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Executives

Kelcey E. Hoyt - Director of Investor Relations

James S. Sawyer - Chief Financial Officer and Executive Vice President

Stephen F. Angel - Chairman, Chief Executive Officer and President

Analysts

P.J. Juvekar - Citigroup Inc, Research Division

Duffy Fischer - Barclays Capital, Research Division

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Peter J. Cozzone - KeyBanc Capital Markets Inc., Research Division

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Vincent Andrews - Morgan Stanley, Research Division

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

David L. Begleiter - Deutsche Bank AG, Research Division

Robert Koort - Goldman Sachs Group Inc., Research Division

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Abhiram Rajendran - Crédit Suisse AG, Research Division

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Praxair (PX) Q3 2012 Earnings Call October 24, 2012 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 Praxair Earnings Conference Call. My name is Steph, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Kelcey Hoyt, Director, Investor Relations. Please proceed.

Kelcey E. Hoyt

Thanks, Steph. Good morning, and thank you for attending our third quarter earnings call and webcast. I'm joined this morning by Jim Sawyer, Executive Vice President and Chief Financial Officer; and Liz Hirsch, our Vice President and Controller.

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

Please also note that our discussion of earnings for the third quarter, including year-over-year and sequential comparison exclude $0.04 of net earnings per share related to an income tax benefit, partially offset by a pension settlement charge and cost-reduction charges, primarily related to severance and business restructurings in Europe within both the industrial GAAP and Surface Technologies businesses. The tax benefit and charges are detailed and reconciled to the GAAP reported numbers in the appendices to this presentation and the press release.

Jim and I will now review Praxair's third quarter results and outlook. We'll then be available to answer questions.

James S. Sawyer

Thank you, Chelsea [sic] (Kelcey), and good morning, everyone. Please turn to Slide 3 for our consolidated third quarter results. Praxair delivered strong results in third quarter despite significant currency headwinds and moderating economic conditions. While year-over-year reported sales declined by about 4%, we're able to maintain relatively even operating profit and earnings per share. The impact of currency on sales was 7%, plus another 1% from lower cost pass-through of natural gas to the selling price of hydrogen. Excluding foreign currency and cost pass-through, sales would have been up 4% and operating profit and EPS up 7%. This demonstrates that we're still able to get leverage down the income statement from improving productivity and strong cash flow and return on capital.

Operating cash flow was a record $746 million, representing about 27% of sales, and capital spending against our project backlog totaled $547 million. Our debt-to-capital ratio for the quarter was 51.6% and debt to EBITDA was 1.9x.

During the quarter, we paid dividends of $164 million and repurchased stock of $106 million, net of issuances. $1.2 million -- billion still remains available under the share repurchase program authorized in January of this year. After-tax return on capital is 14.2% and reflects the large amount of projects under construction and therefore, a significant amount of project capital on our balance sheet that is not yet completed. Return on equity was 29.2%.

And now I'll let Kelcey explain in more detail our third quarter results by segment.

Kelcey E. Hoyt

Thanks, Jim. Please turn to Page 4 for our results in North America. Sales in North America were $1.4 billion, 2% below the prior year quarter. The effects of cost pass-through, primarily lower-cost natural gas, which is contractually passed on to hydrogen customers, reduced sales by 4%. Negative currency translation, driven by the devaluation of the Mexican peso and Canadian dollar against the U.S. dollar, reduced sales by 2%. Sales grew 4% from higher pricing and acquisitions of packaged gas distributors. Underlying energy market sales in North America grew 6% year-over-year. This was driven by our on-site supply systems to refineries, the majority of which are on the Gulf Coast region of the United States. In addition, our oil-well service business in Mexico continued to run at very high levels and delivered solid volume growth in Mexico, providing liquid nitrogen and pressure pumping services to the oil and gas sector.

Sequential energy market sales grew 4%, with the typical third quarter seasonal pickup in our supply of liquid nitrogen, for frac-ing for natural gas liquids and oil in the Alberta region of Canada due to improved weather and road conditions. Underlying sales growth to metals customers was solid at 5% year-over-year. This was due to continued steady liquid argon sales for stainless steel and metal fabrication, as well as oxygen sales on our pipelines in the Northern United States to steel mills.

Regarding chemicals, the fundamentals for North American production remain advantaged or plentiful across natural gases and feedstock. During the third quarter, we did experience some lower volumes due to scheduled customer maintenance, and the environment remains cautious in light of the slowing global economic growth. Underlying manufacturing sales grew 7% year-over-year with growth in all 3 countries: United States, Canada and Mexico.

