Management's Discussion and Analysis Financials Management's Discussion and Analysis Management's Report on Internal Control over Financial Reporting Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting Report of Independent Registered Public Accounting Firm The Consolidated Financial Statements Notes to the Consolidated Financial Statements Five-Year Summary of Selected Financial Data 19 43 44 45 46 50 80 18 We are Air Products. Management's Discussion and Analysis
(millions of dollars, except for share data) Air Products Business Overview 2006 in Summary 2007 Outlook Results of Operations Pension Benefits Share-Based Compensation Environmental Matters Liquidity and Capital Resources Contractual Obligations Off-Balance Sheet Arrangements Related Party Transactions Market Risks and Sensitivity Analysis Inflation Critical Accounting Policies and Estimates New Accounting Standards Forward-Looking Statements 19 19 20 21 21 30 33 33 33 36 37 37 37 38 39 42 42 The company now reports its results by six business segments: Merchant Gases, Tonnage Gases, Electronics and Performance Materials, Equipment and Energy, Healthcare, and Chemicals. A general description of each segment and the key variables impacting the segment follows. Merchant Gases
The Merchant Gases segment provides industrial gases such as oxygen, nitrogen, argon, helium, and hydrogen as well as certain medical and specialty gases to a wide variety of industrial and medical customers globally. There are three principal modes of supply: liquid bulk, packaged gases, and small on-sites. Most merchant product is delivered via bulk supply, in liquid or gaseous form, by tanker or tube trailer. Smaller quantities of industrial, specialty, and medical gases are delivered in cylinders and dewars as "packaged gases." Other customers receive product through small on-sites (cryogenic or noncryogenic generators) via sale of gas contracts and some sale of equipment. Electricity is the largest cost input for the production of atmospheric gases. Tonnage Gases
All comparisons in the discussion are to the corresponding prior year unless otherwise stated. All amounts presented are in accordance with U.S. generally accepted accounting principles. All amounts are presented in millions of dollars, except for share data, unless otherwise indicated. The Tonnage Gases segment supplies industrial gases, including hydrogen, carbon monoxide, nitrogen, and oxygen via large on-site facilities or pipeline systems, principally to customers in the petroleum refining, chemical, and metallurgical industries. For large-volume, or "tonnage" industrial gas users, the company either constructs a gas plant adjacent to or near the customer's facility--hence the term "on-site"--or delivers product through a pipeline from a nearby location. The company is the world's largest provider of hydrogen, which is used by refiners to lower the sulfur content of gasoline and diesel fuels to reduce smog and ozone depletion. Natural gas is the principal raw material for hydrogen. The company mitigates energy price changes through its longterm cost pass-through type customer contracts. Air Products
Air Products and Chemicals, Inc. and its subsidiaries (the company) serve customers in industrial, energy, technology, and healthcare markets. The company offers a broad portfolio of atmospheric gases, process and specialty gases, performance materials, and equipment and services. Geographically diverse, with operations in over 40 countries, the company has sales of $8.9 billion, assets of $11.2 billion and a worldwide workforce of over 20,000 employees. Electronics and Performance Materials
The Electronics and Performance Materials segment uses applications technology to provide material solutions to a broad range of global industries through expertise in chemical synthesis, analytical technology, process engineering, and surface science. This segment provides specialty and tonnage gases, specialty and bulk chemicals, services, and equipment to the electronics industry for the manufacture of silicon Business Overview
Previously, the company managed its operations and reported results by three business segments: Gases, Chemicals, and Equipment. In the fourth quarter of 2006, the company announced the sale of its Amines business and the reorganization of how its other businesses were managed. 19 Management's Discussion and Analysis and compound semiconductors, displays (LCDs, etc.), and photovoltaic devices. The segment also provides performance chemical solutions for the coatings, inks, adhesives, civil engineering, personal care, institutional and industrial cleaning, mining, oil field, polyurethane, and other industries. Equipment and Energy
The Equipment and Energy segment designs and manufactures cryogenic and gas processing equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction (LNG), and helium distribution equipment. Equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. This segment also constructs, operates, and has an equity ownership interest in power generation and flue gas treatment facilities. The company is developing technologies to continue to serve energy markets in the future, including gasification and alternative energy technologies. Performance Materials, and Equipment and Energy showed significant improvement in their results, the Healthcare segment did not perform up to expectations. The company has taken measures that should improve this business. The company also implemented several strategic steps as part of its ongoing portfolio management activities. The company divested its Amines business and sold its Geismar, Louisiana, dinitrotoluene (DNT) facility. The company is currently marketing its Polymer Emulsions business and actively engaging its partner and potential buyers. The company continues to make progress on the restructuring of its PUI business. An impairment charge was recognized for loans to a sulfuric acid supplier in the PUI business. The 2006 global cost reduction plan was implemented, which will eliminate approximately 325 