million, 19% above prior year. Operating margin reflects good leverage from higher volumes, including the hydrogen plant start up. Please turn to Page 5 for our results in Europe.

Sales in Europe were $322 million. Excluding currency effects, sales were 10% above the prior year, driven by 7% organic volume growth. On-site merchant and packaged gases were all above 2009 levels in Germany, Italy and Spain. Merchant volumes showed the strongest growth this quarter, up 11%. Packaged gases are lagging in the recovery due to weak construction in met fab [metal fabrication] markets, particularly in Spain.

Overall, slow positive sequential business trends continue, with Germany showing the most strength driven by exports, and Spain lagging in the economic recovery. This mix is evident in the operating profit, which was $59 million in the quarter compared to $68 million last year. Volumes have improved the most to our largest on-site and pipeline customers, some of whom were making high-margin take or pay payments last year and are now taking product. Packaged gases are higher margin and volumes have been slower to improve coming out of the downturn.

Currency effects, including a net income hedge loss this quarter combined with plant outages and expenses associated with the new business acquisitions also temporarily depressed operating profit and the margin percentage. In August, we announced the acquisition of a 49% ownership interest, but with 50% voting control of the ROC Group's businesses in the UAE, Kuwait and Qatar. This week, we announced a large on-site contract with United Steel in Bahrain. In addition, we have established a presence in two key industrial areas in Russia, and we announced this week a long-term oxygen contract for a steel company in the Volgograd region.

These investments followed several years of research and business development to identify the right locations, the best partners and the highest quality customers with whom to do business. The associated costs of establishing these footprints have been absorbed in our Europe segment, but we are now at the point of winning new business and realizing revenue and earnings growth, which we anticipate will accelerated in the future.

Page 6 summarizes our results in South America. Sales in South America were $506 million, up 16% from prior year. Currency appreciation increased sales by 4%. Underlying sales grew 12% from higher price and volume. On-site and merchant volumes have staged a strong recovery and are close to 2008 levels. Compared to last quarter, merchant and packaged gases have continued to grow, up 2% and 5%, respectively, in the quarter. On-site oxygen volumes weakened a bit, along with fuel production in Brazil due to the strengthening real. The Brazilian government has increased the IOF tax on financial investments coming into the country, what is referred to as the carry trade, in order to prevent the real from appreciating too far.

Operating profit of $117 million grew 24% from prior year, and the operating margin was 23.1%. The strong leverage was due to volume and pricing gains and productivity savings. Overall, we continue to be very bullish on growth prospects in South America. We expect our base business to continue to grow, and we are working on many new project proposals. We anticipate significant hydrogen opportunities with Petrobras, who is investing billions of dollars in upstream refining. These potential projects are large with long lead times. In addition, we are working on numerous other opportunities with fuel, chemical and other manufacturing customers. Our merchant and package businesses will grow with increasing domestic consumption and new gas applications which we bring to our customers.

Please look at Page 7 for our results in Asia. Asia sales of $287 million were 24% above prior year. Excluding the effects of currency and cost pass-through, which is primarily precious metals used in our physical vapor deposition targets business, sales grew primarily from 17% higher volumes. Volume growth came from new project start-ups in China and Korea and strong growth in merchant liquids. Our volumes in China are at record levels.

India's volumes are 15% above prior year and up 4% from last quarter due to organic growth. Electronics has continued to be strong in Asia, though we are expecting growth to moderate next quarter and into 2011. Sales to the flat-panel display market have slowed down, but sales to the semiconductor manufacturers have held up, driven by handheld devices.

We had strong sales of PVD targets this quarter, particularly in Asia. The mix effect of electronic sales and lower xenon pricing, which primarily goes to the plasma market, accounts for the 2% lower price in the Asia segment this quarter. Pricing for merchant industrial gases is up year-over-year in both China and India.

Operating profit in the quarter was $38 million. The significant effect of cost pass-through this quarter reduced the operating margin by 170 basis points. We are also adding sales and engineering resources to support expected future growth. As an example of the new business we are winning, last week, we announced a new 1,700 ton air separation plant for Meishan Steel. This is a project which was deferred in the early days of the economic downturn. Based on the current growth outlook and new energy efficiency technologies we're working on, Meishan has expanded the original project scope and the plant will now come online in early 2012.

