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Air Products & Chemicals, Inc. (NYSE:APD)

Q3 FY08 Earnings Call

July 23, 2008, 10:00 AM ET

Executives

Nelson Squires - IR

Paul E. Huck - Sr. VP and CFO

Analysts

David Begleiter - Deutsche Bank

Jeffrey Zekauskas - JP Morgan

P.J. Juvekar - Citi

Mike Harrison - First Analysis

Laurence Alexander - Jefferies & Co.

Donald Carson - Merrill Lynch

Mark Gulley - Soleil - Gulley & Associates

Kevin McCarthy - Banc Of America Securities

Michael Sison - KeyBanc Capital Markets

Chris Shaw - UBS

Robert Koort - Goldman Sachs

Sergey Vasnetsov - Lehman Brothers

John McNulty - Credit Suisse

Hassan Ahmed - HSBC

Edward H. Yang - Oppenheimer & Co.

Operator

Good morning welcome to Air Products and Chemicals Third Quarter 2008 Earnings Results Conference Call. Just a reminder that you will be in a listen-only mode until the question-and-answer segment of today's conference. [Operator Instructions]. Also, this teleconference presentation and the comments made on behalf of Air Products are subject to copyright by Air Products, and all rights are reserved.

Air Products will be recording this teleconference and may publish all or a portion of the teleconference. No other recording or redistribution of this telephone conference by any other party are permitted without expressed or written permission of Air Products. Your participation indicates your agreement.

Beginning today's conference is Mr. Nelson Squires, Director of Investor Relations. Mr. Squires. You may begin.

Nelson Squires - Investor Relations

Thank you, Amy. Good morning, and welcome to Air Products quarterly earnings teleconference. This is Nelson Squires. Today, our CFO, Paul Huck, and I will review our third quarter results. We issued our earnings release this morning and it is available on our website along with the slides for this teleconference. Please go to airproducts.com and click on the scrolling red banner to access the materials. Instructions for accessing the replay of this call beginning at 2 PM Eastern Time are also available on the website.

Please turn to slide two. As always, today's teleconference will contain forward-looking statements based on current expectations regarding important risk factors. Please review the Safe Harbor language on this slide and at the end of today's earnings release.

Now, I'll turn the call over to Paul.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Thank you Nelson. Good morning and thank you for joining us today. Now please just turn to slide number three, before we look it this quarter's results I would like to spend a few minute updating you on several portfolio management items. First as we mentioned last quarter, we were marketing our remaining emulsions properties enclosed on the sale of those facilities to Ashland on June 30th.

Second, we have completed the review of our strategic alternatives for our U.S. Healthcare business. As part of our review process we performed an asset impairment test and have recorded $315 million impairment charge this quarter. We also reviewed our options for the business with our Board last week. We have approval to sell the business and have already started the process. We have reached an agreement in principle to sell our business in New York and New Jersey, which represents about 10% of our U.S. Healthcare business sales. We expect to close on this transaction in the fourth quarter.

Regarding the remaining U.S. business, we have solicited and received a number of indications of interest in the business. And we are in currently in discussions with those potential buyers. As a result of our Board approval, we will begin reporting the U.S. Healthcare business in discontinued operations starting in quarter four. We will also move the leadership of our European Healthcare business into our Merchant business, reporting it as part of that segment.

Prior to our earnings announcement for the quarter, we will provide you with restated segment information. This transaction will have a favorable impact on a number of key metrics we are working to improve. The sale of business should improve earnings per share from continuing operations by $0.11 in 2008. It will also improve our return on capital employed by 30 basis points and operating margin by 70 basis points. As shown in the U.S. Healthcare results and our pension settlement our year-to-date operating margin would be 14.9%.

Now let me turn to slide four, and review the factors that affected the quarter's performance in terms of earnings per share. Our GAAP or as reported EPS decreased 75%, excluding discontinuing operations and the disclosed items shown at the top of this slide adjusted EPS from continuing operations grew by $0.20 or 18%.

Higher volumes added $0.06. Pricing and margins together including energy and raw materials were unfavorable netting to $0.02. Favorable currency and foreign exchange added $0.06. Higher equity affiliate income contributed $0.06 as we continue to see good growth in operating performance in a number of countries. About half of this is attributable to U.S. GAAP adjustments made by several affiliates in Asia. Fewer shares outstanding contributed $0.03, all other items net contributed $0.01.

Now turning to slide number five, for a review of this quarters consolidated financial results from continuing operations excluding the U.S. Healthcare charge. As you can see, we had another good quarter. We are continuing to make progress on our 2008 financial targets. For the quarter, sales grew 16% versus prior year. Underlying growth excluding equipment and energy was 5% driven by better volumes in our Merchant and Electronics and Performance Materials segments and higher pricing in Merchant Gases. Higher natural gas and raw material pass through contributed 7%, currency contributed 5%.

We continue to make progress reducing SG&A expense as a percentage of sales and we are now at 11.4%. Operating income of $382 million was up 9% from prior year, again due to better volumes and pricing and also favorable currency. Our operating margin declined 100 basis points versus last year entirely due to higher natural gas and raw material cost pass through.

Lower equipment and energy results further reduced our margins. However, this was offset by underlying performance improvement in our Merchant, Tonnage, and Electronic and Performance Materials segments. With the improvements we are forecasting for quarter four, we are on track to achieve our operating margin goal of 15% for the year excluding U.S. Healthcare.

