EX-13.1 2 ex13_1.htm EXHIBIT 13.01 exhibit 13.01
PRAXAIR'S 2005 ANNUAL REPORT TO SHAREHOLDERS
Praxair, Inc. and Subsidiaries
Exhibit 13.01


PRAXAIR, INC. AND SUBSIDIARIES
(Dollar amounts in millions, except per share data)


Year Ended December 31,
 
2005
 
2004
 
2003
 
               
Sales
 
$
7,656
 
$
6,594
 
$
5,613
 
Cost of sales, exclusive of depreciation and amortization
   
4,641
   
3,987
   
3,328
 
Selling, general and administrative
   
987
   
869
   
766
 
Depreciation and amortization
   
665
   
578
   
517
 
Research and development
   
80
   
77
   
75
 
Other income (expenses) - net
   
10
   
20
   
(5
)
Operating Profit
   
1,293
   
1,103
   
922
 
Interest expense - net
   
163
   
155
   
151
 
Income Before Taxes
   
1,130
   
948
   
771
 
Income taxes
   
376
   
232
   
174
 
     
754
   
716
   
597
 
Minority interests
   
(37
)
 
(30
)
 
(24
)
Income from equity investments
   
15
   
11
   
12
 
Income Before Cumulative Effect of Change in Accounting Principle
   
732
   
697
   
585
 
Cumulative effect of change in accounting principle (Note 2)
   
(6
)
 
-
   
-
 
Net Income
 
$
726
 
$
697
 
$
585
 
                     
Per Share Data (Note 1)
                   
Basic earnings per share
                   
Income before cumulative effect of change in accounting principle
 
$
2.26
 
$
2.14
 
$
1.79
 
Cumulative effect of change in accounting principle
   
(0.02
)
 
-
   
-
 
Net income
 
$
2.24
 
$
2.14
 
$
1.79
 
Diluted earnings per share
                   
Income before cumulative effect of change in accounting principle
 
$
2.22
 
$
2.10
 
$
1.77
 
Cumulative effect of change in accounting principle
   
(0.02
)
 
-
   
-
 
Net income
 
$
2.20
 
$
2.10
 
$
1.77
 
Weighted Average Shares Outstanding (000's) (Note 1)
                   
   Basic shares outstanding
   
323,765
   
325,891
   
326,388
 
   Diluted shares outstanding
   
329,685
   
331,403
   
330,991
 
 
               The accompanying Notes on pages 45 to 65 are an integral part of these financial statements.

AR-26



PRAXAIR, INC. AND SUBSIDIARIES
(Dollar amounts in millions, except per share data)

December 31,
 
2005
 
2004
 
           
Assets
             
Cash and cash equivalents
 
$
173
 
$
25
 
Accounts receivable
   
1,386
   
1,231
 
Inventories
   
373
   
328
 
Prepaid and other current assets
   
201
   
160
 
Total Current Assets
   
2,133
   
1,744
 
Property, plant and equipment - net
   
6,108
   
5,946
 
Equity investments
   
218
   
210
 
Goodwill
   
1,545
   
1,551
 
Other intangible assets - net
   
81
   
88
 
Other long-term assets
   
406
   
339
 
Total Assets
 
$
10,491
 
$
9,878
 
               
Liabilities and Equity
             
Accounts payable
 
$
639
 
$
502
 
Short-term debt
   
231
   
454
 
Current portion of long-term debt
   
290
   
195
 
Accrued taxes
   
199
   
129
 
Other current liabilities
   
642
   
595
 
Total Current Liabilities
   
2,001
   
1,875
 
Long-term debt
   
2,926
   
2,876
 
Other long-term liabilities
   
833
   
949
 
Deferred credits
   
627
   
345
 
Total Liabilities
   
6,387
   
6,045
 
               
Commitments and contingencies (Note 19)
             
               
Minority interests
   
202
   
225
 
Shareholders' equity
             
Common stock $0.01 par value, authorized - 800,000,000 shares,
             
 issued 2005 - 363,712,929 shares and
             
 2004 - 359,790,504 shares
   
4
   
4
 
Additional paid-in capital
   
2,489
   
2,314
 
Retained earnings
   
4,022
   
3,529
 
Accumulated other comprehensive income (loss)
   
(1,257
)
 
(1,180
)
Less: Treasury stock, at cost (2005 - 41,374,130 shares and
             
 2004 - 36,169,726 shares)
   
(1,356
)
 
(1,059
)
Total Shareholders' Equity
   
3,902
   
3,608
 
Total Liabilities and Equity
 
$
10,491
 
$
9,878
 

               The accompanying Notes on pages 45 to 65 are an integral part of these financial statements.

 
 
AR-27


 
PRAXAIR, INC. AND SUBSIDIARIES
(Millions of dollars)
Year Ended December 31,
 
2005
 
2004
 
2003
 
               
Increase (Decrease) in Cash and Cash Equivalents
         
               
Operations
             
Net income
 
$
726
 
$
697
 
$
585
 
Adjustments to reconcile net income to net cash
                   
provided by operating activities:
                   
Change in accounting principle (Note 2)
   
6
   
-
   
-
 
Depreciation and amortization
   
665
   
578
   
517
 
Deferred income taxes
   
200
   
89
   
33
 
Non-cash charges and other
   
1
   
11
   
21
 
Working capital
                   
        Accounts receivable
   
(165
)
 
(203
)
 
(96
)
        Inventories
   
(41
)
 
(24
)
 
(22
)
        Prepaid and other current assets
   
(23
)
 
6
   
(19
)
        Payables and accruals
   
192
   
153
   
78
 
Long-term assets, liabilities and other
     (86
 
(64
) 
 
40
 
Net cash provided by operating activities
   
1,475
   
1,243
   
1,137
 
                     
Investing
                   
Capital expenditures
   
(877
)
 
(668
)
 
(983
)
Acquisitions (Note 3)
   
(44
)
 
(929
)
 
(73
)
Divestitures and asset sales
   
34
   
45
   
64
 
Net cash used for investing activities
   
(887
)
 
(1,552
)
 
(992
)
                     
Financing
                   
Short-term debt repayments - net
   
(232
)
 
(113
)
 
(94
)
Long-term debt borrowings
   
453
   
924
   
1,432
 
Long-term debt repayments
   
(224
)
 
(145
)
 
(1,295
)
Minority interest transactions and other
   
(48
)
 
(8
)
 
(5
)
Issuances of common stock
   
242
   
212
   
246
 
Purchases of common stock
   
(396
)
 
(394
)
 
(271
)
Cash dividends
   
(233
)
 
(195
)
 
(149
)
Net cash provided by (used for) financing activities
   
(438
)
 
281
   
(136
)
                     
Effect of exchange rate changes on cash and cash equivalents
   
(2
)
 
3
   
2
 
Change in cash and cash equivalents
   
148
   
(25
)
 
11
 
Cash and cash equivalents, beginning-of-year
   
25
   
50
   
39
 
Cash and cash equivalents, end-of-year
 
$
173
 
$
25
 
$
50
 
                     
Supplemental Data
                   
Taxes paid
 
$
127
 
$
154
 
$
109
 
Interest paid
 
$
175
 
$
156
 
$
168
 
Tax benefits from stock option exercises
 
$
28
 
$
28
 
$
24
 
Debt from consolidation of equity companies
 
$
-
 
$
-
 
$
9
 
 
The accompanying Notes on pages 45 to 65 are an integral part of these financial statements.
 
AR-28

 
PRAXAIR, INC. AND SUBSIDIARIES
(Dollar amounts in millions, except per share data, shares in thousands)

                           
Accumulated
     
           
 
             
Other
     
 
Common Stock 
 
Additional
 
Treasury Stock
 
 
   
Comprehensive
       
                 
Paid-in  
               
Retained
    Income (Loss)        
Activity
   
Shares
   
Amounts
   
Capital
   
Shares
   
Amounts
   
Earnings
   
 (Note 9)
 
 
Total
 
                                                   
Balance, December 31, 2002
   
173,950
 
$
2
 
$
1,965
   
11,682
 
$
(547
)
$
2,593
 
$
(1,673
)
$
2,340
 
                                                   
Net income
                                 
585
         
585
 
Translation adjustments
                                       
313
   
313
 
Minimum pension liability, net of $5 million taxes
                                       
8
   
8
 
Comprehensive income
                                             
906
 
                                                   
Dividends on common stock ($0.46 per share, Note 1)
                                 
(149
)
       
(149
)
Issuances of common stock
                                                 
For the dividend reinvestment and stock purchase plan
   
48
                                       
-
 
For employee savings and incentive plans
   
3,535
         
183
   
(1,681
)
 
79
               
262
 
Purchases of common stock
                     
4,614
   
(271
)
             
(271
)
Two-for-one stock split (Note 1)
   
177,418
   
2
         
14,250
         
(2
)
       
-
 
Balance, December 31, 2003
   
354,951
 
$
4
 
$
2,148
   
28,865
 
$
(739
)
$
3,027
 
$
(1,352
)
$
3,088
 
                                                   
Net income
                                 
697
         
697
 
Translation adjustments
                                       
230
   
230
 
Minimum pension liability, net of $31 million taxes
                                       
(58
)
 
(58
)
Comprehensive income
                                             
869
 
                                                   
Dividends on common stock ($0.60 per share)
                                 
(195
)
       
(195
)
Issuances of common stock
                                                 
For the dividend reinvestment and stock purchase plan
   
106
         
4
                           
4
 
For employee savings and incentive plans
   
4,734
       
162
   
(2,758
)
 
75
               
237
 
Purchases of common stock
                     
10,063
   
(395
)
             
(395
)
Balance, December 31, 2004
   
359,791
 
$
4
 
$
2,314
   
36,170
 
$
(1,059
)
$
3,529
 
$
(1,180
)
$
3,608
 
                                                   
Net income
                                 
726
         
726
 
Translation adjustments
                                       
(28
)
 
(28
)
Minimum pension liability, net of $25 million taxes
                                       
(49
)
 
(49
)
Comprehensive income
                                             
649
 
                                                   
Dividends on common stock ($0.72 per share)
                                 
(233
)
       
(233
)
Issuances of common stock
                                                 
For the dividend reinvestment and stock purchase plan
   
88
         
4
                           
4
 
For employee savings and incentive plans
   
3,834
         
171
   
(3,216
)
 
101
               
272
 
Purchases of common stock
                     
8,420
   
(398
)
             
(398
)
Balance, December 31, 2005
   
363,713
 
$
4
 
$
2,489
   
41,374
 
$
(1,356
)
$
4,022
 
$
(1,257
)
$
3,902
 
 
The accompanying Notes on pages 45 to 65 are an integral part of these financial statements.


