Praxair (PX) Stephen Angel on Q4 2015 Results - Earnings Call Transcript

| About: Praxair, Inc. (PX)

Praxair, Inc. (NYSE:PX)

Q4 2015 Earnings Conference Call

January 29, 2015 11:00 AM ET

Executives

Kelcey Hoyt - Director, IR

Matt White - SVP and CFO

Analysts

Mike Harrison - Seaport Global Securities

Emily Wagner - Susquehanna

Michael Sison - KeyBanc

Jeff Zekauskas - JPMorgan

Duffy Fischer - Barclays

Prashant Juvekar - Citigroup

Vincent Andrews - Morgan Stanley

David Manthey - Robert W. Baird

John Roberts - UBS

Chris Wolf - Goldman Sachs

Stephen Byrne - Bank of America Merrill Lynch

Operator

Good day, ladies and gentlemen, and welcome to the Full Year and Fourth Quarter 2015 Praxair Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Ms. Kelcey Hoyt, Director of Investor Relations. Ma'am, you may begin.

Kelcey Hoyt

Thanks Tamara. Good morning and thank you for attending our fourth quarter earnings call and web cast. I'm joined this morning by Matt White, Senior Vice President and Chief Financial Officer.

Today's presentation materials are available on our website at praxair.com in the Investors section. Please read the forward-looking statement disclosure on page two of the slides and note that it applies to all statements made during this teleconference. Please also note that our discussion of earnings, including year-over-year and sequential comparisons excludes previously disclosed adjustments in 2015 and 2014. These items are detailed and reconciled to the reported GAAP numbers, and the appendices to this presentation, and the press release.

Matt and I will now review Praxair's 2015 full year and fourth quarter results, as well as our outlook for 2016, including earnings guidance. We will then be available to answer questions.

Matt White

Thanks Kelcey and good morning everyone. I'd like to kick off the call with a recap of 2015 and then update you on the trends we are currently seeing in the business segment. Its pretty clear that there were some tough macro headwinds in 2015. Double digit foreign currency devaluations, some of the worst recessionary conditions on record in South America, and a plummet in commodity prices created challenging conditions for industrial growth.

Despite these events, our organization did what it does best, adapt to current conditions and take appropriate actions on things we can't control. And while there were many accomplishments of our employees around the world to mitigate these challenges, I'd like to highlight four key areas.

First, we continued our strong management of cost and price. This is the hallmark of the Praxair culture. We adjusted our cost structure inline with economic trends, saving over $75 million per year. We improved pricing levels in nearly every region of the world, and we delivered strong productivity results. All of these efforts were quite visible in the financial statements, and led to record operating and EBITDA margins of 23.1% and 33.8% respectively.

Second, we prudently managed capital. We maintained our industry leading return on capital and delivered one of the highest free cash flow results in company history, by achieving 25% operating cash flow as a percentage of sales, and trimming capital expenditures 9% from prior year.

During 2015, we also raised the dividend 10% as part of the $1.5 billion return to shareholders through dividends and stock repurchases, and we accomplished this without using leverage, as we held net debt flat.

Third, we never lost sight of the priority for quality growth. We signed six large growth projects for about $700 million of investment, including the largest in company history, to extend our hydrogen and nitrogen pipeline complex in the U.S. Gulf Coast, to supply the Yara/BASF joint venture. Acquisitions also played an important role, with around 15 accretive deals being closed or announced, including the European industrial business of Yara, to help contribute another percent of global growth for the company.

We recently announced the joint venture with GE Aviation, to enhance our presence in the aerospace market, and provide additional resilient growth prospects, and we continue to deploy our application technologies to find more usage for our products, that enable our customers to increase productivity, lower costs, and improve their environmental footprint.

And finally, we recognized the cyclical shift in some of our end markets, and quickly adapted with a series of actions and initiatives. The renewed focus on more resilient industries and synergistic acquisitions at a reasonable price, will provide continued growth opportunities, in a world that is cyclically weaker across many sectors.

So collectively, these actions mitigated the current headwinds and better position the company for future earnings accretion, when markets turn. But unfortunately, we are seeing many negative trends continue into 2016.

When I look around at the current industrial state of the world, I don't see many things getting better, and a few are getting a little worse. The combination of excess supply and reduced demand, continues to put strain on several industrial end markets. However, we have exclusive customer supply contracts with our cylinders, tanks and pipelines, that are located at customer sites. The challenge, is that we are replenishing the gases to these assets at a lower frequency, due to our customer's lower production rates. While consistent with other prior industrial cycles, this will eventually turn and improve.

In North America, the impact of lower hydrocarbon pricing, continues to pressure many industries, including mining, oil and gas, railcar production, heavy equipment and general manufacturing. Furthermore, the stronger dollar has put additional strain on the U.S. manufacturing competitiveness. These negative trends can be seen in recent industrial production and PMI reports. However, we continue to see good demand in consumer oriented sectors, like food, beverage, automotive, healthcare, refining and chemicals. The U.S. Gulf Coast petrochemical buildout still provides good opportunities, renew on-site contracts, and we are pursuing several bids of which we expect to convert to new supply contracts soon.

