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KBR, Inc. (NYSE:KBR)

Q3 FY08 Earnings Call

October 31, 2008, 11:00 AM ET

Executives

Rob Kukla, Jr. - Director, IR

William P. "Bill" Utt - President and CEO

T. Kevin DeNicola - Sr. VP and CFO

Analysts

Andy Kaplowitz - Lehman Brothers

Vance Edelson - Morgan Stanley

Jamie Cook - Credit Suisse

Barry Bannister - Stifel Nicolaus

Dan Pickering - Pickering Energy Partners, Inc.

Steven Fisher - UBS Investment Research

John B. Rogers - D.A. Davidson & Co.

Operator

Good day and welcome to the KBR 2008 Third Quarter Earnings Call hosted by KBR. This call is being recorded. As a reminder, your lines will be in a listen-only mode for the duration of the call. There will be a question-and-answer session immediately following prepared remarks and you will receive instructions at that time.

For opening remarks and introductions, I would like to turn the call over to Mr. Rob Kukla, Director of Investor Relations. Please go ahead.

Rob Kukla, Jr. - Director, Investor Relations

Thanks Teresa. Good morning and welcome to KBR third quarter 2008 earnings conference call. Today's call is also being webcast and a replay will be available on KBR's website for seven days. The press release announcing the third quarter results is also available on KBR's website.

Joining me today are Bill Utt, Chairman, President and Chief Executive Officer; and Kevin DeNicola, Senior Vice President and Chief Financial Officer. In today's call, Bill will provide opening remarks and business outlook. Kevin will address KBR's operating performance, financial position, backlog and other financial items. We will welcome questions after we complete our prepared remarks.

Before turning the call over to Bill, I would like to remind our audience that today's comments may include forward-looking statements, reflecting KBR's views about future events and their potential impact on performance. These matters involve risks and uncertainties that could impact operations and financial results and cause our actual results to differ from our forward-looking statements. These risks are discussed in KBR's Form 10-K for the year-ended December 31, 2007, KBR's quarterly reports on Forms 10-Q and KBR's current reports on Form 8-K.

Now, I'll turn the call over to Bill Utt. Bill?

William P. "Bill" Utt - President and Chief Executive Officer

Thanks Rob and good morning everyone. I am very pleased with KBR's third quarter results. Consolidated KBR revenue for the third quarter of 2008 totaled $3 billion, up almost 39% from the $2.2 billion for the third quarter of 2007.

Year-over-year improved quarterly revenue was obviously led by a 600% increase for services which accounts for the addition of BE&K into the KBR financials. Next was a 35% increase for Upstream, a 34% increase for Downstream and a 12% increase in G&I.

Income from continuing operations for the third quarter of 2008 was $74 million or $0.44 per diluted share compared to $60 million or $0.35 per diluted share for the prior year third quarter, representing a 23% increase.

Last quarter I spoke in great detail about the adverse and unexpected jury award of $40 million related to a 2003 LogCAP III subcontract, which resulted in a second quarter charge of $0.15 per share. I was very pleased that our judgment has been answered in the case on August 26th, which reduced the total judgment to just over $27 million. A $13 million reduction positively impacted income from continuing operations for the third quarter of 2008 by $0.05 per share.

KBR still believes there are additional arrears in the award and we are evaluating our options which may include a settlement or an appeal. Based on the ultimate outcome, we believe that a majority of these costs are ultimately billable to our customer. Also during the third quarter of 2008, the Gulf Coast region, particularly Galveston and Houston bore the brunt of hurricane Ike on Friday, September 12th. After the hurricane, much of the downtown area was inaccessible and millions of residents were without power, some for several weeks.

KBR's Houston offices were back up and running on the Wednesday after the hurricane. Although damage to KBR's facilities was minimal a few floors in the KBR tower did sustain broken windows which caused water damage. Events surrounding hurricane Ike did have a negative impact on KBR's third quarter earnings of approximately $0.04 to $0.05 per share, primarily related to a few days of un-billable work hours, while KBR's offices were closed as well as for facility repair expenses net of insurance.

I am very pleased with the backlog growth both with and without the BE&K acquisition. As a result of the close of BE&K on July 1, 2008, backlog increased approximately $2 billion. Total backlog increased to $15.3 billon at the end of September 2008. A 21% increase from the sequential quarter and a 27.1% increase from the September 2007 quarter. Without the impact of BE&K, KBR's backlog increased 5% over the sequential quarter and a little over 10% over the prior third quarter.

Now let me discuss some operational highlights for our KBR business units. With respect to our Upstream business unit, each of KBR's LNG projects and our lump-sum turnkey projects remain profitable. This key to LNG project continues to proceed very well and at the end of the third quarter was 30% complete. At the end of September 2008, the Tangguh LNG project was 97% complete. And we expect the first range to complete in early 2009.

The Yemen LNG project remains on track for the completion of the first train in the first half of 2009. At the end of the third quarter of 2008, the Yemen LNG project was 89% complete.

During the third quarter, KBR announced that Kellogg joint venture group was awarded a work authorization by Chevron, Australia to finalize the front-end engineering and design work for the Chevron operated Gorgon project. This is positive news in regards to the importance of this project to our customer and essentially funds the project through the final investment decision.

