Praxair's Management Presents at DbAccess Global Industrials and Basic Materials Conference (Transcript)

Seeking Alpha

Praxair, Inc. (PX)

DbAccess Global Industrials and Basic Materials Conference

June 13, 2013 3:20 pm ET

Executives

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

Kelcey E. Hoyt - Director of Investor Relations

Analysts

David L. Begleiter - Deutsche Bank AG, Research Division

Presentation

David L. Begleiter - Deutsche Bank AG, Research Division

Our next speaker and next presenter is Praxair. We have with us Kelcey Hoyt, Vice President of Investor Relations; and Jim Sawyer, long-time CEO of Praxair.

Question-and-Answer Session

David L. Begleiter - Deutsche Bank AG, Research Division

We'll just kick off with a Q&A here on a fireside chat format. So, first, Jim, how's business? How's demand by region and by key end market?

James S. Sawyer

Great. Thank you, Dave. So I'll just kind of do a walk around the world, which I think I've been a lot of one-on-ones in the last couple of days, so I'm saying the same thing. Basically, I think probably, most of you know we can slice and dice our business by geography, by end market, who the customer is and also by what we call our distribution segment, large customers being on-site customers, where we build the plant at the customer location. And those end markets tend to be more in refining, steel, chemicals, large customer plants. Then we have the merchant distribution, which is basically taking byproducts, oxygen, nitrogen, argon, from the on-site plants, liquefying it and putting it into truck or trailer trucks and driving it to customers. Typically, hospitals and healthcare, food processing takes nitrogen; argon, going into metallurgy and other processes.

And then a smaller distribution segment called the packaged gas businesses with the high-pressure cylinders and different markets there as well. And the high-pressure cylinders are probably -- 40% of our sales go into metal fabrication, welding, machinery, that type of thing.

So I guess I'll just start out by saying that in the U.S., the process industries, steel, chemicals, refining, are all very strong and continuing to be very strong and taking advantage of the low natural gas prices and cheap energy in the United States, taking advantage of cheap money and also taking advantage of what I'll call high labor productivity so that their ultimate labor costs are very competitive around the world.

So in the oxygen to steel side of the equation, I think the U.S. steel producers are now among the lowest-cost steel producers in the world. And what we're seeing is some of them are beginning to make a technology shift, where they are consuming more natural gas in the blast furnace, the substitute for metallurgical coal to get the same carbon which goes into the carbon steel. They're doing that because natural gas is cheaper form of carbon -- or cheaper source of carbon than the coke is. And when they do that, they require more oxygen, so our intensity of oxygen per unit of steel production continues to go up year after year. So that's pretty strong right now in North America.

All of you know, I think, that the chemical industry has advantage now with cheap feedstock, and we see that going very well today. There are a number of potential chemical projects which are under construction. And so 5 years ago, I would have said that any new chemical projects will either be in the Middle East, where the source of the oil is, or probably in China, where the consumption of the plastic's going to be. But now the U.S. has popped back up as an effective place to make chemicals. And so far, we've seen a couple of customers which had mothballed certain projects start them up again, and that's kind of another adjustment, I think, that can take place fairly quickly in terms of taking advantage of low natural gas prices in a fairly quick manner and without a lot of capital investment.

The refining industry is doing similarly. I think U.S. is now the low-cost refining area in the world and being very efficient on the labor side, as well as the feedstock side. And what we're seeing the refiners do is use more hydrogen in the refining process, so we make hydrogen out of natural gas. And the price that we sell hydrogen to the refineries at is a formula of the natural gas, so we achieve natural gas -- what they pay for a unit of hydrogen going into the refinery versus a barrel of crude oil is about half what it used to be. And consequently, they're using more hydrogen in the refining processes as well.

