by Fred H. Siemer, CFA

 November 4, 2011

THIRD QUARTER REVIEW

Notes From The Conference Calls:

Given the slow growth of the US economy and the political and debt problems in the EU, managements are extremely cautious in their earnings outlook for the coming year. This leads to an unusually wide range for EPS forecasts for 2012, despite positive double-digit year-to-year (yty) earnings comparisons in the just completed third quarter and a still strong order book for industrial gases and welding equipment.

In the US, activity remains robust in manufacturing, energy, and petrochemical industries, although demand is strongest from larger rather than small customers. Large customers have lower margins causing some pressure on industrial gas margins.

Record sales are being reported despite the fact that for most players, volumes are still below peak levels pre-recession.

Helium, argon, and acetylene are in short supply in some Regions.

All companies are experiencing weak demand and pricing in Southern Europe.

Although 3Q sales to the Electronics Industry were acceptable, all companies see a slowdown in Electronics portending a downward cyclical trend. Air Products forecasts the SMI at only 0-5% next year.

Balance sheets are strong, with several companies completing significant share buy-back programs.

Company Comments

Airgas (ARG)

Sales of $1.9B were up 12% yty on gains of 6%, 4%, 2% from volume, selling prices, and acquisitions, respectively. SSS were up 10% with Hardgoods up 14% and Gas & Rent 7%.

Operating Income of $144MM was up 14% yty and Margin of 12.2% advanced 20bp.

Adjusted EPS was $1.03/sh. up 24% yty. This good performance despite 7 cents/sh. in charges for SAP implementation and depreciation. Earnings Guidance of $0.95-0.98 for F3Q and $3.97-$4.07 for fiscal year 2012.

Air Liquide (AL)

Group sales of Euro 3,597 were up 6.6% yty. Sales for Gases & Services were Euro 3,223 up 5.9%, as reported, and up 7.7% on a comparable basis. Sales by Region were as follows: EU 4.3% vs. the 6.7% gain reported in 3Q 2010. Americas 10.6% vs. 10.3%, A/P 12.5% vs. 15.8%. Of note, merchant gases grew at double-digit rates in the Americas, sales in Canada were up 9.5% yty. In Asia Pacific (A/P), China was again a standout with gains of 30%. Demand in Japan is only slowly recovering. Sales in Emerging Markets advanced by 24% yty, while Advanced Markets gained 6%. By Product, sales to Large Industries and Electronics gained 11% yty. Outlook: Management confirms steady growth in profits for the remainder of 2011.

Air Products(APD)

Sales of $2.6B were up 11% yty, with Volume and Price contributing 4% and 2%, respectively. Operating Income of $425MM was up 6% yty. Margin of 16.3% was down 80bp.,

but 50bp of the decline was due to unfavorable foreign exchange. EPS was $1.51 vs $1.35 up 12% yty. Earnings for the fiscal year were $5.73 up 14%yty. Earnings Guidance: For F1Q $1.31-$1.39; for fiscal 2012 $5.90-$6.30. Capital Spending: APD is in a building mode and is adding salesman to better serve the cylinder market after the failure of the Airgas tender. CAPX is projected at $1.9-$2.2B up from the $1.4B spent in 2010.

Chart Industries(CTLS)

Sales of $211.3MM advanced a record 52% yty. Operating Income was $66.6MM vs. $42.8MM in the prior year. Margins of 31.5% improved 70bp. Adjusted EPSof $0.62 increased from the $0.27 reported in the prior year quarter. Guidance: Management reaffirmed sales of $750-$820MM and EPS of  $1.90-$2.10 for the year.

Lincoln Electric(LECO)

Sales of $701.6MM were up 35.1% yty. Equipment and Consumables had gains of over 30%. Operating Income of $74.8MM advanced 55.3% yty. Net Income of $55.5MM was up 71% yty helped somewhat by a lower tax rate, as earnings surged in lower taxed overseas markets. EPS of $0.66 was up 73.7% from the $0.39 in the prior year, as a major stock buyback was completed. Sales in North America were up 35% yty and demand remains strong. Exports were up 27%, with exports to BRIC countries up 37%. The US Manufactuging Index was up 3.7% yty in September and the Purchasing index is still high. A 5% price increase on welding machines may have led to some pre-buying. Sales in EU, A/P, SA, & Harris advanced yty at 49%, 23%, 30%, & 34.5%, respectively.

