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Praxair (NYSE:PX)

Q2 2011 Earnings Call

July 27, 2011 11:00 am ET

Executives

James Sawyer - Chief Financial Officer and Executive Vice President

Kelcey Hoyt - Director of Investor Relations

Analysts

Michael Sison - KeyBanc Capital Markets Inc.

Donald Carson - Susquehanna Financial Group, LLLP

Jeffrey Zekauskas - JP Morgan Chase & Co

Michael Harrison - First Analysis Securities Corporation

Robert Koort - Goldman Sachs Group Inc.

Mark Gulley - Ticonderoga Securities LLC

John Roberts - Buckingham Research Group, Inc.

James Sheehan - Deutsche Bank AG

Edward Yang - Oppenheimer & Co. Inc.

Kevin McCarthy

Laurence Alexander - Jefferies & Company, Inc.

P.J. Juvekar - Citigroup Inc

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 Praxair Inc. Earnings Conference Call. My name is Angela, and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

And now I'd like to turn the conference over to your host for today, Kelcey Hoyt, Director, Investor Relations. Please proceed.

Kelcey Hoyt

Thanks, Angela. Good morning. Thank you for attending our second quarter earnings call and webcast. I'm joined this morning by Jim Sawyer, Executive Vice President and Chief Financial Officer; and Liz Hirsch, our Vice President and Controller. Today's presentation materials are available on our website at praxair.com in the Investor section. Please read the forward-looking statement disclosure on Page 2 and note that it applies to all statements made during the teleconference.

Jim and I will now review our second quarter results and outlook for the balance of 2011. We'll then be available to answer questions.

James Sawyer

Thank you, Kelcey. And good morning, everyone. Please turn to Slide #3 for our consolidated results. Praxair delivered another solid quarter, with earnings per share growth of 16% versus the 2010 second quarter and 7% earnings per share growth from this year's first quarter.

We started up 6 new major products during the quarter serving the steel, chemicals, and electronics sectors. More importantly, we announced new contract signings on 5 major projects, bringing our backlog of new projects under contract and construction to $2.7 billion, more than twice the size of the backlog we had 5 years ago, and these projects come on stream between now and 2014, building strong and profitable growth.

Consolidated sales in the quarter were $2.9 billion, up 13% versus the prior year quarter. Sales were higher to all major end markets, with the strongest year-over-year growth in manufacturing, metals and chemicals. Higher volumes contributed 5% growth and price contributed 2%. New project startups in Asia, South America and North America also contributed to volume growth. Pricing opportunities are improving with capacity utilization, increases and inflation and are most strongly reflected in Asia, South America and North America.

Sequentially, sales grew 6%, primarily due to higher volumes, price and currency. Operating profit grew to $627 million in the quarter, 15% above the prior year, and the operating margin increased to 21.9%. Higher volumes combined with price and productivity savings were the primary contributors to the growth.

Net income of $425 million rose 15% from the prior year. Earnings per share were a record $1.38, up 16%. Earnings per share grew faster than net income due to share repurchases under our $1.5 billion share repurchase program authorized in mid-2010. $568 million remains available under the program, which we expect to complete by the first quarter of next year.

During the quarter, we paid dividends of $151 million and repurchased stock of $205 million net of issuances. Our debt-to-capital ratio for the quarter was 47.5% and debt-to-EBITDA was 1.7x. Sequentially, our after-tax return on capital for the quarter improved to 14.7% and return on equity increased to 27.1%.

Now Kelcey will discuss our segment results. Please turn to Page 4.

Kelcey Hoyt

Thanks, Jim. Sales in North America were $1.4 billion, 7% above the prior quarter due primarily to underlying volume growth and price. Merchant liquid and packaged gas volumes both showed strong growth versus the prior as manufacturing continued to improve.

Sequentially, underlying sales grew 4% from the first quarter due to volume and price. The impact of the divestiture of the U.S. Homecare business, which was completed in early March of this year, reduced sales for the quarter by 3% year-over-year and 2% sequentially. Organic merchant sales grew 11% year-over-year with broad-based demand for all liquid products including oxygen, nitrogen, carbon dioxide, argon and liquid hydrogen. Sequentially, organic merchant sales grew 3%.

On-site sales were steady year-over-year and include the startup of the new hydrogen plants in Whiting, Indiana. For those of you who attended our Global Hydrogen Growth Focused Investor Day last month, remember that this project is structured as a tolling agreement, such that we do not invoice for energy but only for the added value of our Steam Methane Reforming process. Consequently, the contribution to sales dollars is low, and what we show as volume growth understates the physical capacity added and its strong earnings contribution.