 
AR-29

 
MANAGEMENT'S DISCUSSION AND ANALYSIS
 

BUSINESS OVERVIEW

Praxair is the largest industrial gases supplier in North and South America, is rapidly growing in Asia, and has strong, well-established businesses in Europe. The company's primary products are oxygen, hydrogen, nitrogen, argon, carbon dioxide, helium, electronics gases and a wide range of specialty gases. Praxair Surface Technologies supplies high-performance coatings that protect metal parts from wear, corrosion and high heat. In 2005, 94% of sales was generated in four regional segments (North America, Europe, South America, and Asia) primarily from the sale of industrial gases. The Surface technologies segment generated the remaining 6% of sales.

Praxair serves approximately 25 industries as diverse as healthcare and petroleum refining; computer-chip manufacturing and beverage carbonation; fiber-optics and steel making; and aerospace, chemicals and water treatment. The diversity of end markets creates financial stability for Praxair in varied business cycles.

Praxair focuses its operational and growth strategies on the following 11 core geographies where the company has its strongest market positions and where distribution and production operations allow the company to deliver the highest level of service to its customers at the lowest cost.

North America
 
South America
 
Europe
 
Asia
United States
 
Brazil
 
Spain
 
China
Canada
     
Italy
 
India
Mexico
     
Germany/Benelux
 
Thailand
           
Korea

 
Praxair manufactures and distributes its products through a network of hundreds of production plants, pipeline complexes, distribution centers and delivery vehicles. Major pipeline complexes are located in the United States, Brazil, Spain and Germany. This network is a competitive advantage, providing the foundation of reliable product supply to the company's customer base. The majority of Praxair's sales are conducted through long-term contracts which provide stability in cash flow and the ability to pass-through changes in energy costs to its customers. The company's primary growth markets include: hydrogen for refining; oxygen for healthcare; nitrogen and carbon dioxide for oil and gas production; and high purity gases for the semiconductor manufacturing industry.

EXECUTIVE SUMMARY - FINANCIAL RESULTS & OUTLOOK

Praxair delivered strong financial results in 2005. Sales growth was driven by the company's strategy of focusing primarily on its core geographies, by above-average growth in its global hydrogen, healthcare and electronics businesses and by strong growth in its base business. New applications technologies increased industrial gas sales above underlying economic growth rates. Many of the technological applications help Praxair's customers improve their energy efficiency, reduce their environmental emissions, or improve their productivity. Operating profit and net income grew as a result of higher sales and the company's disciplined focus on fixed-cost management, productivity savings, and capital investment.

2005 YEAR IN REVIEW

w 
Sales up 16% to $7,656 million versus $6,594 million in 2004, reflecting increased sales in each of its geographic segments.

w 
Operating profit of $1,293 million, a 17% increase over $1,103 million in 2004, reflecting volume growth, higher pricing and productivity savings which more than offset higher energy costs and general cost inflation.

w 
Income before cumulative effect of change in accounting principle of $732 million and diluted earnings per share of $2.22, which included a $92-million income-tax charge ($0.28 per diluted share) related to the company's repatriation of $1.1 billion and other tax adjustments (see Note 7 to the consolidated financial statements).

w 
Cash flow from operations of $1,475 million, a 19% increase over $1,243 million in 2004.

2006 OUTLOOK

w 
Sales in the range of $8.1 billion to $8.4 billion

w 
Operating profit in the range of $1,350 million to $1,425 million, including an estimated stock option expense of $40 million

w 
Diluted earnings per share of $2.65 to $2.75, including an estimated stock option expense of $0.08

w 
Effective tax rate in the range of 26% to 27%

w 
Capital expenditures in the area of $900 million to $950 million

The above guidance should be read in conjunction with the section entitled "Forward-Looking Statements" on page 44.

Praxair provides quarterly updates on operating results, material trends that may affect financial performance, and financial earnings guidance via earnings releases and investor teleconferences. These materials are available on the company's website: www.praxair.com but are not incorporated herein.
 
AR-30

 
CONSOLIDATED RESULTS

The following table provides summary data for 2005, 2004 and 2003:

(Millions of dollars)
                   
Variance
Year Ended December 31,
 
2005
 
 
2004
 
 
2003
   
2005 vs. 2004
 
 
2004 vs. 2003
 
                                 
Sales
 
$
7,656
 
$
6,594
 
$
5,613
   
16
%
 
17
%
Gross margin (a)
 
$
3,015
 
$
2,607
 
$
2,285
   
16
%
 
14
%
      As a percent of sales
   
39.4
%
 
39.5
%
 
40.7
%
           
Selling, general and administrative
 
$
987
 
$
869
 
$
766
   
14
%
 
13
%
      As a percent of sales
   
12.9
%
 
13.2
%
 
13.6
%
           
Depreciation and amortization
 
$
665
 
$
578
 
$
517
   
15
%
 
12
%
Other income (expenses) - net
 
$
10
 
$
20
 
$
(5
)
           
Operating profit
 
$
1,293
 
$
1,103
 
$
922
   
17
%
 
20
%
Interest expense - net
 
$
163
 
$
155
 
$
151
   
5
%
 
3
%
Effective tax rate
   
33.3
%
 
24.5
%
 
22.6
%
           
Income (b)
 
$
732
 
$
697
 
$
585
   
5
%
 
19
%
Number of employees
   
27,306
   
27,020
   
25,438
   
1
%
 
6
%
                                 
(a) Gross margin excludes depreciation and amortization expense.
                 
(b) Income is before the 2005 cumulative effect of change in accounting principle. It includes a $92 million, or $0.28 per diluted share, income tax charge for the repatriation of foreign earnings pursuant to the American Jobs Creation Act of 2004 and other tax adjustments.                                                                                                 

 
2005 Compared With 2004

Sales in 2005 increased $1,062 million, or 16%, versus 2004. Favorable currency movements, principally in South America, Canada and Asia, generated 4% of sales growth. Acquisitions contributed 5% to sales growth due to the acquisition of industrial gas assets in Germany and Home Care Supply (HCS) in 2004. Underlying sales growth of 6% was driven by realized price increases in North and South America and volume growth mainly in the worldwide energy, chemicals, metals and manufacturing markets. The underlying volume growth of 2% understates the strong demand throughout the year in most of the company's end markets and regions. Volume growth was mitigated by reduced on-site volumes in North America due to temporary customer outages and business interruptions in the second half of the year partly resulting from Hurricanes Katrina and Rita. The increase in raw material costs resulting from higher natural gas prices, which Praxair is contractually entitled to pass through to on-site hydrogen customers, increased sales by $72 million, or 1%, with an insignificant impact on operating profit.

Gross margin in 2005 improved $408 million, or 16%, versus 2004, in line with the sales increase. Significant energy-cost increases, averaging 16% in 2005, and general inflation were offset by pricing increases and productivity initiatives.

Selling, general and administrative expenses in 2005 were $987 million, or 12.9% of sales, versus $869 million, or 13.2% of sales, for 2004. The $118 million increase was primarily due to the year-over-year impact of acquisitions in 2004 and currency effects. General inflationary pressures continued to be offset by worldwide cost efficiency programs.

Depreciation and amortization expense in 2005 increased $87 million, or 15%, versus 2004. The increase was primarily due to an increase in the 2005 capital base resulting from plant start-ups and increased capital spending due to the strong project backlog. Acquisitions and currency effects also contributed to the growth.
 
 

 
AR-31

 
Other income (expenses) - net in 2005 was a $10-million benefit compared to a $20-million benefit in 2004. See Note 6 to the consolidated financial statements for a summary of the major components of Other income (expenses) - net.

Operating profit in 2005 increased $190 million, or 17%, versus 2004. Strong volumes and pricing, the continued impact of productivity and cost reduction initiatives, and the contribution from acquisitions were primarily responsible for the operating profit growth. Favorable currency effects contributed 4% to operating profit growth.

Interest expense - net in 2005 increased $8 million, or 5%, versus 2004 as a result of the increase in average full-year debt levels compared to the prior year, which was due to the financing of acquisitions made in 2004.

The effective income tax rate for 2005 was 33.3% versus 24.5% in 2004. In 2005, income taxes included a charge of $92 million for the repatriation of foreign earnings pursuant to the American Jobs Creation Act of 2004 and income tax reserve and valuation allowances adjustments, and a net $9 million income tax benefit in Europe principally related to a tax legislation change (see Note 7 to the consolidated financial statements). 2004 income taxes included a $3 million income tax benefit resulting from the resolution of various tax matters. Excluding these tax items, the underlying effective tax rates were approximately 26% in 2005 and 25% in 2004. This increase was due primarily to higher earnings contributions in countries with higher marginal tax rates. For 2006, Praxair expects a full-year effective tax rate in the range of 26% to 27%.

At December 31, 2005, minority interests consisted principally of minority shareholders' investments in Europe (primarily in Italy), Asia (primarily in China and India) and North America (primarily within Praxair Distribution). The increase in minority interests of $7 million in 2005 was due to improved profitability of the entities located in Italy and China.

Praxair's significant equity investments are in Italy, the United States and Spain. The company's share of net income from corporate equity investments increased $4 million in 2005 primarily due to an asset impairment charge of $3 million recorded in 2004 for an unconsolidated joint venture.

Income in 2005 increased $35 million, or 5%, versus 2004. Income excluding the impact of the third-quarter income tax charge of $92 million increased 18%. Operating-profit growth was the primary driver of the net-income improvement.

The number of employees at December 31, 2005 was 27,306, reflecting a small increase of 286 employees from December 31, 2004.


2004 Compared With 2003

Sales in 2004 increased $981 million, or 17%, versus 2003. Strong volume growth, primarily in the energy, metals, healthcare, manufacturing, chemicals and electronics markets, increased sales by 9% as worldwide economic activity strengthened. Price increases were realized in all regional segments and increased overall sales by 2%. Currency movements, primarily in Europe, South America and Asia, favorably impacted sales growth by 3%. The increase in raw material costs tied to natural gas prices, which Praxair is contractually entitled to pass through to on-site hydrogen customers, increased sales by $40 million, or 1%, with an insignificant impact on operating profit. The acquisition of HCS in June 2004 and the German acquisition in December 2004 increased sales by 2%.