Linde (LNGF)

Sales for the Group were Euro 3435MM up 4.1% yty and up 6.5% on a comparable basis. For Gases & Services Sales of 2834 were up 6.6% yty and 7.4% on a comparable basis. Operating Income of 771MM was up 7.4% yty and Margins of 27.2% were up 20bp. In the Americas, Sales of Euro 605MM were flat yty, but Operating Income of Euro 135MM was up 4.7% yty. By Product Line Sales for Healthcare, Bulk, Tonnage,& Cylinders were up yty 4.2%, 11.4%, 6.5% & 6.4%, respectively.

Praxair (PX)

Sales of $2.9B were up 14% yty with Volume and Price contributing 6% & 3%, respectively. Foreign exchange, Pass throughs and Divestitures contributed 5%, 1%, and (1%).  Sales in NA of $1.4B were up 11% yty primarily driven by Volume & Price up some 7% & 3%, respectively. Sales in EU,SA,&A/P were up some 11%,20%, & 19%, respectively. Operating Income of $632MM was up 15%yty and Margin of 21.8% was up 10bp. EPS of $1.40/sh. was up 16% yty aided by share buy backs of $250MM in the quarter. Guidance for the fourth quarter is uncertain, as there has been some deceleration in order trends and the strong Brazilian Real will contribute to a 5cents/sh. currency headwind. The EPS estimate is in a range of $1.33-$1.38/sh. For the year, EPS should fall in the range of $5.40-$5.45 on Sales of $11.2B

Fred H. Siemer, CFA, is President of Siemer Management Co. and has over 25 years of experience in the Chemical and Investment Industries. He established “Chemical Research for Wall St.” in 1985, and “Wall St. Views” in 2005, which is copyright “all rights reserved”. He can be reached via e-mail at FHSChem1@aol.com.

The Baird/CryoGas Industrial Distributor Survey

2Q11 Industrial Gas & Hardgoods Survey Conducted in Partnership with CryoGas International

Robert W. Baird and Company (www.rwbaird.com) surveys over 40,000 US companies in the distribution of industrial products each quarter and receives responses from over 600 independent distributors and manufacturers with combined annual revenue of approximately $80 billion. Included in this group are a large sample of the 850+ US distributors of industrial gases and related hardgoods. This report highlights the Gases and Hardgoods Distributors’ responses to the 2Q 2011 Industrial Distributor survey.

Revenue & Pricing Trends: Revenue and pricing trends for Gases and Hardgoods respondents as compared to results from All Distributors (Overall) are shown in Figure 1.

Gases & Hardgoods: Revenue growth in Hardgoods again outpaced Gases during the quarter; however, consistent with recent quarters, the gap continues to slowly narrow. The differential stood at 3.7% last quarter, narrowing to 2.5% in 2Q11. As expected, both categories continue to see higher year/year (y/y) selling prices with Hardgoods very strong at + 6.0%. Certain majors remain aggressive in the market, placing continued pressure on margins. Expectations for 2H11 are largely consistent with current trends, with growth in Gases expected to moderate slightly and growth in Hardgoods expected to be very consistent.

Overall Distribution: Among All Distributor respondents (Overall), revenue was +9.7% y/y versus +8.7% y/y last quarter in spite of increasingly difficult comparisons, reflecting very solid activity levels in most industrial end markets and continued lackluster non-residential construction activity. Price/Gross Margins remain slightly lower (-30bps y/y), driven by commodity pressure in markets that remain relatively soft. The average 2011 revenue forecast for All Distributors is +8.3%, up slightly vs +7.2% last quarter.

Revenue Trends: Average y/y revenue growth in 2Q11was +8.0% in Gases and +10.5% in Hardgoods. This compares to the +9.7% increase seen across the broader Industrial Distribution (Overall) market, as shown in Figure 2. Many distributors surveyed noted an uptick in bigger-ticket sales, which we view as encouraging for the future.

Pricing Trends: On average, higher average selling prices (y/y basis) were seen in both Gases (+3.2%) and Hardgoods (+6.0%). This compares to +3.2% pricing seen across the broader Industrial Distribution market as shown in Figure 3. Hardgoods pricing was particularly strong, with most distributors noting price increases on a wide variety of items ranging from filler metals to welding equipment and everything in between. Overall, inflationary pressures continue to persist.