Page 8 shows our results for Surface Technologies. PST sales were $141 million this quarter, 8% above prior year, excluding currency effects and on par with last quarter. EBPVD jet engine coatings were strong and aviation coatings in U.S. and Asia improved from last quarter. Coatings for industrial gas turbines are below prior year due to lower new builds. Demand for coatings for oil field gate valve components grew. Operating profit of $23 million grew 28% from prior year and 5% from last quarter, showing strong operating leverage from higher volumes and productivity initiatives. Now I will turn this back to Jim to discuss what we're seeing in our global end markets and our fourth quarter earnings guidance.

James Sawyer

Thanks, Liz. Please turn to Page 9. This slide gives you our customary detail on sales growth to our major end markets compared to both prior year and to last quarter. It shows an organic sales growth, excluding currency, cost pass-through and acquisition effects. Our sales in the energy markets are primarily refinery hydrogen. Our volumes from existing customers have been very steady. This quarter, we had a customer outage, which offset the positive contribution from the world scale plant we started up in Whiting, Indiana late in the quarter.

We expect future growth to come primarily from new refinery investment in overseas markets for upgrading and new capacity. The potential number of new projects is very large and the size of these projects is large so we continue to see hydrogen as a significant growth driver for us. We also continue to be positive on new business opportunities related to enhanced oil recovery, and we are participating in a number of pilot projects around the world.

Electronic sales were strong. Our sales were up 17% from last year, excluding the cost pass-through due to strong demand in Asia from semiconductor manufacturers and the flat-panel makers. As Liz mentioned earlier, our PVD's target sales have been strong in line with increased industry capacity utilization. Towards the end of the quarter, we saw demand from flat-panel manufacturers slowed and we expect this trend to continue into the fourth quarter. The solar and LED markets should continue to provide good growth. Lower pricing of specialty gases continues to offset some of the volume growth.

Sales to chemical customers have continued to be very strong in the U.S., Germany and in Asia. Infrastructure investment and rising consumer demand in emerging markets and the economic recovery in the U.S. and Europe have all been supportive of chemical production, and low natural gas prices are really helping the U.S. producers. We believe that this end market will be one of the key drivers for new on-site projects overseas in the next several years.

Sales to metals were up sharply year-over-year. However, we did see a sequential slowdown this quarter due to the end of inventory restocking and a softening of order backlog at customers. As a result, several large customers took maintenance outages in the quarter. Global steel production in Q3 declined about 6% from the second quarter, but is forecasted to increase in the fourth quarter and we're seeing this already in China. Our outlook is for modest growth to continue in 2011.

Sales to manufacturing were 12% above 2009 and flat versus second quarter. The underlying trends are positive, stronger in emerging markets and slower and more choppy in the U.S. and Europe. Our sequential results reflect the normal seasonal decline in sales in Europe due to the summer holidays. Please turn to Page 10 for our fourth quarter earnings guidance.

Our guidance for the fourth quarter of 2010 is for earnings per share to be in the range of $1.18 to $1.23. We expect to see modest sequential volume growth. Year-over-year comparisons will be more muted. At this point, we expect minimal currency effects. This therefore brings our 2010 full year earnings per share guidance on an adjusted basis to a range of $4.67 to $4.72, which is up 17% to 18% above our 2009 adjusted earnings of $3.99. This represents record earnings for Praxair and is significantly above our $4.20 peak earnings in 2008. We've achieved this even though our volumes are not fully back to 2008 levels, primarily because of new projects coming on line in cost reduction and productivity, which have given us a good operating leverage on volumes as they recover.

So this should also indicate to you that as we go forward into 2011, there are still more leverage to come from our base business. We're expecting full year sales to be about $10 billion and full year capital spending to be in the area of $1.4 billion. We will begin specific earnings guidance for 2011 in January when we announce our fourth quarter earnings. But let me say a few words on our general outlook.

Our base business continues to improve. We expect the pace of growth to be slow, but steady in the U.S., Canada and in Europe where consumer spending is below pre-recession levels and where excess manufacturing capacity will mitigate the need of our customers to build new production facilities for several more years perhaps. We took a lot of cost out in these locations in the downturn and are being judicious and selective about adding them back. This is why we expect traditional margin leverage as volumes continue to improve.