Gross margin in 2004 improved $322 million, or 14%, versus 2003. Gross margin as a percentage of sales declined 120 basis points to 39.5% versus 2003. The reduction was due primarily to the start-up of two steam-methane reformers on the U.S. Gulf Coast, which operate at lower operating margins due to the pass-through of natural gas costs in sales.

Selling, general and administrative expenses in 2004 were $869 million, or 13.2% of sales, versus $766 million, or 13.6% of sales, for 2003. The $103 million increase was primarily due to general cost inflation, acquisitions and currency increases.

Depreciation and amortization expense in 2004 increased $61 million, or 12%, versus 2003. The increase was principally due to increased capital spending in 2003, acquisitions and currency increases in Europe and South America.

Other income (expenses) - net in 2004 increased by $25 million to a $20-million benefit in 2004 compared with a $5-million loss in 2003. See Note 6 to the consolidated financial statements for a summary of the major components of Other income (expenses) - net.

Operating profit in 2004 increased $181 million, or 20%, versus 2003. Strong sales volumes, continued productivity initiatives and moderate price increases across all segments were primarily responsible for 15% of operating profit growth in 2004. Currency appreciation, primarily in Europe and South America, was responsible for the remaining 5% growth.

Interest expense in 2004 increased $4 million, or 3%, versus 2003. The debt levels and interest rates remained comparable to those in 2003 through November 2004. Interest expense increased slightly in December due to an increase in debt to finance the German acquisition.
 
 

 
AR-32

 
The effective income tax rate for 2004 was 24.5%, versus 22.6% for 2003. The increase in the effective rate was due primarily to higher earnings contributions in countries with higher marginal tax rates. Income taxes include a benefit of $3 million in 2004 and $10 million in 2003 resulting from the resolution of various tax matters from prior years. Excluding these tax items, the underlying effective tax rates were approximately 25% in 2004 and 24% in 2003.

At December 31, 2004, minority interests consist of minority shareholders' investments in Europe (primarily in Italy), Asia (primarily in China and India) and North America (primarily within Praxair Distribution). The increase in minority interest of $6 million in 2004 was due primarily to improved profitability of the entities located in Italy and China.

Praxair's significant equity investments are in Italy, the United States and Spain. The company's share of net income from corporate equity investments declined slightly to $11 million in 2004 due primarily to a $3-million asset impairment charge for an unconsolidated joint venture offset by improved profitability in other joint ventures.

Net income in 2004 increased $112 million, or 19%, versus 2003. The increase was due to improved operating profit which was partially offset by the higher effective tax rate.

The number of employees at December 31, 2004 was 27,020, reflecting an increase of 1,582 employees from December 31, 2003 due primarily to the June acquisition of HCS (+1,263) and the German acquisition (+266) in December.

Change in Accounting Principle

In the fourth quarter of 2005, Praxair completed its assessment of conditional asset retirement obligations required for the adoption of FASB Interpretation No. (FIN) 47, "Accounting for Conditional Asset Retirement Obligations." The assessment resulted in the recognition of a liability related to asset retirement obligations for assets currently in use. As a result, a $6 million non-cash transition charge to earnings was recorded as a cumulative effect of change in accounting principle. See Note 2 to the consolidated financial statements.

Related Party Transactions

The company's related parties are primarily unconsolidated equity affiliates. The company did not engage in any material transactions involving related parties that included terms or other aspects that differ from those which would be negotiated with independent parties.

Costs Relating to the Protection of the Environment

Praxair's principal operations relate to the production and distribution of atmospheric and other industrial gases, which historically have not had a significant impact on the environment. However, worldwide costs relating to environmental protection may continue to grow due to increasingly stringent laws and regulations, and Praxair's ongoing commitment to rigorous internal standards. Environmental protection costs in 2005 included approximately $10 million in capital expenditures and $21 million of expenses. Environmental protection expenditures were approximately $6 million higher in 2005 versus 2004 primarily due to increases in capital projects and increased compliance costs. Praxair anticipates that future environmental protection expenditures will be similar to 2005, subject to any significant changes in existing laws and regulations. Based on historical results and current estimates, management does not believe that environmental expenditures will have a material adverse effect on the consolidated financial position or on the consolidated results of operations or cash flows in any given year.

Legal Proceedings

See Note 19 to the consolidated financial statements for information concerning legal proceedings.

 

 
AR-33

 
SEGMENT DISCUSSION
 
The following summary of sales and operating profit by segment provides a basis for the discussion that follows (for additional information concerning Praxair's segments, see Note 4 to the consolidated financial statements):

(Millions of dollars)
                   
Variance
Year Ended December 31,
   
2005
 
 
2004
 
 
2003
 
 
2005 vs. 2004
 
 
2004 vs. 2003
 
                                 
Sales
                               
North America
 
$
4,680
 
$
4,191
 
$
3,627
   
12
%
 
16
%
Europe
   
1,105
   
847
   
699
   
30
%
 
21
%
South America
   
1,126
   
866
   
708
   
30
%
 
22
%
Asia
   
543
   
487
   
389
   
11
%
 
25
%
Surface technologies
   
475
   
447
   
400
   
6
%
 
12
%
Eliminations
   
(273
)
 
(244
)
 
(210
)
           
   
$
7,656
 
$
6,594
 
$
5,613
   
16
%
 
17
%
                                 
Operating Profit
                               
North America
 
$
685
 
$
623
 
$
548
   
10
%
 
14
%
Europe
   
263
   
214
   
170
   
23
%
 
26
%
South America
   
202
   
152
   
114
   
33
%
 
33
%
Asia
   
95
   
80
   
64
   
19
%
 
25
%
Surface technologies
   
48
   
34
   
26
   
41
%
 
31
%
   
$
1,293
 
$
1,103
 
$
922
   
17
%
 
20
%


North America

The North America segment includes Praxair's industrial and packaged gases operations in the U.S., Canada and Mexico. North America also includes several product lines servicing the electronics and healthcare markets.

Sales for 2005 increased $489 million, or 12%, versus 2004. Acquisitions contributed 2% to sales growth due to the mid-year 2004 acquisition of HCS. Underlying sales growth of 7% was due to higher pricing and volumes, as compared to 2004. Pricing increased sales by 5% and was the result of the contractual pass-through of higher power costs to on-site customers, surcharges for higher power and transportation fuel costs for merchant and packaged gases, and the impact of pricing actions. Volume growth of 2% reflects strong merchant liquid and packaged gases volumes offset by lower on-site volumes, which was primarily a result of customer outages on the U.S. Gulf Coast in the second half of 2005, resulting in reduced volumes to the chemicals and refining industries. Volumes to general manufacturing markets were strong throughout the year. Merchant-liquid demand was strong in most end markets, particularly energy and oil well services. Strong results in Canada and Mexico also contributed to sales growth. The increase in raw material costs resulting from higher natural gas prices, which Praxair is contractually entitled to pass through to on-site hydrogen customers, increased sales by $72 million, or 2%, with an insignificant impact on operating profit.

Operating profit in 2005 increased $62 million, or 10%, versus 2004. Acquisitions and currency favorably impacted operating profit growth by 3%. Underlying growth was 7%, in line with sales growth, from the combined impact of pricing actions and cost reduction activities, which more than offset the significantly higher energy costs and underlying general cost inflation.

On June 14, 2004, Praxair acquired 100% of the outstanding common shares of HCS for a purchase price of $245 million. HCS was the largest privately-held home-respiratory and medical-equipment provider in the United States with 59 locations in 13 states. See Note 3 to the consolidated financial statements for additional information related to the acquisition.
 
 
 
AR-34

 
Sales for 2004 increased $564 million, or 16%, versus 2003. Higher demand in the energy, manufacturing, metals and chemicals marketplaces led to strong volume growth of 9%. Acquisitions contributed 3% to sales growth, driven primarily by the HCS acquisition. Overall price increases of 3% were primarily driven by price attainment in Praxair's Canadian and U.S. packaged-gas business, on-site business and in Mexico. The increase in raw material costs resulting from higher natural gas prices, which Praxair is contractually entitled to pass through to on-site hydrogen customers, increased sales by $40 million, or 1%, with an insignificant impact on operating profit.

Operating profit in 2004 increased $75 million, or 14%, versus 2003. Stronger sales to the manufacturing, metals, chemicals and electronics markets was the primary driver to operating-profit growth. Total productivity and pricing actions largely offset underlying inflationary pressures. Acquisitions and currency favorably impacted operating profit by 2%. Operating profit as a percentage of sales decreased 20 basis points to 14.9%. This decline was solely due to the HCS acquisition and the start-up of two steam-methane reformers in the third quarter, both of which operate at lower operating margins. Excluding the effect of the acquisition and the new hydrogen business, operating profit as a percentage of sales was higher than 2003 levels by 30 basis points.


Europe

Praxair's European industrial gases business is primarily in Italy, Spain, Germany, the Benelux region and France. On December 2, 2004, Praxair acquired industrial gas assets and related businesses in Germany for a purchase price of $667 million. The acquired assets and businesses consist of industrial gas plants and pipeline assets in the Rhine/Ruhr and Saar areas, bulk distribution and packaged-gas businesses. The businesses serve large customers in the refining, chemical and steel industries along the pipeline systems, in addition to 40,000 smaller customers in bulk, medical, specialty and packaged gases. See Note 3 to the consolidated financial statements for additional information related to the acquisition.

Sales for 2005 increased $258 million, or 30%, versus 2004. The full-year impact of the German acquisition accounted for 28% of the sales growth. The favorable impact of the stronger euro increased sales by 1%. Excluding the acquisition and the impact of currency, sales increased 1% due to higher volumes from new business and applications. Organic business activity remained stable, with modest volume growth in Spain and Germany offsetting weaker volumes in Italy and Western Europe due to a slowing economic environment.

Operating profit for 2005 increased $49 million, or 23%, versus 2004. The contribution of the German acquisition accounted for most of the operating-profit growth. Inflationary pressures continued to be largely offset by productivity programs.