So I'll kind of sum that up, and the large industries are saying that the extent to which our customers is fairly readily taking advantage of low natural gas prices by tweaking their feedstocks or their capacity or changing their processes or starting up a plant that was mothballed. I think we've already seen a lot of that. The next leg, obviously, will be to what extent people will be building new facilities, either -- probably not very many grassroots facilities but brownfield facilities in manufacturing. And I do think the U.S. has now become a very cheap manufacturing location, and there's a couple of auto plants being built. But so far, not a lot built there.

Now still in the United States, I'll move on to the smaller customers, merchant customers and packaged customers. The steady-state businesses, which is a lot of merchant, which is healthcare and food and beverage, are just going on as normal. And packaged gas is about -- 40% of what we do goes into metal fab, and then a big portion of that goes into nonresidential construction. And that's an area we've seen taper off. And it kind of surprised me when I saw the data, but government sponsor about half of nonresidential construction in this country. And during and after the recession, that number went up with the highway programs and all the rest of it. But now during the sequestration period, government funding of nonresidential construction is falling, and that is -- certainly not in a major way, but in a minor way, volumes for hard goods in our packaged gas business. And I think that that will probably run its course by the end of the year, and then hopefully, as we get some construction in some end market areas, packaged gas will start to grow faster.

I'll just move on to Brazil, which, I think, is on a lot of people's minds because we have a large business in Brazil. Brazil has been in recession for the last 2, 2.5 years. Many factors, I think, leading up to that or causing that recession and then preventing it from working its way out, partially, the strength of the real a couple of years ago, which made Brazil less competitive, and things like steelmaking. And then last year, we had demand for China for our commodities go down, and so exports to China went down, and that further hurt some of the exporting businesses in Brazil.

But on the consumption side, the consumer spending, it seems to be okay, and there's a large pent-up demand for construction, mainly funded by the government, Petrobras, as well as the construction of airports and railroad stations and stadiums for the World Cup and the Olympics and so forth. So just in January, we started to see Brazil getting a little bit stronger. We continue to see it getting stronger as the year has moved on. And I think that we are partly out of the woods in Brazil, maybe not all the way out of the woods. And it may take a long time to get all the way out of the woods because the country is really still not very competitive because of very strict labor rules, a lot of labor inflation and a lot of infrastructure bottlenecks. So it's got to take a while to really get back to a growing economy. But at this point, if you look at the urban part of Brazil, it's really a mature -- a relatively mature economy, and so it's no longer really an emerging economy. It's starting to struggle with some of the same tight labor issues that Europe has and so forth.

Moving to Europe, our businesses are primarily in Spain and Italy than [indiscernible] Germany, the port of Antwerp and in Scandinavia. And the northern part of Europe, Scandinavia is doing great. Germany and Antwerp are doing pretty well. Spain and Italy are still suffering from a lack of government spending, a lack of credit availability from the banks and still slightly going down.

So I'm not the best predictor of when that's going to turn around, but I think when it does turn around, there's a lot of pent-up demand for maintenance and capital spending, equipment spending, that when it does turn around, we're going to pick up there.

And lastly, going to Asia, India is doing quite well, well as it's ever been doing. China has picked up from last year. In 2012, I would say that our base business, sort of excluding the startup of new projects, this may be flat with the year before, so there was really no growth in demand. And in some areas, the product volumes were lower than 2012. Some of that may be attributable to the change in the leadership, Communist Party leadership in China, where it just seemed like last year, like people just were making decisions in state-owned enterprises. And also, there was a bit of an inventory correction in the materials space. So in November, we started to see that pick up, and now I think our business is doing quite well in China, and we've got a number of projects startups coming down the pipe. A lot of projects in coal gasification for the feedstock, for the chemical industry, for example.

So all in all, I think a pretty positive outlook. I think a couple of soft spots, a couple of stronger spots, but generally speaking, from our portfolio point of view, we're 55% in North America, and that's one of the strongest spots. Europe, I think we could see some improvement. Brazil, we are seeing some improvement, and Asia, I think, is back to normal.

So I think I'll stop with that one so far.