positions and resulted in the write-down of certain underperforming assets. Through this initiative, the company will simplify and streamline its business practices and management structure. A $1,500 share repurchase program was announced, of which $496 was completed in 2006. Sales of $8,850 were up 14% from the prior year, due to higher volumes in Merchant Gases, Tonnage Gases, and Electronics and Performance Materials and strong performance in Equipment and Energy, particularly in LNG. Increased pricing to recover higher costs in Merchant Gases also increased sales. Sales declined from lower pricing in Electronics and Performance Materials. Operating income was $1,061, compared to $996 in the prior year. Operating income benefited primarily from higher volumes, partially offset by the charge for a global cost reduction plan, lower electronics specialty material pricing, and higher costs to support volume growth. In 2006, the company adopted SFAS No. 123R, "Share-Based Payment," which resulted in current year stock option expense of $43. Net income was $723, compared to $712 in the prior year, while diluted earnings per share of $3.18 was higher than $3.08 in the prior year. A summary table of changes in diluted earnings per share is presented on page 21. For additional information on the opportunities, challenges, and risks on which management is focused, refer to the 2007 Outlook discussions provided throughout the Management's Discussion and Analysis which follows. Healthcare
The Healthcare segment provides respiratory therapies, home medical equipment, and infusion services to patients in their homes in the United States and Europe. The company serves more than 500,000 patients in 15 countries and has leading market positions in Spain, Portugal, and the United Kingdom. Offerings include oxygen therapy, home nebulizer therapy, sleep management therapy, anti-infective therapy, beds, and wheelchairs. Chemicals
The Chemicals segment consists of the Polymer Emulsions business, which is currently being marketed to potential buyers, and the Polyurethane Intermediates (PUI) business, which is being restructured. 2006 in Summary
The company delivered solid growth in sales, operating income, net income, and return on capital in 2006. These results were driven principally by strong underlying base business volume increases in most of our business segments. While Merchant Gases, Tonnage Gases, Electronics and 20 We are Air Products. Changes in Diluted Earnings per Share
2006 DilutedEarningsperShare OperatingIncome(after-tax) Underlying business Volume Price/raw materials/mix Costs Acquisitions Divestitures Currency Gain on sale of a chemical facility Impairment of loans receivable Global cost reduction plan Healthcare inventory adjustment Hurricane impacts (A) 2006 2005 Stock option expense OperatingIncome Other(after-tax) Interest expense Discontinued operations Cumulative effect of an accounting change Average shares outstanding Other TotalChangeinDilutedEarningsperShare
(A) 2005 $3.08 Increase (Decrease) $.10 $3.18 · Electronics and Performance Materials volumes should continue to grow based on new investment and asset management. Margins are expected to improve from the product and asset rationalization plans implemented in 2006. · Equipment and Energy sales should remain strong from high LNG activity. However, income is expected to be slightly lower as spending on energy development opportunities will be higher in 2007. · The company has taken actions expected to increase volumes and improve the way the Healthcare segment is managed. Healthcare should benefit from increased volumes in the U.S., from the new home respiratory contract in the U.K., and from actions taken to reduce operating costs. · The company is currently marketing its Polymer Emulsions business and actively engaging its partner and potential buyers. The company continues to make progress on the restructuring of its PUI business. The company remains focused on increasing productivity and managing costs. The global cost reduction plan, implemented in 2006, should provide benefits to the company in 2007 and beyond. .92 .01 (.44) .05 (.01) (.03) .19 (.19) (.21) (.05) .04 .04 (.12) .20 (.03) (.10) (.03) .06 (.10) $.10 Results of Operations
Consolidated Results
2006 Sales Cost of sales Selling and administrative Research and development (Gain) on sale of a chemical facility Impairment of loans receivable Global cost reduction plan Other (income) expense, net OperatingIncome Equity affiliates' income Interest expense Effective tax rate Income from continuing operations Income (loss) from discontinued operations, net of tax Cumulative effect of an accounting change, net of tax NetIncome BasicEarningsperShare DilutedEarningsperShare $8,850.4 6,558.3 1,080.7 151.4 (70.4 ) 65.8 72.1 (68.4 ) 1,060.9 107.7 119.3 26.6 % 748.3 (18.7 ) (6.2 ) 723.4 $3.26 $3.18 2005 $7,768.3 5,654.5 1,013.6 132.3 -- -- -- (27.6) 995.5 105.4 110.0 26.9% 707.5 4.2 -- 711.7 $3.15 $3.08 2004 $7,031.9 5,094.7 956.2 126.1 -- -- -- (31.5) 886.4 92.8 120.9 27.4% 608.4 (4.3) -- 604.1 $ 2.70 $2.64 Includes insurance recoveries, estimated business interruption, asset write-offs, and other expenses. 2007 Outlook
The company is forecasting earnings per share growth again in 2007. Entering 2007, the company expects domestic manufacturing growth between 2% and 3% for the year. The company anticipates silicon growth in 2007 of approximately 5% and flat-panel display growth of approximately 40%. For natural gas, the company expects the 2007 price to be moderately lower than the 2006 average cost. Foreign currencies are expected to be relatively stable year-to-year. Two risks facing the company in 2007 are raw material and energy price volatility and lower manufacturing growth. · Merchant Gases should benefit from operating leverage on existing assets, increased productivity, improved pricing, and new investments, particularly in Asia. · Tonnage Gases should benefit from the full-year impact of the new hydrogen facilities brought onstream during 2006. 21 Management's Discussion and Analysis Discussion of Consolidated Results