Sales for 2004 increased $148 million, or 21%, versus 2003. The favorable impact of the stronger euro increased sales by 10%. Acquisitions accounted for approximately 6% of the sales growth, driven by the German acquisition and the full-year impact of the 2003 consolidation of Indugas, a former joint venture. Excluding the acquisitions and the impact of currency, sales increased 4% due to improved volumes. Liquid and packaged-gas volumes in Spain, Italy, and Western Europe remained at healthy levels as the metals, healthcare and electronics markets continued to grow at robust levels.

Operating profit for 2004 increased $44 million, or 26%, versus 2003. The improvement in operating profit was principally due to the continued favorable impact of a stronger euro and increased sales, each of which generated half of the increase. Cost reductions related to productivity programs primarily offset inflation on existing cost structures.

South America

Praxair's South American industrial gases operations are conducted by its subsidiary, White Martins Gases Industriais Ltda. (White Martins), the largest industrial gases company in Brazil. White Martins also manages Praxair's operations in Argentina, Bolivia, Chile, Colombia, Paraguay, Peru, Uruguay and Venezuela.

Sales for 2005 increased $260 million, or 30%, versus 2004. The favorable impact of currency increased sales by 17%. Excluding the impact of currency, sales increased 13%, driven by higher pricing and volumes primarily to the manufacturing and healthcare markets.

Operating profit increased $50 million, or 33%, versus 2004. Higher pricing and cost-reduction programs outpaced underlying inflation pressures, favorably impacting operating profit. The favorable impact of currency contributed 15% to operating profit growth in 2005.

Sales for 2004 increased $158 million, or 22%, versus 2003. The sales improvement was driven by volume increases of 9% and realized price increases of 9% to on-site, liquid and packaged-gases customers.
 
 
AR-35

 
Currency improvements increased sales by 4%. Continued strong volume increases in the metals, manufacturing and healthcare markets principally drove the sales volume growth.

Operating profit increased $38 million, or 33%, versus 2003. The increase in operating profit was principally due to the increase in sales and the favorable impact of currency fluctuations, which grew operating profit by 21% and 12%, respectively. Continued cost savings initiatives and pricing offset inflationary impacts on cost structures.

 
Asia

The Asia segment includes Praxair's industrial gases operations in China, India, Korea and Thailand, with smaller operations in Japan, Malaysia and Taiwan.

Sales for 2005 increased $56 million, or 11%, versus 2004. Strong volume growth, primarily to the electronics and metals markets, contributed 9% to the increase. The increase in sales to electronics, the segment's largest end-market, was due to sales of sputtering targets and strong demand for specialty gases for the semiconductor and LCD markets. Growth in the on-site and liquid product lines, primarily in China, Korea and Thailand, also contributed to volume increases. Pricing declined by 2%. Favorable pricing trends in Thailand and India were offset by pricing declines in electronics specialty gases. Favorable currency movements improved sales by 4%.

Operating profit for 2005 increased $15 million, or 19%, versus 2004. The increase in operating profit was a result primarily of volume growth and cost-efficiency improvements in the supply system.

Sales for 2004 increased $98 million, or 25%, versus 2003. Strong volume growth, primarily in the electronics, metals and chemicals markets, increased sales by 18%. Realized price increases were 3% for the year and favorable currency movement improved sales by 2%. The 2003 consolidation of a former joint venture in China increased sales by 2%.

Operating profit for 2004 increased $16 million, or 25%, versus 2003. The improvement in operating profit was a result primarily of the strong volumes, which increased operating profit by 25%. The 2003 consolidation of a former joint venture added 4% growth for the year. Cost-reduction initiatives largely offset the negative impact of inflation.


Surface technologies

Surface technologies provides high-performance coatings and thermal-spray powders in the U.S. and Europe, with smaller operations in Asia and Brazil.

Sales for 2005 increased $28 million, or 6%, versus 2004. Higher volumes of coatings for OEM aircraft engine parts primarily drove the overall volume increase of 3%. Industrial coatings for power turbines and oil field service components also were higher compared to the prior year. Realized price increases were 2%.
 
Operating profit for 2005 increased $14 million, or 41%, versus 2004. The increase was principally driven by the higher sales volumes. Pricing actions and cost reduction activities offset increasing raw material costs.

Sales for 2004 increased $47 million, or 12%, versus 2003. The favorable impact of currency increased sales by $22 million, or 6%, compared to the prior year. Volume increased 6%, primarily as a result of higher volumes of high-end coating sales for OEM aircraft engine parts and other industrial coatings. The aviation-repair business continued to be soft, reflecting the weak financial condition of the commercial airline industry.
 
Operating profit for 2004 increased $8 million, or 31%, versus 2003. The increase in operating profit was driven by benefits from increased volumes, primarily of industrial coatings, and the benefits of prior-year cost-reduction initiatives.
 
 

 
AR-36

 
Currency

The results of Praxair's non-U.S. operations are translated to the company's reporting currency, the U.S. dollar, from the functional currencies used in the countries in which the company operates. For most foreign operations, Praxair uses the local currency as its functional currency. There is inherent variability and unpredictability in the relationship of these functional currencies to the U.S. dollar and such currency movements may materially impact Praxair's results of operations in any given period.

To help understand the reported results, the following is a summary of the significant currencies underlying Praxair's consolidated results and the exchange rates used to translate the financial statements (rates of exchange expressed in units of local currency per U.S. dollar):


   
Percent of
                   
   
2005
 
Income Statement
 
Balance Sheet
   
Consolidated
 
Average Year Ended December 31,
 
December 31,
Currency
 
Sales (a)
 
2005
 
2004
 
2003
 
2005
 
2004
European euro
 
  17%
 
0.80
 
0.81
 
0.89
 
0.85
 
0.73
Brazilian real
 
12%
 
2.43
 
2.92
 
3.06
 
2.34
 
2.65
Canadian dollar
 
9%
 
1.21
 
1.31
 
1.41
 
1.17
 
1.21
Mexican peso
 
4%
 
10.96
 
11.30
 
10.74
 
10.68
 
11.13
Chinese RMB
 
2%
 
8.20
 
8.28
 
8.28
 
8.07
 
8.28
Indian rupee
 
2%
 
44.02
 
45.41
 
46.74
 
45.20
 
43.74
Korean won
 
2%
 
1,027
 
1,151
 
1,192
 
1,013
 
1,046
Argentinean peso
 
1%
 
2.92
 
2.94
 
2.95
 
3.03
 
2.98
Venezuelan bolivar
 
<1%
 
2,107
 
1,883
 
1,609
 
2,150
 
1,920

(a)  
Certain Surface technologies segment sales are included in European and Brazilian sales.


 
AR-37


LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL DATA

(Millions of dollars)
             
Year Ended December 31,
   
2005
   
2004
 
 
2003
 
Net Cash Provided by (Used for)
                   
                     
Operating Activities
                   
Net income plus depreciation and
                   
amortization and change in accounting principle
 
$
1,397
 
$
1,275
 
$
1,102
 
Working capital
   
(37
)
 
(68
)
 
(58
)
Other - net
   
115
   
36
   
93
 
Total provided by operating activities
 
$
1,475
 
$
1,243
 
$
1,137
 
                     
Investing Activities
                   
Capital expenditures
 
$ 
(877
)
$
(668
)
$
(983
)
Acquisitions
   
(44
)
 
(929
)
 
(73
)
Divestitures and asset sales
   
34
   
45
   
64
 
Total used for investing
 
$
(887
)
$
(1,552
)
$
(992
)
                     
Financing Activities
                   
Debt increases (reductions) - net
  $
(3
)
$
666
 
$
43
 
Minority transactions and other
   
(48
)
 
(8
)
 
(5
)
Issuances (purchases) of stock - net
   
(154
)
 
(182
)
 
(25
)
Cash dividends
   
(233
)
 
(195
)
 
(149
)
Total provided by (used for) financing
  $
(438
)
$
281
 
$
(136
)
                     
Other Financial Data (a)
                   
                     
Debt-to-capital ratio
   
45.6
%
 
47.9
%
 
46.2
%
After-tax return on capital
   
13.2
%
 
12.5
%
 
12.8
%
 
 
(a)
Non-GAAP measures. See the Appendix on page 70 for definitions and reconciliations to reported amounts.
 
Cash Flow from Operations 
 
 
2005

Cash flow from operations increased $232 million to $1,475 million in 2005 from $1,243 million in 2004. The growth is a result of the strong cash flow generated from the improved operating profits on higher sales and continued focus on the management of working capital which grew at a slower pace than sales. Pension contributions were $140 million in 2005.

2004
 
Cash flow from operations increased $106 million to $1,243 million in 2004 from $1,137 million in 2003. The growth was a result of the strong cash flow generated from the improved profits on higher sales, partially offset by cash used for worldwide pension contributions of approximately $119 million.

Investing 
 
(a) Includes the purchase of  previously leased
assets for $339 million (see Note 5 to the
consolidated financial statements).

2005

Net cash used for investing activities of $887 million in 2005 decreased $665 million versus 2004. Cash used for acquisitions decreased by $885 million as 2004 included the German and HCS acquisitions. This decrease was partially offset by higher capital expenditures in 2005, which increased $209 million to $877 million, reflecting a strong backlog of projects that will begin production in 2006 and 2007.

Acquisition expenditures in 2005 were $44 million, related primarily to the purchase of a North American packaged gas distributor in December.

Divestitures and asset sales in 2005 totaled $34 million, a decrease of $11 million from 2004. An increase in underlying asset sales in 2005 was offset by a $20-million sale of assets in Europe related to a customer contract termination in 2004.

On a worldwide basis, capital expenditures for 2006 are expected to be in the range of $900 million to $950 million, with investments in many of the company's end markets including energy, metals and manufacturing. By region, the largest amount of forecasted capital expenditures is expected to be in North America and Asia. By end-market, the largest concentration is expected to be in energy. The spending will fund growth activities, maintenance and cost-reduction programs in each of the company's segments. At December 31, 2005, $596 million of capital expenditures had been approved and committed.
 
AR-38

 
2004

Net cash used for investing activities of $1,552 million in 2004 increased $560 million versus 2003 due primarily to the two significant 2004 acquisitions, partially offset by a reduction in capital expenditures. Capital expenditures in 2004 totaled $668 million, a decrease of $315 million from 2003, which included the purchase of leased assets for $339 million.