We're very bullish about growth in the less developed emerging countries. And Praxair has what we believe to be the strongest footprint for profitable growth among our major competitors in the key countries. We expect to generate strong growth in Brazil, the other Latin American countries in South America, Mexico, China and India where our existing businesses are significant.

Our recently established platforms in the Middle East and Russia will add to this footprint for growth. These are all regions where the rising standard of living is driving increased consumer spending. This in turn drives investments in industrial and manufacturing infrastructure as well as in more energy production. These projects require significant amounts of industrial gas supply and the increasing trend of our customers to outsource our gas supply rather than buy and operate their own plant as the overall growth opportunity for us.

We therefore expect our project backlog to continue to grow. As these projects start up, they should contribute about 3% to 5% revenue growth per year. It will be a little bit lumpy quarter-by-quarter and year-by-year depending on the size of the projects, timing of start up and the capital-to-sales profile. We continue to be selective about which projects we work on and want to win, and these are ones where we see the opportunity to earn a nice spread above our cost of capital from an on-site contract, coupled with merchant liquid distribution.

As our track record has shown, we will continue to focus on developing innovative application technologies for our customers and winning new on-site opportunities, combined with a relentless focus on capital discipline and productivity. This is key to producing double-digit earnings growth, which we expect to deliver for the foreseeable future. And now I will take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Mike Sison from KeyBanc.

Michael Sison - KeyBanc Capital Markets Inc.

Jim, in terms of your commentary, I was -- in regard to steel production improving, is that more indicative of things getting better for those markets, or shutdowns going away and production getting better sequentially?

James Sawyer

Right, the way I kind of see it over the cycle, we went in to the steep recession with almost 40% of capacity shut down for a while, while they work off inventories. It started to come back up in the third and fourth quarter of last year, and then we saw a very significant improvement in the period from February until May of this year, followed by kind of a slump in this third quarter just ended. And we feel very strongly about it. The slump in the quarter just ended. It's really just a function of the fact that the growth in the first and second quarter was involved with inventory rebuilding. And we expect that the underlying demand is stronger than production in the third quarter and that will pick up in the fourth quarter and on into 2011.

Michael Sison - KeyBanc Capital Markets Inc.

Then in terms of the leverage potential heading into 2011, could you give us an idea where global merchant operating rates are by the end of the year, and then your base on-site business as well? And if the economy continues to grow, how does that sort of improve in terms of the rates heading into '11?

James Sawyer

Well, what we've seen is that where we've had base business picking up, we've been getting about a 35% operating margin leverage on the specific incremental sales. And the on-site business has picked up fairly significantly in most places because it was down a lot due to inventory destocking and then restocking. Merchant has begun to pick up in the second quarter here in the U.S., but we're still right around 80% capacity utilization, which is not a good number. We'd much rather be at 85% to 90%. And then Europe is perhaps the weakest, and we suffered in Europe, but not only excess capacity, but extremely competitive pricing over there. So I'm not sure how to answer the question in terms of leveraging to 2011. But as long as we continue to see the demand grow in the merchant and packaged gas businesses around the world, we'll get operating leverage from the incremental volume, plus I expect we'll move up to a tighter capacity utilization in terms of supply and demand balance where we'll be able to increase pricing the way we did in prior years.

Michael Sison - KeyBanc Capital Markets Inc.

And one quick one on solar. How big is that now in the electronics business? And do you think the momentum there in terms of the markets can continue into 2011?

James Sawyer

Our solar business today is around $75 million of sales, and that's really sales of a variety of gases to the flat-panel manufacturers. And those manufacturers basically tend to buy merchant gases from whatever producers in the region. And due to our very good footprint, we're very competitive in having the right merchant and helium and so forth where we need it. We're expecting 2011 growth to be about 70% higher than 2010 because of some new production facilities coming on stream, which were started a while ago. And then from there, we expect it to continue to be strong, but it's going to depend on how much government subsidies continue to go into solar panel manufacturers.

Operator

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

Kevin McCarthy

Jim, you mentioned that there would have been some inventory restocking between February and May of this year, and it looks like you've had somewhat flatter volume patterns since then. And yet looking ahead, you expressed some confidence that sequential growth would resume. And so I was wondering if you could just elaborate on what is inspiring that confidence? Are you seeing it already as you look at September and October volumes?