For the quarter, our net income and our diluted earnings per share increased by 16% and 18% respectively. Our return on capital improved with return on capital employed increasing to 12.5% up 50 basis points from last year. Now Ill turn the call over to Nelson to review our business segment results. Nelson?

Nelson Squires - Investor Relations

Thanks, Paul. Please turn to slide six, Merchant Gases. Merchant Gases grew at a solid pace during the quarter. Sales of $973 million were up 19% versus prior year. Currency contributed 8% and volume contributed 5%, pricing added 4% and acquisitions 2%.

Merchant Gases operating income of $177 million was up 20% versus prior year and segment operating margin of 18.2% was up 20 basis points. Mainly, due to pricing and volume gains margins were down sequentially by 30 basis points due to significantly higher energy and fuel cost in May and June.

Let me now provide a few highlights by region. Please turn to slide seven. In North America, our sales increased to 11% driven by continued strong pricing gains and solid volume growth. We are seeing the expected volume growth in oxygen and nitrogen versus last year, realizing the impact of new business signings from previous quarters.

Liquid nitrogen for oil field services was also very strong in the quarter. We are bringing on previously announced capacity at three of our facilities and are pleased with the loading and returns on these news expansions. Pricing continued its strong trend, however, we were not able to keep up with rising energy cost in the quarter. In this quarter alone we saw an unprecedented 30% increase in the cost of diesel fuel. Diesel is now up over 50% versus prior year.

We implemented another fuel surcharge on 1 July our third this year to recover the most recent cost increases which haven't incurred since our previous surcharge implementation on 1 May, 2008. We expect this action to help drive improvement in our overall segment margins in the fourth quarter. New business signings continued their strong pace in the quarter and this fiscal year will be our best ever in terms of both quantity and quality of signings.

In Europe sales increased 23% over prior year with price adding 3%, volumes 1%, currency 15%, and acquisitions 4%. Business continued to be generally soft in the UK and Spain. Plant utilization remains high on the continent. Signings were strong in the quarter especially in the UK where we have prior product available.

We are also beginning to see the impact of increased volumes as a result of new signings in previous quarters. Pricing was solid and we are in the process of launching several actions across Europe to address rising energy cost.

In Asia, Merchant sales were up 21% over last year, volumes contributed 15%, currency 4%, and price 2%. Similar to our other regions on July 1st, we implemented price increases in China, Taiwan, Korea, Malaysia, and Indonesia to recover energy costs.

Please turn to slide eight, Tonnage Gases. Sales of $976 million increased 26% compared to last year. Volumes were flat versus prior year as new plants on-streams were offset by lower spot sales. Natural gas and raw material prices were higher versus prior year and added 23%, while currency added 3%. Sequentially, volumes were down 3% due to lower refinery run-rates.

Operating income of $126 million was up 4% compared to last year and 13% versus prior quarter due to improved operating efficiencies. Operating margin of 12.9% was 260 basis points lower than last year, held down by significantly higher natural gas cost pass through. This impacted margins sequentially as well though the impact was offset by performance bonuses and improved operating efficiency. We announced two significant contract signings in the quarter with U.S. Steel and Nanticoke, Ontario, Canada and Total at Port Arthur, Texas. New business activity continues at a solid pace and we expect to announce additional signed agreements in the near future.

Please turn the slide nine, Electronics and Performance Materials. Segment sales of $580 million were up 9% compared to last year. Volumes were up 6%, pricing 1% and currency contributed 2%. Electronic sales were up 5% compared to last year driven by higher sales in specialty materials and tonnage and offset by lower equipment sales in the skew reduction effort. Excluding equipment in the skew reduction effort, sales increased 20%. Electronic sales were down 1% sequentially due to lower equipment sales. Ex-equipment, sales increased 4%.

In Performance Materials overall volumes grew 5% versus prior year and 7% sequentially. Continued weakness in North America was more than offset by strong sales to Asian customers.

Overall operating income of $70 million was up 13% versus prior year. Operating margin of 12.1% was up 40 basis points versus prior year. We expect to see continued margin improvement in the current quarter, as the cost to support the skew reduction efforts will be largely behind us and the full benefits of the restructuring effort will begin to take hold. While capital spending in the semiconductor industry has slowed as expected in 2008 we were successful in winning two FAB awards in Asia during the quarter. Bid activity has also begun to pick up. Activity level in the Total Voltaic [ph] area continues to be very high as well.

Please turn the slide 10, Equipment and Energy. Sales of $107 million in this segment decreased due to lower L&G activity. Operating income of $4 million decreased versus prior year and prior quarter. Our backlog of projects now totals $228 million. We signed agreements for two larger separation units in the quarter which have been added to the backlog.

Please turn to slide 11, Healthcare. Healthcare segment sales of a $172 million were up 9% compared to prior year, due primarily to currency. Sequentially sales were up 1%, reflecting continued solid results in Europe. Excluding the impairment charge, operating income of $13 million was up 54% versus prior year and higher European results and currency. Operating margins were at 7.6%, improving 220 basis points versus prior year. Our margins improved 210 basis points sequentially due to strong performance in Europe.

Now, I will turn the call back over to Paul.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Thanks, Nelson. Now if you will turn to slide 12. Now let's take a look at our guidance. As I mentioned earlier we'll be moving to U.S. healthcare business to discontinued operations in quarter four. On a continuing operations bases this will add $0.07 to 2007, and $0.11 to our 2008 guidance. Therefore the equivalent range to our 2008 $4.95 to $5.05 guidance would now be $5.06 to $5.16. Based upon the third quarter improvements and a strong outlook for quarter four we are raising this range $0.10 on the bottom and $0.05 on the top, to $5.16 to $5.21 and now expect to deliver 21% to 22% growth in 2008 versus last year.