The continued work on the field for the project is going very well and was a nice contributor to the third quarter results. We are helping our customer in reevaluating the scope and scale of the facility, which is now comprised of three 5 million metric ton per annum trains, as they work towards a final investment decision. We remain pleased with the current pipeline of projects across Upstream end-markets and are well positioned to convert these prospects into future work for KBR.

For government and infrastructure, the first couple of Request for Proposals or RFPs under the LogCAP IV contract have been issued and two bids have been formally submitted. These RFPs have been relatively small in terms of dollar amounts in comparison to the overall LogCAP III spent.

With regards to our customers' primary objective of diversifying the contractors on the LogCAP IV project, we would not be surprised if KBR does not win these initial transition task orders as we expect the customer to use these early task orders to engage and establish other contracts, other contractors in the LogCAP operations. Until we complete transition from LogCAP III to LogCAP IV occurs which could possibly be in the back half of 2009.

We expect our work under LogCAP III to essentially continue at present levels. We have previously guided that under LogCAP IV, KBR's experience of work in the region should enable it to win its spare share work, which we estimate to be approximately 40 plus percent of the work. We also believe that LogCAP IV should yield an increase margin over the current LogCAP III work.

We are continuing to experience a strong selling throughout our other G&I businesses. In the Middle East area, we see continued demand for commercial and core several infrastructure projects. Even at the current oil prices, the Gulf Cooperation Council countries remain committed to major development of infrastructure, which includes housing and retail commercial projects as well as several projects such as roads and bridges.

KBR is currently the program manager for the Palm Island project in the United Arab Emirates, and we have strong relationships with our customers in the region. We are also seeing a willingness to outsource defense support services from countries in the region that are friendly with the western countries. These defense support services would be in areas, where KBR would leverage on its past LogCAP experience including logistics, support services, defense infrastructure and training.

In the Asia-Pacific area, we are seeing strong demand particularly in the minerals markets. There are several projects located in the region including Australia, Indonesia and India that are need of design, construction and mining facility management services.

KBR is currently working on several iron ore and coal mining projects in Australia for Rio Tinto and BHP Billiton. We have also been pursuing opportunities for the Department of Defense and Ministry of Defense in the UK outside of the LogCAP III contract; in other geographical areas such as Europe, Africa and other parts of the Middle-East. These services would include supporting deploy troops, infrastructure construction, logistics and support services. The exact same expertise and experience that KBR is providing under the LogCAP contract and the Allenby & Connaught project.

I am also pleased that no additional charges were taken during the quarter on the Skopje Embassy project. And the progress is being made to close out the construction activities in a reasonable manner. At the end of September 2008, the project was essentially 82% complete. We maintain our position that the project will be substantially complete and we'll achieve early occupancy in January of 2009.

Last week the G&I business unit announced two project awards. The first was related to multiple project task orders by the U.S. Army Corp of Engineers under its current CENTCOM Multiple Award Task Order contract valued at $197 million. Under this competitively big contract, KBR will provide design, engineering, construction management and project management services on improving and repairing runways, taxiways, hangars, maintenance facilities and communication towers at several airfields in Iraq.

The second award was also from the U.S. Army Corp of Engineers that will allow KBR to compete for future task orders under their Omaha District Security, Disaster, Infrastructure and Construction contract which has a total contract value of $490 million to be dispersed among three contractors. Under the contract and a part of award of future task orders, KBR will provide a full range of construction services to support the fast track construction projects to various federal agencies.

The KBR services business unit revenue and backlog grew substantially in the third quarter of 2008 because of the BE&K acquisition. With this acquisition services grew from about 5% of total KBR revenue in the second quarter of 2008, to almost 18% of total KBR revenue in the third quarter of 2008.

The integration of BE&K into KBR is going very well and we are ahead of our cost synergy targets which we will continue to expect to be in the range of $13 million a year. These savings began on the closing date and will be fully implemented by January 1, 2009, by which time the majority of transition work will be complete.

During the third quarter of 2008, BE&K contributed a few cents to KBR's earnings per share. Since the close of the BE&K acquisition, we have been very pleased with the awards BE&K has received. One of the strategic aspects of the BE&K acquisition was to enable BE&K to leverage KBR's larger balance sheet and available capital resources to pursue and capture larger projects than they were able to do historically. Two such awards over the past several months reflect this success.

First, BE&K was awarded a $232 million contract for the construction of an activated carbon plant in Red River Parish, Louisiana for ADA-ES, Inc. Under this contract BE&K will provide full engineering procurement and construction services on this plant.

Second, although the contract value was not publicly disclosed BE&K was awarded a contract for full engineering, procurement and construction services for a new baghouse unit by Georgia Power for their Plant Scherer near Macon, Georgia. The EPC services will include the installation of a new baghouse, major new ductwork and ancillary facilities for Georgia Power's 3200 megawatt coal fire power facility.

Other rewards for BE&K include a $64 million contract by EFACEC Power Transformers for the construction of a power transformer manufacturing facility in Rincon, Georgia and a contract by Weyerhaeuser to rebuild a large recovery boiler at its cellulose fiber mill located in Columbus, Mississippi.