James Sawyer

We had a fairly significant number of customer outages in the third quarter, several in the U.S., China and Europe. And they always say they're shutting for maintenance, but you don't know exactly why they're shutting. But those have come to an end, and so we expect a strong fourth quarter. And I think that inventories in chemicals and steel are still low. The U.S. chemical producers have an advantage in feedstock cost, and volume growth in China is going to be very significant also. Chemicals will be our larger end market growth in China as we build more oxygen facilities for core gas locations.

Kevin McCarthy

And then in Europe, Jim, you mentioned, I think, that you had some startup costs connected to your new investments in the Middle East and Russia. What is the approximate magnitude of that?

James Sawyer

Right, it wasn't one of our best quarters in Europe from a reported operating profit point of view. But we're basically looking at getting our operating margin back on track to north of 20%. We had some hedge cost in Europe. We had startup costs with the new projects in the Middle East and Russia. We have a pilot Enhanced Oil Recovery project going on in the Emirates, which is a drain to us right now. But we expect Europe to be back into the low 20s operating margin in the fourth quarter next year.

Kevin McCarthy

And then final question, if I may. You had quite good operating margins in North America unlike Europe. You mentioned that you've got a different contract structure with BP Whiting that carries very high margins. I'm just wondering, was that a meaningful factor in your view in explaining the sequential margin expansion domestically?

James Sawyer

Yes, it was not a meaningful factor yet because we just started it in September. And that project has two world scale hydrogen plants. One of which we started in September, and the other one will start in the first quarter of next year. And what we've done with that contract, and it's really our preferable way of business, is to essentially operate at the tolling agreement where we never pay for the natural gas and we don't invoice the natural gas to the customer. Consequently, it has less than half of sales as it would if we were buying natural gas invoiced to the customer for that, but at the same operating profit. So that would add to operating margin percentage, much more than it would add to sales. But doing the contract that way takes an element of risk out of the oil project since we don't stand in a purchase agreement of natural gas and the sales agreement of hydrogen.

Operator

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

David Begleiter - Deutsche Bank AG

Jim, just wonder, on the backlog, you mentioned you started up four projects. How many did you add? Did any fall off? And that $2.5 billion number for year end still the correct number?

James Sawyer

Yes, basically, we held pretty much flat in terms of backlog in the second quarter to third quarter. We still expect to be about $2.5 billion as the year turns over. And there are about five extremely very, very large projects that we're negotiating right now and very close to announcing. However, they're also the kind of projects that you kind of negotiate almost forever before the customer finally makes up his mind about what he wants to do. But we've got a couple in South America and a couple in Russia and Asia. And so depending on the timing of those projects, we'll have a significant increase in backlog going into 2011. And our capital spending will probably go up about 15%.

David Begleiter - Deutsche Bank AG

And Jim, just on the September 1 selling price increase that you guys announced, is that fully implemented? Will that be fully realized?

James Sawyer

Well, it's fully implemented in terms of invoices sent to customers, but it's not fully realized in terms of the timing of those invoices and the payment of those invoices. Those increases are typical of what we do. They apply to some of our customers whose contracts are up for renewal and others who are on open status contracts. And I wish to start to get some more traction from those going into the fourth quarter and next year.

David Begleiter - Deutsche Bank AG

And Jim, just last on packaged gases. Any change in the competitive intensity in the market the last few months?

James Sawyer

No, it's been -- the whole sales, the whole volume I think is a little slower to recover because it's kind of a late cycle thing. And part of the packaged gas sales are related to nonresidential construction, which really hasn't picked up yet. But no changes in the competitive dynamics.

Operator

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

Robert Koort - Goldman Sachs Group Inc.

Jim, just a question on natural gas pass-through in the U.S. Obviously the gas prices has gone down quite a bit. Do you have a sense on how much that might have helped margins year-on-year?

James Sawyer

Year-on-year, it was fairly small. We had a 1% increase in our overall sales from natural gas. It was up about 30% -- our natural gas prices were up about 30%. So it probably contracted our operating margin by about a half a percentage point.

Robert Koort - Goldman Sachs Group Inc.