Year-to-date ex-U.S. healthcare and pension settlement charge, we have earnings per share from continuing operations of $3.79. This gives us fourth quarter guidance of $1.37 to $1.42.

Turning to slide number thirteen. As we look forward from quarter three to quarter four we see the following. On the positive side, we expect to see increased earnings sequentially from the following areas. In Merchant Gases we continued to implement price increases and fuel based surcharges to recover escalating energy costs.

In Tonnage Gases we expect higher operating performance bonuses and lower maintenance spending in quarter four. In electronics and performance materials we anticipate higher electronics, specially materials volumes and lower cost, partially due to our product line rationalization efforts. And finally we expect to book Q4 effective tax rate of approximately 24% as a result of continuing benefits from our tax planning strategies.

Slightly offsetting these sequential improvements is our forecast for lower equity affiliates income due to one time favorable adjustments in this quarter. On the economic front globally the outlook is turning more pessimistic over the past three months. The credit crisis continues to spread, consumer confidences drop, and inflation concerns are rising with higher energy and commodity prices.

Fortunately growth in manufacturing exports continues in the U.S. and I am generally pleased with our volume growth and new business signings broadly. While there is continued economic uncertainty and speculation, we still see strength and growth in our markets both near term and long-term.

Turning to slide 14. We are currently developing our plans for the next three years and we are excited by the opportunities we see going forward. As Nelson said in his business commentary, we continue to see strong bid activity in Tonnage Gases as both hydrogen for refining and oxygen for gasification, continued to grow.

To get an accurate look at our capital spending, you do have to make one adjustment. A few years ago there was an accounting change that moved the one-on-one onsite to capital lease treatment. Previously this was shown in property plant and equipment capital spending. You can see this as use of cash under our operating cash flows in the line item non-current capital lease receivables.

Therefore you need to add this to our property plant and equipment capital line. When you do, you see our capital spending is about $1.4 billion for 2008. About 40% of this is for long term onsite and pipeline contracts. In fiscal 2007 the equivalent spending was $1.1 billion and 40% was for onsite contracts.

Looking forward to fiscal 2009, we expect that capital spending under the same method will rise to $1.7 billion to $2 billion level and approximately 50% of this will be in the onsite area. As a rule of thumb you can translate the amount of sales produced by each dollar of capital in the onsite merchant areas by 70%. What this says is that the same demand factors we have discussed with you in the past year are delivering significant growth opportunities as we expected. These factors are higher energy prices and demand, higher capital cost, and stricter environmental rates. While this results in more of our business moving to long-term take or pay contracts we are using our cyclicality and providing greater consistency in our cash flows.

Turning to slide 15, while we are not done with our 2009 forecast, I can share with you what we are seeing? For our Merchant, Tonnage and Electronics and Performance Material segments we expect to see underlying sales growth from volume and price of about 6% to 7%. This excludes any changes due to currency or energy and raw material pass through. This is slightly below our longer term forecast due to the current manufacturing environment we are seeing around the world.

In 2009 we would expect our equipment and energy segment to be about even with 2008 as the impact of new orders offsets the projects completed this year. Our top priority continues to be to improve our returns by making progress towards our 17% margin goal for 2010.

Our efforts are focused on achieving productivity through the full year benefit of the product line rationalization efforts in Electronics and the elimination of the restructuring cost we have carried in this area. Continued transactional cost reduction by using share services NFAP globally, continued benefits from making the right decisions on how to source products, run our plans and price our products driven by the business information we get from SAP. And in higher energy price world, many improvements that we've identified in the past now look even more promising. We're taking action and turning them into cost saving.

We will have more specific guidance at the year-end call in October. Right now, 2009 is shaping up to be another solid year of earnings growth driven by both volume and productivity gains. Growth in 2010 and 2011 also looks strong. As we have said before, we have good visibility into our business because of the long-term contract in the nature of much of the business. For those years we are seeing even stronger growth as the impact of increasing capital spending comes on stream and starts generating revenues and profits.

Finally, you can see the changes we've made over the past few years are delivering consistent strong growth in revenue, income, and returns. We remain committed as a team to continue taking advantage of the excellent market opportunities we have to continue this growth and deliver increased shareholder value.

Thank you. And now I will turn the call over to Amy to take your questions.

Question And Answer

Operator

Thank you. [Operator Instructions]. Our first question comes from David Begleiter with Deutsche Bank.

David Begleiter - Deutsche Bank

Thank you. Paul on the --

Paul E. Huck - Senior Vice President and Chief Financial Officer

Good morning.

David Begleiter - Deutsche Bank

n the CapEx outlook. What are the returns on capital metrics of the backlog right now?

Paul E. Huck - Senior Vice President and Chief Financial Officer

If you have the return on capital it is above... and the returns which we have experienced in our existing business, we're probably seeing our returns going up overtime. It's hard to give an average because it's a mix of risk there Dave. And we are looking at the projects individually. But I can assure you that we are exceeding our return on capital from a cash flow standpoint by very good margin.

David Begleiter - Deutsche Bank

And any reason why the CapEx would be down in 2010 given the strength of the backlog?

Paul E. Huck - Senior Vice President and Chief Financial Officer

No. I'm very specific about that I think as we look at 2009 we look at CapEx growing and given the biding activity which we have today and the projects which we are working on. We would expect our CapEx to grow in the 2010 and 2011, primarily driven by onsite contracts hydrogen and gasification.