Earlier this month, KBR acquired Wabi Development Corporation, an Ontario based general contractor for approximately $19.5 million. This acquisition expands KBR's capabilities which currently revolve around upgrading and utilities work to more mining extraction and primary separation work in Northern Alberta. This acquisition will allow KBR to utilize and expand its resource base to include both ABTU and CLIC labor resources. The Wabi's fiscal year ended July 31, 2007, Wabi generated approximately Canadian $124 million in revenue and we acquired Wabi for about three times EBITDA multiple. The Canadian heavy oil market still remains strong and we expect some good work to come from this market; especially building up the Wabi acquisition.

Additionally, KBR's joint venture in Mexico to provide offshore maintenance and repair services to platforms in the Gulf of Mexico recently signed two long term contracts that will utilize both of our vessels. For our Downstream business unit, the Ras Tanura and the Yanbu Export Refinery projects in Saudi Arabia contributed significantly to the third quarter results. The EBIC project continues to progress very well and is approximately 99% complete. Construction and commissioning is targeted to be complete in the first quarter of 2009. Opportunities in the Downstream pipeline continue to remain solid.

And now I will turn the call over to Kevin. Kevin?

T. Kevin DeNicola - Senior Vice President and Chief Financial Officer

Okay, thanks Bill. I'll begin by reviewing KBR's consolidated third quarter 2008 results which primarily focus on year-over-year comparisons. Our consolidated KBR revenue for the third quarter of 2008 totaled $3 billion compared to $2.2 billion in the third quarter of 2007. Consolidated operating income was $144 million in third quarter of 2008 compared to an income of $102 million in the third quarter of 2007.

Operating income in the third quarter of 2008 included a $13 million partial reversal of the $40 million second quarter charge related to the Asko [ph] litigation. Operating income in the third quarter of 2007 included $18 million pretax gain on the sale of KBR's interest in the Brown & Root-Condor joint venture in Algeria and a $6 million gain related to a favorable settlement on a road project.

And before discussing each business unit, I'd would like to explain the new reported business unit called Other, which you saw in this morning's press release and Form 10-Q and this new Other business unit represents BE&K's engineering and technical labor brokerage business, which is called Alstace [ph] which provides staffing for external projects. And we have not yet decided how it will be properly allocated to KBR's core business units.

Upstream revenue was $550 million in the third quarter of 2008 up $143 million or 35% from the third quarter of 2007. Business unit income was $53 million at third quarter compared to $57 million reported in the third quarter of '07. Business unit income in the third quarter of '07 included and $18 million pretax gain on the sale of BRC.

Partially offsetting the year-over-year decline were increases in the Skikda LNG project increased work scope on Gorgon LNG project. North rank and two off shore project in Australia, the Kashagan project in the Caspian area and an FPSO project.

Government and infrastructure revenue in the third quarter of 08 was $1.8 billion compared to $1.6 billion for the prior year third quarter. Business unit was $104 million in the third quarter including the $30 million partial reversal of the $40 million second quarter charge related to the Asko litigation. And that compares to $98 million in third quarter of '07 which includes a $6 million gain related to a favorable settlement on our road project.

The increase in business unit income was related to a LogCAP III work, a UK facilities project in Iraq for the Ministry of Defense, higher levels of construction activity on the Allenby & Connaught project and multiple water projects in Australia and Scotland.

Services revenue was $539 million in the third quarter up from $77 million in the third quarter of '07. Business unit income was $27 million compared to $6 million for the prior third quarter due primarily to the addition of BE&K projects. Third quarter of '08 results also benefited from work on the Scotford upgraded project in Canada, service and maintenance vessels in the Gulf of Mexico and several industrial services projects.

Downstream revenue was a $138 million in the third quarter of '08 compared to a $103 million in the third quarter of '07. Business unit income was $15 million in the third quarter compared to $4 million in the prior third quarter. The increase in business unit income was primarily driven by the addition of BE&K projects in progress on the Ras Tanura integrated project in Saudi Arabia.

Technology revenue for the third quarter of '08 was $19 million compared to 26 in the third quarter of '07. Business unit income in the third quarter of '08 was $4 million compared to $5 million for the prior year third quarter. Decrease primarily relates to several projects with lower activity during the third quarter compared to the previous year's third quarter, which was partially offset by a fluid cat crack in revamp project in Colombia.

Now with respect to the ventures unit, business unit income for the third quarter was zero or breakeven compared to a loss of $3 million for the third quarter of 2007. And the improvement was primarily related to no further losses recorded on the Alice Springs-

Darwin Railroad project. Investment in this railroad was reduced to below zero in the second quarter to the extent of our future funding obligations.

Now let's review other financial items. General and administrative expenses in third quarter were $55 million, that's up $3 million from the second quarter of '08. And that's primarily related to BE&K. For the full year we expect corporate cost to be approximately $225 million, which includes the impact from the BE&K acquisition.

Our effective tax rate for the third quarter was 36%. That was flat compared to the second quarter of 2008. Now, with three full quarters of implementation of our tax strategy to diligently utilize foreign tax credits, we now expect the full year 2008 effective rate to be in the 36% to 37% range.