And then in the Middle East, this ROC asset, I noticed it's the biggest independent, but does that mean it's the biggest or what does the competitive landscape look like in the Middle East? And what kind of growth rates do you expect there?

James Sawyer

What we mean by independent is we mean it's non-captive supplier. And ROC is a very well established and very high market share, and merchant gas is in packaged gases, but not a very strong presence or with no presence at all in on-site sales. And as I think you know, traditionally in the Middle East, where there are large chemical facilities and so forth, they tend to buy the oxygen plants. That is starting to change. We just signed a major contract in Bahrain for oxygen supply to a steel company. And so our strategy there really is to take our ability to sign on-site contracts, and ROC's established merchant and packaged gas businesses. And the two of them together, work to the kind of margins that you can get by having integrated business.

Robert Koort - Goldman Sachs Group Inc.

And then last thing if I might. Do you have any risk, you think, in your three or four plants in Venezuela? Or is that way down the target list of what might be in danger?

James Sawyer

That's a good question. I think we've always believed that the target list of what might be endangered are high profiles. But given that they've hit another company, it's kind of down in the low-profile area. I think it's something will always continue to be an issue, or risk I should say.

Operator

Your next question comes from the line of P.J. Juvekar from Citi.

P.J. Juvekar - Citigroup Inc

So Jim, your competitor is adding and connecting their hydrogen pipelines on the Gulf Coast. Does that put you at a disadvantage when it comes to building for new projects?

James Sawyer

No, because there are no customers in between those two endpoints. The pipeline basically will allow them to balance where they might have excess production, and maybe not enough production. But there really aren't customers along that stretch, so there's not anything that we're going to miss because we're already located in the western side in the Texas region. And so we don't see any impact from us. It's obviously going to be a large capital expenditure for them. But it'll probably give them maybe the equivalent of what we've got with our cavern in terms of the ability to actually store gas and then release it as the market [indiscernible].

P.J. Juvekar - Citigroup Inc

And Jim, refinery hydrogen has been growing in the U.S., sort of double digit for several years now. Do you think that opportunity stepped out or is it still growing in double digits?

James Sawyer

I think it's definitely slowed down in terms of the outlook going forward for a couple of reasons. One of them is that there were a couple of aspects to the growth and a strong driver was the air emission requirements reduced the amount of sulfur allowed to be in diesel and gas, and that's all worked its way through the system. So the need of the refiners to add hydro-frac-ing, hydro-treating news [ph], I think, is going to slow down, although there are still a significant number of opportunities that we're working on. So I think we'll be able to add a couple of year, perhaps, but probably not at double-digit rates in the U.S.

P.J. Juvekar - Citigroup Inc

And just sticking to energy, one more question. Natural gas prices are going down because of all this shale gas production. How big is shale gas frac-ing business for you in terms of revenues and how fast is it growing?

James Sawyer

The shale gas production that is coming from the new technology for potentially sideways drilling is very deep and too deep to fracture with gas instead of just using water frac-ing down there. So we're not participating in that part of the market.

Operator

Your next question comes from the line of Jeff Zekauskas from JPMorgan.

Jeffrey Zekauskas - JP Morgan Chase & Co

In your discussion about hydrogen in South America, you talked about negotiations that were ongoing. Did you mean to imply that if the projects would go forward, Praxair would win them? Or is it more uncertain than that?

James Sawyer

Well, there are several layers of uncertainty. I think we're very well positioned to win them and the first decision is for the refinery projects itself to go forward. One of those, I believe, has already left the gate and is definitely going to go forward. Others are probably uncertain. And then the refiner, Petrobras, has to decide whether they're going to build the plant themselves or outsource it. And then if they outsource it, I think we're a very important position for them.

Jeffrey Zekauskas - JP Morgan Chase & Co

And then secondly, your operating income in North America went up $20 million sequentially on really no increase in sales? So is there something eccentric about the third or eccentric about the second quarter? What's the right level of profitability?

James Sawyer

Basically, the overall sales growth is flat, but we had a significant pickup in merchant sales, which came with a lot of operating leverage. Less pickup in packaged gas. And then we had some curtailed plants, primarily in hydrogen, which has a low margin percentage. So that's kind of the thing. And lastly, natural gas prices were lower sequentially, so that our sales were sort of artificially impacted down sequentially.