Packaged gas sales remained healthy, in line with manufacturing strength. And Praxair distribution, our Canadian and U.S. packaged gas business, same-store sales, which excludes currency and acquisitions, were 5% above the last year. Gases were up 5% and hard goods were up 6%. Packaged gas primarily serves the manufacturing market, but sales were also strong year-over-year to metal fabrication, automotive and energy in support of customer activity in the Bakken and Eagle Ford region. Sequentially, sales modestly declined as growth began to moderate to metal fabrication and manufacturing.

The pipeline of activity for potential further gas -- further packaged gas acquisitions remained strong. Year-to-date, we've closed 4 acquisitions in Texas, California and New York, as well as formed a joint venture with one of our long-term distributors, nexAir, in the Southeast United States.

North American operating profit was $374 million, 10% above the prior year quarter. Excluding the negative impact of currency translations, operating profit would have grown 12% from the prior year quarter. The operating margin was 26.9%, reflecting higher pricing and productivity, which more than offset cost increases. In addition, lower cost pass-through, which reduced sales with minimal impact on operating profit, contributed 1% to the operating margin percentage for the quarter versus prior year.

44% of our large project backlog with long-term contracts is in North America. We are constructing 12 projects with customers across the United States, Canada and Mexico for energy, chemicals, metals and manufacturing industries. In 2013, we are on track to start the 2 large hydrogen projects under construction for Valero at St. Charles and Port Arthur, and the hydrogen pipeline expansion to serve Motiva and Louisiana. In addition, 2013 customer plant start-ups will include oxygen supply in the Southeast United States, as well as 2 plants in Canada. 2014 includes a plant start-up for Deacero in Mexico. Calsite [ph] activity for new on-site plants in North America is increasing, and we are seeing activity in energy, chemicals, manufacturing and metals markets.

Now please to turn to Page 5 for our results in Europe. Sales in Europe decreased 2% for the third quarter versus 2011. The weaker euro reduced sales by 13%. The sales increase from acquisition is due to an increased ownership interest in Europe Praxair located in Scandinavia, which we consolidated in the fourth quarter of 2011. Underlying sales were down 1% versus the prior year, as 2% lower volumes offset the higher pricing attained across all of our operating countries. Volumes in Spain and Italy were below the prior year quarter, primarily attributable to merchant and packaged gases. Germany experienced modestly decreased volumes as customer demand has weakened due to lower industrial economic activity.

Sequentially, volumes declined 4% versus the second quarter, with a typical summer holiday seasonality extending into continued lower levels of demand. Operating profit of $60 million was 12% below the prior year. Excluding acquisitions and currency, underlying operating profit decreased 7%, primarily driven by lower sales volume, partially offset by improved pricing.

During the quarter, we took further action to rightsize the cost structure of our European business to reflect expected longer-term slower growth in the region, especially Southern Europe. $36 million of our $56 million cost reduction charge related to the Europe segment for employee severance costs and business restructuring actions, including consolidation of packaged gas filling stations. We are expecting about a 2.5 to 3-year payback.

Page 6 shows our results in South America. South American segment sales were $560 million, down 15% from the prior year quarter. Underlying sales grew 1% for the quarter, primarily due to higher pricing, partially offset by lower volumes. Negative currency impacts, primarily the weakening of the Brazilian reais against the U.S. dollar, reduced sales by 17% in the quarter. Higher volumes from new on-site production facilities were more than offset by lower volumes to merchant and packaged gas customers, largely attributable to the weaker industrial production in Brazil. Year-over-year sales increased to metals and health care customers and were lower to manufacturing and chemicals customers.

Sequentially, underlying sales were up 2% for the quarter, driven by higher pricing with steady volumes. Negative currency impact reduced sales by 3% in the third quarter versus the second. About 20% of Praxair sales in South America come from countries outside of Brazil, including Colombia, Argentina, Chile, Peru, Venezuela, Paraguay, Bolivia and Uruguay. Underlying sales in these countries grew 11% versus the prior year quarter and 6% sequentially with growth in chemicals, food and beverage, health care and manufacturing.

Operating profit in South America was $112 million, 20% below the prior year quarter, primarily due to negative currency translation impact of 18%. X currency, operating profit was down 2% compared to the prior year as higher pricing was more than offset by the impact of a lower mix of higher-margin packaged gas and merchant liquid volumes.

The third quarter of this year was Brazil's fourth consecutive quarter of negative industrial production year-over-year, although the sequential industrial production numbers are beginning to show some slight improvement. Current Brazil Central Bank consensus industrial production for the full year 2012 remains negative. 2013 consensus industrial production is currently about 4%.