Packaged gas sales continues to improve as manufacturing activity gradually increases in the U.S. In PDI, our U.S. and Canadian business, same-store sales were 12% above last year and grew 5% sequentially. Gases were up 8% and hard goods were up 20%. We do expect that the gas and hard goods growth will eventually become more aligned as we move to a later stage of the manufacturing recovery.

North America operating profit was $336 million, 14% above the prior year quarter. We delivered 14% operating profit growth on 7% sales growth, so you can see the multiplier effect of improved operating leverage. Merchant pricing trends for all products remains positive.

As these contracts are typically of a 3- to 5-year duration, our ability to increase the price is impacted by the timing of contract renewals. We expect to continue to realize low single-digit percentage impact from pricing actions in North America this year.

During the second quarter, we started up several plants. In Canada, at Essar Steel, we increased existing capacity at the Sault St. Marie Ontario site to 2,700 tons per day of gaseous oxygen and added merchant liquid capacity to support growing local atmospheric gas and U.S. argon markets.

In the United States, at Thyssenkrupp, we started up a new air separation unit with a capacity of 400 tons per day for their carbon and stainless steel processing facilities in Alabama. This plant will also generate liquefied industrial gases for the growing merchant customer base in the region.

And in Mexico, at Johnson Controls, we started up a new VPSA plant with a capacity of 140 tons per day of oxygen for their facility built to recycle lead acid batteries.

During the second quarter, we significantly increased our North American project backlog, with multiple hydrogen projects to support refineries in the Gulf Coast and lower Mississippi Valley, as the refineries are upgraded for the processing of heavier crudes.

We have signed contracts to supply combined additional volume of 270 million standard cubic feet per day to support the 2 hydrocrackers that Valero was currently constructing, one in Port Arthur, Texas; and one in St. Charles, Louisiana.

These projects represent long-term contracts with a good return that will begin to generate revenue as they come on stream in late 2012 and early 2013. We also added a new contract to supply Motiva's Norco Refinery with incremental hydrogen volume beginning in 2012.

All 3 of these projects were highlighted at our Global Hydrogen Growth Focused Investor Day last month. The slides and webcast replay remain available on our website and speak to our global growth opportunities in hydrogen as well as our longer-term outlook.

In the electronics market, we signed a multiyear contract with Hemlock Semiconductor to supply high purity hydrogen to their new $1.2 billion polysilicon manufacturing facility under construction in Tennessee with a 2012 start. We currently supply nitrogen and hydrogen to Hemlock's facility in Michigan.

Now please turn to Page 5 for our results in Europe. Sales in Europe were $367 million, and excluding foreign currency, somewhat flat with the prior year quarter. Volume growth in Germany was offset by lower packaged gas sales in Southern Europe, where growth remains stalled by the credit crisis. Germany had higher volumes as compared to last year and last quarter in all 3 distribution methods. Growth was strongest in manufacturing, metals and chemical end markets.

Italy is growing modestly in sales year-over-year in merchant and on-site. Packaged gas volumes declined year-over-year. Italy's sequential trends are positive across all end markets. In Spain, merchant volumes were above prior year, but packaged gas remains slower to recover as construction in met fab remains weak.

Operating profit was $69 million, below the prior year quarter. During the second quarter of this year, we experienced plant turnarounds that resulted in higher costs to supply the product, both from an energy and a distribution perspective. We are also incurring some modest restructure costs.

We continue to reduce fixed costs via targeted restructuring in the region as the volumes and mix of products do not appear to be improving in the near term. In addition, the second quarter of last year included a $4 million benefit from net income hedges.

During the second half of 2011, we expect little volume recovery in Europe and expect the typical third quarter seasonal sales decline due to the summer holidays. This will be partially offset by recent price actions, as well as some cost improvements due to restructure actions previously taken and less dislocation costs as the plants are brought back into operation.

Page 6 shows our results in South America. South American segment sales were $611 million, up 25% from the prior year quarter. Excluding currency and cost pass-through, underlying sales grew 12% versus the prior year quarter from 7% higher volumes and 5% higher price. Merchant and packaged gas sales grew 13% year-over-year, excluding currency, and 3% sequentially due to continued strong demand locally in manufacturing, food and beverage and healthcare.

On-site volumes grew year-over-year and sequentially due to strong metals market during the quarter. Year-over-year volume growth was supported by several new plant startups. Operating profit in South America was $139 million, an increase of 22% versus the quarter year ago. Underlying operating profit grew, primarily due to higher volumes, higher pricing and productivity.

Cost inflation continues and power and distribution cost recovery remains a significant focus for our Brazilian team. New project opportunities remain strong across South America. Earlier this month, we announced a long-term agreement with Braskem to build and operate a new cryogenic air separation plant with a capacity of 200 tons per day in Northeast Brazil. This will increase our supply to Braskem's polyvinyl chloride facility expansion project.