David L. Begleiter - Deutsche Bank AG, Research Division

That was very thorough, Jim. Jim, just on the backlog, on bidding activity, what's the level of bidding activity both in China, is it up or down versus a year ago, as well as the rest of Asia and even the U.S.? Is bidding activity still strong?

James S. Sawyer

All right. Bidding activity, which would really be described as customers or potential customers who are going to build a greenfield plant or a brownfield expansion, which requires one of our gas products, they're typically the on-site projects, large projects where we will quote a monthly facility fee, which will pay for a plant that we would build at their location. And the level of activity for new projects is still about the same, I would say, as a year ago, but historically, it's still very strong. And it's pretty widespread. There's strength in the Americas. There's strength in South America. There's some strength in Europe, surprisingly, as well as Asia. So it's pretty well balanced in terms of geography, and it's also balanced in terms of end market with some in chemicals, some in refining, some in other industries. So overall, the level of activity is strong. And I'll just make a couple of comments on this backlog. The gestation period for these large projects is typically 3 to 4 years, meaning that we spend a year with the customer trying to figure out what he really wants to do, negotiating with the customer, figuring out what the size of the plant needs to be, what the pressures and quantities and qualities and so forth need to be. And then it could be just a negotiated contract or could be one where they maybe pick 2 industrial gas suppliers and say who's going to give us a better proposal. But generally, the proposals are evaluated on their merits, probably more so than specifically on the price because the price that our customers pay for our gas is very low compared to their own operating cost. But then we move into basically a 2-, 2.5-year construction period, where we've got money in the ground and no revenue to show for it, and then usually, about a 6-month startup window, during which time we need to show that the plant is operating and delivering a product that they need in a specification that they need, and then they need to start making monthly take-or-pay payments to us. So over the last 5 years, I would say that in 2008 and 2009 and in early 2010, we didn't sign very many new projects because back then, I said that no matter what industry you're in, every corner of the world, there was excess capacity, so there was really no desire for our customers or potential customers to build new projects. And at the same time, there was not much credit availability either. So we had kind of a dearth of signings during that time period, which means that we had a kind of a dearth of startups in 2011 and 2012. And kind of in 2010, we started up the last projects that had been signed in 2007. Now the 2011, 2012, '13, we signed a lot of projects, and so we built up a fairly large backlog projects which are under construction but have not yet started up. That number, as we calculated, is about $2.5 billion today. We'll be starting up roughly $1 billion of projects in the second half of 2013, and we'll also be signing a number of projects. My guess is that we'll be starting up more than we'll be signing in the next half, and maybe that so-called backlog number will decline to about $2 billion. But in the meantime, we'll be back to generating double-digit earnings growth year-on-year in the third quarter, the fourth quarter and on into 2014.

David L. Begleiter - Deutsche Bank AG, Research Division

Jim, on the backlog, is this $2 billion a more normalized number? And is CapEx peaking this year and should be lower -- will be lower going forward, obviously?

James S. Sawyer

Yes. I think our capital spending peaked last year at about $2.2 billion, and that was, again, a function of the way in the signing of projects. This year, capital spending will be lower, probably $1.8 billion to $2 billion, as we're starting up projects. So I think that going forward, it will be in about that range, which is roughly 15% of sales as opposed to 20% of sales last year.

David L. Begleiter - Deutsche Bank AG, Research Division

I know capital -- revenue per dollar of capital vary by project, but this $1 billion of new startups, what should they add from a sales and earnings perspective?

James S. Sawyer

Right. Well, it's difficult to quote that without specifying a particular time frame, but for the projects that we're starting up, yes, it's about $0.50 of sales for $1 of capital startup. So that will give us $600 million, more or less, of annualized sales increase. But of course, it will be starting at different times and then enough operating profit to make it to the bottom line to grow earnings double digit as well.

David L. Begleiter - Deutsche Bank AG, Research Division

Jim, switching back to China, talk about -- have Yingde impacted your business at all? And what is the level now of the competitive intensity in the marketplace with Yingde being active in larger plant sizes?