The government continues to exercise stimulus levers increase demand, including decreasing the interest rate again in October to a record low of 7.25%, which now results in a record low real interest rate as well of about 2%. In addition, the Brazilian government recently announced the reduction in taxes on power to benefit both consumers and businesses that will go into effect beginning in 2013. We continue to remain very positive on Brazil in the medium to long term, given the strong growth fundamentals in place as it continues to transition from an export-driven economy to a more local consumption-driven market with a growing middle class. In addition, there should be quite a bit of pent-up demand for infrastructure buildout in front of the 2014 World Cup and the 2016 Olympics.

We continue to see strong new project proposal activity. This demonstrates the confidence of local businesses in the longer-term growth. Proposal activity is broad based across South America and Brazil, Peru, Colombia, Argentina and Chile, primarily in energy, manufacturing and metals. South America currently has 7 projects in the backlog across 4 countries, which include Brazil, Peru, Argentina and Uruguay and diverse industries such as metals, chemicals and manufacturing. These projects are scheduled to start up during 2013 and 2014.

Now please turn to Slide 7 for our results in Asia. Sales of $358 million grew 3% versus the prior year quarter. Volume growth of 5% came primarily from higher on-site sales in China and Korea, including new plant start-ups for metals and chemicals customers in China. Overall growth was mitigated by lower demand from the electronics end market, including semiconductor, flat-panel display and solar customers. Lower merchant and packaged gas pricing, primarily due to the electronics end market, reduced sales by 1% from the prior year quarter. We expect this challenging price environment to continue in the near term.

Electronics demand remains weaker than expected. Approximately 25% of our electronic market sales are to the semiconductor industry. Semiconductor sales continue to experience negative year-over-year growth during the third quarter and were flat sequentially due to the sluggish PC market. The solar industry continues to struggle with overcapacity, and China has about 50% of the global manufacturing capacity. Polysilicon and wafer prices continue to decline.

Negative currency impact, primarily the weakening of the Indian rupee against the U.S. dollar, reduced sales by 4% in the quarter. Cost pass-through increased sales by 3% during the quarter, primarily driven by higher India power pass-through and on-site sales. Asia's operating profit of $52 million declined 6% from the prior year quarter, excluding the impact of negative currency translations. Lower price decreased operating profit by about 3%, primarily for argon and silane pricings.

In addition, we experienced seasonally higher power cost in Korea. The rates reset at an increase each year in the third quarter, and cost recovery is typically delayed. And in Thailand, our food freezing business margin was impacted by low shrimp yields due to a shrimp disease, causing a decline in higher-margin merchant CO2 volumes they use for freezing. During the quarter, we signed a long-term contract with Oxiranchem to construct and operate an air separation plant with a capacity of 500 tons per day of oxygen to supply to their chemical facility located just north of Shanghai. The plant is scheduled to start up in 2014 and will also supply oxygen and nitrogen to the Yangzhou Chemical Industry Park.

Our backlog of projects in Asia is continuing to grow with 17 projects in China, India, Korea and the Middle East that will start up between the fourth quarter of this year and into 2015. New project activity for the region remains strong. We have not seen any weakening in the negotiation and bidding process for new project activity. The growth continues to be driven by longer-term secular growth needs. This includes China's policy for more energy independence and the utilization of abundant coal supply for gasification as a feedstock for the chemical industry. We build, own and operate worldscale oxygen plants for use in the gasification process.

Also, China is focused on spreading the wealth to the central and western part of China, not just on the East Coast. And we have a large project under construction in Chongqing in the center of China, which is going to be a strong growth for us when it starts up in 2014. And with emerging economies in general, the per capita consumption of industrial gases is only a small percent of what it is in United States and Europe, which as they develop over time, will utilize more and more industrial gases.

Our results for Surface Technologies are shown on Page 8. Surface Technologies sales for the quarter were $157 million, up 2% compared to the prior year, excluding currency. The underlying sales growth came from increased aerospace coatings and increased coatings for energy markets, particularly coatings for parts used in the oil and gas market. Operating profit was $25 million for the quarter. Higher volumes and leverage from improved pricing increased operating profit. These benefits were more than offset in the quarter by negative currency translation impacts of 8%.

During the quarter, we took action to consolidate and rationalize certain operations and product lines, primarily in Germany and Italy, in the weak industrial coatings sector. $16 million of our $56 million cost reduction charge related to the Surface Technologies segment. We are expecting about a 2-year payback.

And now I'll turn the call back to Jim, who will discuss our outlook and updated earnings guidance for the fourth quarter of 2012.