Please turn to Slide 7 for our results in Asia.

Asia had another very strong quarter. Sales of $341 million grew 22% versus the prior year quarter due primarily to 12% volume growth. On-site and merchant volume in China, India and Korea grew from stronger demand from metals, electronics and chemicals customers, including new plant startups.

Underlying merchant sales grew 24% year-over-year, with strong growth in all liquid products. Merchant pricing trends remain positive, especially in liquid argon, oxygen and nitrogen. We saw continued strength in our electronics business with sales in Asia up 12% versus the prior year quarter, excluding currency and 7% sequentially. This was due primarily to strong PVD target sales to the semiconductor industry.

Asia's operating profit increased to $56 million, up 27% from the prior year quarter. Operating profit increased faster than sales due to the effect of higher volumes, price and ongoing productivity initiatives.

In addition, late last month, we announced a start up of a supply of numerous gases to Shanghai Hua Li Microelectronics 12-inch integrated circuit chips production line in Shanghai at one of the top high-tech parks. In fact, Praxair is the leading glass supplier in the park.

Our results for surface technologies are shown on Page 8. PST sales this quarter were $168 million, up 13% year-over-year, excluding foreign currency. Aviation and industrial coatings volumes are strong. The industrial gas turbine market remain steady and is expected to improve during the second half of the year.

Longer term, we expect this business to benefit from the shift away from nuclear power in Japan and Europe. The second quarter operating profit and margin improved due to the higher volumes.

Now I'll turn the call back to Jim, who will discuss our global end market trends and our updated earnings guidance for the remainder of 2011.

James Sawyer

Thanks, Kelcey. Please turn to Page 9, which shows our global end market trends. This page shows year-over-year sales growth for our major markets excluding currency, acquisitions, divestitures and natural gas pass-through. So it represents real organic growth from price and volume. We've included the sequential growth numbers next to the year-over-year quarter to show the current trends as well.

Our energy market sales include refinery hydrogen, gas well frac-ing, oil well services and our LNG and CNG businesses in Brazil. Year-over-year growth includes the startup of the BP Whiting tolling agreement, partially offset by sporadic volatility in other areas, including this quarter's prolonged thaw in the Canada oil well services and some significant spot hydrogen sales from our cavern on the Gulf Coast in the year-ago quarter.

The electronic sector was solid during the second quarter, but we did begin to see signs of order softening in the end of June, including semiconductors and flat panel. We signed 2 new on-site contracts during the quarter in China and the United States and these plants, along with 3 world scale high-purity nitrogen plants under construction in Korea, will continue to be [indiscernible] over the next several years.

Sales in the metals industry grew 15% year-over-year, primarily as the result of new project startups in the U.S., Canada, Brazil and Asia.

Strong growth and volumes in the chemical sector include the ramp-up of sales to SOPO's coal gasification plant in China, other small startups and generally strong volume in the U.S. and Canada.

Sales to manufacturing were 12% above last year and 4% higher than the first quarter. The manufacturing end markets strengthened in all geographies, except Europe, and Latin America and Asia is being driven by strong underlying economic growth. In the U.S., however, we're seeing a late stage recovery from the recession but are still not back to where we were in 2007. About half of our sales of this broad sector are related to heavy machinery, metal fab, construction, et cetera. This is a late stage end market as demand climbs when customers are adding new production capacity, infrastructure or space.

In the aerospace market, our surface technology business is well positioned on coatings for current and next-generation more fuel-efficient planes and engines. The orders out of the packaged gas sales, which have recovered very nicely this year with the recent Paris Air Show, for OEMs that we supply is positive but will take a couple of years for benefits to show up in sales.

And now please look at Page 10 for our earnings guidance. Our earnings guidance for the third quarter is for EPS of $1.35 to $1.40. We're modestly raising 2011 full year earnings per share guidance to a range of $5.40 to $5.50. We expect sales to be in the area of $11.2 billion.

Our guidance for the balance of 2011 is based on our short-term outlook for key market sectors augmented by specific actions we expect to achieve during the balance of the year.

The general observation appears that the strong economic growth we've seen over the past year will be moderating a bit in the second half. Specifically in the United States, we expect steel and chemical volumes to be relatively flat going forward sequentially. Packaged gas sales, which have recovered very nicely this year with a rebound in manufacturing, will likely grow in the high single-digits for the balance of the year.

Europe will likely get off to a slow start beginning with the summer slowdown and continued negative sentiment regarding the government fiscal situation. The key issue which is hurting us there is the deferral of purchasing decisions by businesses due to the uncertain economic outlook. Once these clouds clear up, I do believe we will see a recovery in European manufacturing and packaged gas sales like we've seen in the U.S.

Mexico and South America continue to be strong. And although the Brazilian government is raising interest rates, I do not see a slowdown there. Likewise, both China and India are expected to show double-digit growth for the foreseeable future.