Our total backlog at September 30, 2008 was $15.3 billion compared to $12.6 billion at June 30th. This sequential backlog increase was primarily due to the addition of the backlog from BE&K, which added approximately $2 billion to the backlog as of July 1, 2008 close. Also, additional work added to our Middle-East operations. Overall, the backlog portfolio mix at the end of the third quarter was 80% cost reversible, 20% fixed price, which compares to 76% and 24% respectively to the sequential quarter.

Now let me turn to liquidity and the balance sheet; at the end of the September 2008, our balance sheet remains strong with no debt and cash and cash equivalents of $1.1 billion of which $302 million is cash associated with our consolidated joint ventures and another $236 million from advance payments related to our contract in progress.

And total cash balance decreased by $446 million during the third quarter of 2008, primarily driven by approximately $550 million related to the BE&K acquisition, approximately $196 related to KBR's share repurchase program. Partially offsetting this decline was an increase of $91 million related to our consolidated joint ventures and a $20 million increase in advance payments on a contract in progress.

Total cash flows provided by operating activities for the first nine months ended September 30th was $1 million, which included payments of $158 million related to net committed cash from advance payments from consolidated joint ventures, and other consolidated subsidiaries and a contract in progress. And this compares to total cash flows as used in operating activities of $24 million for the first six months ended June 30, 2008. While we run the topic of cash, let me take a few moments to discuss our outlook for further users of cash.

With financial and banking issues currently dominating political discussions, we believe that terms with strong balance sheet particularly from a cash and debt perspective, we will be in a better position to function and capture opportunities to grow the businesses. And KBR continues to have strong cash position and were certainly causing the fact that in these financial times company must be diligent in their cash management.

We continue to have plenty of credit revolver capacity available but we still need to maintain our strong balance sheet to help weather the tough times that the overall economy is experiencing.

As you are aware KBR initiated and completed a share repurchase program during the third quarter of 2008 which resulted in 8.4 million shares being repurchased at an average purchase price of $22.35. This repurchase program was certainly the right thing at that point in time. And we're certainly aware of where the stock prices today, but given the current state of the U.S. capital markets, we're taking a more conservative approach to evaluating our options for another program.

And KBR also remains committed to actively pursuing opportunistic acquisitions similar to the Wabi acquisition that Bill spoke about earlier. Working capital Iraq was $123 million at the end of the third quarter of 2008 and that's down approximately $88 million from the sequential quarter due to timing of collections and receivables.

Capital expenditure totaled $11 million. Depreciation was $16 million during the third quarter of 2008. Capital expenditures were up approximately $3 million compared to the sequential quarter, primarily due to increased real estate and IT spending. And we have revised our expectation for capital expenditures for full year 2008 to be just over $50 million that's including the BE&K, that's from the previously discussed expectations of less than $60 million.

As you may have noticed in the income statement the minority interest and net losses and subsidiaries in line for the third quarter of 2008 was $22 million that's a $6 million from the sequential quarter and $9 million increase from the prior year quarter. The factors driving these increases are increased work on consolidated projects while we owe our joint venture partners their share of the projects profits, particularly from the Pearl GTL and Gorgon LNG Projects.

Now I'll turn it back to Bill for his final remarks.

William P. "Bill" Utt - President and Chief Executive Officer

Thanks Kevin. Although we're aware of the financial and credit market concerns, we maintain our strong outlook on our end markets and opportunities. We have not yet seen any indication that major projects in the international energy sectors are being cancelled for delay and have not experienced any material impacts to our business. We understand the environment that we potentially face over the next few months and years. So we are working to conservatively manage our business for any unforeseen impacts to the project opportunities associated with the financial and credit markets.

Our cash position is strong, we have a solid balance sheet and have access to lines of credit through our revolver that will enable KBR to continue to pursue work and capture opportunities when they arise.

KBR's backlog is strong at $15.3 billion. KBR currently has not experienced any project cancellations from work currently in our backlog. With the economic outlook remaining uncertain it is possible the customers may cancel or delay projects that are currently underway. However, we feel the likelihood any significant impact to our current backlog from cancellations is limited.

Now we will take your questions. We ask that you please limit your comments to one question and one follow-up. Thank you.

Question And Answer

Operator

Thank you. [Operator Instructions]. And we will go first to Andy Kaplowitz.

Andy Kaplowitz - Lehman Brothers

Hi guys good morning.

William P. "Bill" Utt - President and Chief Executive Officer

Good morning.

Andy Kaplowitz - Lehman Brothers

Last quarter you had mentioned a timing issue around an LNG $0.09 charge, and that Board was trying to review or the customers were which trying to view whether to accept charge to give the money back to you guys. Can you tell us where that stands now?

William P. "Bill" Utt - President and Chief Executive Officer

Yes, we have continue to work with our customers on the change order. We continue remain very optimistic about our ultimate policy resolution of the change order. However, we have not been able to or the customers not been able to get their partnership board schedule or scheduled in that hawk board [ph] to consider this change order and we are advised that the next meeting for this partnership Board will be in December. So we are optimistic that from that meeting we will be able to conclude that change order.

Andy Kaplowitz - Lehman Brothers

Great, thanks. And for my follow up, BE&K, so you give the numbers in the queue and the only question I have for you there is that the margins look a little lower than I would have thought around 3%, in clean division overhead. And so just curious, is that sort of amortization of intangibles? Is that, can that margin improve overtime? Am I missing something?