Jeffrey Zekauskas - JP Morgan Chase & Co

And then lastly on your other income. I think for the first nine months, maybe there's a $34 million positive delta. What is that? And is that something that will reoccur next year or we've sort of exhausted whatever this net benefit is?

James Sawyer

Right. Well, other income is fairly flat, close to zero right now, which is probably where we'll tend to be most of the time. We've got certain things here, our expense against other income and certain things that have to be accounted for as positive in other income. One of which is the sales of our partnerships in the gas frac-ing business, which has been contributing practically nothing for the last 18 months. And then lastly, we've got some hedge cost that go in and out of other income. But I think that it'll stay probably around the zero number plus or minus, and it would be a good way to model it.

Operator

Your next question comes from the line of Laurence Alexander from Jefferies.

Laurence Alexander - Jefferies & Company, Inc.

I guess first question, on the Russian opportunity, can you give us a sense for how large the two zones that you've entered are? And what it took for you to add those to your list of target geographies and what criteria you were using?

James Sawyer

Well, it took a lot of hemming and hawing

on our part as we spent probably five years looking after our share in deciding whether to invest there, where to invest there and how to mitigate the risks that are involved with that. But we basically are, in spite of the fact that the Russian natural gas and oil industry which is a huge opportunity for us, from a risk point of view, we've decided that's not a place where we want to go. So we're focused more on the chemicals and steel industry and mining industry. And the Volgograd region, south of Moscow, is where a lot of those chemical and steel plants are located, which we believe would offer the opportunity potentially someday to put it in a pipeline enclave, but we would only build that customer-by-customer as we sign contracts. And then secondly, way out in the euro mountains is the primary mining area and there's a lot of chemical and steel production and heavy industry there as well. All of that is currently captive. All the euro region, the Volgograd region is captive. And then the plants are extremely low efficiency, 30-year old Russian-designed plants, if you will. So there's huge opportunity to be able to decap existing customers by just building a new plant for them, and the savings that they get in energy efficiency versus operating the old plant is more than enough to allow them to pay our take-or-pay contract monthly and give us the return on capital that we're looking for. So those are the two regions, and that's kind of the strategy there.

Laurence Alexander - Jefferies & Company, Inc.

And secondly, on pricing. I guess the last few quarters, there's been remarks about competitive pricing behavior in different regions. To what extent is this just a function of the utilization rates? Or do you feel that there's been a shift in industry discipline compared to the last recession in the current environment?

James Sawyer

Well, I think it's kind of a case-by-case area. But in some regions, our competitors have built huge amounts of excess merchant liquid capacity without justification, and that's one of the problems they have with their return on capital. But then what they try to do is to load up the plant by coming in and trying to take customers weight [ph]. And so you see that once in a while in certain regions. I wouldn't say that it's -- we certainly don't see it in North America, but that's kind of their strategy.

Operator

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

Mark Gulley - Soleil Securities Group, Inc.

My first question has to do with geography. Jim, for a long time, you've talked about the fact that you participated in a number of geographies, and now just recently you've added Middle East and Russia as you've discussed so far. Any of the geographies that you're looking to reenter, perhaps, or break into the first time? It used to be like a dozen or so. Now we're up to 14 or so. Could it go to 20, for example?

James Sawyer

Not at this time. I mean, we basically, as you know -- we basically try to get a high return on capital by optimizing, being in the on-site of the merchant and the packaged gas business. And having a number one position in a geography -- geography, just defined, basically, is a one-day truck drive [ph]. But having a number one position in terms of production and distribution. And so there are only a few places left in the world where we believe you can actually go in there and do that, and these Middle East and Russia are some of them.

Mark Gulley - Soleil Securities Group, Inc.

Secondly, on refinery hydrogen, I'm sure delighted to make the progress you have at BP Whiting, Indiana. But can you give us an update on the other coast? What's happening at Chevron in Richmond?

James Sawyer

I can't give you much of an update on Chevron in Richmond. Chevron is still at an impasse with the environmental groups as to when they will be able to restart construction. And I understand that they're working through a court-appointed mediator to work out a solution. Once that solution is worked out, then we're probably a year off from restarting the construction activity, and then starting up the plants. So I would say, 2011 is ruled out for that, maybe early 2012.