David Begleiter - Deutsche Bank

And what's the only onside projects, the ones you aggressively bid for, what's your win rate?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It's hard to actually get a win rate because these are large, are large deals but I think we feel very good about our win rate on here. I don't really keep track of a batting average per say in that area for us. A lot of the jobs, which we are getting now Dave and we really aren't bidding, a lot of them sit on our pipeline systems or sit with existing customers who we have build our relationship with. And so it's a deal for us which they aren't going out and getting some of the bids on.

David Begleiter - Deutsche Bank

Thank you very much.

Operator

Thank you. Our next question comes from Jeff Zekauskas with JP Morgan.

Jeffrey Zekauskas - JP Morgan

Hi, good morning.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Good morning Jeff.

Jeffrey Zekauskas - JP Morgan

Couple of things, the equity income went from I think $35.5 million last year to $46.5 million, so it's up 30%. And you're operating profits I think were up 8%, so what's the difference, what's going on in equity income that's so strong?

Paul E. Huck - Senior Vice President and Chief Financial Officer

The first thing in which we said Jeff is, about half of that gain is due to some adjustments for converting to GAAP in our Asian affiliates, U.S. GAAP, as they made adjustments. Over a period of time, we have consolidated that now, and taken a look at those things. If you then look at the other things you have to look at the underlying economies in which these are. Next you can affiliate is getting very strong growth in volumes, principally due to a lot of things on oil recovery. We continue to grow in India; we continue to grow in Italy. So it's the underlying growth in those areas.

Jeffrey Zekauskas - JP Morgan

So I take it that's about $0.03 a share benefit.

Paul E. Huck - Senior Vice President and Chief Financial Officer

The benefit from equity affiliates in term.

Jeffrey Zekauskas - JP Morgan

Yes.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes.

Jeffrey Zekauskas - JP Morgan

And secondly can you just remind me like what your output in standard cubic feet is in hydrogen and when you look at the new business you bringing on for '09, how much does that grow and for 2010 when you are just talking about new capacity you are bringing on?

Paul E. Huck - Senior Vice President and Chief Financial Officer

When you look at the new capacity which we are bringing on in '09 in hydrogen, in '09 it is not substantial for us as we look at that right now. We have most of the new capacity which we have won in hydrogen comes on stream in 2010, 2011 for us, alright. And if you look at the annual sales of the onsite business it is about at the run rate today and the current hydrogen price is up $4 billion, about 75% or so of that 80% of that is hydrogen for us.

Jeffrey Zekauskas - JP Morgan

Okay, thank you very much.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Sure.

Operator

Thank you our next question comes from P.J. Juvekar with Citi.

P.J. Juvekar - Citi

Good morning.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Good morning P.J.

P.J. Juvekar - Citi

You know, you guys did a big U turn in healthcare. If you are trying to make earnings less cyclical and increase return on capital then by same logic why wouldn't you sell your equipment business?

Paul E. Huck - Senior Vice President and Chief Financial Officer

If you take a look at the equipment business P.J. it is something which we have which actually supports the onsite business. We have been through this probably a lot of times with people, is that it leads to orders in the future for us. So a lot of the work which we have done in the equipment business to sell large air separations plans has actually led us to have the right solutions in the gasification end of projects which we are doing very well. We have number of projects in China, which we are working on our backlog right now, and so that does support.

The other thing is the O&G business, it helps us acquire presence in the Middle East as does the oxygen plant sale business which we have there. So lot of there is really is support business in the onsite area and has performed very well for us, so its part of that business.

It doesn't really put a lot of cyclicality into it. It doesn't take a lot of capital for it. It is not something which I would like to sell to somebody and put somebody else into the business of this.

P.J. Juvekar - Citi

Well I understand the ASU business but L&G energy business is cyclical?

Paul E. Huck - Senior Vice President and Chief Financial Officer

The L&G business is, absolutely. It does go up and down. It doesn't require a lot of investment for us. We think... we actually think that Air Products is the high value honor for this business we think...

P.J. Juvekar - Citi

Okay...

Paul E. Huck - Senior Vice President and Chief Financial Officer

We think the skills which we have build up and we don't think we could get the same value off of somebody else.

P.J. Juvekar - Citi

Right, I am not saying you should sell it; I just wanted to understand your logic.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Okay, that's fine.

P.J. Juvekar - Citi

The second question I have is on operating margins and your operating margin goals.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes

P.J. Juvekar - Citi

Are you focusing on the right things, because with this natural gas raw material pass through the operating margins are becoming quite volatile and it's very difficult to track them against the goals.

Paul E. Huck - Senior Vice President and Chief Financial Officer

And P.J. and you are right, if you take a look at the onsite business and the Tonnage Gas business as you saw this quarter and the margins were taken down by that. However, if you look at the Electronics business, the Performance Materials business, the Merchant gas business, all of those are businesses in which we have established targets for margins. And so we have an overall target, but I think more importantly we have targets for each of those areas. And as to get to the Electronics and Performance Materials business above 15 to get the Merchant gas business above 17, if the pass through prove and presents some improvement on the Tonnage side as long as I am looking and getting a good return I going to be happy with that business. So I think we are focused right but I know we are focused right on this year, on the right metrics for how we are measuring and going after this business.

P.J. Juvekar - Citi

And just I have a follow up question, just a quick question on the --

Paul E. Huck - Senior Vice President and Chief Financial Officer

P.J, I just got to correct. I made a mistake. I said the Merchant Gas business was negative above 20%. I think I said 17% that was error on my part. Okay.