William P. "Bill" Utt - President and Chief Executive Officer

Within the BE&K business, we are obviously writing off intangibles and there is a certain balance that's being written off over a very short period of time which tends to depress margins. We are optimistic that, we can overtime through the amortization of these intangibles as well as bringing it more into a KBR framework, bring margins closer to what we're seeing.

Andy Kaplowitz - Lehman Brothers

Got you. Your main service margin is around 10%. Is that the ultimate goal for BE&K?

William P. "Bill" Utt - President and Chief Executive Officer

I think that's hard to say, because the services business includes pipe fabrication and includes the returns on assets for the service vessels we have in Mexico which typically return margins greater than 10%. So the services margins are kind of billed by the asset base businesses. But where we can look at the hydrocarbon business just on the services like time basis, we should see a convergence. But I would not expect that we will be able to get it to 10% because that brings an asset... intense asset businesses that tend to pull that overall margin up.

Andy Kaplowitz - Lehman Brothers

Got you. Given the contract awards we have seen in BE&K it seems like... it doesn't seem like there is been much of a slowdown in that businesses but can you give us just a view on how that businesses has been faring over the last few months?

William P. "Bill" Utt - President and Chief Executive Officer

It's mix because be in case in the lot of different businesses, yeah, we think the general construction market will remain strong but we keep an eye on what's happening in the U.S. markets because of the credit crisis that we have. We are obviously more comfortable today with the work we're doing for utilities that tend to have rate base recovery and due balance sheet financings.

In the building group, there is segment of that business where they have done the construction management for developer finance facilities which is a part of that business not the major part and we seen that market reducing or contracts significantly because of the absence of financing now in that business we're still optimistic about their healthcare practice and their educational practice which appear to be a little bit less directly impacted by what's going on in the economy.

Andy Kaplowitz - Lehman Brothers

Okay, thank you very much, I'll get back in queue.

William P. "Bill" Utt - President and Chief Executive Officer

Okay.

Operator

And we'll go next to Vance Edelson, Morgan Stanley.

Vance Edelson - Morgan Stanley

Hi, thanks a lot. Could you let us know on the billboard hours for Ike, they got pushed back, is that work that's just lost or does it possibly now show up in the fourth quarter results?

T. Kevin DeNicola - Senior Vice President and Chief Financial Officer

Well, it's not lost work; it is work that we will eventually manifest itself into our P&L. We have a fixed capacity of people so, if we miss out on, for example, a 100,000 hours of work or a million hours of work, that work will be earned out at the end of the job and when we probably, we do not expect to see that return in the fourth quarter because people are otherwise busy doing the work that we got in the backlog for the fourth quarter.

But it's ... it will occur over time its that just the disruption that we had of people not able to get into work, the offices being closed. We elected to pay people salaries during the time that they couldn't work around Ike and so that was the nature of the earnings impact that we saw from Ike and it's not a... it's not lost work its just will be recognized over the next series of quarters as we get caught up on these projects.

Vance Edelson - Morgan Stanley

Okay, got it. And as a follow up and this is a more general question if for argument's sake, the U.S. pulled out of Iraq sooner rather than later, can you just give us a feel for what your responsibilities would be in kind of the scope and the duration of the work to get that done?

William P. "Bill" Utt - President and Chief Executive Officer

Well, we reorganize that any decision of amount of people and the timing is really for government and we as a contract or we simply respond to it. Our sense is that there would be a short term increase in work as we do a lot of movements of people, equipment, provisions out of theater to other areas and get those to their respective storage locations.

So there is also the expectation that we would have to recondition the equipments so it could be stored as well as return the existing camp sites to the condition that we found them. So our work would likely follow the troop strength but we would say initial blip and we would kind of trail the reduction in troops in terms of where we expect our billings would be.

Vance Edelson - Morgan Stanley

Okay, its very helpful. Thanks.

Operator

Our next question is from Jamie Cook, Credit Suisse.

Jamie Cook - Credit Suisse

Hi, good morning. My first question Bill is sort of a longer term strategic question. Given what we're seeing in the energy markets as you think about KBR longer term. How important do you think it is to diversify out of the energy market, BE&K obviously was a nice sort acquisition that now looks much better than I guess, I originally thought it did, and so kudos to you.

I mean how you think about that? And then my second question is, can just walk us through ... if we think about your business model which parts of the business do you view as sort of being more recurring versus... have a recurring earnings stream versus the more cyclical components. Is there any way we could think of a base earnings case for KBR?

William P. "Bill" Utt - President and Chief Executive Officer

Okay. That's a very broad series of questions and let me just try to address bite-by-bite. I think that the first element you talked about diversifying out of energy and I would like to make some comments about our perspectives of the international hydrocarbon environment if we could.

Jamie Cook - Credit Suisse

That will be great.

William P. "Bill" Utt - President and Chief Executive Officer

First of all, while the prices declined significantly from highs of around $150 a barrel to around $70 a barrel a day. Based on our discussions with our customers, their price tax have recently been in the $65 to $70 a barrel price range. So, just based on a change in oil price only, we're still at a point where our customers were making affirmative investment decisions for projects.