South America has not improved, but rather worsened, which is consistent with our expectations. The combination of political turmoil in Brazil and the seasonal outages, significantly curtail the volumes, which will likely continue into Q1 for the carnival holiday, and possibly beyond. I believe the election result in countries like Venezuela and Argentina, will bode well for future business opportunities, but it will take some time to see any impact on the ground.

We continue to take appropriate actions to preserve the quality of the business. But frankly, South America is becoming less and less of a component of our consolidated results, due to the severe currency devaluation. So the potential downside impact is less than prior years.

Europe is stable and slightly growing in several regions. Commodity consuming nations like Germany, Spain, Benelux and Italy have benefited from the lower cost of oil and weaker Euro. This is evidenced by the strong growth we are seeing in our port events or pipeline expansion, such as the recently announced Total contract. In addition to the positive growth across both cyclical and non-cyclical industries, commodity producing nations like Russia and those in Scandinavia are negatively feeling the effects, but we have partnered with some of the most competitive and lowest cost producers in the world. So they are still running their assets in this environment, and we anticipate that to continue.

Asia segment trends are quite different depending upon the country. Thailand and India continue to perform well, and we are seeing strong pockets of growth in both countries. Korean growth is primarily focused on the electronics industry, which has been in a strong cycle for a few years now. Although, certain areas are projected to slow. And China is the country getting the most press these days. Clearly, you have a situation of excess capacity across most infrastructure supporting industries, like steel, glass and cement. We have been seeing softness in those areas for few quarters now, and that will likely continue for 2016.

Consumer related industries are still performing well in China, as we continue to see good demand for things like transportation fuels, food, healthcare, environmental solutions and plastics. Examples include our new project startup with Yankuang, and our project signing with CNOOC. So we will have to see how China performs this year. But the underlying growth rates will be lower than what we saw in prior years.

So when you sum it up, we are just not seeing much improvement from the current weak industrial run rates. Given that, our strategic focus that we laid out over the past several months, is still valid in this environment, and you can find that on page three.

This slide shows the key elements of our focus to grow earnings and cash flow, regardless of the underlying economic conditions, and we are still on-track. Starting with the bar at the top, we are currently benefiting from the cost restructuring actions taken mid last year, and we continue to find new price and cost opportunities throughout our business. These are and will continue to contribute positive EPS growth.

On the second bar, we are proceeding well regarding synergistic acquisitions. We still expect to execute $500 million to $600 million of acquisitions this year, with over half already announced. Most of these are in developed markets, or more resilient industries, which will help enhance and insulate our business portfolio from some of the current cyclical trends. And we expect strong project backlog contribution for 2017, as some of our large fixed fee projects are slated to start in that year.

So we have mapped the path to growth for our earnings, but for 2016, it is not enough to offset the combination of foreign currency headwind, and the current trend of negative underlying volumes. I will cover this further, including guidance, at the end of the prepared remarks.

But first, Kelcey can provide some more details on our financial performance for 2016.

Kelcey Hoyt

Thanks Matt. Please turn to slide 4 for an overview of the full year. Overall sales were $10.8 billion steady with the prior year, excluding currency and cost pass-through. Price attainment contributed 1% growth, and was achieved in all reporting segments.

Volume growth from projects was about half weighted towards Asia, with the remainder of the contribution in Europe and North America. The full year volume decline, net of project contributions, was driven by weaker base volumes in the Americas, primarily in the upstream energy, manufacturing and metals end market.

Globally, food and beverage, healthcare and aerospace end markets were positive, with low to mid single digit organic growth. We completed a number of small industrial gas acquisitions during the year, that contributed about 1% to the overall growth of Praxair. These synergistic acquisitions will continue to enhance our production network density in all operating segments.

Operating profit of $2.5 billion grew 1% year-over-year, excluding foreign currency from higher pricing, cost actions and acquisitions. As a result, we grew full year EBITDA and operating margins to record level. Earnings per share of $5.80 grew 3%, excluding foreign currency.

Please turn to slide 5 for an overview of cash flow; through consistent capital and operational discipline, we generated strong operating cash flow of $2.7 billion for the year, at 25% of sales.

During 2015, $1.5 billion was prudently invested in CapEx for growth and density improvement. These investments are in our core regions and meet our disciplined investment criteria. More than half of the CapEx spend during 2015 occurred in North America, with the rest equally distributed to Asia, Europe and South America. During 2016, CapEx is expected to be even more weighted towards North America, given its larger share of the backlog.

When our end markets and geographies are in lower growth cycles like today, we typically generate more free cash flow than periods of stronger capital investment. Since the majority of our capital spend is for growth projects, that are only initiated with executed customer contracts. As a result, this morning we announced a 5% increase to our quarterly dividend, which represents our 23rd consecutive annual increase. This is consistent with our policy to grow dividends each year. The remaining cash that we have after growth investments and dividends, is directed towards share repurchases. During 2015, we reduced our outstanding share count by 2%. This was our sixth consecutive year of reducing the share count by at least 1%.