Regarding our own business, we expect to start up 12 plants during the second half of the year, representing all geographies and major markets. Notably, we'll be starting an EOR facility in the U.S., our first major Russian project, several steel facilities in South America and India and our second major coal gasification facility in China.

Over the longer term, the opportunity set for major atmospheric gases and hydrogen contracts continues to grow. Additionally, we believe we're winning more than our fair share of new contracts as evidenced by our growing backlog.

Capital spending will ramp up in the second half, as we begin work on some of the new projects announced earlier this year. Total capital spending for the year will be about $1.8 billion at the high end of our previous guidance.

Finally, I'd like to remind you, we'll be presenting at several investor conferences during the third quarter. Please check our website for the calendar of events, presentations and access to the webcast.

And now we'll be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question will come from the line of P.J. Juvekar with Citi.

P.J. Juvekar - Citigroup Inc

So your operating margins in Asia of 16.4% are the lowest of any region and about 800 basis points below North America. I mean, can you talk about some of the reasons, is the high degree of competition leading to these lower margins?

James Sawyer

Yes, we've talked about this before. And it is absolutely not a conclusion that competition or underlying business project margins are lower than in other regions. About 1/3 of our sales in Asia, or about $100 million during the quarter, are in our electronics sector at an average margin of about 12%. If you kind of back that out and look at what the remaining gases would be, our actual industrial or gas business x electronics is over 20% operating margin. The other reason it's slightly below the other quarters is because of the fact that we are basically about $1 billion a year business, actually growing to $1.5 billion. But because of all the business development activities we have, we have a business development process, R&D and so forth in Asia, which is really more aligned to a $2 billion business, we think. Another place you can look to compare them is the EBITDA margin. And in Asia our plants are much newer than they are in the rest of the world and, therefore, depreciation is a higher percentage of sales. So I just like to emphasize that the quality of the business in China and India and Korea is fully as good from an earnings point of view as anywhere else in the world.

P.J. Juvekar - Citigroup Inc

And secondly, on Europe, can you talk about how much volumes were up in Germany and then what happened to volumes in Southern Europe?

James Sawyer

Right. Overall, volumes were fairly flattish in Europe. And there's kind of 2 trends that people look at going on in Europe, and I think most people are familiar with that. Germany tends to be doing better than Spain or Italy, and we're seeing that generally. But the other thing that we're seeing in Europe is that the packaged gas business in Europe really still has not recovered from the recession. And that's really because capital spending hasn't picked up. People aren't investing in new machinery, real estate, construction and so forth. And our highest margin businesses in Europe have been and continue to be the packaged gas business. And that's really what's been causing our European margins to suffer over the last couple of years. And then lastly on top of that, it's really a very difficult region to get any positive price. We do have cost inflation there like everywhere else but due to the high levels of competition in the marketplace by our European competitors, getting price is virtually impossible.

Operator

And your next question will come from the line of Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies & Company, Inc.

I guess first as a follow-up question on the pricing comment on Europe. As you think over the last 10, 15 years, is this an issue with operating rates in Europe? Or have you just seen a change in competitor discipline in that market?

James Sawyer

Well, I think you just have to look at -- obviously, operating rates are low. But in this business, you basically have contracts with customers, so it's not really like the chemical business where you say, well, a low operating rate, therefore, implies lower pricing. That's really not the case in the industrial gas industry. But if you look at who the participants are in the industry, the major participants in the industry are European companies who are more focused on market share than they are on shareholder value. And that's really the problem.

Laurence Alexander - Jefferies & Company, Inc.

And secondly, on the comments on electronics, I mean can you give a little bit more detail on your outlook for the different electronic markets in the back half of the year and would it be fair to characterize the trends in Q3 as perhaps being sort of flattish compared to Q2?

James Sawyer

I would expect them to be fairly flattish. I think that the big step up in volumes in flat-panel over the last couple of years are flattening out. And the big step up in computers as well. But I don't think it's all that ugly. But I think that we've got a very, very nice recovery in electronics over the last couple of years, and it's probably pretty much run its course.

Operator

And your next question will come from the line of Edward Yang with Oppenheimer.

Edward Yang - Oppenheimer & Co. Inc.

Jim, it doesn't seem like European volumes will improve anytime soon, so how much can you take out in terms of costs?

James Sawyer

Well, that's a good question. That's been on our minds, and we're focusing very clearly on that. We are always looking at productivity, and we are paring additional cost. We do have restructuring charges. We didn't point them out in the quarter, but we have a fair amount of severance cost, both in the PST business, which is about 1/2 Europe, as well as our industrial gas business in Europe. And so we've got some restructuring cost going on to continue to lower our cost structure there. And that's just generally what we have to do everywhere. The world is very competitive, things are changing. You've got to move quickly to compare your cost structure, where you don't need those costs, and bulk up your resources where you do need them, like in Asia.