James S. Sawyer

Yes, I would say, actually, that -- I mean, I may be a little bit off base on this. I'll check with my Chinese colleagues. But I would say that the level of competitive activity in China is probably less than it was over the last couple of years because I think Yingde, which is a little startup company there, is full and can't build what they've already committed to build. And at the same time, I think our European competitors, Air Liquide and Linde, have become a little bit more cautious on just how much money they actually want to spend in China. So I would say that the level of competitive activities is less than it was a few years ago.

David L. Begleiter - Deutsche Bank AG, Research Division

And just on the coal gasification side in China, talk about how you've approached the business versus Air Products. They're doing larger maybe one-off projects the middle of Inner Mongolia. How do you assess the risk of coal gasification projects? How do you compare your backlog on coal gas there or backlog in coal gasification?

James S. Sawyer

Well, that's a very good question. And the level of activity in China continues to be strong. The complexion of it has changed over the last 20 years. 20 years ago, our first projects in China were building oxygen plants to serve the steel industry. And I think we've got probably 8 of those operating today specifically for the steel industry. The steel industry's no longer growing because there's excess steel capacity in China. Our projects are all with the blue-chip companies, Meishan and Baoshan, and at the blue-chip companies' facilities, which are state-of-the-art steelmaking facilities. So we don't see a huge risk of making money and getting repaid in those enough. I'll preface that by saying that the 2 big risks in this business are building a project on budget, on schedule, safely, to specification. That's one. The second one is after you've done that, assuming that's an on-site over-the-fence contract, is having the customer pay you 15 years of monthly payments to pay for that plant. And in order to mitigate that second risk, we generally only will do a project with a blue-chip sponsor. In the case of these coal gasification projects, SOPO, which is the largest acetic acid producer in China, is our first project. And then we've got 2 more operating, where various joint ventures involving -- Bayer and BASF are the customers. And where those projects are in existing petrochemical parks and complexes, where they're low-cost producers and they are right in the center of the whole chemical process industry and where there's existing demand for the product. There are going to continue to be a lot more of these coal gasification projects in those regions, and those are also the regions where we're building customer density, production and distribution density with our on-site merchant and packaged business. So we're very keen on those projects. The other set of projects that I kind of draw a line on is projects that are sponsored by a coal mining company as opposed to a chemical company. And all of these are basically coal gasification. They make some form of syngas to make some form of chemical feedstock and the backward integrate and use the solid fossil fuel at a stationary plant. Now there's an argument which I totally buy into, which says that if you're going to do that, you should build a chemical plant at the mouth of the coal mine because it's cheaper to transport chemicals than it is to transport coal. And that -- so the coal mining companies are singing that song and saying we're going to build a big coal gasification plant at the mouth of the coal mine, and we're going to make syngas and then hope that the chemical industry comes. And these are very large projects, sometimes 3x and 4x the size of the ones in mainland China. And the criteria that I just talked about for the steel industry, where we only want to do business with a blue-chip customer entity, doesn't really work there because these are entities which are shell companies, subsidiaries of coal mining companies that are yet to be capitalized. And then secondly, I'm not that confident that the demand for the chemicals is going to be there. And so while we signed long-term take-or-pay contracts with our customers and while we've always been successful in getting paid under those minimum take-or-pay, I could tell you it's not easy to get paid when the customer's plant is not producing. And in a place like China, where most likely, our ability to get due process under the law in a similar contract is not as good as it might be in the United States, really not willing to take the customer credit risk on those projects. So we're basically saying we're not going to -- we've worked on those. We tried to get the coal company to be the guarantor, and they would not do that. And so we're really just focused on the mainstream coal gasification projects with blue-chip companies in existing petrochemical parks.

David L. Begleiter - Deutsche Bank AG, Research Division

Understood. Let me ask the audience. Any questions for Jim? Otherwise, I'll keep on going. Jim, I'm very sorry, there's a question from the audience.

Unknown Analyst

Can you -- how you continue to maintain and gain pricing despite kind of the volume drags you're seeing across the market?