Now please turn to slide 6 for an overview of the fourth quarter; fourth quarter sales were $2.6 billion and 1% lower than the prior year, excluding currency impacts and cost pass through. Organic sales increased from higher pricing in most operating segments. Lower base volumes continue to be driven by the Americas, primarily in the manufacturing, upstream energy and metals end markets. This was partially offset by new volumes from project startups in Asia and Europe, as well as global growth in refining, food and beverage, healthcare and aerospace end markets. Small acquisitions within all segments contributed 1% growth.

By operating segment, North America's organic sales declined 3% year-over-year and 1% sequentially. The business achieved price improvement in the U.S., Mexico and Canada. Weaker volumes for manufacturing customers drove about half of the volume decline. This was primarily due to hardgoods, as customers are reducing investment in capital equipment, given the uncertainty in demand, and headwinds from imports, with the strengthening of the U.S. dollar. The remaining volume softness was driven by upstream energy and metals, with metals down 16% organically year-over-year and 8% sequentially. This was partially mitigated by end market growth from refinery, healthcare and food and beverage customers.

In Europe, organic sales grew 4% year-over-year and were down 1% sequentially. Year-over-year growth was primarily driven by price attainment in most countries, project contribution in Russia, and higher base volumes in Spain. Sequential volume declines were primarily due to upstream energy customers.

South America's underlying sales were down 1% year-over-year, as volume declines in most end markets were partially offset by price contribution, acquisitions and growth in the healthcare and food and beverage end markets. Sequentially, volumes were down 6%, due to further deteriorating industrial production and extended holiday shutdowns by customers in Brazil. This occurred in most end markets with the largest impact in manufacturing, which represents about 20% of Brazil sales.

Underlying growth in Asia was 6% higher than last year, and 2% higher sequentially, primarily driven by new project startups in China and India, growing carbon dioxide sales in Thailand, and acquisitions. Surface Technologies organic growth was down 2% year-over-year, driven by energy and industrial end markets; and up 4% sequentially, driven by stronger aerospace coatings.

Global consolidated operating profit was $624 million in the fourth quarter and grew 5% over the prior year, excluding foreign currency. We are seeing the benefits of our restructuring actions, price attainment and acquisitions. The fourth quarter operating profit end margin also benefited from a gain on sale in North America.

Earnings per share of $1.47 grew 5% year-over-year, excluding currency. Operating cash flow was $791 million, represented 30% of sales, and funded $387 million of capital expenditures. The company paid $204 million of dividend and repaid $203 million of debt to hold net debt steady for the year.

Our project backlog, which we define as projects with CapEx greater than $5 million and associated with a fully executed customer supply contract, is currently $1.5 billion and comprised of 18 projects.

During the fourth quarter, we signed two long term contracts for new projects, located in North America and Europe, and started two projects in Asia. Existing backlog projects will startup and contribute to growth during 2016 through 2018, as shown on slide 16. North America now reflects about 45% of the backlog.

We continue to look selectively for tuck-in acquisitions in our core business, which are high quality, low risk properties, where we can bring synergies to the business we are buying, and we can achieve an attractive return on investment.

During the fourth quarter, we bought three industrial gas businesses in the U.S., with multiple locations and combined sales of more than $20 million annually. And we increased ownership of an existing joint venture in Asia.

I now turn the call back to Matt, who will discuss our outlook and earnings guidance for 2016.

Matt White

Please turn to page 6; our full year guidance for 2016 is in the range of $5.30 to $5.70. While the entire range is below our 2015 EPS, it does include $0.42 or 7% anticipated headwind from foreign currency translation. The lower right of the slide, you can see the average 2015 FX rates for some of our major currencies, which were all much stronger than what the current spot rates are today.

Excluding the FX impact, we expect underlying EPS to grow to be a low of minus 2% to a high of plus 5%. There are a few key drivers that comprise this range. We expect to deliver positive EPS growth from our price, productivity and the 2015 cost actions. Many of these items are already completed, and we have a high level of confidence in our ability to continue to improve our earnings going forward, through these company-specific actions.

We also are expecting EPS accretion through our acquisitions and share buyback program. These are good examples of contribution from our capital allocation process. We have closed several synergistic acquisitions, and anticipate completing a few more early this year, which will be immediately accretive to our results. These are primarily tuck-in acquisitions, that serve more resilient markets and enhance our existing portfolio.

In addition, our excess free cash flow has enabled us to consistently repurchase shares without increasing debt levels. So we also feel good about contribution from these areas, as most of them are already completed.

Product volume is really the key unknown factor, and an addition to foreign currency will vary the most in the near term. You can see the range showing more downside risk than upside.

The top end of this range, represents our project volume startup, which we have good visibility into, and assumes slightly positive underlying volume growth. The bottom end represents the same project growth with current underlying volume trends of negative low to mid single digit percent.

As I mentioned earlier, this volume is tied to our existing network of pipelines, tanks and cylinders. So the contracts and assets are in place, but we simply aren't supplying them at the same rate, due to the slower demand environment. We will continue to take actions to improve on this range, but this is our best estimate at this time.