Sales
% Change from Prior Year 2006 2005 Underlying business Volume Price/mix Acquisitions Divestitures Currency Natural gas/raw material cost pass-through TotalConsolidatedSalesChange 11 % 1 % 1 % -- (1 % ) 2 % 14 % 5% -- 1% (1)% 2% 3% 10 % ral gas and raw material costs contractually passed through to customers accounted for a 2% increase in sales. Operating Income Operating income of $1,060.9 increased 7%, or $65.4. Favorable operating income variances resulted from higher volumes of $293, the gain on sale of a chemical facility of $70, and acquisitions of $15. Operating income increased $4 from improved pricing, net of variable costs. Pricing increases were primarily in Merchant Gases and were mostly offset by lower pricing in electronics specialty materials. Operating income increased $29 due to insurance recoveries exceeding estimated business interruption and asset write-offs and other expenses related to Hurricanes Katrina and Rita. Costs increased $136, due principally to higher volumes and inflation. Operating income declined $8 from unfavorable currency effects as the U.S. dollar strengthened against the Euro and the Pound Sterling. Operating income included charges of $66 for the impairment of loans receivable and $72 for the global cost reduction plan. An inventory adjustment in the Healthcare segment decreased operating income by $17. Stock option expense reduced operating income by $43 as the company adopted SFAS No. 123R at the beginning of 2006. Equity Affiliates' Income Income from equity affiliates of $107.7 increased $2.3, or 2%. The increase was primarily due to higher equity affiliate income in the Chemicals segment. 2006 results in the Merchant Gases segment included the impact of an antitrust fine levied against an Italian equity affiliate of $5.3. 2005 vs. 2004 Sales Sales of $7,768.3 increased 10%, or $736.4. Underlying base business growth of 5% resulted primarily from improved volumes in Merchant Gases, Tonnage Gases, and Electronics and Performance Materials, as further discussed in the Segment Analysis which follows. The acquisition of five small U.S. healthcare companies increased sales by 1%. Divestiture of the company's Mexican polymers business accounted for a 1% decrease. Sales increased 2% from favorable currency effects, driven primarily by the weakening of the U.S. dollar against the Euro and the Pound Sterling. Higher natural gas and raw material costs contractually passed through to customers accounted for a 3% increase in sales. Operating Income Operating income of $995.5 increased 12%, or $109.1. Favorable operating income variances resulted from higher volumes of $183, favorable currency effects of $29, and Operating Income
Change from Prior Year 2006 2005 PriorYearOperatingIncome Underlying business Volume Price/raw materials/mix Costs Acquisitions Divestitures Currency Gain on sale of a chemical facility Impairment of loans receivable Global cost reduction plan Healthcare inventory adjustment Hurricane impacts (A) 2006 2005 Stock option expense OperatingIncome
(A) $ 996 293 4 (136 ) 15 ( ) 4 (8 ) 70 (66 ) (72 ) (17 ) 15 14 (43 ) $1,061 $886 183 (75) (13) 11 (11) 29 -- -- -- -- -- (14) -- $996 Includes insurance recoveries, estimated business interruption, asset write-offs, and other expenses. 2006 vs. 2005 Sales Sales of $8,850.4 increased 14%, or $1,082.1. Underlying base business growth of 12% resulted primarily from improved volumes in Merchant Gases, Tonnage Gases, and Electronics and Performance Materials along with higher activity in Equipment and Energy, as further discussed in the Segment Analysis which follows. The acquisition of Tomah 3 Products and a small healthcare company in Europe increased sales by 1%. Sales decreased 1% from unfavorable currency effects, driven primarily by the strengthening of the U.S. dollar against the Euro and the Pound Sterling. Higher natu- 22 We are Air Products. acquisitions of $11. Operating income declined $75 from lower pricing, net of variable costs, primarily from lower electronics specialty material pricing, and higher power and fuel expenses. Operating income decreased by $13 from higher costs primarily due to inflation, partially offset by productivity benefits. Divestitures decreased operating income by $11. Operating income was also negatively affected by the impacts of Hurricanes Katrina and Rita during 2005. As a result of the hurricanes, the company sustained property damage and lost sales; customer and supplier interruption; and higher feedstock, product sourcing, and distribution costs. The impact of the hurricanes was estimated to have been approximately $14. Equity Affiliates' Income Income from equity affiliates of $105.4 increased $12.6, or 14%. The increase was attributable to higher equity affiliate income in the Merchant Gases segment. impacts of inflation. Partially offsetting these impacts, the company expects to realize cost savings from the global cost reduction plan implemented in 2006 and cost savings from productivity initiatives. Research and Development (R&D)
2006 vs. 2005 R&D increased 14%, or $19.1, due to cost inflation and higher spending on Equipment and Energy and Electronics and Performance Materials projects. R&D spending as a percent of sales was 1.7% in both 2006 and 2005. 2005 vs. 2004 R&D increased 5%, or $6.2, due to cost inflation and increased spending on projects. R&D spending declined slightly as a percent of sales to 1.7% from 1.8% in 2004. 2007 Outlook R&D investment should approximate 2006 levels and will continue to be focused on the requirements of emerging businesses. Selling and Administrative Expense (S&A)
% Change from Prior Year 2006 2005 Acquisitions Currency Stock option expense Other costs TotalS&AChange 1 % (1 % ) 4% 3 % 7 % 3% 1% -- 2% 6% Gain on Sale of a Chemical Facility