P.J. Juvekar - Citi

Okay. And in your answer to Jeff Zekauskas questions about this equity income, you said there was a conversion of some of this equity income to U.S. GAAP, does that means it was not reported under U.S. GAAP before, was there cash benefit?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It was reported under GAAP before but what happens here is that the conversion were done in the country and we took the work back here and we looked and made adjustments as to how they did the conversions. And the conversions were wrong.

P.J. Juvekar - Citi

And was there a catch up benefit in the quarter?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes, there was... and that was due... and that was about half of the increase.

P.J. Juvekar - Citi

Okay. Thank you.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Okay.

Operator

Thank you. Our next question comes from Mike Harrison with First Analysis.

Mike Harrison - First Analysis

Hi, good morning.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hi Mike.

Mike Harrison - First Analysis

It's my understanding that one of your competitors recently raised pricing in Europe. I was wondering if you could talk about the impact that you have seen, as a result of that on the pricing environment in Europe?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes, in the pricing environment in Europe is getting better, as we've talked about that. We're out there trying to get our prices up in that area. You can see in this quarter and I think in slide seven that our prices were up 3% quarter three way over '07.

Mike Harrison - First Analysis

And then was wondering if you could give us an update on the Eastman gasification project? Is construction there still plan to begin in early '09, or if there have been any changes there?

Paul E. Huck - Senior Vice President and Chief Financial Officer

On the project, I think you are best to talk Eastman and there the person who is actually trying and we are both, the customer of the project and a supplier. We are excited to be in it, we see as a great opportunity for us but I don't want a comment on my customer's project for you.

Mike Harrison - First Analysis

Okay. And then in the Merchant business you were talking about the two fuel surcharges you put in place. Can you walk through, how those work. And as you see diesel prices rising, what assumptions had you been making about fuel cost and is the surcharge then something that is static or is it something that changes with changes in fuel costs?

Nelson Squires - Investor Relations

Hi, Mike. This is Nelson. I will comment on that. It is indexed to a basically published information on diesel fuel cost index. Both the Government and Air Products do forecast going forward. Clearly the run up that we saw in the last quarter that we talked about the 30% jump. We talked about in May and June and you could really see it happen over about of four to six week period. Clearly it got out in front of us from that standpoint. We were pretty comfortable with what we had out there in May versus forecast. What we have done with the July action, is increased the amount required to not only catch up but also get ahead of whatever forecast is out there. And then the surcharge will basically adjust if diesel prices fall down and we typically use the three quarter rolling average. Why we like this mechanism, is that our contracts allow us to surcharge and so this is something that we can implement very rapidly and get that in place pretty quickly so we can have a fairly quick impact on the P&L.

Operator

Thank you. Our next question comes from Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies & Co.

Good morning.

Nelson Squires - Investor Relations

Hi Laurence.

Laurence Alexander - Jefferies & Co.

I guess first of all, on the tonnage, what was the incremental margin on the flat sales or how much of the delta we think about in Q4 versus Q3?

Paul E. Huck - Senior Vice President and Chief Financial Officer

The margin on the spot sales, if you look at that really depends upon what the price was for gas there, but I think you can look at spot sales margins incrementally and not being questioned for the overhead activities of somewhere in the 20% range or so.

Laurence Alexander - Jefferies & Co.

Okay. And do you have a rough sense for... you have done a good job on taxes this year, do you have a rough sense for whether the tax rate is sustainable next year or should we expect it to creep higher?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Right now I would expect it to be up a percent or two over the 25% which I'm going to book over all in this year. But that's something which we are currently taking a look at. It depends a lot of decisions on how we manage our cash and fund things but we obviously try to keep this as low as possible and pay as few taxes as we are required to.

Laurence Alexander - Jefferies & Co.

And then the nascretion [ph] on healthcare is $0.11 for this year, that's about $0.09 in first three quarters?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It's about $0.08 in the first three quarters.

Laurence Alexander - Jefferies & Co.

Okay and I guess just lastly on, this has been an unusual quarter, having pricing lagging energy cost. Is there anything, is there a mix issue embedded in that or are there particular end markets where you have had an issue?

Paul E. Huck - Senior Vice President and Chief Financial Officer

No. What happened was that the diesel cost went up a lot more than what we anticipated and we have taken the action to get the price increases out there, but that was simply the fact we didn't see and there wasn't anyone who saw the amount of increase in the diesel cost which occurred in May and June.

Laurence Alexander - Jefferies & Co.

Okay, thank you.

Operator

Thank you. Our next question comes from Don Carson with Merrill Lynch.

Donald Carson - Merrill Lynch

Thank you. Paul a question on the Tonnage business, you talked about volume slow down due to lower refinery utilization rates, question there is, is that specific to some of your customers, I would have thought that those who were switching over to greater dist [ph] with production would have required even more hydrogen? And then I know you have three projects that you have signed, but haven't announced and you have got some potential in the oil sands. Again what would be the volume impact from these projects as they start up in 2010, 2011, what percentage of your existing business would they?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Okay, Don, if you take a look at the on the customers yes, it was specific to few of our customers in the Tonnage area for hydrogen and it was around how the refining was running, whether refining was up or down. We don't think there was anything long-term. Overall we think the dynamics here are for the refineries to acquire a lot more high vision in the future, to make more transportation fields, and to also process heavier and more solid crudes. If you take a look at the projects in which we have the... the three projects and the work which we're doing in oil sands. I think what we are looking at is sales growth its going to be lumpy obviously with the projects but if you look over a period of time something in 15% to 20% range for us is what we are predicting.