Edward Yang - Oppenheimer & Co. Inc.

And if volumes in Europe get worse, how much protection, if any, do you get from your take or pay contracts?

James Sawyer

Well, actually, the on-site business in Europe is doing just fine. And it came out of the recession really 1.5 years ago, and you don't see that in the quarter-on-quarter comparisons anymore because it's been fully lapped. It's really the packaged gas business, and it's just really related to the low level of construction activity and so forth. And I don't see anything getting worse there. In fact, as I mentioned in my remarks, I actually think that -- I think in some areas, it has to get better. Just like in the United States 2 years ago, nobody was buying any cars but there was a pent up backlog for more cars to be built and sold. And I think you're going to see the same thing in Europe in machinery and capital goods and so forth. But right now, companies are just waiting on making capital spending decisions.

Operator

And your next question will come from the line of Mike Harrison with First Analysis.

Michael Harrison - First Analysis Securities Corporation

I was wondering if I could get some of your thoughts on the operational issues that Air Products was talking about in their call last week. You had said last quarter that you weren't benefiting from some of the issues they talked about 3 months ago. But now this quarter, we're seeing you guys report 11% North America merchant organic growth, and Air Products showed 3%. So I was wondering if you could maybe just give some commentary, maybe a little more context to help us understand that discrepancy in the growth rates.

James Sawyer

Yes, I mean, we had the same discussion a quarter ago, and we obviously hear what you hear, that's public information, and scratch our heads trying to figure out what that means or where that might be coming from. But honestly, we really don't know. And if we did, we probably wouldn't be much in a position to comment on it. But I think that this business is all about -- if you want to get good financial performance, you just have to have flawless operational performance. And that means operating hundreds of plants flawlessly every day, thousands of trucks flawlessly. And obviously, we have issues that come along the way, but that's just what it takes.

Michael Harrison - First Analysis Securities Corporation

And then, not to harp on Europe too much, but Air Products suggested that they were starting to see some improvement in that challenging pricing environment. Do you see any evidence that supports that view? And I was also hoping you could give some specifics on the restructuring costs in the quarter to help us get to kind of a normalized margin for Q2.

James Sawyer

Right. We haven't seen anything positive with pricing in Europe except in some specific specialty gases where actually we're getting quite some pretty good price. But overall, we don't see it. We'd love to get it. We've announced some price increases and so forth. But we'll just have to wait and see. And I think that one of the issues in Europe is that as a generalization, pricing in Europe has always been higher than pricing in the United States. And that's just -- we've never, in my career, ever seen strong price increases in Europe. On the restructuring costs, just a couple million dollars in both the gases segment and also the PST segment, so not a huge number. A couple of basis point changes in margin, every dollar counts, right?

Operator

And your next question will come from the line of David Begleiter with Deutsche Bank.

James Sheehan - Deutsche Bank AG

This is James Sheehan sitting in for David. So could you just give us some color on LOX, LIN pricing in Asia, and what are your plant loadings like in that business currently?

James Sawyer

Right. So when you talk about Asia, our 3 markets in Asia are primarily India, China and Korea. And we're pretty much sold out in China, and we are increasing LOX, LIN pricing there. I think you might have heard us talk earlier about -- one of our major drives in China is to -- as many other countries but I think more importantly in China, is to operate our standard business operating model in liquid oxygen and liquid nitrogen and carbon dioxide and so forth, where we build and install customer tanks at customer location and sign long-term contracts. We tend to be able to win this business by bringing application technology. But still, in the China market, there is a fairly large, what I will call, distributor segment where you've got distributors picking up LOX and LIN from producers, who are primarily the captive producers in China, like the steel and chemical industry captive producers, and delivering those to consumers. But they're not under a long-term contract and they don't own the equipment. So therefore, they don't have the same strength and ability to increase price. So we have kind of a longer-term strategy, and one of the things that we track every single month is the rate of increase in our installed base of customer contracts. And that's really where we're starting to get some price. But it will be several years out because, as you know, usually there are 3- to 5-year contracts, and your real opportunity to get price is on the contract rollover.

James Sheehan - Deutsche Bank AG

Okay. And then just sticking to Asia there. You've got a nice little bump up in margins during the quarter sequentially. And I imagine some of that is seasonal, but you do have supply demand tightening a bit in that market. Do you expect the strong margins to continue in the second half?