The second point is that with the falling oil prices, we believe that this is going to drive a reduction in the cost to construct facilities. And, we're seeing lower cost in materials, lower cost in our commodities that we use; we're seeing a lower cost for equipment.

And if you remember back in 2004-2005, people were justifying major capital projects at $30 a barrel, and in part because of the cost side was supportive of justifying projects at $35-$30 a barrel. So, today its $65-$70, and that was a customer price take based on the three months ago price supply chain for us, and we expect that our price of delivering the construction projects is going to follow us. So, we're still keeping in our minds a positive incentive for projects to go forward.

The next aspect Jamie, is really yeah, and as we have looked at the last year, we haven't seen a lot of big awards and one of the theories that we talk about around here has been, that it has an inverted yield curve, where the short term price of oil has been above the long-term expected price that we estimate to be between $70 and $90 a barrel.

And so, in the price visit $150, we could see why customers could be taking decisions not to lock in the capital cost of a project based on a cost deck of $150 a barrel and why wouldn't be attracted to earn that out at $70 to $90 a barrel over the life of the investment.

So, as we look at the days environment, we have what we're calling more, a more normally yield occur, where you have $60 to $70 oil, a cost structure based on $60 to $70 and a long-term price expectation. That's not materially different from the $70 and $90, a barrel. So, we think you are going to see some broader... basically more projects move forward, because of a more sustainable investment climate with a normal cost yield curve.

The fourth element we look at is, if you go back and look out IEA and what they think, given the present depletion rates and assuming zero demand growth globally, that by 2025, we need to develop an additional $40 million barrels a day of production. And so, you see the depletion curve driving a continued investment in that space and I don't believe that's going to go away, because I don't think we're going to see that much demand destruction in the market.

And then, the last point is that the big customers we have in the hydrocarbon side are typically balance sheet financing, they are the international oil companies or the national oil companies. So, as we look at the hydrocarbon market, we think it's a great place for us, but as we look at transaction like BE&K, it is not for the reason of diversifying away from hydrocarbons.

For us its more of trying to establish positions in our value chain that allow us to be a viable competitor from the conceptual consulting of a project all the way through the maintenance of the asset over the life of the projects. So, BE&K was great for us, because it helped accelerate our presence back into the construction area of the business as well as double our maintenance business.

And these were two areas that we talked about building us KBR and they really fit right in the mainstream for strategically, where we want to take the company. The added benefit was they came with a bunch of engineers that we think we can utilize to grow our engineering business and as we saw over the last 12 to 18 months, we have seen a construction in the supply of engineers to do the work and we like the engineers that we have acquired and we think that it makes KBR a stronger, better and more vibrant provider of services not only to the existing BE&K customers, but also to our normal KBR business.

So, as we kind of wind to what's recurrent earnings versus cyclical, we're trying to do develop the business model that allows us to have relevant positions in consulting in front end engineering and the engineering procurement construction and the maintenance services business. We believe that as we have brought in a greater degree of risk awareness to the company that the cyclicality that KBR was known for in terms of inconsistent project results is going to dampen a little bit.

I think we are seeing a little bit of that within the results we talked about this quarter and I think we are making some positive strides to bringing a much less volatile business and a more predictable and systematic level of performance to the companies. So probably taken maybe a little longer than maybe the question... the answer you are hoping for but it is a very integrated question and one that gets into what are we trying to do with KBR as a business.

Jamie Cook - Credit Suisse

All right.Thank you very much. I'll get back in queue.

William P. "Bill" Utt - President and Chief Executive Officer

Okay.

Operator

And our next question from Barry Bannister, Stifel Nicolaus.

Barry Bannister - Stifel Nicolaus

Hey, question I have is about LogCAP. Given this is a fairly politically charged season on the hill you usually get very, very strong positive feedback but in the press and in public it sometimes not. So is there a chance that the reason to legal issues regarding electrical work which we have done to DoD standards might cause some reduction in your fitness report that would affect the operating margins in subsequent quarters as it happened when you step down briefly. I believe two quarters ago in term of these LogCAP operating margin?

William P. "Bill" Utt - President and Chief Executive Officer

Well we're continuing to work with our customers to contemplate how one transitions from a contingency type activity to a sustainment. And so we're working with them to look at the realities of an extended presence. And so we get back to allow the electrical issues. There is a lot of issues that I talked about that really don't involve KBR. And so, we have take a very thorough look at really where our exposures on those issues and we have made comments in the Q regarding the fact that we feel our liability is not present some of these cases.

Regarding the award issues, we continue to establish objectives with our customer every quarter. We continue to get feedback and our achievement of those objectives relative to expectations. I think we're still on track along historical lines towards the performance of KBR against these objectives.

We do get a lot of press being KBR; I guess the good news is that with everything going on in the capital markets, there hasn't been a lot of time people could spend looking at the contractors in Iraq. And, so it's been a fairly quite time for us which we appreciate the break.

But in terms of our business, vis-à-vis the expectations of our customer, we believe that we continue to deliver a high level of performance that should at the end of the day manifest itself in terms of how we are scored on our award fee boards.