James S. Sawyer

Thanks, Kelcey. Please turn to Slide 9 for our updated outlook. North America, again, led the way with operating profit up 10% in light of a 2% currency headwind from Canada and Mexico. Year-to-date business conditions have been much stronger than the rest of the world, although we have seen the strong ramp-up in 2011 and the first half of 2012 moderate during the third quarter. Meanwhile, we've seen no improvement in Europe or South America. The slowdown in China is not only hurting our results in Asia but also South America, as exports of raw materials to Asia has slowed. In the near term, producers and consumers along supply chains are becoming more cautious in reducing inventories. We expect there will be more inventory correction in the fourth quarter and are anticipating extended holiday shutdowns. Hence, we decided to reduce our earnings outlook for the fourth quarter to $1.35 to $1.40 of fully diluted EPS. In order to continue to rightsize our organization, we undertook modest restructuring in Brazil in the first and second quarters and further restructuring actions in our European industrial gases and Surface Technologies businesses during the first quarter.

Our long-term outlook remains positive. We estimate our capital spending forecast for 2012 to be about $2.2 billion against the current backlog of $2.6 billion of projects under construction with committed customer contracts. As each projects start up over the next 2 to 3 years, they'll contribute to sales and earnings growth. Over the long term, we expect to get around 4% to 6% top line sales growth from the contribution in new projects.

In addition, we had new merchant and packaged gas business, with organic growth driven by a strong pipeline of new application technologies, as well as the migration of existing application technologies globally.

We do expect the future global economic growth will be slower but that our secular growth drivers in energy, environment and emerging markets still have long legs. We believe our strategy of focusing on our core business and execution capabilities will continue to drive strong margins, cash flow and return on capital. And as you can see from our history of annual dividend increases and share repurchases, we're focused on delivering those results to our shareholders.

With that, I'd like to turn this call over to Q&A. [Operator Instructions]

Question-and-Answer Session

Operator

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

P.J. Juvekar - Citigroup Inc, Research Division

Jim, so your North American volume growth this year in the first 3 quarters sort of declined or decelerated from 7% growth to 4% to 0%, and last time that happened was in 2008. So what are you seeing? Are you seeing that other regions are dragging down U.S. growth? And was this -- your on-site seemed okay, so was it mostly from merchant that dragged down the growth?

James S. Sawyer

Right. I think that in 2011, really, end of 2010, 2011, in the first half of 2012, North America really climbed out of the recession and we finally got our base business, same-store sales and packaged gases back to pre-2008 levels. As we move into the third quarter, the sequential growth was limited. We had some turnarounds and so forth. So our minus 1% Q3 versus Q2 really is not meaningful of anything. But we're definitely seeing the ramp-up that we saw over the last 1.5 years slowing down. And I think that's tied to consumers. If you look at Caterpillars' results, they mentioned that dealers of farm equipment are reducing inventories. I think that's the kind of thing that you're seeing across the board. Now I don't think it's at all like 2008. I think it's just a rather a 6-month period of caution in the third and fourth quarters as we wait to see who gets elected and what happens to the fiscal cliff, but there's been some deferral in people making decisions to build things. And that's kind of flattened out the growth in the packaged and merchant business.

P.J. Juvekar - Citigroup Inc, Research Division

And just secondly, have you seen any project delays or slowdown like what some of your competitors are seeing?

James S. Sawyer

No. I guess I would say this. The projects that we have in our backlog and under construction, there is no change in the status of those projects. They've got contractual commitment. The customers are going ahead in completing the facilities that we're going to be supplying. And we have language in those contracts. We're within a certain period of time; we start up the plant and they start paying us. So the stuff in the backlog is unchanged aside from a few that we started up in the quarter and a few that we added to the backlog. Now in the category that I call projects under proposal or negotiation, that continues to be very strong. We have not seen customers who had been talking about projects and looking for proposals. We have not seen them defer the projects that they're on. So that takes a long time for people to make decisions. We may yet see some deferral, but we haven't yet. And I think that's largely because most of the projects that we're negotiating and building right now are really projects that are required by the customer for more secular reasons rather than economic reasons. So for example, we started up our last fuel project in China in July, and there's really virtually no steel in the backlog. So they just slowed down and steel consumption is really not going to affect the backlog all that much or the active projects either.

Operator

Your next question will come from the line of Duffy Fisher with Barclays.

Duffy Fischer - Barclays Capital, Research Division

You've talked about the bidding for the projects under proposal still being strong. Are you still seeing the same kind of discipline in the pricing that competitors would be giving for those projects, or have you seen some of the slowness in the economy start to affect maybe the returns that some competitors might take?

James S. Sawyer

By and large, I think that what happens in the on-site business is that you make a contract with a customer and you live with that return for 15 years or 20 years. And so there's no reason to go in and try to take a loss leader and think you'll make it back later on. So I think that's the way we look at the projects. We haven't seen any real change in the marketplace in terms of competitive dynamics. It's a very competitive industry, but we really haven't seen a change. And the returns on capital, the projects that we're signing are basically as good or as high as the ones that we've signed in the past. Having said that, I'll say that the smaller projects tend to -- we're in a very niche position, and tend to have the highest returns, and the larger stand-alone projects tend to have returns in the low to mid-teens.