On 31 March 2006, the company sold its DNT production facility in Geismar, Louisiana, to BASF Corporation for $155.0. The company wrote off the remaining net book value of assets sold, resulting in the recognition of a gain of $70.4 ($42.9 after-tax, or $.19 per share) on the transaction. See Note 20 to the consolidated financial statements for additional information on the sale. 2006 vs. 2005 S&A expense of $1,080.7 increased 7%, or $67.1. S&A as a percent of sales declined to 12.2% from 13.0% in 2005. The acquisitions of a small healthcare company in Europe and Tomah 3 Products increased S&A by 1%. Currency effects, driven by the strengthening of the U.S. dollar against the Euro, decreased S&A by 1%. Stock option expense increased S&A 4%, due to the adoption of SFAS No. 123R. Underlying costs increased S&A by 3%, primarily due to inflation. 2005 vs. 2004 S&A expense of $1,013.6 increased 6%, or $57.4. S&A as a percent of sales declined to 13.0% from 13.6% in 2004. The acquisitions of U.S. healthcare companies increased S&A by 3%. Currency effects, driven by the weakening of the U.S. dollar against the Euro and Pound Sterling, increased S&A by 1%. Underlying costs increased 2% due to cost inflation partially offset by productivity initiatives. 2007 Outlook S&A will increase in 2007. The company expects increases due to additional costs to support volume growth and the Impairment of Loans Receivable
In the second quarter of 2006, the company recognized a loss of $65.8 ($42.4 after-tax, or $.19 per share) for the impairment of loans receivable from a long-term supplier of sulfuric acid, used in the production of DNT for the company's PUI business. See Note 20 to the consolidated financial statements for further information. Global Cost Reduction Plan
In the fourth quarter of 2006, the company announced a global cost reduction plan (2006 Plan), which resulted in a charge of $72.1 ($46.8 after-tax, or $.21 per share). The charge included $60.6 for severance and pension-related costs for approximately 325 position eliminations and $11.5 for asset disposals and facility closures. Several cost reduction initiatives in Europe will result in the elimination of about two-thirds of the 325 positions at a cost of $37.6. The company will reorganize and streamline certain organizations and activities in Europe, which will focus
23 Management's Discussion and Analysis on improving effectiveness and efficiency. Additionally, in anticipation of the sale of a small business, a charge of $1.4 was recognized to write down the assets of the business to net realizable value. The company completed a strategy review of its Electronics business in 2006. The company has decided to rationalize some products and assets, reflecting a simpler portfolio. A charge of $10.1 was recognized principally for an asset disposal and the write-down of certain investments/assets to net realizable value. Additionally, a charge of $3.8 was recognized for severance and pension-related costs. In addition to the Europe and Electronics initiatives, the company continues to implement cost reduction and productivity-related efforts to simplify its management structure and business practices. A charge of $19.2 for severance and related pension costs was recognized for these efforts. The charge for the 2006 Plan has been excluded from segment operating profit. The charge was related to the businesses at the segment level as follows: $31.2 in Merchant Gases, $19.5 in Healthcare, $17.3 in Electronics and Performance Materials, $2.9 in Tonnage Gases, $.9 in Equipment and Energy, and $.3 in Chemicals. As of 30 September 2006, $1.1 of the severance costs had been paid by the company. Cost savings of $23 are expected in 2007. Beyond 2007, the company expects the 2006 Plan to provide annualized cost savings of $39, of which the majority is related to reduced personnel costs. Interest Expense
2006 Interest incurred Less: interest capitalized InterestExpense $135.8 16.5 $ 119.3 2005 $122.0 12.0 $110.0 2004 $ 126.4 5.5 $120.9 2006 vs. 2005 Interest incurred increased $13.8. The increase resulted from a higher average debt balance excluding currency effects, resulting principally from the share repurchase program. The increase was partially offset by the impact of a stronger U.S. dollar on the translation of foreign currency interest and lower average interest rates. Capitalized interest was higher by $4.5 due to higher levels of construction in progress for plant and equipment built by the company, principally for Tonnage Gases projects. 2005 vs. 2004 Interest incurred decreased $4.4. The decrease resulted from lower average interest rates and a lower average debt balance, excluding currency effects, partially offset by the impact of a weaker U.S. dollar on the translation of foreign currency interest. Capitalized interest was higher by $6.5 due to higher levels of construction in progress for plant and equipment built by the company, principally for Merchant Gases, Tonnage Gases, and Electronics and Performance Materials projects. 2007 Outlook The company expects interest incurred to be higher relative to 2006. The increase is expected to result from a higher average debt balance, as the company continues its $1,500 share repurchase program and makes additional pension contributions. Other (Income) Expense, Net
Items recorded to other income arise from transactions and events not directly related to the principal income earning activities of the company. Note 20 to the consolidated financial statements displays the details of other (income) expense. 2006 vs. 2005 Other income of $68.4 increased $40.8. Other income included $56.0 from hurricane insurance recoveries in excess of property damage and related expenses. This net gain does not include the estimated impact related to business interruption. Other income in 2006 also included $9.5 from the sale of land in Europe. No other items were individually material in comparison to the prior year. 2005 vs. 2004 Other income of $27.6 decreased $3.9. No items were individually material in comparison to the prior year. Effective Tax Rate