Turning to the first quarter, we are calling an EPS range of $1.20 to $1.28. This range is down 10% to 16% from last year, of which 9% relates to FX impact. So we are anticipating underlying EPS to be down 1% to 7%. While we have the full benefit of cost reductions in our results, we don't expect that to fully offset the lower volumes, seen primarily in North and South America. We expect Q1 to be the weakest for 2016, given the normal seasonal impact coupled with the abnormally low volume trends, coming out of 2015. We saw extended seasonal outages during the fourth quarter, and we anticipate similar trends for the first quarter.

The first half of 2016, especially the first quarter, will be more challenging than the back half. However, we have developed a strategy around this environment, and have taken actions in anticipation of these trends. Our business usually leads these cycles, given the nature of our industry and end markets. We expect the lead to recovery. And while near term trends will be pressured, we will continue to take prudent and appropriate actions for long term shareholder value creation.

I'd now like to open up the line for Q&A.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. And our first question comes from the line of Mike Harrison with Seaport Global Securities. Your line is now open.

Mike Harrison

Hi, good morning.

Matt White

Good morning Mike.

Mike Harrison

Matt, can you give us any color on the timing and kind of volume contribution of new project startups during 2016? It looks from your chart there like you are expecting maybe kind of 3% to 4% volume contribution there at the high end potentially. And then how much stronger does that get, as we get into 2017 with the new project startups?

Matt White

Sure Mike. So I think, starting with 2015, as you may recall, we had talked about 2015 being kind of close to 2% -- 1% to 2% range on project contribution. I am expecting that to be similar heading into 2016. We have a fairly similar profile of startup. 2017 is where we really expect that to step up, and that will be closer to the 3%, 4% kind of mid-term range that we had given out a few years ago. So, we do have a gap in 2015 and 2016 on project startups. Part of it are things like the Chevron project. As you recall, that we ultimately ended up selling that asset, and as opposed to starting up as a sale of gas. But I would expect 2016 to be similar to 2015.

Mike Harrison

All right. And then you noted some CO2 supply outages in Latin America. What portion of your sales in Latin America come from CO2, and is that negatively impacting your ability to supply beverage CO2? Can you just give a little color on that?

Matt White

Sure. I would say, first of all when you look at merchant and package in total, for South America, it's about two-thirds of the whole business there. CO2 is an important merchant liquid for us, and as you probably know it, we generally feedstock -- we get the feedstock from various processes and industries. And given the situation in Brazil from an industrial perspective, rates are so low on everything from refineries to ammonia plants to chemical plants, that the CO2 sources now are actually going down for extend outage periods.

So what's happening there is, while we are still meeting the requirements that there are for food and beverage, its causing us -- extra costs. We have to haul the product much further, dislocation costs. So yes, its creating some inefficiencies in our system right now, given our supply-source outages, and its just something we have to manage and live with. I do hope that some of these will come backstream here, back in the first quarter, we are seeing a few begin to startup again. But that's something that impacted in Q4, will impact in Q1, and we will have to see beyond that.

Mike Harrison

All right. And then the last one for me, the pricing number in Asia was flat. Have you gotten to a point where you have neutralized the impact of the merchant overcapacity there? Where are you getting offsets to the negative merchant pricing?

Matt White

So with Asia, we still see some good pricing for either specialty or electronic assets, whether that's helium, xenon, neon, and those continue to contribute some positive pricing. The merchant gases of LIN and LOX and argon, still are pressured. But as you know, we have been going more towards a direct model, less through a distributor model. So I'd say, we are getting a combination of -- I will call it mix benefit by shifting more direct. And also, we are trying to take some price action. But the supply/demand imbalance there still is an issue, especially in certain parts of the country, and we will just see in terms of capacity. If you start to see some steel capacity come out of these tier-II, tier-III steel player, that will help the mix on the merchant liquid.

Mike Harrison

Understood. Thank you very much.

Operator

Thank you. And our next question comes from the line of Don Carson with Susquehanna Financial. Your line is now open.

Emily Wagner

Hi its actually Emily Wagner on for Don this morning. We just had a couple of questions in terms of the volume terms in North America. How much could you say the trend was driven by weakness in Canada and Mexico in the fourth quarter?

Matt White

Well, I would say right now, one of the -- the two biggest areas we are seeing from softness in North America, the recent trends would be in metals and in hardgoods. And the hardgoods is really mostly Canada and U.S., and that's just a function of both less equipment and less hardgoods going into some of these sectors like heavy equipment, energy, manufacturing, and also we are just electing not to sell some of these hardgoods, given the margins are just not attractive to us at this time.

As far as the metals, that's primarily U.S. We are seeing some slower volumes from some of the import issues coming into the country, as well as just some of the slowing demand on certain infrastructure projects. But Mexico is mostly an energy issue that's played out in our results. It has been in our run rate for a couple of quarters, almost a year, and excluding that, Mexico is still doing quite well. Canada is mostly an energy issue story, and that also has had some negative impact here over the last few quarters, there could be a little more risk going forward. Excluding that, Canada, on the Eastern side of the country, is doing fairly well, due to the weak currency there, its making their products more competitive. But I would say, most of the challenges you're seeing in the U.S. are either related to the strong dollar, which is hurting the manufacturing, or the impact of the energy metals side, that's working its way through the supply system.