Duffy Fischer - Barclays Capital, Research Division

Okay. And then again given kind of the projects under proposal, $2.6 billion in backlog, is it fair to assume that it's still a decent bet that CapEx is up next year versus this year?

James S. Sawyer

We haven't given guidance for CapEx next year. We'll be spending close to $2.2 billion this year in the quarter just ended with the highest CapEx we've had. I don't expect it to go up next year. I expect it to probably go down a little bit, but we're in heavy spending right now on 3 steam methane reformers. We're in the heavy spending part of that cycle, and they're going to start up in the first half of 2013.

Operator

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

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

On the FX side, are you doing any currency hedging at this point?

James S. Sawyer

Not much of anything right now.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Okay. And on packaged gases, did you provide a breakdown between price versus volume or rent versus hard goods?

James S. Sawyer

I think both the gas volumes and hard goods were up roughly 5% or 6%. And so that -- what you're seeing there is that as we came out of the recession, the hard goods growth was much faster than the gas growth. And that was -- when you go back into a recession, the hard goods goes lower because people stop buying welding equipment. So now that we're in kind of an equilibrium with both growing the same amount, within that 5%, roughly half price and half volume.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Okay. And in Europe, Europe is down to about 13% of revenues, and it's only about 10% of your operating profit at this point. Given that you might be thinking that this might be a long slog there, are you seeing additional opportunities for more substantial restructuring there other than the rightsizing actions that you've taken, such as asset swaps or divestitures, selective actions there?

James S. Sawyer

We're not planning on any divestiture or swaps or any type of transactions like that in Europe. And certainly something could come down the road, but we're not planning anything like that. And basically, in the 2008 recession, we did a fair amount of cost cutting, but one of the rules that we had was that we weren't going to take out any capacity, so that we would still have that capacity when volume came back. We've now come to conclusion in Europe that some of the demand is never going to come back. And that is specifically in Spain and Italy in the packaged gas business where I think construction in Spain was driven rough -- very rapidly by the lowering interest rates when they got into the eurozone, subsidies from the European Union and a number of other things that basically drove construction, which aren't there anymore. So we've included that. We have too much capacity in packaged gases, and we're rationalizing some fill stations, and so that's all we can do right now without cutting into volume and so forth.

Operator

Your next question will come from the line of Peter Cozzone with KeyBanc Capital Markets.

Peter J. Cozzone - KeyBanc Capital Markets Inc., Research Division

In regards to your long-term growth targets, can you just tell us how you feel about those targets now that maybe the macro environment might be a bit more sluggish than expected when you last laid those out?

James S. Sawyer

I think that there are parts of our growth that we have control over, which is basically applications technology and the projects. I think they are pretty well still intact. Now we've always said that some of the growth will come from just general increases in industrial production globally. I agree with what you're saying. I think that for the next 10 years, industrial production will be slower than it was for the last 10. Who knows? But -- so that will probably temper some of the growth there, but we're not going to wait for a rising tide to hit our earnings goals, so we'll continue to focus on productivity and pricing and restructure bit by bit as we have to.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Great. And then one follow-up on the PDI business, can you give us some color on the recent trends as far as maybe how those progress throughout the quarter and your expectations here given the more uncertain macro environment?

James S. Sawyer

Yes, I'm guessing that we'll have relatively flattish volumes sequentially going from the second to the third quarter, also from the third and fourth quarter. And that's just coming over the top, I guess, because I do think that as we get into the holiday season, it's always difficult to predict. But in times when there's a little bit of excess capacity and not enough demand, people tend to take longer shutdowns at year end. Now in times when it's the reverse thing, they work right through just the holiday season, but I'm just expecting this quarter that we're going to have more people rationalizing.

Operator

Your next question will come from the line of Don Carson with Susquehanna Financial.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Jim, just trying to think of what kind of earnings tailwind you'll get next year from all these new projects, even with sluggish IP these new projects contributed a lot. I know you used to be more precise in terms of EPS contribution. Can you give us some help on that front?

James S. Sawyer

For 2013, I mean we haven't really come out with any guidance there. In fact, next week, we've got our folks in from around the world to put together our overall plan for next year. So we don't have any kind of bottoms-up look at that. But I would say that we're going to expect North America to continue to lead the way. We're going to continue to get pretty significant growth from project start-ups in North America. And then we really need to get Europe and South America out of the tank, but some of that is going to depend on what happens with the quarter slowdowns there. But generally speaking, I think I will -- I would like to give you some guidance that we'll have sales growth in the 5% to 10% range without acquisitions, leading more with some acquisitions, and we're getting earnings growth in the double-digit area again.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

And I know in the past you talked maybe about 5 percentage points of growth just with the new projects alone. Is that still a relevant number or is there sort of a pickup next year with some of this new SMRs in North America?