Kelcey E. Hoyt

So how we're getting pricing, even though the utilizations are a little bit lower.

James S. Sawyer

Yes. So how are we getting pricing with lower utilization? The first comment I have to make on that is that this industry is not a what I'll call commodity industry. The commodity industry to me is an industry where there's a spot price for the product and where there's a producer, a middleman, distributor and an end market customer. And I think it's very difficult to earn the cost of capital over the cycle in those industries because more often than not, the spot price for the product is not high enough to earn you your cost of capital back. This industry is very different. The key distinguishing factor is that we sell gases so cheaply that the transportation cost far outweighs the production cost, and so you can't transport these products to a clearing house that will be a commodity price. So we end up putting in, basically, dedicated supply systems, certainly, for the on-site customers, as well as the merchant customers, where we put the tankage, the meter and the quality control at the hospital and the cylinder rental in the packaged business. So it's a long way to get around to saying that capacity utilization is not an indicator of price in this business. Obviously, it's easier for us to get price when there is a shortage of product available, which is the case right now in helium, but that's about the only gas where there's truly a shortage available. But generally, we have a different price with each customer depending on what the customer's volume requirements are, how far away from the plant are, what's the cost of electricity in that area and what's the competitive environment like. So we will typically get, on average, roughly 2%, 3% price increases. We're seeing that in Mexico, the U.S., Canada. We're even seeing positive pricing in Europe, about 1%-plus. And then in South America, we're getting nice positive pricing, but inflation's running about 6%, 7%, 8%, and we're not getting enough pricing to offset inflation. So we're having to go back and get more productivity to offset inflation there.

David L. Begleiter - Deutsche Bank AG, Research Division

Another?

Unknown Analyst

Jim, 2 areas you didn't talk about. Could you speak a little bit about your opportunity set in both Russia and the Middle East and, in particular, the industry structure there that you like or dislike? And then lastly, if you had limited capital to spend, is there one region in the world, given your dominant share and density, or industry that you'd actually place that wager and bet?

Kelcey E. Hoyt

The opportunity set in Russia and the Middle East, and the second one is just prioritization of capital.

James S. Sawyer

Right. Basically, as I mentioned earlier, we have the #1 market position in North and South America, and the European's kind of doing Europe. And so most of the regions are kind of taken in a sense of who's going to get the highest returns in that region. The Middle East and Russia are 2 that were not, and so we've got some business going on in the Middle East in the form of a joint venture with another company in packaged and merchant business, as well as a couple of small plants. But I would say generally that the outlook for the Middle East today is not as good as I would have hoped it was maybe 4, 5 years ago, when we started getting into the Middle East, because basically, 2 things have happened since then. You've had all the Arab Spring activities going on. When Egypt became the hotbed for protest and revolution, we were working on a project in Egypt. And I said don't even work on that anymore because that's not going to get paid for. So that's an issue. But secondly, we would have said that -- as I said before, all our chemical plants would be built in the Middle East and that in most of the countries in the Middle East, we're also trying to take their petrochemical income and diversify it into other industries. And we're sponsoring the construction of other industrial parks in glass and manufacturing and so forth that would have been a growing market. I think we're seeing less of that than we had expected to see. Now Russia, I think maybe stronger than we expected to see. There's a lot of demand in Russia just for replacement air separation units for the aging air separation units that are being used today. And so we've got a handful of projects there. But basically, the comment on one, as an example, the monthly facility fee this customer is going to pay for oxygen is less than what they were paying for electricity to run their old plant. And so that's -- we put in a new modern, energy-efficient plant. It saves a huge amount of power cost to the customers. So that's what we call a form of decaptivation, where essentially, we're taking market share away from a customer, not away from a competitor. And that's actually an avenue of growth for us above and beyond just the same market growth year after year.

David L. Begleiter - Deutsche Bank AG, Research Division

Very good. Maybe can you just give a -- talk about NuCO2, how that integration's progressing and the opportunity you see from that business going forward?