The effective tax rate equals the income tax provision divided by income before taxes less minority interest. 2006 vs. 2005 The effective tax rate was 26.6%, down slightly from 26.9% in 2005. Excluding the impact of the sale of the Geismar, Louisiana, DNT production facility, the global cost reduction plan charge, and the impairment of loans receivable, the effective tax rate was 27.1% in 2006. In the fourth quarter of 2006, the company recorded a tax benefit of $20.0 related to its reconciliation and analysis of its current and deferred tax assets and liabilities. This benefit was effectively offset by the impact of tax law changes and foreign and other tax adjustments. 24 We are Air Products. 2005 vs. 2004 The effective tax rate was 26.9%, down from 27.4% in 2004. Income tax expense in 2005 included a charge related to the company's annual reconciliation and analysis of its deferred tax assets and liabilities that was offset by higher foreign tax credits due to the American Job Creation Act of 2004, higher export tax benefits, and favorable income mix. 2007 Outlook The company expects the effective tax rate in 2007 to remain approximately equal to the 2006 adjusted rate of 27.1%. The 2006 adjusted rate excludes the impact of the sale of the Geismar, Louisiana, DNT production facility, the global cost reduction plan charge, and the impairment of loans receivable. Cumulative Effect of an Accounting Change
The company adopted Financial Interpretation (FIN) No. 47, "Accounting for Conditional Asset Retirement Obligations," effective 30 September 2006, and recorded an after-tax charge of $6.2 as the cumulative effect of an accounting change. FIN No. 47 clarifies the term, conditional asset retirement obligation, as used in SFAS No. 143, "Accounting for Asset Retirement Obligations," which refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event. Net Income
2006 vs. 2005 Net income was $723.4, compared to $711.7 in 2005. Diluted earnings per share was $3.18, compared to $3.08 in 2005. A summary table of changes in earnings per share is presented on page 21. 2005 vs. 2004 Net income was $711.7, compared to $604.1 in 2004. Diluted earnings per share was $3.08, compared to $2.64 in 2004. Discontinued Operations
In the second quarter of 2006, the company announced initiatives designed to make Air Products a more focused, less cyclical, higher growth, and higher return company. One of the initiatives was the exploration of the sale of the Amines and Polymer Emulsions businesses as part of the ongoing portfolio management activities of the company. On 29 September 2006, the company completed the sale of its Amines business to Taminco N.V., a producer of methylamines based in Belgium. The sales price was $211.2 in cash, with certain liabilities assumed by the purchaser. The company recorded a loss of $40.0 ($23.7 after-tax, or $.11 per share) in connection with the sale of the Amines business and the recording of certain environmental and contractual obligations that the company retained. A charge of $42.0 ($26.2 after-tax, or $.12 per share) was recognized for environmental obligations related to the Pace, Florida, facility. At 30 September 2006, the liability was included in continuing operations on the consolidated balance sheet. In addition, fourth quarter results also included a charge of $8.3 ($5.2 after-tax, or $.02 per share) for costs associated with a contract termination. As a result of the sale, the operating results of the Amines business have been classified as discontinued operations in the company's consolidated financial statements for all fiscal years presented. The discontinued operations generated sales of $308.4, $375.2, and $379.5 and income (loss), net of tax, of ($18.7), $4.2, and ($4.3) in 2006, 2005, and 2004, respectively. Note 5 to the consolidated financial statements contains additional details regarding discontinued operations. Segment Analysis
The company manages its operations and reports results by six business segments: Merchant Gases, Tonnage Gases, Electronics and Performance Materials, Equipment and Energy, Healthcare, and Chemicals. Refer to the Business Overview discussion beginning on page 19 for a description of the business segments. Merchant Gases
2006 Sales Operating income Equity affiliates' income $2,712.8 470.0 82.4 2005 $2,468.0 414.0 82.1 2004 $2,230.3 405.2 68.8 Merchant Gases Sales
% Change from Prior Year 2006 2005 Underlying business Volume Price/mix Currency TotalMerchantGasesSalesChange 7 % 4% (1 % ) 10 % 7% 1% 3% 11 % 25 Management's Discussion and Analysis 2006 vs. 2005 Merchant Gases volumes were higher in all regions due to stronger manufacturing growth and new customer signings, despite hurricane impacts. Sales also benefited from the company's ability to implement price increases to recover higher costs. Merchant Gases Sales Sales of $2,712.8 increased 10%, or $244.8. Underlying base business growth improved sales by 11%. Sales increased 7% from stronger volumes. · Liquid bulk volumes in North America improved 2%. Stronger liquid oxygen (LOX), liquid nitrogen (LIN), and liquid argon (LAR) volumes were largely offset by lower liquid hydrogen volumes due to the impacts of Hurricanes Katrina and Rita. LOX/LIN/LAR volumes improved 5% as demand increased among most end markets. · Liquid bulk volumes in Europe increased 5%. The business continued to grow volumes through new customer signings and benefited from increased purchases from a tonnage customer prior to commencing on-site supply. · Packaged gases volumes in Europe were up 1%, and increased 2% on a cylinder per workday basis driven by strong growth in new and differentiated products. · LOX/LIN volumes in Asia were up 23%, driven mainly by solid demand growth across the region. Pricing increased sales by 4%. Prices for LOX/LIN improved by 11% in North America and 1% in Europe due to pricing programs and favorable customer mix. Currency decreased sales by 1%, primarily from the strengthening of the U.S. dollar against the Euro and the Pound Sterling. Merchant Gases Operating Income Operating income of $470.0 increased $56.0. Operating income increased from higher volumes by $72 and $33 from improved pricing and customer mix. Price increases were implemented principally to recover higher energy costs. Insurance recoveries related to Hurricanes Katrina and Rita exceeded estimated business interruption impacts, asset write-offs, and related expenses by $17. Higher costs in support of increased volumes reduced operating income by $52. Operating income decreased $14 from stock option expense as the company adopted SFAS No. 123R. Merchant Gases Equity Affiliates' Income Merchant Gases equity affiliates' income of $82.4 increased by $.3, with higher income reported primarily in the Latin American affiliates, partially offset by the impact of an antitrust fine levied against an Italian equity affiliate of $5.3. 