Emily Wagner

Have you broken out your end markets exposure in North America to energy and steel?

Matt White

Yeah. We actually provide that in all of our external filings. So you will see that in the 10-K that will come out here in a few weeks. But you can see it from our last Q also.

Emily Wagner

Okay. Thank you.

Matt White

Welcome.

Operator

Thank you. And our next question comes from the line of Michael Sison with KeyBanc Capital. Your line is now open.

Michael Sison

Hey, good morning.

Matt White

Good morning Mike.

Michael Sison

Can you give us your thoughts on, maybe longer term, where can South America sort of be in terms of earnings power over time, given to where its at in the past, and where it is now?

Matt White

Yeah. Mike, you may recall, we have actually included in the package, the backup, sort of how South America has been as a portion of our business over time. And it's something that, at its height as a segment, it was almost 20% of the operating profit of the entire company. Today, it's slightly above 10%. So we have seen these cycles go up and down on the segment. I mean, you look today, South America as a whole, as a percentage of the company, is approaching kind of 2003-2004 levels.

So I would say, if it continues on its path of shrinking, the shrinking is less severe, than obviously coming off the peak at 2010-2011. But if it does recover the kind of the levels we have seen in the past, that's pretty significant upside, both from a growth perspective and the topline, but over the earnings, because we tend to get pretty accretive growth when it recovers.

So we will have to say; as I mentioned earlier I think, you are seeing some positive developments on the government side, in countries like Argentina and Venezuela. It will take time to work through, but you are getting more business friendly approaches in some of the governments there. I think Brazil needs more time to work through their issues. 2016 will be another tough year. 2017, we will have to see. But they do have an election in 2018. But I think right now, that is the lowest level it has been in over a decade, as far as an impact to our organization, and we will just have to see going forward.

Michael Sison

Right. And then just a quick follow-up, you talked about acquisitions, an area that can help growth this year. You have kind of done half of what you had hoped. Are the rest of them, kind of smaller ones, are there bigger opportunities? Can you look at your JVs? Can you just kind of walk us through where growth can come from in that this year?

Matt White

Sure. It will probably be a collection of smaller ones. As Kelcey mentioned, we did another three in the U.S., just this quarter here in packaged gas. And that will give us over $20 million of incremental sales. But it will be many, packaged gas, tuck-ins, primarily in the Americas, but we do have some opportunities in Europe and Asia as well. And we will just have more that will be coming through here, just given the situation that we have, as far as some of the targets are being more, I'd say open around valuation and strategic options.

Michael Sison

Great. Thank you.

Matt White

Welcome.

Operator

Thank you. And our next question comes from the line of Jeff Zekauskas with JP Morgan. Your line is now open.

Jeff Zekauskas

What's the $28 million other income item, and how does it distribute through the segments?

Matt White

So most of that Jeff, is the gain on asset sale that Kelcey had mentioned, and its primarily North America.

Jeff Zekauskas

Where else is it?

Matt White

Its spread all over. Normally other income, we average per year $10 million to $15 million net income, and it’s a combination of things like some non-consolidated affiliate income, that maybe before tax line, gains, losses on asset sales, etcetera. So the rest of it would be spread across, but the larger piece is North America.

Jeff Zekauskas

Thanks. I think your interest expense this year has bounced around a little bit? And that I think in the third quarter it was $35 million and it was $42 million in this one. Can you talk about the volatility in it, and what do you expect for 2016?

Matt White

Sure, in our interest, as you can imagine, we have capitalized interest, the normal bond it. But we also have the derivatives on all of our intercompany loans that we hedge. So the primarily volatility we have been seeing, has been their gains, frankly, that we have picked up on these intercompany hedges. Mostly China, and their sort of one-off items. But its just a little bit of noise that's creating that on a normalized basis, our interest run rate should be kind of mid-40s. We have been doing some terming out of our bonds. So while its causing our interest costs to go up a little bit, it's actually improving the bond portfolio for us, for being out much longer in terms of term.

But I would say, modeling our interest, probably mid 40s is kind of where we expect the next few quarters.

Jeff Zekauskas

And then lastly, do you think that the direction of your capital expenditures over a three to five year period will be downward or flat or upward?

Matt White

Well, the last couple of years has been downward. And it's really going to be a function of the projects we sign. But when I look right now, we are saying around $1.5 billion for 2016. I think it can be lower than that. We are taking actions to manage that. If we sign a few large projects here, that could alter the course. So its really a function of how many growth projects we sign. But the non-large growth, we are absolutely continuing to take efforts to manage those numbers down and in line with what we are seeing in the markets around us.

So I think it can go down on its own, and then the rest is just a function of new project signings.

Jeff Zekauskas

Okay, great. Thank you so much.

Matt White

Welcome.

Operator

Thank you. And our next question comes from the line of Duffy Fischer with Barclays. Your line is now open.

Duffy Fischer

Yes. Good morning. There has been a lot talked about the difficulties of steel in China, and the hope that some of the smaller, maybe unprofitable guy shut down and they have their own air separation units, so you take some offline that way. But there are also some steel plants that are somewhat competitive, that maybe have their own oxygen that would be looking to sell it in a tough financial situation like that. And if so, is that stuff that would interest you investing in China kind of at this low point, or you are trying to pull back from investing in China today?