Donald Carson - Merrill Lynch

Okay. And Nelson a follow up on Merchants, you talked about some capacity additions in the U.S. you are still seeing volume growth. What are your operating rate trends there? And if you could also tell us what operating rates are doing in Europe?

Nelson Squires - Investor Relations

U.S. operating rates are holding pretty steady. I mean, we're consuming this product that we're bringing on stream, if anything we probably saw a slight pick up quarter-to-quarter in utilization. Even with the capacity coming on stream. As we said before we were careful in where we place this product, these expansions and the demand has come in as expected.

So that continues to work pretty well for us. In Europe, clearly UK is right from a loading perspective. As we made the comment in the commentary, we are happy to see some of our signings rates picking up and some new customer's that have come on stream specifically in the UK have helped us load those plans.

Our volumes or capacity is pretty tight and remains tight on the continent. We are not seeing any slippage in utilization rates. And our Eastern Europe plans are still very tight as you were adding some capacity and pull in to address that. So it still remains pretty tight across the system which should continue to support our pricing efforts.

Donald Carson - Merrill Lynch

And by tight community in the U.S. you are still sort of in the mid upper 80s?

Nelson Squires - Investor Relations

Yes, upper 80s.

Donald Carson - Merrill Lynch

Alright. Okay. Thank you.

Operator

Thank you. Our next question comes from Mark Gulley with Soleil - Gulley & Associates.

Mark Gulley - Soleil - Gulley & Associates

Hi, good morning guys.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hey, good morning, Mark.

Mark Gulley - Soleil - Gulley & Associates

I want to talk a little bit by CapEx-to-sales. If I did the math it would appear as if for next year your CapEx-to-sales on an adjusted basis is going to be coming in the 15% area, well above the 10% where you have been running and the industry has been running for a while. And lot closer to the battle, 20% when I care to remember. So, is that 15% CapEx-to-sales number that's going to be, something sustained for a while? And are you concerned about a capacity searcher?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Mark, I do believe that and the number is going through sustained going out in the future. I'm not concerned about the capacity coming on stream because this CapEx is sold as we are bringing it on stream. It is in the Tonnage gas area, principally for hygiene and refining and oxygen for gasification are the two areas in which we look at. And so it is not like the old days where we... a lot of plant and equipment was going in the liquid plant area.

Mark Gulley - Soleil - Gulley & Associates

Okay, fair enough. The industry has been very successful in getting price increases and surcharges for sometime now. Are you starting to see any kind of push back at all and customer saying enough is enough that we really can't absorb these higher costs?

Nelson Squires - Investor Relations

Mark, Nelson, responding that, we have not seen the push back. What we have talked about in the previous calls is that our customers have been more successful in last two or three or four years of passing these increases on to their customers and that trend certainly is continuing. Again with our third surcharge of the year our customers understand why we're doing if they are seeing those prices themselves. And so we continue to be successful at getting those out there.

Mark Gulley - Soleil - Gulley & Associates

And the final question is one of your competitors has announced another share repurchase program as they look at their balance sheet. I know, you haven't talked a lot about '09 but Paul, can you share with us whether not surplus free cash flow could be used to buy more stock for your products?

Paul E. Huck - Senior Vice President and Chief Financial Officer

And the answer is yes. And I have been through the... and the way in which we use our cash and we still have about $840 million of authority from our board on that and we would use it in that way.

Mark Gulley - Soleil - Gulley & Associates

Thanks Paul.

Operator

Thank you. Our next question comes from Kevin McCarthy with Banc of America Securities.

Kevin McCarthy - Banc Of America Securities

Good morning.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hi Kevin.

Kevin McCarthy - Banc Of America Securities

If I look at the equipments in Energy business, it looks like your backlog improved sequentially there, you have some new equipment orders, profit was down quite a bit in the quarter. If you look at that $4 million operating income number, had that compared to what you would envision as a cyclical trough level in that business, trying to gauge how close we might be to the cyclical bottom there?

Paul E. Huck - Senior Vice President and Chief Financial Officer

I think we are close to the bottom there.

Kevin McCarthy - Banc Of America Securities

Okay. So you would expect that business to remain in the black through the bottom?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes.

Kevin McCarthy - Banc Of America Securities

Okay. Then to follow up on tonnage a little bit, you referenced slower spot sales. Could you advice, what percentage of sales in that business were spot and whether or not you are seeing customers that are offline completely because of operating problems or is it a situation where your are seeing folks throttle back due to poor spreads?

Paul E. Huck - Senior Vice President and Chief Financial Officer

With regards to the percentage of sales would you have. If you take a look at the pipeline systems which we operate somewhere in 10% and 15% of the systems are available for spot, in general. So that would be the way in which I would look at that. As far as the customers coming down, there were some turns which customers had and they were also decisions on the customers part to operate in and cut back. So we saw both of those things.

Kevin McCarthy - Banc Of America Securities

Okay. And finally can you give us an updated time line on your ASU starts at Reidsville and Ashland, I was expecting Reidsville to come up fairly soon here.

Nelson Squires - Investor Relations

Reidsville is on stream. Ashland will be up very soon like within the next 30 days.

Kevin McCarthy - Banc Of America Securities

Great, thank you very much.

Operator

Thank you, our next question comes from, Mike Sison with KeyBanc Capital Markets.