Acquisition expenditures in 2004 were $929 million, an increase of $856 million from 2003. The 2004 expenditures related primarily to the German and HCS acquisitions.

Proceeds from divestitures and asset sales in 2004 were $45 million, a decrease of $19 million from 2003. The 2003 time period included $50 million related to the sale of Praxair's Polish business which was offset by the $20-million asset sale related to a customer contract termination.


Financing
 

Praxair's financing strategy is to secure long-term committed funding at attractive interest rates by issuing U.S. public notes and debentures and commercial paper backed by a standby long-term bank credit agreement. Its international operations are funded through a combination of local borrowing and inter-company funding to minimize the total cost of funds and to manage and centralize currency exchange exposures. As deemed necessary, Praxair manages its exposure to interest-rate changes through the use of financial derivatives (see Note 14 to the consolidated financial statements and the section entitled "Market Risks and Sensitivity Analyses" on page 43).

At December 31, 2005, Praxair's total debt outstanding was $3,447 million, $78 million lower than $3,525 million at December 31, 2004. The December 31, 2005 debt balance includes $2,177 million in public notes and $1,270 million representing primarily worldwide bank borrowings. At December 31, 2005, Praxair was in compliance with its borrowing covenants and its global effective borrowing rate was approximately 5%. See Note 13 to the consolidated financial statements for additional information on the company's indebtedness.

Cash used for financing activities was $438 million in 2005 compared to cash provided by financing activities of $281 million in 2004. The swing in cash used for financing activities is largely due to net proceeds from debt issuances of $666 million in 2004 to fund the German and HCS acquisitions. Cash used for dividend payments increased $38 million to $0.72 per share compared to $0.60 in 2004, an increase of 20%. Cash used for minority transactions and other increased $40 million to $48 million in 2005 due primarily to dividend payments to a minority shareholder in Italy.

In 2005, the company executed a plan to repatriate $1.1 billion of undistributed foreign earnings pursuant to the American Jobs Creation Act of 2004 (see Note 7 to the consolidated financial statements). To fund the repatriation for Europe and Canada, the company entered into a five-year, $400-million revolving credit facility and a five-year, $200-million revolving credit facility with a syndicate of international banks. At December 31, 2005, $253 million and $140 million were outstanding against the $400-million facility and $200-million facility, respectively. The proceeds received in connection with these borrowings were used to finance the repatriation and were temporarily used in the United States primarily to repay short term borrowings and commercial paper. Also during 2005, Praxair repaid $150 million of 6.85% notes that were due on June 15, 2005. The repayment was funded through the issuance of commercial paper. See Note 13 to the consolidated financial statements for further information related to the company's indebtedness.
 
 

 
AR-39

 
Other Financial Data

The following discussion includes non-GAAP measures that may not be comparable to similar definitions used by other companies. Praxair believes that its debt-to-capital ratio is appropriate for measuring its financial leverage. The company believes that its after-tax return on capital ratio is an appropriate measure for judging performance as it reflects the approximate after-tax profit earned as a percentage of investments by all parties in the business (debt, minority interests and shareholders' equity). See the Appendix on page 70 for definitions and reconciliation of these two non-GAAP measures to reported amounts.

Praxair's debt-to-capital ratio decreased 230 basis points to 45.6% at December 31, 2005 over 2004. The improvement is attributed to an increase in shareholders' equity due to 2005 net income slightly offset by an increase in 2005 dividends declared and paid.

After-tax return on capital increased 70 basis points to 13.2% at December 31, 2005 compared to 2004 due to increased 2005 operating profit partially offset by an increase in average capital year-over-year.

Off-Balance Sheet Arrangements and Contractual Obligations

The following table sets forth Praxair's material contractual obligations and other commercial commitments as of December 31, 2005:
 
(Millions of dollars)
 
Contractual Obligations
 
Other Commercial Commitments
 
 
   
Debt and 
   
Obligations
                               
Due or
   
Capitalized
   
Under
   
Unconditional
                         
Expiring by
   
Lease
   
Operating
   
Purchase
         
Construction
   
Guarantees
       
December 31,
   
Maturities
   
Leases
   
Obligations
   
Total
   
Commitments
   
and Other
   
Total
 
                                             
2006
 
$
521
 
$
81
 
$
160
 
$
762
 
$
456
 
$
67
 
$
523
 
2007
   
541
   
60
   
111
   
712
   
118
   
-
   
118
 
2008
   
564
   
46
   
97
   
707
   
22
   
2
   
24
 
2009
   
542
   
34
   
75
   
651
   
-
   
-
   
-
 
2010
   
400
   
24
   
53
   
477
   
-
   
-
   
-
 
Thereafter
   
879
   
89
   
318
   
1,286
   
-
   
5
   
5
 
   
$
3,447
 
$
334
 
$
814
 
$
4,595
 
$
596
 
$
74
 
$
670
 
                                             


Debt and capitalized lease maturities of $3,447 million exclude interest thereon, are more fully described in Note 13 to the consolidated financial statements and are included on the company's balance sheet as long- and short-term liabilities. Maturities of short-term borrowings under revolving credit facilities of $533 million and $393 million are included in 2009 and 2010 maturities, respectively, due to the company's ability and intent to refinance amounts outstanding against these facilities through the final maturity date under such agreements.

Obligations under operating leases of $334 million represent non-cancelable contractual obligations primarily for manufacturing and distribution equipment and office space. See Note 5 to the consolidated financial statements for further details.

Unconditional purchase obligations of $814 million represent contractual commitments under various long- and short-term take-or-pay arrangements with suppliers. These obligations are primarily minimum-purchase commitments for helium, electricity, natural gas and feedstock used to produce atmospheric gases, carbon dioxide and hydrogen. During 2005, payments under these contracts totaled $562 million, including $237 million for electricity and $218 million for natural gas. A significant portion of these obligations are passed on to customers through similar take-or-pay contractual arrangements. Purchase obligations that are not passed along to customers do not represent a significant risk to Praxair. Praxair generally enters into contracts to purchase products and services that do not have minimum purchase provisions.

Construction commitments of $596 million represent outstanding commitments to customers or suppliers to complete authorized construction projects as of December 31, 2005. A significant portion of Praxair's capital spending is related to the construction of new production facilities to satisfy customer commitments which may take a year or more to complete.

Guarantees and other of $74 million include $12 million related to required minimum pension contributions and $62 million related to Praxair's contingent obligations under guarantees of certain debt of unconsolidated affiliates.
 
 
 
AR-40

 
Unconsolidated equity investees had total debt of approximately $215 million at December 31, 2005, which was non-recourse to Praxair with the exception of the guaranteed portions described above. Praxair has no financing arrangements with closely-held related parties.

See Note 19 to the consolidated financial statements for more information concerning commitments and contingencies. In addition, see Note 9 to the consolidated financial statements for a summary of long-term liabilities which consist primarily of pension and other post-retirement benefit costs (OPEB).


Pension Benefits

The non-cash minimum pension liability increased $74 million to $315 million at December 31, 2005 ($206 million after-tax) from $241 million at December 31, 2004 ($157 million after-tax). The increase in the minimum pension liability was due primarily to an update to the mortality assumption and a decrease in the discount rate assumption used for the U.S. Pension Plans. The increase did not affect net income as the offsetting, after-tax charge was made to Accumulated other comprehensive income within Shareholders' equity pursuant to U.S. GAAP.

Pension contributions were $140 million in 2005 and $119 million in 2004. Estimates of 2006 contributions are in the area of $100 million, of which $12 million is required. During January 2006, contributions of $84 million were paid to Praxair's U.S. Pension Plans.

Praxair assumes an expected return on plan assets for 2006 in the U.S. of 8.25%. In 2006, consolidated pension expense is expected to be approximately $53 million versus $44 million in 2005 and $37 million in 2004.


Insurance

Praxair purchases insurance to limit a variety of risks, including those related to workers' compensation, third-party liability and property. Currently, the company self-retains the first $5 million per occurrence for workers' compensation and general liability and retains $2.5 million to $5 million per occurrence for its various properties worldwide. To mitigate its aggregate loss potential above varying retentions, the company purchases insurance coverage from highly rated insurance companies at what it believes are reasonable coverage levels. This includes Praxair's participation in a property insurance consortium for which some of the premiums are retrospective in nature and may increase due to the overall loss experience of all members within the consortium. At December 31, 2005 and 2004, the company had recorded a total of $42 million and $43 million, respectively, representing an estimate of the retained liability for the ultimate cost of claims incurred and unpaid as of the balance sheet dates. The estimated liability is established using statistical analyses and is based upon historical experience, actuarial assumptions and professional judgment. These estimates are subject to the effects of trends in loss severity and frequency and are subject to a significant degree of inherent variability. If actual claims differ from the company's estimates, financial results could be impacted.

Praxair recognizes estimated insurance proceeds relating to damages at the time of loss only to the extent of incurred losses. Any insurance recoveries for business interruption and for property damages in excess of the net book value of the property are recognized only when realized.

CRITICAL ACCOUNTING POLICIES

The policies discussed below are considered by management to be critical to understanding Praxair's financial statements and accompanying Notes prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). Their application places significant importance on management's judgment as a result of the need to make estimates of matters that are inherently uncertain. Praxair's financial position, results of operations and cash flows could be materially affected if actual results differ from estimates made. These policies are determined by management and have been reviewed by Praxair's Audit Committee.

Depreciable Lives of Property, Plant and Equipment

Praxair's net property, plant and equipment at December 31, 2005 was $6,108 million, representing 58% of the company's consolidated total assets. Depreciation expense for the year ended December 31, 2005 was $649 million, or 10% of total operating costs. Management judgment is required in the determination of the estimated depreciable lives that are used to calculate the annual depreciation expense and accumulated depreciation.

Property, plant and equipment are recorded at cost and depreciated over the assets' estimated useful lives on a straight-line basis for financial-reporting purposes. The estimated useful life represents the projected period of time that the asset will be productively employed by the company and is determined by management based on many factors, including historical experience with similar assets, technological life
 
AR-41

 
cycles, geographic locations and contractual supply relationships with on-site customers. Circumstances and events relating to these assets, such as on-site contract modifications, are monitored to ensure that changes in asset lives or impairments (see "Asset Impairment" below) are identified and prospective depreciation expense or impairment expense is adjusted accordingly. Praxair's largest asset values relate to cryogenic air-separation production plants with average depreciable lives of 15 years.