Kelcey E. Hoyt

We typically get about 4% to 6%.

James S. Sawyer

Yes, we still get 4% to 6%. We'll get probably more than that next year but -- because we've got a lot of projects starting up, because it's usually about a 3-year gestation period on these projects. And the projects that would have been signed in 2009 would be starting up in 2012. But because of the recession, there was a big lull in project signings, and now we're experiencing the lull in start-ups, but we've got a lot more starting up next year.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

And then just one follow-up. Some of your competitors have talked about heightened level of competitive activity in the U.S. liquid market. Are you seeing any evidence of that? And just as -- did you mention what your Lin/Lox operating rate was in the U.S.?

James S. Sawyer

I think the emerging market is fine. We're doing very well in the merchant market. When you got liquid oxygen, liquid nitrogen; you've also got argon and helium and liquid hydrogen in there. And to some extent, you also have the gases used for frac-ing, liquid nitrogen and liquid CO2. And so sometimes depending on the frac-ing and the weather, you'll see kind of spikes up that come in the merchant side. I think we've all seen a decline in liquid hydrogen, partially attributable to the end of the space shelf, okay? So there are things like that, that are going on. And but I think that overall, we'll continue to see merchant demand growth grow faster than industrial production.

Kelcey E. Hoyt

And Don, the operating rate spend in the low-80s is pretty consistent with what we've seen most of this year.

Operator

Your next question will come from the line of Vincent Andrews with Morgan Stanley.

Vincent Andrews - Morgan Stanley, Research Division

Just a couple of questions on Brazil. You referenced sort of a 4% consensus industrial production number for 2013. Is that consistent with -- when you talk to your customers, or are they sort of expecting something along those lines?

James S. Sawyer

No, no. I think that it's been negative this year. I think that when it turns around, you'll usually see a fair amount of volatility in Brazil. When things slow down, they speed up quickly and there's a big growth. So I could see a number bigger than that if the economy starts to turn around. So I think that's a -- we're in pretty good shape there. The one thing that I think is on my mind is to what extent the slowdown in Chinese demand impacts the rest of the world. And China is Brazil's largest trading partner. So I do think we're experiencing a situation where turnaround would have already started to begin, but it's being delayed by increasing demand from China. And so that's all got to be part of the equation of what happens next year.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

And just as a follow-up to that, if we work backwards from the Olympics and the World Cup and the idea that, that will stimulate some infrastructure demand, what is sort of the deadline where that needs to start showing up in order for it be there for those events?

James S. Sawyer

Well, they should be working on that stuff and building things now. And Petrobras is also a big driver of construction. They've got so much spending going on, but what's slowed down is manufacturing and what's slowed down is some of the export business. So it's hard to say, but I think you'll see some pickup from those things, but you're also going to see hopefully some pickup in consumer spending and auto and truck production and so forth.

Operator

Your next question will come from the line of David Manthey with Robert W. Baird.

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

First off, with your comments, Jim, about the growth potentially being slower going forward, you mentioned a few other things you would focus on. But how confident are you longer term or medium term that you'll be able to get operating leverage at those lower levels of growth?

James S. Sawyer

Well, I think what -- you just have to look at our segment results coming out of the recession to see that when we're in the recession, our North America margins were around 20%, maybe 18%, 19%. And that's because, particularly in the merchant and packaged business, you don't have a lot of customers go away, but you had a lot of customers taking less demand, which means that you've had less revenue per delivery or product, if you will. As that demand turns back, we got a lot of operating leverage in North America. Now what we're seeing in South America and Europe is exactly where we're in North America in 2008, where volume was off and we've got -- we've been going through negative operating leverage as volume had declined. So if volume keeps declining more, we'll have to take some more cost out. But I do think that in both Europe and South America that construction in metal fab and machinery and repair activity is probably below equilibrium and will come back to some extent. So what we want to see is our margins go up there. And I think we'll get some operating leverage out of that.

David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division

Okay. And so relative to your longer-term organic growth targets through 2015 of 8% to 12%, if that comes in, do you still feel confident that the 10% to 15% operating profit and the 12% to 18% EPS is doable between now and then, assuming we're in a normal kind of slow growth economy, not recession?

James S. Sawyer

I think it's July. I do think that we're going to be in the lower end rather than higher end just as long as you don't get much help from the economy.