Mark Gulley - Soleil Securities Group, Inc.

And I don't know, maybe you said it, but I missed it. Did you comment on merchant operating rates regionally and how they stand?

James Sawyer

I did. In the U.S., we're about 80% in terms of merchant operating rates. So we've still got a long way to go back up to the 85% and 90% area, which would be significant and more profitable for us.

Operator

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

Michael Harrison - First Analysis

Just trying to get a little better understanding of the sequential margin decline in Asia. Can you quantify the unusual business development expenses that were reflected in the margin number this quarter? And maybe talk a little bit about how that expense will change over the next couple of quarters?

James Sawyer

A couple of things about it. I think people realize and have asked this question for a long time why our margin in Asia are lower than the rest of the world. And there are generally two reasons for that. One of them is, about 40% of our sales in Asia are in electronics with below 10% operating margins. And that tends to bring down the traditional industrial gases, which is more in the 20% range. Secondly, we've moved a lot our business expenses. We have actually moved our procurement organization to Shanghai, so that we can focus on low-cost country sourcing in China. So we'll be buying more equipment out of China and less out of Europe and the U.S. Currently, we're getting up close to about 80% of our equipment coming from China in this Chinese plant. Then on top of that, it's kind of a bad quarter for us because we had some plant outages and we had power cost increases in Korea, and then genuinely higher expenses elsewhere. So kind of as a rule of thumb, I think you could think of about, when these things are gone, kind of getting the margin up close to 20%. So that would be about another $10 million of operating profit for the quarter.

Michael Harrison - First Analysis

And you commented the merchant gas pricing trends are positive in Asia. Are you getting enough pricing at this point to cover those higher power costs? Or was that a component of the margin squeeze this quarter? And how long do you think until that dissipates?

James Sawyer

It's different country-by-country. In China, we're getting good pricing increases and increasing margins. India, we're getting good pricing increase and then decreasing margins also. Korea has kind of got the worst of all situations, which is that power costs have gone up substantially this quarter in Korea. And normally, merchant pricing would go up with that. But we've got one of the situations that I've just described. A lot of excess capacity coming along by competitors. And therefore, pricing in Korea is down, while our power cost is up.

Michael Harrison - First Analysis

Last question I had for you is just with regard to Mexico. I was wondering if you're seeing any operational problems related to some of the security issues going on there?

James Sawyer

We haven't had any in terms of any interruptions of our plants or our distribution vehicles. But it's clearly a big concern of us and our people down there. And hopefully, it'll get better, specially in the Monterey area, which always used to be one of the safer areas. It's a big concern of ours, not so much for the operations but for the people.

Operator

And your final question comes from the line of David Manthey from Robert W. Baird.

David Manthey - Robert W. Baird & Co. Incorporated

Could you tell us how much of the 6% growth at PDI was from price? And then could you discuss the acquisition environment at PDI?

James Sawyer

First of all, there have been very little activity in acquisitions in PDI. And I think, generally, the situation is that most of the acquisitions would come from independent distribution business owners. And since volumes are still 10% or more below where they were in 2008, there just hasn't been -- we're valuing those companies lower than we would have in 2008. So there hasn't been much acquisition activity. The 6% growth was mostly volume. But I think as volume start to get more closer significant past the utilization, there'll be more opportunity to get price.

David Manthey - Robert W. Baird & Co. Incorporated

And then last question, when do you anticipate reaching full capacity at BP Whiting?

James Sawyer

I would say, probably, in June of next year.

Operator

At this time, I would like to now turn the call back over to Mr. Sawyer for closing remarks.

James Sawyer

Yes, again, thank you all for attending the conference call. We are very excited about the future opportunities that we still see out there. Had a few issues in our quarter, mainly in Europe and Asia this year, but we continue to see a strong growth in new project activity continue to ramp up in our backlog. And the average projects in the backlog are currently at about a 16% ROR. It's a little bit down from the 18% that we used to have. Somebody asked that question. So we're quite bullish on what we expect to see in 2011. Thank you very much.

Operator

Ladies and gentlemen, thank you for your participation in today's conference call. You may now disconnect. Have a wonderful day.

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