Michael Sison - KeyBanc Capital Markets

Paul when take a look at that 15% goal that you had thought for the total company for operating margins, are you on track there for Merchant gasses and Electronic Performance Material this year?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes, we are. As far as the progress, yes.

Michael Sison - KeyBanc Capital Markets

Okay, then when you think about electronics business, I thought I heard you say that it was growing 20% excluding equipment?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes

Michael Sison - KeyBanc Capital Markets

Is that run-rate sustainable? Can you give us little bit of idea where the winds or where the growth is coming from there?

Nelson Squires - Investor Relations

Certainly Mike, this is Nelson. Materials growth is very strong so that number was ex-equipment and ex-skew reduction effort, the 20%. Continuing to see good volume growth in products like NF3 and the other key products that we are selling. Our ACT product line continues to perform very well. That's all in the face of silicon that's growing probably a little lighter than last year probably in the 5% to 6% versus a full year 7%. So we are getting a multiple on the silicon growth as we expected. Our prospects as we see things flat panel is also done a bit better than expected this year. We expect that to basically continue. Silicon growth appears to be solid.

So that looks like it will continue and the other part of this is we are bringing the new NF3 capacity on as we speak in Korea and we expect that to be largely loaded fairly quickly. And behind that is again some new low key products which are picking up momentum in sales. So, we think we're going to continue in a solid growth pattern there.

Michael Sison - KeyBanc Capital Markets

Okay and then, if you take a look at the European healthcare business, can you just sort of remind us why you are saying that business is a good business to keep? When you put it into Merchant, will it... the press margins, health margins, margins about the same?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It was going to help the margins in the Merchant area as it goes in and so you can see the map from the stuff which we have put out there. But overall Mike, this structure of the market is not the same as in the U.S. Bulk of the business, which we have in Europe is bid and you get it... and you get the business and you're able to serve it. Then that's not the same thing as what occurs here in the market here.

Michael Sison - KeyBanc Capital Markets

Okay. And one last quick question. You seem to be little more pessimistic in the overall global economy. Can you just give us a little bit... at least a little more pessimist then what you thought in April and May, can you just give us an idea of maybe regionally or are there any certain end markets there that are causing you to be little bit of watchful in terms of the economy?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It is not so much driven by the end market, it is more driven by the factors, that we continue to see the bank saving trouble. So we continue to see that happen. We see a drop in consumer confidence which has to have, which is going to... its going to... it has to reflect itself back. We actually think that consumer confidence is too low for how the economy is actually working. And then probably the bad news which comes over on the news on TV every night, weighs upon people and they hear it too much. But there are a lot of good things in the economy too. If you look at the underlying the strength of especially in the U.S. of exports has really bowled manufacture economy here. So it's a balanced look on those things. Overall we think the manufacturing sector is actually performing the best of anybody. So, in our area we are feeling pretty good.

Michael Sison - KeyBanc Capital Markets

Thank you guys.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Thanks.

Operator

Thank you. Our next question comes from Chris Shaw with UBS.

Chris Shaw - UBS

Hey, good morning.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hi Chris.

Nelson Squires - Investor Relations

Hi Chris.

Chris Shaw - UBS

To beat those spot sales versus the data. From the way you described it the reduction in spot sales reflection of refinery usage rates as well, utilization [ph] rates?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes.

Chris Shaw - UBS

And then most everything has been covered. But was the accretion from the impact of investing in U.S. Healthcare for the quarter?

Paul E. Huck - Senior Vice President and Chief Financial Officer

$0.03, it will be when you look at it.

Chris Shaw - UBS

Okay. That's all I got. Thanks.

Nelson Squires - Investor Relations

Okay. Chris.

Operator

Thank you, your next question comes from Marybeth Connolly with Goldman Sachs.

Robert Koort - Goldman Sachs

Actually it's Bob Koort. Good morning guys.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hi Bob.

Robert Koort - Goldman Sachs

Just a quick question on, healthcare and I am sure you will be glad to start talking about it soon, but why the magnitude to write off and then why sell it piece meals [ph] trying to package it, so I thought at least the strategy when you guys owned it was doing critical math to provide some synergy?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Sure. As far as the size of the charge it is based upon an impairment analysis of trying to take a look at the cash flows of the business Bob and that's what it comes out to be. And so our view of the business, based upon the things which we are seeing today and what's happened in the marketplace is a lot worse than it was a year ago and that's why the size of the charge. As far as trying to grab and sell things in pieces we are not. We are actually trying to... we are growing to market with the thing is a whole. The New York and New Jersey Properties came as an opportunity for us, in that business actually. It was in very bad place for us as far as from a cash standpoint. And we had an opportunity from a local guy who wanted that business and we chose the sell it.

Robert Koort - Goldman Sachs

Thank you.

Paul E. Huck - Senior Vice President and Chief Financial Officer

You're welcome.

Operator

Our next question comes from Sergey Vasnetsov with Lehman Brothers.

Sergey Vasnetsov - Lehman Brothers

Good morning.

Nelson Squires - Investor Relations

Hi Sergey.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Good morning, Sergey.

Sergey Vasnetsov - Lehman Brothers

Paul can you help us understand how much of the factor was the escalation of the construction course. And by that I mean total construction course, labor, materials, etc. If you said number may be from 75 to 78 or maybe you have even annual numbers?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Construction cost on capital spending?

Sergey Vasnetsov - Lehman Brothers

Correct.