Operator

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

David L. Begleiter - Deutsche Bank AG, Research Division

Jim, on the backlog with the 3 SMRs starting up next year, is it elective that the backlog will be down a year from now from what you see in the bid activity?

James S. Sawyer

Well, it's certainly possible because, as I said before, we've got a lot of project starting up in the next 12 months. And as they start up, they come out in the backlog. So it will be going down unless we sign a lot of new contracts, but I'm pretty confident that the ones that we're negotiating right now, we will win most of. And that over the long run, we'll be able to keep the backlog in the area of $2 billion to $2.5 billion, which is what we need to support 4% to 6% sales growth.

David L. Begleiter - Deutsche Bank AG, Research Division

And lastly, do you have early read on pension expense for next year versus this year?

James S. Sawyer

Yes. Our pension expense for next year probably will be about $20 million or $0.05 a share higher than this year.

Operator

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

Robert Koort - Goldman Sachs Group Inc., Research Division

Jim, I don't think you mentioned the same restraints on helium. Have you got your BLM supply figured out there? And are you back to normal or are you still in allocation and has that offered you some up between the takes and market share?

James S. Sawyer

No, we're not on allocation. We had a couple of temporary allocations because of the facilities being down. But we've still got a strong supply from the BLM and from the other sources that we supply from. And I think we're the only producer of helium that's not going to be on allocation right now.

Robert Koort - Goldman Sachs Group Inc., Research Division

And then you mentioned earlier maybe the next decade looks a little bit different from capital investment in some of the end markets where your customers operate. How would you expect that to manifest through your strategies? If you just spend a few more CapEx dollars and maybe a little more return of capital to shareholders? Do you change the country focus? Have you sort of come to grips with any big picture issues, or is this just a standard issue of macroeconomic and cyclical speed bump here?

James S. Sawyer

You know me, Bob. I'm always on the pessimistic side. But I just think that we've got budget balances and so forth to deal with. I do think that North America economy in the industrial side will be strong. We're seeing an uptick in projects right now, primarily related to the chemical industry. There are about 15 proposed chemical facilities, which either need oxygen or nitrogen or CO2. So we're looking at a lot of proposal activity going on in North America. So I think that that will be the main driver. I think that we've got a lot of projects going on in South America, both inside of Brazil and outside of Brazil, a lot of projects in Colombia and Peru and Argentina and so forth, and I think that will be strong. Russia, we probably got more project on our -- that we can manage right now. So we're quickly addressing that. But I think that projects outlook will continue to be strong, and I don't think that we'll need to reduce our expectations for our capital spending.

Operator

Your next question will come from the line of Jeff Zekauskas with JPMorgan.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

You often talk about new projects adding something like 4% to 6% to revenue growth. But if I look at your first 3 quarters, I think your volumes are up about 2%. So is it the case that really fewer projects came on to affect revenues this year, or is it that they came on but that the underlying industrial gas business across the globe is down a couple of percent. That is, why isn't the underlying volume growth stronger for the amount of new projects that you have coming on?

James S. Sawyer

Well, I guess the first reason is that, while we did start up a few projects this year, we haven't started up that many. As I mentioned earlier, 2012 is a lull year for start-ups because just 2009 was a lull year for signings. Now the -- well we have started the projects up and we're getting the volume and the revenue from them, but our base business volumes in packaging and merchant in Europe are significantly down year-over-year and the same thing in South America. And pricing is down in China. So that's really kind of offset the contribution from the new projects.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

And then secondly, what was the merchant gas volume growth rate in the United States in the third quarter? And was it above GDP or below GDP or above industrial production or below industrial production?

James S. Sawyer

Merchant gas volume were up some in the third quarter year-over-year, but there were some puts and takes inside of that. There was less gas use in frac-ing than the year before and that's a big volume swinger. So we still had strong argon and helium and CO2 volumes.

Operator

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

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Jim, just wanted a follow-up on merchant gases. If you look back over the past couple of quarters, do you believe that you've picked up any market share in North American merchant gases? If I look at your volumes, they seem to be running a bit higher than your principal competitors. Wondering if there are any shares shifts or if it might be attributable to mix or other issues.

Stephen F. Angel

Well, I guess mathematically, if our volume is growing faster than theirs, you might come to conclusion that we must be picking up share. But I certainly don't think we picked up any share that would have been their existing customer. It may be that we've signed new business at a faster rate. Or I can even put another spin on that, which is that it all depends on the customers who you get married to. If you get married to customers who don't grow, then you live with that. If you get married to customers who grow faster, then that's a good place to be.

Kevin W. McCarthy - BofA Merrill Lynch, Research Division

Okay. It makes sense. I guess, just as a related follow-up, your same-store sales in packaged gases look to have run about 200 basis points or so higher than your main competitor there. Is it a similar dynamic that you've been doing in packaged gases, Jim? Maybe you can elaborate on what's going on there?