Based upon the assets as of December 31, 2005, if depreciable lives of machinery and equipment, on average, were increased or decreased by one year, annual depreciation expense would be decreased by approximately $29 million or increased by approximately $32 million, respectively.

Pension Benefits

Pension benefits represent financial obligations that will be ultimately settled in the future with employees who meet eligibility requirements. Because of the uncertainties involved in estimating the timing and amount of future payments, significant estimates are required to calculate pension expense and liabilities related to the company's plans. The company utilizes the services of several independent actuaries, whose models are used to facilitate these calculations.

Several key assumptions are used in actuarial models to calculate pension expense and liability amounts recorded in the financial statements. Management believes the three most significant variables in the models are the expected long-term rate of return on plan assets, the discount rate, and the expected rate of compensation increase. The actuarial models also use assumptions for various other factors, including employee turnover, retirement age, and mortality. Praxair management believes the assumptions used in the actuarial calculations are reasonable, reflect the company's experience and expectations for the future and are within accepted practices in each of the respective geographic locations in which it operates. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.

The weighted-average expected long-term rates of return on pension plan assets were 8.50% for U.S. plans and 7.75% for international plans for the years ended December 31, 2005 and 2004. These rates are determined annually by management based on a weighted average of current and historical market trends, historical and expected portfolio performance and the current and expected portfolio mix of investments. A 0.50% change in these expected long-term rates of return, with all other variables held constant, would change Praxair's pension expense by approximately $6 million.

The weighted-average discount rates for pension plan liabilities were 5.62% for U.S. plans and 5.45% for international plans at December 31, 2005 (5.85% and 5.50%, respectively, at December 31, 2004). These rates are used to calculate the present value of plan liabilities and are determined annually by management. The discount rate for the U.S. plan is established utilizing a bond matching model provided by the company's independent actuaries. The portfolio of bonds includes only Moody's Aa-graded corporate bonds and matches the U.S. plan's projected cash flows to the spot rates and calculates the single equivalent discount rate which produces the same present value. The discount rates for the international plans are based on market yields for high-quality fixed income investments representing the approximate duration of the pension liabilities on the measurement date. A 0.50% change in discount rates, with all other variables held constant, would change Praxair's pension expense by approximately $10 million and would impact the projected benefit obligation (PBO) by approximately $114 million.

The weighted-average expected rate of compensation increase was 3.25% for U.S. plans and 3.0% for international plans at December 31, 2005 and 3.0% for U.S. and international plans at December 31, 2004. The estimated annual compensation increase is determined by management every year and is based on historical trends and market indices. A 0.50% change in the expected rate of compensation increase, with all other variables held constant, would change Praxair's pension expense by approximately $4 million and would impact the PBO by approximately $21 million. A change in this assumption usually coincides  with a change in the discount rate assumption, and the earnings impacts generally offset one another.


Asset Impairment

Goodwill

At December 31, 2005, the company had goodwill of $1,545 million, which represents the aggregate of excess purchase price for acquired businesses over the fair value of the net assets acquired. The company performs a goodwill impairment test annually or more frequently if events or circumstances indicate that an impairment loss may have been incurred. The impairment test requires that the company estimate and
 
 
AR-42


compare the fair value of its reporting units to their carrying value. As of December 31, 2005, goodwill was assigned to eight reporting units in amounts ranging from $1 million to $952 million. Fair value is determined through the use of projected future cash flows, multiples of earnings and sales and other factors.
 
Such analysis requires the use of certain future market assumptions and discount factors, which are subjective in nature. Estimated values can be affected by many factors beyond the company's control such as business and economic trends, government regulation, and technological changes. Management believes that the assumptions used to determine fair value are appropriate and reasonable. However, changes in circumstances or conditions affecting these assumptions could have a significant impact on the fair value determination, which could then result in a material impairment charge to the company's results of operations.

See Note 11 to the consolidated financial statements for disclosures concerning the carrying value of goodwill.

Property, Plant and Equipment

Property, plant and equipment is tested for impairment whenever events or changes in circumstances indicate that the carrying amount of an individual asset or asset group may not be recoverable. To test recoverability, the company compares management's best estimate of the future cash flows expected to be generated from the asset or asset group to compare against the carrying amount of the asset or asset group. Should these undiscounted future cash flows be less than the carrying amount of the asset or asset group, an impairment charge reducing the carrying amount to fair value is required. Fair value is determined based on the most appropriate valuation technique, including discounted cash flows. This analysis requires management to make various subjective estimates and assumptions, including the amount of projected future cash flows related to the potentially impaired asset or asset group, the useful life over which cash flows will occur and the asset's residual value, if any.

 
Income Taxes

At December 31, 2005, Praxair had deferred tax assets of $473 million (net of valuation allowances of $206 million), and deferred tax liabilities of $935 million. Income tax expense was $376 million for the year ended December 31, 2005.

In the preparation of consolidated financial statements, Praxair estimates income taxes based on diverse legislative and regulatory structures that exist in various jurisdictions where the company conducts business. Deferred income tax assets and liabilities represent tax benefits or obligations that arise from temporary differences due to differing treatment of certain items for accounting and income tax purposes. Praxair evaluates deferred tax assets each period to ensure that estimated future taxable income will be sufficient in character (e.g. capital gain versus ordinary income treatment), amount and timing to result in their recovery. A valuation allowance is established when management determines that it is more likely than not that a deferred tax asset will not be realized to reduce the assets to their realizable value. Considerable judgments are required in establishing deferred tax valuation allowances and in assessing probable exposures related to tax matters. Praxair's tax returns are subject to audit and local taxing authorities could challenge the company's tax positions. The company's practice is to review tax-filing positions by jurisdiction and to record provisions for probable tax assessments, including interest and penalties when assessed, if applicable. Praxair believes it records and/or discloses such potential tax liabilities as appropriate and has reasonably estimated its income tax liabilities and recoverable tax assets.

NEW ACCOUNTING STANDARDS

See Notes 1 and 2 to the consolidated financial statements for information concerning new accounting standards and for information regarding the 2005 change in accounting principle, respectively.


MARKET RISKS AND SENSITIVITY ANALYSES

Praxair is exposed to market risks relating to fluctuations in interest rates and currency exchange rates. The objective of financial risk management at Praxair is to minimize the negative impact of interest rate and foreign exchange rate fluctuations on the company's earnings, cash flows and equity.

To manage these risks, Praxair uses various derivative financial instruments, including interest-rate swaps, currency swaps, forward contracts and commodity contracts. Praxair only uses commonly traded and non-leveraged instruments. These contracts are entered into primarily with major banking institutions thereby minimizing the risk of credit loss. Also, see Notes 1 and 14 to the consolidated financial statements for a more complete description of Praxair's accounting policies and use of such instruments.
 
 

 
AR-43

 
The following discussion presents the sensitivity of the market value, earnings and cash flows of Praxair's financial instruments to hypothetical changes in interest and exchange rates assuming these changes occurred at December 31, 2005. The range of changes chosen for these discussions reflect Praxair's view of changes which are reasonably possible over a one-year period. Market values represent the present values of projected future cash flows based on interest rate and exchange rate assumptions.


Interest Rate and Debt Sensitivity Analysis

At December 31, 2005, Praxair had debt totaling $3,447 million ($3,525 million at December 31, 2004). There were no interest-rate swap agreements outstanding at December 31, 2005 and 2004, respectively. As considered necessary, interest-rate swaps are entered into as hedges of underlying financial instruments to effectively change the characteristics of the interest rate without actually changing the underlying financial instrument. For fixed-rate instruments, interest-rate changes affect the fair market value but do not impact earnings or cash flows. Conversely, for floating-rate instruments, interest-rate changes generally do not affect the fair market value but impact future earnings and cash flows, assuming other factors are held constant.

At December 31, 2005, Praxair had fixed-rate debt of $2,241 million and floating-rate debt of $1,206 million, representing 65% and 35%, respectively, of total debt. At December 31, 2004, Praxair had fixed-rate debt of $2,458 million and floating-rate debt of $1,067 million, representing 70% and 30%, respectively, of total debt. Holding other variables constant (such as foreign exchange rates, swaps and debt levels), a one-percentage-point decrease in interest rates would increase the unrealized fair market value of the fixed-rate debt by approximately $71 million ($97 million in 2004). At December 31, 2005 and 2004, the after-tax earnings and cash flows impact for the subsequent year resulting from a one-percentage-point increase in interest rates would be approximately $8 million and $7 million, respectively, holding other variables constant.


Exchange Rate Sensitivity Analysis

Praxair's exchange-rate exposures result primarily from its investments and ongoing operations in South America (primarily Brazil, Argentina and Venezuela), Europe (primarily Italy, Spain, and Germany), Canada, Mexico, Asia (primarily China, India, Korea and Thailand) and other business transactions such as the procurement of equipment from foreign sources. Among other techniques, Praxair utilizes foreign exchange forward contracts to hedge these exposures. At December 31, 2005, Praxair had $768 million notional amount ($679 million at December 31, 2004) of foreign exchange contracts of which $756 million ($679 million in 2004) were to hedge recorded balance-sheet exposures or forecasted transactions and $12 million were to hedge anticipated net income (none at December 31, 2004). At December 31, 2005, Praxair's net income hedges related to anticipated net income in South America which settled on January 2, 2006.
 
Holding other variables constant, if there were a 10% adverse change in foreign-currency exchange rates for the portfolio, the fair market value of foreign-currency contracts outstanding at December 31, 2005 and 2004 would decrease by approximately $5 million and $35 million, respectively, which would be offset by an equal but offsetting gain or loss on the foreign-currency fluctuation of the underlying exposure being hedged.