Paul E. Huck - Senior Vice President and Chief Financial Officer

If we take a look at that and go from lets say 2003 to 2004 before commodity prices starting to run up, it depends upon the area the country. But we could see capital cost being up anywhere from 25% to 50%.

Sergey Vasnetsov - Lehman Brothers

Okay. And so, when you sign your new contract formalities, do you try to achieve a certain profit for Tonnage of output or you've taken into account higher current construction costs and that becomes your base factor.

Paul E. Huck - Senior Vice President and Chief Financial Officer

We price based upon the cost of the capital there. So what we're doing is recovering on the cost of capital there. So it is not based upon the output, its based upon the cost which we are going to have to invest there.

Sergey Vasnetsov - Lehman Brothers

Okay and lastly on the topic. When you think about your move from $1.4 billion in '08, so lets say $1.8 billion in '09 how much of this increase is due to high construction cost?

Paul E. Huck - Senior Vice President and Chief Financial Officer

From '08 to '09 it's not a lot probably.

Sergey Vasnetsov - Lehman Brothers

So you must have --

Paul E. Huck - Senior Vice President and Chief Financial Officer

And maybe 5 to 10.

Nelson Squires - Investor Relations

So it is mostly volume driven.

Paul E. Huck - Senior Vice President and Chief Financial Officer

A lot of the inflation on the construction has already occurred. The other thing Sergey and we are taking a different look as far as on the rest of these projects. We are trying to pass a lot more of that risk on to our customers here.

Sergey Vasnetsov - Lehman Brothers

Okay. Thank you.

Operator

Thank you. Our next question comes from John McNulty with Credit Suisse.

John McNulty - Credit Suisse

Yes, good morning, just two questions.

Nelson Squires - Investor Relations

Hi John

John McNulty - Credit Suisse

In the Merchant CapEx that you are going to be spending, can you give us a rough idea of regionally where that CapEx is going to be spent for the Merchant capacity coming on in '09?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Okay, the bulk of that is being spent in Asia. It has to do with capacity for Electronics and Performance Materials which a lot of that is in Asia and that lot of expansions on the liquid products is Asia also and the bulk of that.

John McNulty - Credit Suisse

Okay that's helpful and then in the material or the performance materials business with volumes up 5%, can you give us some help in understanding where that's actually coming from, I thought this business was mostly inks and codings related which certainly wouldn't be an up 5% type number?

Paul E. Huck - Senior Vice President and Chief Financial Officer

The bulk of this is Asia and is driven by good demand in the epoxy area, which goes around the infrastructure improvements being made in Asia.

John McNulty - Credit Suisse

Okay, great. Thanks a lot.

Nelson Squires - Investor Relations

Sure.

Operator

Thank you, our next question comes from Hassan Ahmed with HSBC.

Hassan Ahmed - HSBC

Good morning guys.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hi Hassan.

Hassan Ahmed - HSBC

Clearly a fair bit of chemical and general process industry activity in the Middle East, so could you guys just give me your view of the lay of the land out there, essentially in terms of future gases growth, and maybe also elaborate on essentially a product strategy to win incremental business in the region.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes, and that... the Middle East is a market which Air Products has worked in for a while. We actually have two plants which will be coming on later in the year which are sale of gas JV's in that area. What is far as from other in the market for gases in that area has been principally been sale of equipment. We are trying to convert that to a sale gas market for oxygen, nitrogen, and hydrogen. We are working very hard at and we think we are going to make and be a success in that area. And we are excited about that opportunity.

Hassan Ahmed - HSBC

So you think the prudent strategy is that a sale of equipment leads to sale of gases there?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes.

Hassan Ahmed - HSBC

And there will be a move towards let's say outsourcing on the part of the Middle Eastern companies, outsourcing in terms of gasses?

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes.

Hassan Ahmed - HSBC

Thanks.

Operator

Thank you and our final question will come from Edward Yang with Oppenheimer.

Edward H. Yang - Oppenheimer & Co.

Hi good morning, Paul.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Hi Ed.

Edward H. Yang - Oppenheimer & Co.

Just on NF3, what was the growth in volumes and pricing this quarter and also in the prior quarter?

Paul E. Huck - Senior Vice President and Chief Financial Officer

If we look at that on the NF3, I have to check here, hold on for a second, I will pull a number here as far as NF3, I don't have the individual product volumes brought in front of me. But if we look at that the pricing and volume basically were an offset over the whole speck materials area. We are up versus about 17% in volume in that area in the quarter over the prior year right now, I just got the number.

Edward H. Yang - Oppenheimer & Co.

And in the second quarter, it was faster or slower?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It's about flat with Q2.

Edward H. Yang - Oppenheimer & Co.

And on Merchant in Europe, again the improvement in volumes there was that driven by England, Spain or Germany?

Paul E. Huck - Senior Vice President and Chief Financial Officer

It was driven by probably the UK because that's the area in which we have the capacity of sale, in the other countries I am sold out.

Edward H. Yang - Oppenheimer & Co.

Okay. Thank you very much.

Paul E. Huck - Senior Vice President and Chief Financial Officer

Yes.

Operator

Thank you and at this time, I would like to turn it back over to you for any additional or closing remarks.

Nelson Squires - Investor Relations

Thanks, Amy. Please go to our website to access a replay of this call beginning at 2:00 PM today. Thank you for joining us and have a nice day.

Operator

Thank you. That does conclude today's conference. Thank you for your participation and have a great day.

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Source: Air Products & Chemicals, Inc.F3Q08 (Qtr. End 06/30/08) Earnings Call Transcript
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