2005 vs. 2004 The Merchant Gases segment experienced volume growth across most of its products and regions despite the impacts of Hurricanes Katrina and Rita in the fourth quarter of 2005. Merchant Gases Sales Sales of $2,468.0 increased 11%, or $237.7. Underlying base business growth increased sales by 8%. Higher volumes improved sales by 7%. · Liquid bulk volumes in North America improved 5%. LOX/LIN volumes improved 6%, along with the improving economy. Liquid hydrogen volumes improved from increased demand by the government sector, partially offset by the impacts of Hurricanes Katrina and Rita. Helium volumes improved from increased magnetic resonance imaging activity. · Liquid bulk volumes in Europe declined 1%. Underlying base business decreased due to lost business, including reduced demand at existing accounts and the conversion of certain liquid customers to on-site supply, partially offset by growth from the signing of new customer accounts. · LOX/LIN volumes in Asia were up 22%, driven mainly by solid demand growth across the region, particularly in Korea and Taiwan. Volumes also benefited from added capacity in China. Pricing increased sales by 1% as prices for LOX/LIN in North America remained flat while LOX/LIN pricing in Europe increased 3%, due to pricing programs and favorable customer mix. Currency increased sales by 3%, primarily from the weakening of the U.S. dollar against the Euro. Merchant Gases Operating Income Operating income of $414.0 increased by $8.8. Favorable operating income variances resulted from higher volumes for $49 and favorable currency effects for $17. Operating income declined $34 from higher costs, including costs to implement productivity initiatives and the impacts of Hurricanes Katrina and Rita. Lower pricing, net of variable costs, decreased operating income by $23 due to higher power and fuel expenses. 26 We are Air Products. Merchant Gases Equity Affiliates' Income Merchant Gases equity affiliates' income of $82.1 increased by $13.3, with higher income reported across most regions. 2007 Outlook Merchant Gases sales are expected to be higher in 2007 based upon volume growth due to higher manufacturing activity and the impact of higher raw material costs recovered through price increases. Plants in the U.S. are operating at close to capacity. As such, the company is making efforts to debottleneck plants and convert larger customers to onsites in an attempt to free up capacity for smaller customers. In Asia, new plants across the region are expected to drive double-digit volume growth. The European business is focused on improving margins from loading facilities, recovering energy costs, and cost savings from the 2006 global cost reduction plan. Currency unfavorably impacted sales by 1% as the U.S. dollar strengthened against the Euro and Pound Sterling. Natural gas cost contractually passed through to customers increased sales by 8%. Tonnage Gases Operating Income Operating income of $341.3 increased $89.5. Operating income increased $57 from higher volumes and $24 from a favorable change in customer mix and operating efficiencies. Insurance recoveries related to Hurricanes Katrina and Rita exceeded estimated business interruption impacts, asset write-offs, and related expenses by $15. Operating income decreased $6 from stock option expense as the company adopted SFAS No. 123R. 2005 vs. 2004 The Tonnage Gases segment experienced strong growth during the first three quarters of 2005. The fourth quarter, however, was negatively impacted by Hurricanes Katrina and Rita. Tonnage Gases Sales Sales of $1,740.1 increased $210.4, or 14%. Underlying base business volumes increased sales by 5%. Volumes in 2005 benefited from the full-year impact of new plant capacity but were negatively impacted by Hurricanes Katrina and Rita in the fourth quarter. Hydrogen growth continued to be led by the ongoing trend for refiners to meet lower sulfur specifications. Currency increased sales by 1%, primarily from the weakening of the U.S. dollar against the Euro and the Pound Sterling. Higher natural gas cost contractually passed through to customers accounted for an additional 8% sales increase. Tonnage Gases Operating Income Operating income of $251.8 increased by $19.7. Favorable operating income variances resulted from higher volumes of $12, favorable customer mix of $10, and currency effects of $5. Operating income declined $7 from the impacts of Hurricanes Katrina and Rita. 2007 Outlook Tonnage Gases sales are expected to be higher in 2007 due to additional volumes provided by the full-year impact of new hydrogen plants brought onstream in 2006. The increased volumes should be partially offset by lower natural gas prices contractually passed through to customers. Operating results in 2007 should improve from the expected higher volumes, partially offset by the impact of insurance recoveries in 2006. Tonnage Gases
2006 Sales Operating income $2,224.1 341.3 2005 $1,740.1 251.8 2004 $1,529.7 232.1 Tonnage Gases Sales