FORWARD-LOOKING STATEMENTS

This document contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's reasonable expectations and assumptions as of the date the statements are made but involve risks and uncertainties. These risks and uncertainties include, without limitation: the performance of stock markets generally; developments in worldwide and national economies and other international events and circumstances; changes in foreign currencies and in interest rates; the cost and availability of electric power, natural gas and other raw materials; the ability to achieve price increases to offset cost increases; catastrophic events; the ability to attract, hire, and retain qualified personnel; the impact of changes in financial accounting standards; the impact of tax and other legislation and government regulation in jurisdictions in which the company operates; the cost and outcomes of litigation and regulatory agency actions; continued timely development and market acceptance of new products and applications; the impact of competitive products and pricing; future financial and operating performance of major customers and industries served; and the effectiveness and speed of integrating new acquisitions into the business. These risks and uncertainties may cause actual future results or circumstances to differ materially from the projections or estimates contained in the forward-looking statements. The company assumes no obligation to update or provide revisions to any forward-looking statement in response to changing circumstances. The above listed risks and uncertainties are further described in Item 1A (Risk Factors) in the company's latest Annual Report on Form 10-K filed with the SEC which should be reviewed carefully. Please consider the company's forward-looking statements in light of those risks.


 
AR-44


 
 
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 

Operations - Praxair, Inc. (Praxair or company) is one of the largest industrial gases companies worldwide, the largest in North and South America. Praxair produces, sells and distributes atmospheric, process and specialty gases, and high-performance surface coatings to a diverse group of industries including aerospace, chemicals, electronics, energy, food and beverage, healthcare, manufacturing and metals.
 
Principles of Consolidation - The consolidated financial statements include the accounts of all significant subsidiaries where control exists and, in limited situations, variable-interest entities where the company is the primary beneficiary. Equity investments generally consist of 20% to 50% owned operations where the company exercises significant influence. Operations less than 20% owned, where the company does not exercise significant influence, are generally carried at cost. Pre-tax income from equity investments that are partnerships or limited-liability corporations (LLC) is included in Other income (expenses) - net with related taxes included in Income taxes and remaining equity earnings are reported as Income from equity investments, net of income taxes. Partnership and LLC net assets are reported as Equity investments in the balance sheet. Significant inter-company transactions are eliminated and any significant related-party transactions have been disclosed.

Use of Estimates - The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and to disclose contingent assets and liabilities at the date of the financial statements during the reporting period. While actual results could differ, management believes such estimates to be reasonable.

Revenue Recognition - Revenue is recognized when: a firm sales agreement exists; product is shipped or services are provided to customers; and collectibility of the fixed or determinable sales price is reasonably assured. A small portion of the company's revenues relate to long-term construction contracts and are generally recognized using the percentage-of-completion method. Under this method, revenues from sales of major equipment, such as large air-separation facilities, are recognized based primarily on cost incurred to date compared with total estimated cost. Changes to total estimated cost and anticipated losses, if any, are recognized in the period determined. For contracts that contain multiple products and/or services, amounts assigned to each component are based on its objectively determined fair value, such as the sales price for the component when it is sold separately or competitor prices for similar components. Certain of the company's customer contracts qualify for lease accounting treatment under EITF Issue 01-8, "Determining Whether an Arrangement Contains a Lease." The associated revenue streams are classified as rental revenue and are not significant for the years ended 2005, 2004 and 2003. Sales returns and allowances are not a normal practice in the industry and are de minimis.

Amounts billed for shipping and handling fees are recorded as sales, generally on FOB destination terms, and costs incurred for shipping and handling are recorded as cost of sales.

Cash Equivalents - Cash equivalents are considered to be highly liquid securities with original maturities of three months or less.

Inventories - Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for certain U.S. operations and the average-cost method for most other operations.

Property, Plant and Equipment - Net - Property, plant and equipment are carried at cost, net of accumulated depreciation. The company capitalizes interest as part of the cost of constructing major facilities (see Note 6). Depreciation is calculated on the straight-line method based on the estimated useful lives of the assets, which range from 3 years to 40 years (see Note 10). Praxair uses accelerated depreciation methods for tax purposes where appropriate.

The company performs a test for impairment whenever events or changes in circumstances indicate that the carrying amount of an individual asset or asset group may not be recoverable. Should projected undiscounted future cash flows be less than the carrying amount of the asset or asset group, an impairment charge reducing the carrying amount to fair value is required. Fair value is determined based on the most appropriate valuation technique, including discounted cash flows.
 
Asset-Retirement Obligations - An asset-retirement obligation is recognized in the period in which sufficient information exists to determine the fair value of the liability with a corresponding increase to the carrying amount of the related property, plant and equipment which is then depreciated over its useful life. The liability is initially measured at discounted fair value and then accretion expense is recorded in each subsequent period. The company's asset-retirement obligations are primarily associated with its on-site long-term supply arrangements where the company has built a facility on land leased from the customer and is obligated to remove the facility at the end of the contract term. The company's asset-retirement obligations are not material to its financial statements.
 
 

 
AR-45

 
Foreign Currency Translation - For most foreign operations, the local currency is the functional currency and translation gains and losses are reported as part of the Accumulated other comprehensive income (loss) component of Shareholders' equity as a cumulative translation adjustment (see Note 9). For other foreign operations, the U.S. dollar is the functional currency and translation gains and losses are included in income.

Financial Instruments - Praxair enters into various derivative financial instruments to manage its exposure to fluctuating interest and currency exchange rates and energy costs. Such instruments primarily include interest-rate swap agreements; currency swap; forward contracts; and commodity-swap agreements. These instruments are not entered into for trading purposes. Praxair only uses commonly traded and non-leveraged instruments. There are two types of derivatives the company enters into: hedges of fair-value exposures and hedges of cash-flow exposures. Fair-value exposures relate to recognized assets or liabilities, and firm commitments; while cash-flow exposures relate to the variability of future cash flows associated with recognized assets or liabilities, or forecasted transactions.

When a derivative is executed and hedge accounting is appropriate, it is designated as either a fair-value hedge or a cash-flow hedge. Currently, Praxair designates all interest-rate and commodity-swap agreements as hedges; however, currency contracts are generally not designated as hedges for accounting purposes. All derivatives are linked to an appropriate underlying exposure. On an ongoing basis, the company assesses the hedge effectiveness of all derivatives designated as hedges to determine if they continue to be highly effective in offsetting changes in fair values or cash flows of the underlying hedged items. If it is determined that the hedge is not highly effective, then hedge accounting will be discontinued prospectively.

Changes in the fair value of derivatives designated as fair-value hedges are recognized in earnings as an offset to the change in the fair values of the exposures being hedged. The changes in fair value of derivatives that are designated as cash-flow hedges are deferred in Accumulated other comprehensive income (loss) and are recognized in earnings as the underlying hedged transaction occurs. Any ineffectiveness is recognized in earnings immediately. Derivatives that are entered into for risk-management purposes and are not designated as hedges (primarily related to anticipated net income and currency derivatives other than for firm commitments) are recorded at their fair market values and recognized in current earnings.

The company recognizes the changes in the fair value associated with currency contracts as follows: hedges of debt instruments are recorded in Interest expense and generally offset the underlying hedged items; hedges of other balance-sheet exposures, commodity contracts, forecasted transactions, lease obligations, firm commitments and anticipated future net income are recognized in Other income (expenses) - net and generally offset the underlying hedged items; and hedges of net investments in foreign subsidiaries are recognized in the cumulative translation adjustment component of Accumulated other comprehensive income (loss) on the consolidated balance sheet to offset translation gains and losses associated with the hedged net investment.

Praxair uses the following methods and assumptions to estimate the fair value of each class of financial instrument. The fair value of interest-rate swaps and currency-exchange contracts is estimated based on market prices obtained from independent dealer or market quotes. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. Due to their nature, the carrying value of cash, short-term investments and short-term debt, receivables and payables approximates fair value.

Goodwill - When a business is acquired, the excess of the purchase price over the fair value of the assets and liabilities acquired is recorded as goodwill (see Note 11). Goodwill is reviewed annually in April or more frequently if events or circumstances indicate that an impairment may have occurred. The impairment test requires that the company estimate and compare the fair value of its reporting units to their carrying value. Fair value is determined through the use of projected future cash flows, multiples of earnings and sales and other factors.

Other Intangible Assets - Patents are recorded at historical cost and are amortized over their remaining useful lives. Customer and license/use agreements, non-compete agreements and other intangibles are amortized over the estimated period of benefit. The determination of the estimated period of benefit will be dependent upon the use and underlying characteristics of the intangible asset. Praxair evaluates the recoverability of its intangible assets subject to amortization when facts and circumstances indicate that the carrying value of the asset may not be recoverable. If the carrying value is not recoverable, impairment is measured as the amount by which the carrying value exceeds its estimated fair value. Fair value is generally estimated based on either appraised value or other valuation techniques.
 
 
 
AR-46

 
Income Taxes - Deferred income taxes are recorded for the temporary differences between the financial statement and tax bases of assets and liabilities using currently enacted tax rates. Valuation allowances are established against deferred tax assets whenever circumstances indicate that it is more likely than not that such assets will not be realized in future periods. The provision for income taxes includes probable exposures for tax matters and related interest and penalties when assessed, if applicable.
 
Pension and Other Retirement Programs - Most Praxair employees worldwide are covered by various pension plans. The cost of pension benefits under these plans is determined using the projected-unit-credit actuarial cost method. Funding of pension plans varies and is in accordance with local laws and practices.

Praxair accrues the cost of retiree life and health insurance benefits during the employees' service period when such benefits are earned.

Post-employment Benefits - Praxair recognizes the estimated cost of future benefits provided to former and inactive employees after employment but before retirement on the accrual basis.

Stock Split - On October 28, 2003, Praxair's board of directors declared a two-for-one split of the company's common stock. The stock split was effected in the form of a stock dividend of one additional share for each share owned by stockholders of record on December 5, 2003, and each share held in treasury as of the record date. Information pertaining to shares, earnings per share and dividends per share has been restated in the accompanying financial statements.