James S. Sawyer

Right. So we acquired a business called NuCO2 a couple of months ago. It's an example of one of the long-term processes in our industry, which is that 100 years ago, it was really just a packaged gas industry. And then merchant was developed, on-site was developed, and merchant and on-site are cheaper ways to serve the customer than cylinder, and that's why they were developed. What NuCO2 has done is taken the high-pressure carbon dioxide cylinders that you used to see behind the bar at the McDonald's, where the fountain things are, which provided the carbonation to the beverage. And what they did, and we were part of that, but we eventually sold our business to them and then bought them back again, was to convert that from a packaged gas business to a liquid business by putting relatively small 500-pound liquid carbon dioxide tanks out of McDonald's and substituting that for 100 deliveries of 35-pound pressurized containers. And if you get enough distribution density, in other words, the truck being able to drop off 15 or 20 fills a day, you reach the scaling where that can become very profitable. But in order to do that, you need to sign up all the McDonald's and Wendy's and 7-Elevens in the Chicago area, for example. And then your trucks have enough routing density to be able to do that. So it really is a business which follows our same business model of having our market share and strong routing density. We closed on it in March, and 2 comments I would say about how it's going are that from a financial point of view, the earnings and sales are just slightly higher than we had forecasted a couple of months ago. But I think more importantly than that, when you buy a company, then you got to lift up the hood and look under the hood and see really what's happening down there. And we're very pleasantly surprised at the strength of the people, the management team, the processes and safety process and so forth. We're above what we expected, so we're very happy with the acquisition.

David L. Begleiter - Deutsche Bank AG, Research Division

Very good. Maybe just comment on the hydrogen business going forward and the growth you could see there over the next 5 years.

James S. Sawyer

Right. So the hydrogen business is being driven by 2 factors in the refining industry, one factor being the more and more stringent motor fuel standards, which require the refiners to get -- to take the sulfur out of the diesel fuel and the sulfur out of the gasoline. And the second one being for refiners to be able to refine higher sulfur -- heavier sour crudes, which 5 years ago, I would have said that we would become -- the country would become more dependent on heavy sour crude, Canadian tar sands and Mexican Mayan. But the development of horizontal drilling has found more natural gas, more natural gas liquids and more low-sulfur crude than anybody really expected. So the demand for hydrogen would have been much stronger had we developed more tar sands activity. Now we're doing a big plant up in Alberta that we just announced a few months ago, so there's still a lot of that going on. But on the flip side of that, the refiners are using more hydrogen per barrel of oil refined because hydrogen is that much cheaper to them than the oil. So we're still expecting there to be significant growth in hydrogen business going forward.

David L. Begleiter - Deutsche Bank AG, Research Division

Maybe just last question, Jim. How is the packaged gas M&A pipeline today for you guys?

James S. Sawyer

The packaged gas?

David L. Begleiter - Deutsche Bank AG, Research Division

Acquisition pipeline.

James S. Sawyer

Acquisitions?

David L. Begleiter - Deutsche Bank AG, Research Division

Yes, in packaged gases, right.

James S. Sawyer

Yes. All of the acquisitions we make are family-owned companies. And I would say when a family decides to sell, it's a family decision which has lot to do with the family and conditions rather than to do with us or anybody who wants to buy it. Last year, I think it was an open window for families to decide to sell their packaged gas businesses because the business was strong, pricing was good, volumes were good, so it's kind of the high end of the market, plus there was the threat of an increase in the capital gains tax rate, which would have hurt these families if they sold after the increase in the capital gains tax rate. So a lot of them were motivated to sell up to the end of 2012. Now that doesn't seem to have passed, but of course, it could happen anytime. But I would expect a lower level of acquisitions in 2013 than we made in 2012.

David L. Begleiter - Deutsche Bank AG, Research Division

Very good. With that, we'll call it to end, and thank you very much, Jim, and thank you, Kelcey.

James S. Sawyer

Thank you all very much for coming.

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