James S. Sawyer

I can't speak for what's going on with competitors, but I think our growth rate has been in line with demand growth. And these quarters, they bounce up and down for everybody. You had one new customer and one new project or something like that and it changes a quarter, especially when you're looking at 2 percentage points over the whole volume area. So I think everybody is doing fine, and I think demand is still strong. I don't think it's just growing as fast as it was a year ago, but I think it's still strong. And you're going to start to see, I think once we get into January and February, more people start buying equipment and building things again.

Operator

Your next question will come from the line of John McNulty with Credit Suisse.

Abhiram Rajendran - Crédit Suisse AG, Research Division

This is Abhi Rajendran calling in for John. A quick question on Europe. Assuming a more moderate macro environment there in the foreseeable future, I guess, what sort of margin target can you reasonably achieve over the next couple of years, is it closer to 20% or do you think you can get into kind of a mid-20s again?

James S. Sawyer

Well, they just -- but we don't get absolutely the 20%. I think if we got some help from the economy in Europe, then we would see strong operating leverage because we've taken a lot of cost out of our operations. Just like we did in the U.S., and I talked about the U.S. before. We took a lot of cost out of 2008, and we didn't add those people back, and that's why we're getting so much operating leverage. And I think we're going to see the same thing in both Europe and South America when volumes come back.

Abhiram Rajendran - Crédit Suisse AG, Research Division

Got it. And then just a quick follow-up on the aerospace aviation market. That's been a pretty, a bright spot for you in the recent past. I guess what's your outlook for this area as it pertains to your surface coatings business?

James S. Sawyer

Surface coatings has got basically 3 end markets, one of which is aerospace, that's about 35% of the sales. I think I'm very optimistic and very positive about that. We have the contracts with the main jet makers so that when the aircraft get delivered and they actually put the engines on them, we're going to see more demand growth in the aerospace. Now unfortunately offsetting that, especially in Europe, has been our industrial consumers who are in the printing and textile and transmission parts and stuff like. It has really been slow in Europe, and that's why we're closing down a couple more plants in Europe this quarter.

Operator

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

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Just looking at the South America business, it's understandable given the weakness that you're seeing in Brazil that you would be highlighting the growth outside Brazil, but can you talk about whether there's been a concerted effort to diversify your South American business out of Brazil? And can you just remind us, what are your strongest market positions outside of Brazil?

James S. Sawyer

Well, I wouldn't say that there's been a concerted effort to kind of change our portfolio. We're kind of agnostic as to what end market we're in and what country we're in as long as we get the right kind of risk return that we're looking for. But as Brazil is going through a recession, Chile, Peru, Colombia are doing just fine, okay? And Argentina and Venezuela are probably another story. But there is a lot of demand for new projects in many of those countries. And for example, there are several projects that refiners are looking at where they don't refine enough losol -- they don't refine enough diesel to fill all the cars up. And so the countries import diesel and gasoline. So there are some refinery projects for iodin, for losol, for diesel. There are other metals projects and general manufacturing projects, in glass and ed [ph] and stuff like that. And so those economies are growing. And I think we're very well situated in them. We have strong market share. We have excellent talent. And they're not that big, but they are a good contributor of growth and high returns for us.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

And then looking at the electronics market, down 3% year-on-year, but up 1% sequentially. Can you just give a little more color on what you're seeing right now in that market? How's the visibility on growth as we head into kind of a period where we would normally expect a seasonal build? Any indications on where customer inventories are, things of that nature?

James S. Sawyer

I'm not really sure. It's not one of our bigger end markets and I'm hardly the expert in it. But there's clearly been a big, big problem in China and in the polysilicon market. And that's just because people expected that thin film panels would be their way of the future and it didn't turn out to be that way. And so pricing has fallen and volumes have fallen there, and we're all getting hurt by that. The reason we had sequential gain was really our business in Korea. We're a primary supplier to Samsung there. And what they tend to do when demand goes down is they've got some fabs that are wholly owned fabs and they've got some fabs that are outsourced, and they tend to bring the work back home when they need to keep the home fabs operating.

Operator

And there are no further questions in the queue. I would now like to turn the call back over to Mr. Jim Sawyer for closing remark.

James S. Sawyer

Great, Steph. Thank you all for attending the conference call. Please feel free to give Kelcey or myself a call if you got any follow-up questions, and we look forward to next quarter, which will be probably the third week of January.

Kelcey E. Hoyt

January 23.

James S. Sawyer

January 23. Have a nice day. Bye-bye.

Operator

Thank you all for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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