James Sawyer

I think they'll get stronger in the second half. And really what we're seeing sequentially is what I started to describe earlier as the ramp up in the projects that we're starting, and that business moving into a kind of a more mature operating stage. So for example, some of the large on-site projects also have liquid sales. And you start up the project and you first just get the on-site sales and then you will ramp up the liquid business. And I think we're doing that very effectively, but it takes time to keep pushing that plant loading up where you're getting good by-product economics. But I think the proof is in the pudding, and we'll continue to see the Asia margins climb pretty much on a lockstep basis. Usually with the exception of the first quarter because you have the lunar holiday there. But I expect our Asia operating margins just to continue to climb up nicely.

James Sheehan - Deutsche Bank AG

Okay. In the North American merchant gas business, can you talk about how much of the sales were due to volume and how much were due to price in Q2?

James Sawyer

In terms of overall merchant sales increases, about 2/3 of it is volume related and 1/3 price related. And on the pricing side, we've announced price increases. We're going to customers to -- on contract maturities to increase those prices. But at the same time, we're also seeing some cost inflationary pressure and we've just got to keep working on the price increases and the productivity to be able to keep expanding that margin.

Operator

And your next question will come from the line of Kevin McCarthy with Bank of America Merrill Lynch.

Kevin McCarthy

I was wondering if you could compare and contrast your view of industry operating rates in the United States versus Western Europe in atmospheric gases.

James Sawyer

You mean the gas operating rates? Is that what you're saying, or end markets?

Kevin McCarthy

The gas operating rates. I'm trying to understand a little bit better why some of your European domicile competitors seem to be more aggressive regionally within Europe relative to the United States.

James Sawyer

Well, they just have a much larger market share over there. And I think that there's still excess capacity in pretty much all market segments in Europe, like actually there is in the United States. So I think that's just their normal business over there. I wouldn't say that the pricing is really a function of operating rates.

Kevin McCarthy

Okay. And just as a follow-up, Jim, when might we expect to see some refinery hydrogen project announcements out of Brazil? It seems as though timelines have been slipping there with your counterparty. Do you think we're getting close?

James Sawyer

That's a good question. We've been asked that question every quarter and every month. But I think we're working closely with Petrobras on the compares refinery project. They did just last week, after several months of delay, had their own 5-year capital spending program approved by their Board of Directors, so that was a positive. And actually, we're hopeful, by the end of the summer, we'll be able to announce a contract signing with them.

Operator

And your next question will come from the line of Mike Sison with KeyBanc.

Michael Sison - KeyBanc Capital Markets Inc.

In terms of your comments in North America being flattish in the second half of the year versus the first half, would that still suggest that volume growth would be positive, and to what degree?

James Sawyer

Yes. I don't see anything being negative. And let me just kind of back into that a little bit. We do have project startups going on in North America. And so just my comments about the economy were really kind of excluding what we're going to accomplish from, number one, project startups; number two, from pricing; and number three, from productivity. But I think that if you kind of look at some of the end markets, that steel volumes will probably be relatively flattish and chemical volumes will probably be relatively flattish from the first half going into the second half.

Michael Sison - KeyBanc Capital Markets Inc.

Got it. And PDI has been posting up some pretty good numbers here. It's slowing down a little bit. Is that more of maybe hard goods tailing off, and sort of the acceleration in gases wherein profitability improves starting to occur now as we head in the second half?

James Sawyer

Well, it actually hasn't slowed down. It's been continuing to accelerate through the year. And it was hit the hardest by the recession, especially the hard goods segment with hard good sales off some 30% from peak to trough. And then typically, it's hard good sales that lead on the way up. And within the category of hard goods, it would be the sales of what a customer would consider to be a piece of capital equipment, like a laser welding equipment or something like that. So what we're seeing there in terms of the economic recovery is very good. It reflects kind of a normal pattern of I would describe it as a job shop getting more orders, and it has the capacity to produce and therefore having to order more equipment. And then those job shops are making equipment for big companies that realize that they don't have enough capacity to compare their markets and need to add capacity. And similarly in nonresidential construction, which is fairly metal fab-oriented as well. So we actually saw a nice double-digit pickup in packaged gases year-over-year in the first half. We have not seen anything tailing off in that. And my comments on the second half are really we had a weak durable goods order this morning, and we'll just have to see how that goes. But I think we're seeing nice recovery from the recession. We're still not back to 2007 levels, but I expect probably that volume growth will be high single digits in the second half year-over-year versus over 10% in the first half year-over-year.

Michael Sison - KeyBanc Capital Markets Inc.

Got it. And one quick one on acquisitions for PDI, is that still an area that there's some opportunities?

James Sawyer

There is. There's a quite a bit of opportunity there. Making acquisitions, companies that are generally family-owned and you can never convince somebody to sell a business unless they want to sell a business. But we're actively looking at several businesses, in discussions with several owners. And I think, we'll probably be announcing a handful of fairly -- PDI-wise, fairly significant acquisitions during the second half.