% Change from Prior Year 2006 2005 Underlying business Volume Currency Natural gas/raw material cost pass-through TotalTonnageGasesSalesChange 21 % (1 % ) 8 % 28 % 5% 1% 8% 14 % 2006 vs. 2005 Tonnage Gases volumes were up significantly due to strong base business growth, including new refinery hydrogen investments. Tonnage Gases Sales Sales of $2,224.1 increased $484.0, or 28%. Underlying base business volume growth increased sales by 21%. Volumes were higher due to the start-up of new hydrogen plants supporting the refinery industry and strong performance in large tonnage on-sites supporting the steel industry. This increase was partially offset by the impacts of Hurricanes Katrina and Rita. 27 Management's Discussion and Analysis Electronics and Performance Materials
2006 Sales Operating income $1,898.6 195.3 2005 $1,701.0 146.0 2004 $1,604.0 139.5 Electronics and Performance Materials Sales
% Change from Prior Year 2006 2005 Underlying business Volume Price/mix Acquisitions Currency TotalElectronicsandPerformance MaterialsSalesChange 13 % (3 % ) 2 % -- 12 % 9% (4)% -- 1% 6% Electronics and Performance Materials Sales Sales of $1,701.0 increased 6%, or $97.0. Underlying base business increased sales by 5%. Sales improved by 9% from higher volumes, driven primarily by increased electronic specialty materials volumes, as electronics markets continued to improve, including strong growth in the silicon and flat-panel display markets. Pricing decreased sales by 4% as the average selling price for electronic specialty materials declined from continued pricing pressure. Currency increased sales by 1% as the U.S. dollar weakened against the Euro and key Asian currencies. Electronics and Performance Materials Operating Income Operating income of $146.0 increased $6.5, or 5%. Operating income was favorably impacted by higher volumes of $82, currency impacts of $4, and lower costs of $9. The 2004 results included costs related to a legal matter. Lower pricing, net of variable costs, primarily from lower electronics specialty material pricing, decreased operating income by $87. 2007 Outlook Volume increases are expected to drive Electronics and Performance Materials results higher in 2007. The expected volume increases are based on forecasts of silicon growth, strong demand growth in the flat-panel display market, new markets and products in Performance Materials, and a full year of operation of the recently acquired Tomah 3 Products. 2006 vs. 2005 The Electronics and Performance Materials segment had a strong year of volume growth but continued to face pricing pressure for electronics specialty materials. However, volume gains continued to outpace price erosion. Electronics and Performance Materials Sales Sales of $1,898.6 increased 12%, or $197.6. Underlying base business increased sales by 10%. Higher volumes improved sales by 13%, primarily from increased electronic specialty materials volumes, with solid demand in the silicon and flat-panel display markets. Pricing decreased sales by 3%, as electronic specialty materials continued to experience pricing pressure. Sales increased 2% from the acquisition of Tomah 3 Products. Electronics and Performance Materials Operating Income Operating income of $195.3 increased 34%, or $49.3. Operating income increased $141 from higher volumes and $5 from the acquisition of Tomah 3 Products. Lower pricing, net of variable costs, primarily from lower electronics specialty material pricing, decreased operating income by $67. Operating income also declined by $13 from stock option expense as the company adopted SFAS No. 123R, by $10 from increased costs to support higher volumes, and by $6 from currency as the U.S. dollar strengthened against the Euro and key Asian currencies. 2005 vs. 2004 Electronics and Performance Materials volume increases were led by electronics specialty materials, but prices dropped due to increasing market pressure. Equipment and Energy
2006 Sales Operating income (loss) $536.5 68.9 2005 $369.4 29.1 2004 $345.6 (2.1) 2006 vs. 2005 Sales of $536.5 increased by $167.1, primarily from higher LNG heat exchanger, large air separation unit, and hydrocarbon processing equipment activity. Currency effects decreased sales by 1% as the U.S. dollar strengthened against the Pound Sterling. Operating income of $68.9 increased by $39.8, primarily from higher LNG activity. The sales backlog for the Equipment business at 30 September 2006 was $446, compared to $577 at 30 September 2005. The business received orders for two new LNG heat exchangers in 2006. It is expected that approximately $357 of the backlog will be completed during 2007. 28 We are Air Products. 2005 vs. 2004 Both sales and operating income increased primarily from higher LNG heat exchanger sales activity. Currency effects improved sales by 2%, due primarily to the weakening of the U.S. dollar against the Pound Sterling. The sales backlog for the Equipment business at 30 September 2005 was $577, compared to $257 at 30 September 2004. The business received orders for seven new LNG heat exchangers in 2005. 2007 Outlook Equipment and Energy sales are expected to remain at strong levels in 2007 due to the continued high levels in the Equipment backlog. Operating income for the segment is expected to decrease slightly from increased spending on energy development opportunities. Healthcare Operating Income Operating income of $8.4 decreased $73.3. Operating income decreased $4 from volumes as growth in Europe of $13 was more than offset by lower volumes in the U.S. of $17. Results in 2006 included a charge of $17 to adjust U.S. inventories to actual, based on physical inventory counts. Operating income declined from higher costs in the U.S. of $33, primarily driven by increased bad debt expense and infrastructure costs to support growth. Higher costs in Europe, primarily due to the new respiratory contract in the U.K., decreased operating income by $20. 2005 vs. 2004 The company continued to expand its Healthcare segment in 2005 through the acquisition of five small U.S. healthcare businesses. Healthcare Sales Sales of $544.7 increased $106.5, or 24%. Sales increased 7% due to strong volume performance across all regions in Europe. Pricing decreased sales by 1% due to lower Medicare pricing in the U.S. Acquisitions increased sales by 16% as the company acquired five small U.S. healthcare businesses. Currency, driven primarily by the weakening of the U.S. dollar against the Euro, increased sales by 2%. Healthcare Operating Income Operating income of $81.7 increased $8.2. Favorable operating income variances resulted from volumes of $12 and acquisitions of $11. Operating income declined $13 from higher costs, primarily from additional operating costs to support new business. 2007 Outlook Healthcare is expected to improve in 2007 as the company's action plan takes effect. In the U.S., the company is expecting volume growth to drive improvement in the business. In Europe, Healthcare should benefit from a reduction in costs and the full-year benefit of the new respiratory care contract in the U.K. Healthcare