Revenue Forecast: Respondents forecast 2011 revenues to grow +7.0% in Gases and +11.1% in Hardgoods. This compares to an average forecast of +8.3% for the broader Industrial Distribution market as shown in Figure 4.
When asked whether they have seen a change in the tone of business from April 2011 to today, 41% of Gases and Hardgoods Distributors saw an improvement in tone, with business remaining solid, but with the growth trajectory decelerating slightly.

2Q11 Industrial Gas & Hardgoods Survey Highlights By David J. Manthey, CFA

Respondents reported 10.5% y/y growth in 2Q11, the highest level of growth since the inception of the survey over two years ago. Price increases in the 3% range (higher for welding hardgoods) indicate supportive demand trends. Noted increases in sales of capital equipment like welding machines should bode well for the future. Expectations for 3Q11 and 2011 overall are for y/y growth in the 7.5–8.5% range, implying a continuation of solid growth trends through year end in North American demand for packaged gas and hardgoods.

Mergers & Acquisitions: Air Products is expecting to add 1–2% to overall growth through 2015 via acquisition, and Airgas has noted an expectation that acquisitions will increase in coming quarters. This is not surprising, given the much-improved industry landscape over the past 12–18 months and the fact that M&A typically accelerates during a recovery. Responses to the survey included, “All of the major players are out there looking” and, “Airgas and Praxair are always there if we are looking to sell.”

Looking to the Future: In recent months, all of the major gas players have either issued or updated longer-term financial goals. In June, both Air Products and Praxair held investor days, outlining/reiterating goals for 2015. Figure 1 outlines the major facets of these targets, including growth, margins, and returns on capital employed (ROCE). Note that some of the targets are margin/return goals, and others are expressed as growth rates that are preceded by a “+” sign.

Key Themes: Common themes among the majors include solid growth expectations due to cyclical recovery and key global growth drivers; improved profitability via volume leverage, productivity gains, and cost reduction; and strong returns on capital employed.

Growth: Across the board, end market growth is expected over each of the companies’ forecast periods. The unanimous opinion is that worldwide growth will be uneven, however, with an expectation for relatively sluggish growth in Europe; good, though possibly moderating growth in North America (consistent with our survey); and strong growth in emerging markets, most notably China and Brazil. End market drivers include a continued rebound in manufacturing, booming energy markets (with particularly strong demand for refinery hydrogen), increasing environmental concerns and regulation, as well as continued growth in healthcare and electronics markets.

Profitability: Revenue growth should lead to improving margins as incremental margins are typically quite high due to significant fixed cost structures among the major gas companies. In addition, each company has specific productivity/cost reduction goals. Air Liquide’s ALMA 2015 program targets operational efficiencies of “more than 200 million Euros each year.” Air Products recently announced the 20/15 by 2015 program, which includes a three percentage point improvement in operating margin due to productivity and leverage. Airgas expects to achieve an incremental $30 million of cost savings plus benefits from SAP and other recent investments in addition to $25+ million already achieved since September 2007. Under the umbrella of HPO (high performance organization) initiatives, Linde hopes to bring costs downby EUR 650–800 million between 2009 and 2012. Praxair, too, hopes to grow operating profit at a faster rate than sales through volume gains and annual cost savings, which last year yielded approximately $400 million in productivity gains.

Returns on Capital: The hallmark of the industrial gas industry is players’ focus on ROCE. While three of four major global producers have growth targets, these appear to be based on a build-up of geographic and end market mix and growth expectations. All four have very specific ROCE targets, which we believe are more important than growth goals.

Continuation of Good Growth and Returns Expected: The major gas companies clearly expect a general continuation of recent solid trends in global gas demand through 2012 and possibly longer. The 2Q11 Baird/CryoGas Survey implies that North American packaged gas and hardgoods markets should continue to grow moderately, and M&A transactions could augment growth for some. In aggregate, despite economic choppiness and seemingly very serious geopolitical and fiscal overhangs, the major industrial gas players are expected to see solid growth along with improving profitability and returns into the foreseeable future.

Dave J. Manthey is a senior research analyst of R.W. Baird. He can be reached at dmanthey@rwbaid.com