Operator

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

Jeffrey Zekauskas - JP Morgan Chase & Co

Praxair's business model over time seems to be built on relatively rapid sales growth, sort of flat gross margins and then keeping overhead expenses growing at a much slower rate than sales. And so in the quarter, the gross margin was sort of flat to down versus last year and versus the first quarter. Do you have gross margin targets over time? Or do you see the gross margin of Praxair as something which is relatively constant at the current level?

James Sawyer

Well, actually, that gross margin is actually one of the things that we -- on an individual business by business level, account by account level, we watch very, very closely. We don't have sort of a corporate-wide target for it. But since you follow the chemical industry, you know that hardest problem for the chemical industry over decades has been declining gross margin over time because of higher feedstock cost and more competition in the environment. We had a fairly significant amount of cost pressure this quarter in a variety of areas, from electric power to natural gas to other raw materials. And we've got, I would say, fairly good price increases during the quarter but not quite enough to offset the overall gross margin, or the overall cost of goods sold pressure. But that's certainly an area that we focus very hard on, and I think it's probably the area that we do better than our competitors at. And if you look at our overall operating margin percentage, benefit over our competitors, most of that lies up in the gross margin.

Jeffrey Zekauskas - JP Morgan Chase & Co

And then secondly, you always do a very good job of keeping your overhead growing at a relatively slow rate. But this year, it's been really slow. It's just been order of magnitude, up 3%, notwithstanding double-digit sales growth. And your performance this year is really much better than your historical performance in growing overhead with the exception of the '09 recession. Is there something unusual about either the accounting this year or does it have to do with your management of your reduced expense levels following the '09 recession?

James Sawyer

There's just one specific unusual thing, which accounts for both sides of that. We sold our Home Healthcare business, and we closed on that on March 1. And the breakdown of cost in the Home Healthcare business was very heavy in fixed cost and very light in cost of goods sold. And so with the sale of that business, and we took about 1% out of sales but a proportionally higher amount out of fixed cost. And that really accounts for what appears to be such a great management of fixed cost. It also accounts for some of the gross margin percentage decline.

Operator

And your next question will come from the line of Bob Koort with Goldman Sachs.

Robert Koort - Goldman Sachs Group Inc.

Jim, I think a couple of folks have asked you about some pretty jarring differences between your U.S. business and your biggest competitor. So if you could help a little bit more on that. And talked -- you talked in your end market commentary about some of the end markets you have there that are maybe later cycle and have been doing better. So I was just curious, do you think you have a different end market mix than the broader market? You're growing faster than the industrial activity in the U.S. And then secondly, of that -- I think you alluded to maybe 7% or 8% volume number, how much of that would be new wins or new customers versus existing customers?

James Sawyer

Right. I would say that our mix of end-use customers in Europe is probably not a whole lot different than any of our competitors there in terms of the mix from package merchant and on-site as well as a mix in the different end markets there. So I don't see any real difference there. In terms of volume coming from project startups, we really have very little volume from project startups in the second quarter. We should get a little bit more as we just started up a new plant in Germany, but that didn't count for a lot in the second quarter. But it should count for more in the third and fourth quarters.

.

Kelcey Hoyt

And North America as well.

Robert Koort - Goldman Sachs Group Inc.

Yes, sorry, Jim, maybe I wasn't clear. I meant specifically in North America.

James Sawyer

Oh, in North America? So -- I'm sorry, I couldn't hear. North America, most of the volume growth actually was from new project startups. And again, I would say that the breakdown of our end markets is probably not significantly different than our competitors.

Robert Koort - Goldman Sachs Group Inc.

And then you mentioned electronics sort of petered off a bit in June and now we're nearly to August. Do you get any angst that it's more than an inventory correction there, or is it maybe a standard issue, mid-cycle pause?

James Sawyer

In electronics, I don't know. I'm not the biggest expert on the semiconductor industry. It's always been a very difficult industry for even the best experts in that industry to forecast. But there was a big year-on-year growth in flat panel displays, in solar panels and integrated circuits over the past couple of years. And what I see is that orders for photovoltaic panels are off, or they're not -- inventories are building faster than orders are coming in, and some concern on flat panel displays as well.

Operator

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

John Roberts - Buckingham Research Group, Inc.

Jim, the energy sales growth trend, it was up 2% year-over-year on the quarter. Combined with the first quarter, you're probably mid-single digits in the first half. Can you talk about the ramp? You gave a guidance at the Hydrogen Investor Day of over 20% revenue growth over the next few years. And so how do -- are we going to get up above 20% here over the next several quarters?