Stock-based Compensation - Praxair accounts for incentive plans and stock options using the provisions of Accounting Principles Board Opinion 25, "Accounting for Stock Issued to Employees." Pro forma information required by Statement of Financial Accounting Standard (SFAS) 123, "Accounting for Stock-Based Compensation," as amended by SFAS 148, requires Praxair to disclose pro forma net income and pro forma earnings per share amounts as if compensation expense was recognized based on fair values for options granted after 1994. Pro forma net income and the related basic and diluted earnings per share amounts would be as follows:




(Dollar amounts in millions, except per share data)
                   
Year Ended December 31,
   
2005
 
 
2004*
 
 
2003*
 
                     
Net Income
                   
As reported
 
$
726
 
$
697
 
$
585
 
Less: total stock-based employee
                   
compensation expense determined under fair value
                   
based method for all awards, net of related tax effects
   
(26
)
 
(28
)
 
(28
)
Pro forma net income
 
$
700
 
$
669
 
$
557
 
                     
Basic Earnings Per Share
                   
As reported
 
$
2.24
 
$
2.14
 
$
1.79
 
Pro forma
 
$
2.16
 
$
2.05
 
$
1.71
 
Diluted Earnings Per Share
                   
As reported
 
$
2.20
 
$
2.10
 
$
1.77
 
Pro forma
 
$
2.12
 
$
2.02
 
$
1.68
 
 
*Pro forma net income amounts have been decreased by $1 million in each of 2004 and 2003 ($0.00 and $0.01 per diluted share, respectively) from amounts previously reported, reflecting a change in expense recognition methodology related to full-retirement-eligible employees in accordance with the required provisions of SFAS 123R. SFAS 123R requires Praxair to recognize the compensation cost related to stock option awards granted to full-retirement-eligible employees over the period from the grant date to the date retirement eligibility is achieved (currently 1 year). Previously, Praxair recognized compensation cost over the nominal vesting period (generally 3 years). As a result, when Praxair adopts SFAS 123R effective January 1, 2006, compensation cost will be stated consistently with the prior periods' pro forma amounts.

The weighted-average fair value of options granted during 2005 was $10.16 ($10.67 in 2004 and $9.24 in 2003). These values, which were used as a basis for the pro forma disclosures, were estimated using the Black-Scholes Options-Pricing Model with the following weighted-average assumptions used for grants in 2005, 2004, and 2003:


Year Ended December 31,                                         
2005
 
2004
 
2003
             
Dividend yield
1.6%
 
1.4%
 
1.3%
Volatility
22.7%
 
32.5%
 
36.5%
Risk-free interest rate
3.9%
 
3.0%
 
2.9%
Expected term years
5
 
5
 
6

These pro forma disclosures may not be representative of the effects for future years as options vest over several years and additional awards generally are made each year. Refer to the discussion below addressing the issuance of SFAS No. 123R.

 
AR-47

 
Recently Issued Accounting Standards

In May 2004, the FASB issued FASB Staff Position (FSP) 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," which provides guidance on how to account for the impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 on post-retirement health care plans. See Note 18 where the company addresses the impact of the subsidy.

In December 2004, the FASB issued a revision to SFAS No. 123, "Accounting for Stock-Based Compensation," entitled SFAS No. 123 (revised 2004), (or "SFAS 123R"), "Share-Based Payment." This statement, among other things, requires companies to expense the value of employee stock options and similar awards and becomes effective for interim and annual periods beginning in the first annual period beginning after June 15, 2005, and applies to all outstanding and unvested share-based payment awards at the company's adoption date. Praxair will adopt the provisions of this statement for its interim period beginning January 1, 2006. This statement's provisions are expected to reduce diluted earnings per share by about $0.08 per year or $0.02 per quarter once adopted. See Note 17 for information related to incentive plans and stock options.

In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29." SFAS No. 153 specifies the criteria required to record a nonmonetary exchange using the carryover basis. The company adopted SFAS No. 153 as of July 1, 2005 and will apply the provisions of this statement prospectively to nonmonetary asset exchange transactions. The adoption of this statement did not have a material impact on the company's consolidated financial statements.


In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3." SFAS No. 154 requires retrospective application for changes in accounting principle whenever practicable, rather than including the cumulative effect of an accounting change in net income in the period of change. SFAS No. 154 applies to voluntary changes in accounting principle and also changes required by new accounting pronouncements if specific transition provisions are not provided. This statement is effective for Praxair beginning January 1, 2006.


Reclassifications - Certain prior years' amounts have been reclassified to conform to the current year's presentation.


NOTE 2. CHANGE IN ACCOUNTING PRINCIPLE

Praxair adopted FIN 47, "Accounting for Conditional Asset Retirement Obligations," effective December 31, 2005. This interpretation provides guidance on when a company has sufficient information to reasonably estimate an asset-retirement obligation's fair value as required under SFAS 143, "Accounting for Asset Retirement Obligations." Under FIN 47, uncertainty as to the timing and/or method of settlement of a conditional asset-retirement obligation should be factored into the measurement of the liability when sufficient information exists. At December 31, 2005, the company recognized transition amounts for existing asset-retirement obligation liabilities, associated capitalizable costs and accumulated depreciation to date. An after-tax transition charge of $6 million was recorded as the cumulative effect of a change in accounting principle for the year ended December 31, 2005.


NOTE 3. ACQUISITIONS

The results of operations of the following acquired businesses have been included in Praxair's consolidated statements of income since their respective dates of acquisition.
 
AR-48

 
Constar LLC

On December 31, 2005, Praxair acquired the packaged gas business and facilities of Constar LLC for a purchase price of $31 million. The acquisition resulted in approximately $12 million of goodwill. The business includes 10 facilities in Georgia, Tennessee and South Carolina which fill and distribute high-pressure industrial, medical and specialty-gas cylinders and other gas containers. Constar also operates several retail stores for the sale of welding and related equipment, supplies and services. The acquisition facilitated Praxair's expansion into a new geography and strengthened the company's ability to serve customers throughout North America.

The allocations of the excess purchase price are based upon preliminary estimates and assumptions. Accordingly, the allocations are subject to revision when the company receives final information, including appraisals and other analyses.

German Acquisition

On December 2, 2004, Praxair acquired certain industrial gas assets and related businesses in Germany for a purchase price of €497 million plus acquisition and other costs of €7 million (or $667 million as of the date of acquisition). The acquisition resulted in approximately $258 million of goodwill. Intangible assets acquired of approximately $28 million consist of covenants not to compete, land rights and other intangible assets which are being amortized over a weighted-average life of 10 years. The purchase was funded largely by a €450 million, five-year revolving-credit arrangement which Praxair entered into with a syndicate of international banks in November 2004 (see Note 13). The assets and businesses acquired consist of industrial gas plants and pipeline assets in the Rhine/Ruhr and Saar areas, and bulk distribution and packaged gas businesses. The businesses serve large customers in the refining, chemical and steel industries along the pipeline systems, plus smaller customers in bulk, medical, specialty and packaged gases. The acquisition significantly strengthened Praxair's operations in the Germany/Benelux region.

Home Care Supply (HCS)

On June 15, 2004, Praxair acquired 100% of the outstanding common shares of Home Care Supply, Inc. (HCS) for a purchase price of $245 million. The acquisition resulted in approximately $172 million of goodwill. Intangible assets acquired of approximately $12 million consist of customer relationships and covenants not to compete which are being amortized over a weighted-average life of 3 years. Headquartered in Beaumont, Texas, HCS was a privately held home-respiratory and medical-equipment provider in the United States. The acquisition expanded Praxair's home-healthcare presence from the mid-Atlantic to Texas, provides an excellent platform for sustained growth and will further accelerate Praxair's hospital-to-home strategy.

Other acquisitions in 2005, 2004, and 2003 were not significant.


NOTE 4. SEGMENT INFORMATION

The company's operations are organized into five reportable segments, four of which have been determined on a geographic basis of segmentation: North America, Europe, South America and Asia. In addition, Praxair operates its worldwide surface technologies business through its wholly owned subsidiary, Praxair Surface Technologies, Inc., which represents the fifth reportable segment.

Praxair's operations consist of two major product lines: industrial gases and surface technologies. The industrial gases product line centers on the manufacturing and distribution of atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). Many of these products are co-products of the same manufacturing process. Praxair manufactures and distributes nearly all of its products and manages its customer relationships on a regional basis. Praxair's industrial gases are distributed to various end markets within a regional segment through one of three basic distribution methods: on-site or tonnage; merchant liquid; and packaged or cylinder gases. The distribution methods are generally integrated in order to best meet the customer's needs and very few of its products can be economically transported outside of a region. Therefore, the distribution economics are specific to the various geographies in which the company operates and is consistent with how management assesses performance.

Praxair evaluates the performance of its reportable segments based primarily on operating profit, excluding inter-company royalties and special charges. Sales are determined based on the country in which the legal subsidiary is domiciled. Corporate and globally managed expenses, and research and development costs relating to Praxair's global industrial gases business, are allocated to operating segments based on sales. Long-lived assets include property, plant and equipment, other intangible assets and goodwill.
 
AR-49

 
The table below presents information about reported segments for the years ended December 31, 2005, 2004 and 2003:


   
2005
 
 
2004
 
 
2003
 
                     
Sales
                   
North America
 
$
4,680
 
$
4,191
 
$
3,627
 
Europe
   
1,105
   
847
   
699
 
South America
   
1,126
   
866
   
708
 
Asia
   
543
   
487
   
389
 
Surface technologies
   
475
   
447
   
400
 
Eliminations
   
(273
)
 
(244
)
 
(210
)
   
$
7,656
 
$
6,594
 
$
5,613
 
Operating Profit
                   
North America
 
$
685
 
$
623
 
$
548
 
Europe
   
263
   
214
   
170
 
South America
   
202
   
152
   
114
 
Asia
   
95
   
80
   
64
 
Surface technologies
   
48
   
34
   
26
 
   
$
1,293
 
$
1,103
 
$
922
 
Total Assets (a)
                   
North America
 
$
5,500
 
$
5,210
 
$
4,638
 
Europe
   
1,706
   
1,866
   
1,145
 
South America
   
1,764
   
1,405
   
1,275
 
Asia
   
977
   
847
   
707
 
Surface technologies
   
544
   
550
   
540
 
   
$
10,491
 
$
9,878
 
$
8,305
 
Depreciation and Amortization
                   
North America
 
$
373
 
$
344
 
$
313
 
Europe
   
101
   
72
   
59
 
South America
   
91
   
70
   
60
 
Asia
   
63
   
55
   
50
 
Surface technologies
   
37
   
37
   
35
 
   
$
665
 
$
578
 
$
517
 
Capital Expenditures and Acquisitions
                   
North America (Notes 3 and 5)
 
$
517
 
$
573
 
$
763
 
Europe (Note 3)
   
107
   
756
   
115
 
South America
   
154
   
96
   
88
 
Asia
   
126
   
153