Matt White

Well, I think, in my mind in China investments, I would sort of break it in two categories. There is investing in assets that relate to infrastructure, whether that's steel, cement, glass. I think right now, that entire sector is just too much capacity. So there needs to be some rationalization and I would see future investments in those areas being extremely limited.

The other sector of the Chinese economy in the consumer side, there still are good investment opportunities. They tend to be smaller plans, they tend to be less capital intensive. It could be, things in environmental, in food, in that we continue to see good opportunities. But when I look at the steel capacity in China right now, our steel customers are what I call tier-I. So these are the Bao steel type customers there. And they are very competitive globally. They are very well integrated, and they can withstand these cycles.

There are tier-II and tier-III steel mills that have been popped up all over the country, and those are the ones I think from a liquidity standpoint and a competitive standpoint are struggling.

Now just the Premier recently here announced their goal to take out about 100 million to 150 million tonnes a year capacity. And just to put that in perspective, that's like the entire capacity of the United States. But they are looking to rationalize and take that out, which I think would be great. I don't know when it will happen, but if that could be accelerated, that should be very beneficial on a couple of fronts, it should reduce some of the steel production and some of the imports to other countries like the U.S. But it also should help on the liquid merchant front.

So in my mind, if those are rationalized, we would not have an interest in those assets. I don't think they are viable, and you can't run the air separation plant without some baseload cost effectively. So I would rather sit back and wait and let some of this rationalization happen that they have announced, and I think that would be beneficial and constructive for the market.

Duffy Fischer

Okay. And then a similar question for Latin America, obviously lot of economic pressure there. Is there a chance that meaningful assets would be available in Latin America, and is that an area, that's still of interest for you to grow in, inorganically?

Matt White

Yeah. I mean, we are in Latin America, and in the 90s, when you had the last sort of economic significant downturn, we did exactly what you are saying, Duffy. We rolled up a lot of the steel mill assets the air separation assets. We consolidated and grew our business fairly significantly during that downturn.

In this downturn, we still are doing things like that. Its just the opportunity set is smaller. There is not as many as there was back 20 years or so ago. So yes, we continue to do it, it just may not be as big as it was in prior years.

Duffy Fischer

Great. Thank you.

Matt White

You're welcome.

Operator

Thank you. And our next question comes from the line of PJ Juvekar with Citi. Your line is now open.

Prashant Juvekar

Yes, hi. As you progress through the fourth quarter, did you see a slowdown from month-to-month, meaning that -- was December much weaker than October, if you take the seasonality out?

Matt White

Yeah. The seasonality part is a little tricky, which you tend to find in weaker demand production environments like we are, is they will extend the seasonal pieces. So they will have normal shutdown that they will actually extend. And I think you saw a little bit of that in certain regions, where they took, for instance, the Christmas Holiday season, or in South America, the summer holiday period, and they extended some of the outages around that. So I would say, we saw the normal seasonal plus a little bit more demand reduction or production reduction, and we will see how that carries into the new year.

Prashant Juvekar

Okay. And then, if I look at your backlog, project backlog, it was about $1.9 billion a year ago. Its now $1.5 billion, and we know there is troubles in Brazil, the slowdown in China. It seems like global CapEx is slowing down. What is your expectation for your project backlog, going forward?

Matt White

So this year, we expect of the startups we have slated, might be another $500 million, $600 million that would come out of the backlog. So with no absolute change, that would drop it to $1 billion or below. I am expecting to sign a few large projects, and that should help tick it back up, but you also need to look at the acquisition front as well. So we are stepping up what we are spending in the acquisition. So I do think some of the backlog, that is declining a bit, is being replaced by acquisitions. I kind of look at both of them equally, in terms of avenues to invest capital to grow. So it is going down a bit. But acquisitions are stepping up a bit, and we have seen this in some of the cycles before.

But holding all else constant, I got about $500 million, $600 million that will come out this year. But we feel good about some of the key large projects that we have, to help bring that up, at least if not fully, partially.

Prashant Juvekar

Thank you.

Operator

Thank you. Our next question comes from the line of Vincent Andrews with Morgan Stanley. Your line is now open.

Vincent Andrews

Thanks very much. Matt, if I just think about your guidance, and I am just going to try to characterize it a bit. You talked about, in 1Q you are expecting sort of the slow volumetric trends to continue from the second half into the first quarter. And then if I think about the comments you made about overall 2016, the two big sort of impacts and uncertainties were foreign exchange and then volume. So if the second half weakness is going to continue into the first quarter, is it a correct statement to say that we need to see some type of positive inflection, kind of into 2Q or into 3Q, in order to get above the mid range of your guidance, absent some further help from maybe foreign currency reversing? Is that not correct?

Matt White

I think that's pretty close. If you exclude foreign currency to your point, I mean, the top end right now, if you started negative in the first half, you would need some positive in the back half to achieve the top end, which is little to no growth. Right? To get zero for the year, if you start a little bit negative, you got to finish a little bit positive.