James Sawyer

Right. It does kind of jump out at you, how low the energy sales growth is during the quarter. Let me just say a couple of things about that. First of all, in last year's second quarter, we had a major refinery customer whose own hydrogen producing facilities were shut down with maintenance. And so we were providing well over the normal level of hydrogen to that customer in last year's second quarter. And that was a Gulf Coast customer where the value of natural gas is part of the price. So it's kind of significant at the sales line. Now offsetting that, we started up the BP Whiting project 6 months ago, which would have -- you would have expected to have more sales growth. But BP Whiting contract is just a tolling agreement, so the dollars of sales for each molecule of hydrogen are only about 1/4 to 1/3 of what they are when it includes natural gas. So it didn't just show up much on the sales line but it's definitely there in the operating profit line. And then we also had a prolonged slowdown this spring in Canada where we just have to stop a frac-ing business because of the thaw and the melting. But that's starting up as we speak.

John Roberts - Buckingham Research Group, Inc.

But again, the revenue guidance, including the loss of natural gas pass-through, I think was over 20% for the energy segment over the next couple of years, right, so we would still expect you at some point here in this Slide 9 global end markets trends to be putting up 20%-plus numbers.

James Sawyer

Yes. It should be up in that area when we start up on these projects. When we start up the Motiva and Valero projects and the Chevron projects over the next couple of years, they'll be major contributors there.

John Roberts - Buckingham Research Group, Inc.

So it will be in next year's -- some quarter next year will be the first quarter that we have a 20%-plus number?

James Sawyer

That will be at the end of 2012.

Operator

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

Mark Gulley - Ticonderoga Securities LLC

First question is I want to come back to the market share trends in LOX, LIN, LAR in the U.S. Again your volume growth is much better than your U.S. competitor. Is that because you have more feet in the street, more access to the customers, your PDI perhaps doing some customer scouting? Are you gaining share in LOX LIN LAR in the United States, Jim?

James Sawyer

Yes, and I can't comment that our market share has gotten any better or worse. We certainly don't see that. But we do get a nice feed from the integration of our packaged gas business and our merchant business, where we do have more sales people out there on the street. And one of the ways that this business changes over time is that you have a large packaged gas customer who becomes large enough in volume to become a mini-bulk or small bulk account. And by having them in the first place as a packaged gas customer, you get to make that conversion there. So that could be part of it.

Mark Gulley - Ticonderoga Securities LLC

And secondly, can you disaggregate the strong PDI sales growth that you saw, the 12%, into volume price and FX?

James Sawyer

Let's see. It basically was about 8% volume, and price was about 4%, and FX about 2%.

Mark Gulley - Ticonderoga Securities LLC

Okay. And then lastly, if you can maybe dust off your crystal ball a little bit, what kind of CapEx growth might you see next year in 12?

James Sawyer

Right. We'll probably be, as we talked in our guidance, about $1.8 billion in CapEx this year. And probably in 2012, in the $2.1 billion, $2.2 billion area.

Operator

And your final question will come from the line of Don Carson with Susquehanna.

Donald Carson - Susquehanna Financial Group, LLLP

Jim, just a question on the backlog, it's been growing quite significantly. Just wonder what the impact is on revenue growth going forward. I know you used to talk that just from the backlog alone and starting up a new projects, you should have 5% revenue growth. Has that -- will that number be growing given the acceleration in the backlog?

James Sawyer

Yes and no. And what I mean to say by that is that the 4% to 6% revenue growth coming out of the backlog will probably stay in that range. But more and more and more of the backlog are low asset turnover, high margin projects, okay. So those will be the large air separation projects for coal gasification and so forth. Not a whole lot of sales contribution but a very high operating margin. And then also, as we shift to more and more of the hydrogen business being a sale contract that excludes natural gas in it, you won't see as many revenue dollars coming through but they'll be higher operating margin dollars. So on average, the projects in our backlog are going to have less revenue contribution per dollar of CapEx but on average, 30% to 40% operating margin contribution.

Donald Carson - Susquehanna Financial Group, LLLP

Okay. And then just to follow up on packaged gases. What are packaged gases margins running, and have they come down as you're getting more hard good sales, especially the low-margin capital goods? Or is there enough operating leverage on the gases and rental side that it's offsetting lower contribution from hard goods?

James Sawyer

All right. I'll tell you, that's very well said. Our operating margin in our packaged gas runs about 15%. And we've been holding that in spite of the fact that hard goods have been growing faster than gases. And so a lot of productivity there, but we've been holding that margin.

Operator

And so at this time I have no further questions within the queue. I'd like to turn the call back over to management for the closing comments.

James Sawyer

Great. Thank you all, again, for participating in our second quarter earnings call. Kelcey will be available to you throughout the remainder of the day for any additional questions, and probably any other day you want to call her. Our third quarter earnings call will be held on October 26, so have a good summer and take care.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This does conclude the presentation, and you may now disconnect. Have a wonderful day.

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