Barry Bannister - Stifel Nicolaus

And then with respect to Afghanistan has that increased materially as a percentage of your task orders under LogCAP IV that you are working on. And then lastly, on LogCAP IV, could you give us some idea of this lumpiness that will be inherent in that where by the payments are I believe every six months not three months or something of that sort where your payments are stretched out and it might affect the timing of LogCAP IV earnings in fiscal '09.

William P. "Bill" Utt - President and Chief Executive Officer

Yes, I will answer the easy question first. LogCAP IV will have lumpiness because the accounting rules which grandfather LogCAP III it will state that under LogCAP IV we cannot recognize award fee scores until they are actually awarded. So we will not be able to include the award fee scores as we have historically on LogCAP III.

And obviously that factors into how we price our base fees and award fees on our task orders under our LogCAP IV. Regarding Afghanistan our work is remaining pretty constant and we're following the efforts of the troopers as they change their performance in theater and their location of performance.

Barry Bannister - Stifel Nicolaus

And just housekeeping its not a question so much but your share count was less than the buy back; is that because it's an average and the end of quarter of shares was closer to 159?

T. Kevin DeNicola - Senior Vice President and Chief Financial Officer

It's a weight average share calculation for the quarter, so it's not the quarter end number that you saw there.

Barry Bannister - Stifel Nicolaus

So you'll use 159 in '09?

T. Kevin DeNicola - Senior Vice President and Chief Financial Officer

Yes.

Barry Bannister - Stifel Nicolaus

Okay, thank you

William P. "Bill" Utt - President and Chief Executive Officer

Be a little higher by 160s, 161, 162, second quarter 8.4 of about 170s.

Barry Bannister - Stifel Nicolaus

Yes, just got it. Thank you. Just got to take 8.4 off of it.

Barry Bannister - Stifel Nicolaus

Yes. Just got it. Thank you.

Operator

We will go next to Dan Pickering, Tudor Pickering Co.

Dan Pickering - Pickering Energy Partners, Inc.

Good morning, guys.

William P. "Bill" Utt - President and Chief Executive Officer

Good morning Dan.

Dan Pickering - Pickering Energy Partners, Inc.

Bill can you talk a little bit about... I'm just trying to gauge overall demand for E&C services in general and I guess the only line you had ask that question is sort of value of your big outstanding and how that's been trending over the last few months and how you expect that trend as we step through the next quarter or two given economic conditions?

William P. "Bill" Utt - President and Chief Executive Officer

Thank you. I answered that question about a year ago, Dan and we went back and took a look at and thinking that given the uncertain times you come back to that, as we looked at the business proposals outstanding from January to the end of the second quarter, to the end of the third quarter. Our proposals outstanding volume has increased and we've seen really we haven't seen any material fall offs in any of our business units. We had a pretty good ramp up in our proposals at G&I, the proposal growth in Upstream is good. Downstream is essentially flat second quarter to third quarter services is down a little bit probably with some of the postponements we talked about, but the proposals outstanding are still pretty solid they have grown during the year, and how they go into the future?

I think that Upstream that we see a solid business for the five reasons that I numerated under Jaime's question. G&I, we're starting to see some of the benefits of our efforts to diversify our offerings, take to get traction. Services business is pretty nimble and we'll continue to look at other opportunities where some of these other markets may be down, we still have a very small share of market, its very fragmented market and so I think we will reposition some sales efforts there and maintain a pretty good volume so, we are swimming in a sea of negativity, there is no doubt about it but as we look at just the actual numbers of our business, it looks pretty solid right now, from second quarter to third quarter, the proposes outstanding grew and so I was pleased with that figure.

Dan Pickering - Pickering Energy Partners, Inc.

That's encouraging. And as you look at that the geographic mix of that was there anything stood out to you in terms of where things geographically were strong than others?

William P. "Bill" Utt - President and Chief Executive Officer

I'd say if you look across the proposals outstanding, the G&I and Upstream and even our Downstream business will be international. And those customers that we see, are balance sheet financers, integrated oil companies, international oil companies,national oil companies. Government and so the biggest part of our business where we have the greatest volume of proposals outstanding appear to be in the markets that have customers who are best able to weather the situation that we're in.

Dan Pickering - Pickering Energy Partners, Inc.

Okay. That's helpful. And then I guess I'm thinking here about pricing in general, we have got raw materials coming down that ought to make things more inexpensive I guess for the customer or projects, theoretically becoming cheaper. Do you view that overall given one of your mix of legacy projects and what you we will be doing going forward? Does that give you a margin expansion opportunity, does it shrink your margins a little bit or do you just... do you see the business are staying pretty stable in terms of how you think about bid margins?

William P. "Bill" Utt - President and Chief Executive Officer

Dan, I look at the business, and we're still digesting through a lot of legacy contracts, and one of the... and second quarter we had a large amount of Escravos revenue that went through the books at zero margin and so that's been a drag. I would say that, the work that we are looking at respectively in the hydrocarbon side or typically at margins that are greater than the reported margins as we just digest our lower margin work.

And so, I think there is your economic, I mean margin expansion just by that factor alone, just getting the bad work out and allowing good work to come in. And then, from our side, I think we continue to do a I think a very good job of identifying the risks and analyzing pricing omen, and that should allow us to have less volatility in our reported results in future periods. So, I think we still have some room to run just based on better operations of the business and the liquidation of lower margin inventory.