At the bottom end of our range, essentially assumes the current negative kind of low to mid single digit trends continue all year, unabated. So yes, that's kind of how we have it laid out right now. Obviously, if we get surprised to the upside on growth, that could help. And the one nice thing about this industry in general is, is when growth comes, and it comes pretty quickly; because as I mentioned, the assets are there, its just a matter of refilling them faster, at a faster rate, or putting more molecules into the pipeline. So we will have to see. But your characterization, I think is pretty close.

Vincent Andrews

Okay. And then just as a follow-up, Airgas yesterday reported negative 10% hardgoods sales in their quarter. And I am just wondering, sort of generically if you think, you made a comment about some of the hardgood weakness, was a function of people just sort of holding off because of uncertainty. I am just wondering, if you still think hardgoods is a real leading indicator of where gas demand is going to be, or some of that negativity has been skewed, maybe by what's going on in oil and gas to such an extent, or maybe there isn't such a clear indicator of the overall U.S. packaged gas business?

Matt White

It has been tough. We have looked on this, and sometimes, it seems like a leading indicator, sometimes it doesn't. But I characterize hardgoods into two basic buckets, you have large equipment and then you have consumables. The large equipment, as you can imagine, its very large numbers that come in lumpy. And when you see large equipment purchases like automatic welders or cutters, that's when things are usually going quite well, and the customer base is confident enough, and furthermore, their backlog is big enough, that they want to invest in automation. So we saw a lot of that, a year plus ago, primarily in the oil patch, but also in the whole center part of the country that served some of the manufacturing sector that build pumps and rigs and other things for the oil patch.

So we were seeing a lot of automated equipment being purchased, and also just a function of shortage of skilled labors, skilled welders and so forth. So that part, we have had to lap. The consumables is the one that can sometimes move right with gas. You are going to use so much wire and contact tips, usually as much gas as you use.

So I would say, the equipment has been a little bit of a front end indicator, and we have seen that. Now, its just a function of some of the consumables and just some other hardgoods that we, personally, are just not going to serve that market if the margins aren't worth our effort at this point.

Vincent Andrews

Okay. Thank you very much.

Operator

Thank you. Our next question comes from the line of David Manthey with Robert W. Baird. Your line is now open.

David Manthey

Thank you. Hi Matt. You mentioned that you are making acquisitions in areas that serve more resilient end markets? I was just wondering if you could help us understand what you meant by that? And then second, as it relates to the sort of generic U.S. tuck-in packaged gas distributor, has the multiple that you're paying for those, changed at all since the Airgas-Air Liquide deal?

Matt White

Okay. First on the resilient markets, I can give you some specific examples we have already announced. So Tecnogas in Peru, CO2 business, primarily food and beverage accounts that it serves. The Yara CO2 business in Europe, similar, a lot of food, beverage, dry ice, which applications go in very different areas. Some of the packaged gas businesses that we are acquiring, have specialty gases, large portion of specialty gases, and those tend to go into more industries like environmental, research, calibration gases. We have also done some medical acquisitions in Canada, with our medical gases business, as well as in South America. So those will be more into some of the hospitals and the home care areas.

So those are kinds of examples where we have gone deeper into what we will call resilient industries, that don't tend to move with the cycles of the manufacturing or industry.

As far as multiples on tuck-ins, we really haven't see much change, as you can imagine. We have been pretty disciplined on how we look at multiples and what we are willing to pay. And clearly, there is a large potential buyer that's going to be in pause for a while here. But we haven't really seen much, as far as valuations change on some of these deals.

David Manthey

Okay. Thank you. And then second, I know your backlog includes only fully executed contracts, but could you talk about what mechanisms those customers would have to either delay or cancel those contracts to the extent they can?

Matt White

Yeah. So for most contracts, a cancellation usually triggers what's called a termination payment, which is essentially a net present value of all the fixed payments. So those are pretty big numbers and pretty onerous, and you just don't see that of any project of any size.

As far as delays, most of our contracts have some type of date, certain clause, which will ensure that if the project is delayed, we either get paid day one regardless, or we get recovery through the fixed facility fee through a higher fee due to the time-loss value.

So we do have mechanisms to account for that. Of the projects that we have right now in the backlog, there is no material delays that we can see. But we do have some mechanisms. Now obviously, if the delay is due to us, that's a different issue. But these are more, if it’s the customers' reasons why they delayed, we do have economic recovery mechanisms.

David Manthey

Got it. Thank you very much.

Matt White

Welcome.

Operator

Thank you. Our next question comes from the line of John Roberts with UBS. Your line is now open.

John Roberts

Thank you. How much of surface tech is now aviation, given that oilfield and industrial hardened equipment is probably down a lot?

Matt White

Yeah, its growing faster than the others, that's for sure. Its roughly about a third. Given the new announcement joint venture we have, we do expect that sector of that business to grow at a much more rapid rate. But its roughly a third.

John Roberts

And then does the JV impair your ability to somehow find options for the remaining part of surface tech over time?

Matt White

No. I think the JV enhances the value of the whole business, and right now, we are doing everything we can to help that business grow, make it more profitable. But clearly, the more we can enhance the value of the business, the more attractive it is overall.