2006 Sales Operating income $570.8 8.4 2005 $544.7 81.7 2004 $438.2 73.5 Healthcare Sales
% Change from Prior Year 2006 2005 Underlying business Volume Price/mix Acquisitions Currency TotalHealthcareSalesChange 5 % (1 % ) 3 % (2 % ) 5 % 7% (1)% 16% 2% 24% 2006 vs. 2005 The Healthcare segment results in 2006 reflected operational issues in the U.S. business and higher than anticipated startup costs of a new contract in the U.K. Healthcare Sales Sales of $570.8 increased $26.1, or 5%. Sales increased 5% due to increased volumes from a respiratory care contract won in the U.K., offset by declining sales in the U.S. Pricing decreased sales by 1% from continued pricing pressures in both the U.S. and Europe. Acquisitions increased sales by 3% as the company acquired one small healthcare business in Europe and had the full-year effect of the acquisitions closed in the U.S. in 2005. Currency, driven primarily by the strengthening of the U.S. dollar against the Euro, decreased sales by 2%. Chemicals
2006 Sales Operating income $907.6 64.0 2005 $945.1 86.1 2004 $884.1 66.8 The Chemicals segment consists of the company's Polymer Emulsions and PUI businesses. The Polymer Emulsions business is currently being marketed for sale and the PUI business is being restructured.
29 Management's Discussion and Analysis 2006 vs. 2005 The Chemicals segment results were lower in 2006 from customer actions that occurred late in 2005. Chemicals Sales Sales of $907.6 decreased $37.5, or 4%. Sales increased from higher raw material costs contractually passed through to customers and other price increases to recover raw material costs. Sales decreased from lower volumes in PUI from the termination of a contract and a customer shutdown that took place in the fourth quarter of 2005. Divestitures negatively impacted sales as the company sold its DNT facility in Geismar, Louisiana. Volumes in Polymer Emulsions were relatively flat as the company continued to focus on recovering higher raw material costs. Chemicals Operating Income Operating income of $64.0 decreased $22.1, primarily due to a customer terminating its contract to purchase toluene diamine in the fourth quarter of 2005. As a result, operating income in 2005 included the present value of the contractual termination payments required under the supply contract. On 31 March 2006, the company sold its DNT production facility in Geismar, Louisiana, to BASF Corporation for $155.0. The company wrote off the remaining net book value of assets sold, resulting in the recognition of a gain of $70.4 ($42.9 after-tax, or $.19 per share) on the transaction. See Note 20 to the consolidated financial statements for additional information on the sale. In the second quarter of 2006, the company recognized a loss of $65.8 ($42.4 after-tax, or $.19 per share) for the impairment of loans receivable from a long-term supplier of sulfuric acid, used in the production of DNT for the company's PUI business. See Note 20 to the consolidated financial statements for further information. 2005 vs. 2004 Chemicals sales improved as a result of pricing actions implemented to recover higher costs, while operating income benefited from a contract termination payment. Chemicals Sales Sales of $945.1 increased $61.0, or 7%. Sales increased from higher raw material costs contractually passed through to customers and other price increases to recover higher raw material costs. Sales decreased from divestitures, as the company sold its Mexican polymers business in 2004, and from lower volumes, which resulted from price increases implemented by the company.
30 We are Air Products. Chemicals Operating Income Operating income of $86.1 increased $19.3. Operating income increased primarily due to a customer terminating its contract to purchase toluene diamine in the fourth quarter of 2005. As a result, operating income included the present value of the contractual termination payments required under the supply contract. 2007 Outlook The company is currently marketing its Polymer Emulsions business and actively engaging its partner and potential buyers. The company continues to make progress on the restructuring of its PUI business. Other
Other operating income includes other expense and income which cannot be directly associated with the business segments, including foreign exchange gains and losses, interest income, and costs previously allocated to the Amines business. Also included are LIFO inventory adjustments, as the business segments use FIFO and the LIFO pool is kept at corporate. Corporate research and development costs are fully allocated to the business segments.
2006 Operating (loss) $(14.9 ) 2005 $(13.2) 2004 $(28.6) 2006 vs. 2005 The operating loss of $14.9 increased by $1.7. No individual items created a material variance in the comparison to the prior year. 2005 vs. 2004 The operating loss of $13.2 decreased by $15.4. The decrease primarily related to an increase in the LIFO pool adjustment in 2004 as the company experienced significant increases in inventory prices. No other individual items created a material variance in the comparison to the prior year. Pension Benefits
The company and certain of its subsidiaries sponsor defined benefit plans that cover a substantial portion of its worldwide employees. The U.S. Salaried Pension Plans and the U.K. Pension Plan were closed to new participants in 2005 and