Dan Pickering - Pickering Energy Partners, Inc.

And Bill, I just wanted to clarify you said in Q2 you had a lot of Escravos revenue?

William P. "Bill" Utt - President and Chief Executive Officer

Yes, I think Q2 was one of the contributors to the reduction in revenue. We had a big slug of Escravos come through that goes without the margin because of the conversion.

Dan Pickering - Pickering Energy Partners, Inc.

Right. And Q3, that was less significant?

William P. "Bill" Utt - President and Chief Executive Officer

Yes.

Dan Pickering - Pickering Energy Partners, Inc.

Okay. Thank you.

Operator

We will go next Steven Fisher, UBS.

Steven Fisher - UBS Investment Research

Hi, good morning. You mentioned the 40% target for a share of the LogCAP IV contract, I'm wondering if you can give some color as to how you get to that numbers, just based on assumption that you have the legacy contract and you should get more than your fair share, or are there certain types of projects that you feel you are more suited to?

William P. "Bill" Utt - President and Chief Executive Officer

It's largely based on what you described, where the established contractor we know the Army best, we have got the very integrated relationship established and we think we will do better than one-third. And that's... you could look at it that depends on the packages of work that they put to bid and how they do it. I don't think they'll get it down to small chunks and may just be big chunks and I know that there is... because of our award and few scores, the customer is very happy with performance and yet we recognize that from a political sense it makes a lot of good sense to get some diversity in the theater. So, we think we do a good job and that we will do better than simply one over three.

Steven Fisher - UBS Investment Research

Got it. And then you mentioned the infrastructure opportunities in the Middle-East and Asia. In the event that Yanbu or Ras Tanura are the next phase of those extends beyond 2009 in terms of starting up. Do you think those infrastructure opportunities could offset what you would have generated from those projects?

William P. "Bill" Utt - President and Chief Executive Officer

I don't think so because Yanbu and Ras Tanura those are big elephants and you'd have to build a very significant scale of these other projects to overcome that. I think they could mitigate some of the impacts and I will also say that, as I talked about our proposals outstanding, important because I hope we don't when all the proposals outstanding because we don't have the resources to do all the work. And so we think that we have enough diversity of projects in our portfolio on hydrocarbon side, such that if one or two disappear or get delayed, we should be able to efficiently manage our labor pools and keep people working.

Steven Fisher - UBS Investment Research

Okay, great. Thank you.

Rob Kukla, Jr. - Director, Investor Relations

Hi, Teresa. Let's go ahead and do one more call please.

Operator

Wonderful. Our final question will be from John Rogers. Please go ahead.

John B. Rogers - D.A. Davidson & Co.

Good morning. Bill, you talked about the activity in the international markets on the G&I side, the non-U.S. Government sponsored work, but bookings in that market have been fairly slow so far this year. Is there a series of project that will be going to be released that you're looking at?

William P. "Bill" Utt - President and Chief Executive Officer

Well part of this is the programs and the customer behaviors and particularly in the Middle-East as they get a number of relationship they give you a small project and if you do a good job they give you another big one and we've seen some other service providers who are not in the E&C space but providing IT services that have got in. They got a couple of small contracts and the next thing they knew they had a series of very large contracts and a very significant volume.

And we believe that we are in the phase of... from the marketing we're doing our initial work over there and we would expect a firm hold through that we should see a growth in the amount of awards we get from these customers as we establish our execution credibility with them on the present projects we are executing.

John B. Rogers - D.A. Davidson & Co.

Okay. And that's something that we should expect to see in 2009 assuming no major unusual event.

William P. "Bill" Utt - President and Chief Executive Officer

We would expect to see some come in 2009 again it will depend on how quickly the ramp up occurs and also on a relative basis how does that volume compared with the other projects that we're also pursuing. They may just get caught in the shadow and we may not talk much about it if we get several of these larger awards that we've been trying to position slower for sometime.

John B. Rogers - D.A. Davidson & Co.

Okay. These are civil and commercial type projects as opposed to your...

William P. "Bill" Utt - President and Chief Executive Officer

They are more civil engineering projects, yes.

John B. Rogers - D.A. Davidson & Co.

Okay. And then just one other quick follow up, in terms of your G&A levels, they have been fairly stable off late. Is that a good run rate now that $55 million a quarter?

T. Kevin DeNicola - Senior Vice President and Chief Financial Officer

I think that what I expect going forward is something just show of the 60 million levels, we have looked at the longer run rate numbers. We will run about 54, 55 namely added BE&K and I think that we should be looking at something just show at 60.

John B. Rogers - D.A. Davidson & Co.

Okay. Great, thank you very much.

Operator

And that does conclude our question-and-answer section today. At this time I'll turn the call back to management for closing remarks.

Rob Kukla, Jr. - Director, Investor Relations

Great guys, thanks you all for joining today. And we look forward to talking with you all in next quarter.

Operator

That does conclude our conference. Thank you for participation. You may disconnect at this time. .

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Source: KBR, Inc. Q3 2008 Earnings Conference Call Transcript

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