John Roberts

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Bob Koort with Goldman Sachs. Your line is now open.

Chris Wolf

Hi guys. This is Chris on for Bob. Just curious, industrial CapEx, where you view that, where are we in this cycle for that -- sort of building off of prior questions?

Matt White

You know, I am probably the wrong person to ask. I am not sure. When you look at the cycles right now, and you look at mining, oil and gas, metals, we are in a pretty tough spot. I think from a demand perspective, they are all in kind of a deep demand cyclical challenge. From a supply perspective, metals is a little different, because of this China situation. So that's one that's short of some capacity rationalization in China. It could be a little more difficult, and that's our view right now.

But oil and gas, and some of the other traditionally cyclical. I don't know. I don't know when they will recover. The movements are pretty radical in a day you're seeing on some of these commodities. So we will have to see going forward. But, its hard to say.

Chris Wolf

Okay. And then, looking at your acquisitions and your backlog, when you guys sort of mentioned this, it seems like you are sort of derisking a portfolio, and is this reflecting just where the near term opportunities are or a long term strategic view?

Matt White

It’s a little bit of both. Clearly, the near term opportunities are greater in some of -- as far as growth, are greater in some of the non-cyclical portions of the portfolio. So by investing in those areas, we can capture greater growth in this current and sort of near term outlook.

I think there is also a long term approach, which is just to further balance our portfolio. I mean, you go back several years, we took advantage of some high cycles in certain commodity markets, and we are not ashamed of that. We did quite well in that front, and now some of those cycles are at low points, and we just need to rebalance our portfolio like we do, and be able to insulate it from some of the cycles, and when those cycles return, we will be well positioned for that as well.

So it’s a little bit of both, and we need to continue to manage our portfolio around these trends.

Chris Wolf

Great. One quick one then, where do you -- after the volume downturns across the globe, where do you see merchant utilization rates, sort of by geography?

Matt White

So, not too different than I think what we said in the past. But the U.S., probably a little lower high. So maybe high 70s versus, we were probably 80 a couple of quarters ago. And part of that is, the energy business was a lot of liquid nitrogen, but also some argon, you're seeing a little weaker, given the manufacturing slowing in the U.S. South America is kind of mid to high 70s. Sounds fairly high, given what you have seen down here, but a lot of our merchant goes into non-cyclical business, so its food, beverage, healthcare. So those still are holding fairly well in South America.

Europe is also mid to high 70s. We are moving a little more product and we have seen some pickup and improvement there. And Asia is kind of, I will call mid-70s, it depends on the country, we had some capacity come on in India, which will lower that number a bit as the capacity gets loaded. China is a little lower, especially now with the New Year. Lunar New Year holiday, you tend to see it soften a bit in Q1. But I'd say that's in the mid-70s.

So not radically different around the world. We definitely have ample capacity for when things recover.

Chris Wolf

Thank you.

Operator

Thank you. And our next question comes from the line of Stephen Byrne with Bank of America. Your line is now open.

Stephen Byrne

Matt, in some of your earlier remarks, you referenced that hydrogen and nitrogen opportunity down in Texas, with that ammonia plant that Yara and BASF are building. We understand that the primary source of the hydrogen is the ethylene cracker of Dow. Is that the case? And if so, are your returns on a project like that meaningfully better than in on-demand hydrogen source, like building an SMR for such a project?

Matt White

Well I think Steve, when you look at the overall Gulf, we have a very strong network of pipelines, a cavern, in the case of the hydrogen situation to store, as well as, on-purpose production, through things like steam methane reformers and air separation units on the atmospheric side, as well as byproduct. So we will take byproduct from core alkali crackers, etcetera, and bring them into our system.

Clearly, having a blend of both, we believe is a nice benefit, because it is a lower capital intensive approach. But you do need both, because you have to give certain reliability and quality standards to the customers you supply into. So this is part of what's always been our long term strategy, in the hydrogen in syngas business, which is to have a combination of both on-purpose and sourcing. And it does help on the capital footprint.

Now clearly, you need to make pipelines, you have to have compression, you have to have assets that can clean up the actual hydrogen source you are taking. Its usually not to the right purity that you need. But its all part of our overall strategy, and it does help us deliver the reliability and quantity that we need for our customer base, and it gives us flexibility, in terms of how we run our asset fleet connected to that whole pipeline.

So I'd say yes, we are very happy with it. We think it gives us a very strong competitive advantage and bidding for new projects, and we are looking to continue bidding off this network for some of the new opportunities throughout the whole Gulf.

Stephen Byrne

And would you say that some of those opportunities might be the other half-a-dozen crackers that are under construction? Are you looking at those as additional sources of hydrogen?

Matt White

Yes. We will continue to look at those as sources. But we don't want to get caught too long either. So its always a combination of managing your source and your sync. And so its just part of that process.

Stephen Byrne

Okay. Thank you.

Operator

Thank you. And I am showing no further questions at this time. I would like to turn the conference back over to Ms. Kelcey Hoyt for any final remarks.

Kelcey Hoyt

Thank you again for participating in our fourth quarter earnings call. If you have any further questions, please feel free to reach out to me directly. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.

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