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NATCO Group, Inc (NYSE:NTG)

Q3 2008 Earnings Call

November 6, 2008 10:00 am ET

Executives

Andy Smith - Vice President of Finance

John Clarke - Chairman of the Board and Chief Executive Officer

Patrick McCarthy - President and Chief Operating Officer

Bradley Farnsworth - Chief Financial Officer

Analysts

Byron Pope - Tudor, Pickering, Holt & Co.

Collin Gerry - Raymond James & Associates

Steve Ferazani - Sidoti & Co.

Operator

Good day, everyone and thank you for joining NATCO third quarter earnings conference call. (Operator Instructions) Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Andy Smith, Vice President of Finance. Go ahead, Sir.

Andy Smith

Good morning. Thank you for joining our third quarter 2008 earnings conference call. You should have a copy of our press release that we issued this morning. If not, please consult our website where it is posted at NATCOGroup.com for a copy.

Our first order of business today is the Safe Harbor disclaimer. Statements made in this call that are forward-looking in nature should be considered forward-looking statements within the meaning under securities laws and regulations, and as such may involve risk and uncertainties as described in NATCO’s filings with the Securities and Exchange Commission.

On the call with me today are the Chairman of the Board and Chief Executive Officer, John Clarke, NATCO’s President and Chief Operating Officer Patrick McCarthy, and Brad Farnsworth, the Company’s CFO. I will turn it over to John.

John Clarke

Thanks Andy. Good morning everyone. On today’s call we will review our third quarter results, provide assessment of our business segments and the current market environment, and update guidance for Q4 and the full year.

We intend to provide first guidance for next year in mid-December when our 2009 profit plan is ready for our Board’s review. I am also pleased to announce the promotion of Greg Jean to Senior Vice President, Automation and Controls who will provide new leadership and management oversight to this important business segment which is to struggle with the number of issues at length. I will elaborate on these in a moment.

But first, recall that I noted on our last call, on August 5 that we were expecting a stronger finish to the second half of the year in record bookings that will carry as well into 2009. For the most part, both comments have held true in spite of few hurricanes, a near collapse in the financial market, global recessionary fears, and certain fundamental shifts in perceptions with respect to investment in our industry both in North America and globally.

While our crystal ball is no better than others, we will try to share some insights as to what we are seeing in the markets, proactive and reactive steps we may take if conditions become clearer, and some unique characteristics of our business franchise which should serve as well in whatever environment we find ourselves.

For the quarter, the markets remained strong for our traditional and standard business throughout North America helped by strong bookings of traditional equipment sales, contributions from two acquisitions offset in part by the effects of higher unrecovered material costs which are now abating in the effects of hurricanes Gustav and Ike.

In our global business, the story is about the significant pick up in new bookings, our building backlogs, and achieving timely revenue recognition as larger projects progress from purchase order to ultimate delivery.

One challenge for the year has been the reinvigoration of growth in revenue and profits in our automation and controls group which had a very poor quarter in terms of financial performance. They have struggled all year with the distraction of the FCPA review.

The third quarter was further impacted by hurricanes, our decision to wind down our Kazakhstan operation, and changes in senior leadership as well as other unplanned personnel departures. Total bookings for the quarter were $222 million bringing year-to-date bookings to a record $637 million. At September 30, our backlog totaled $336 million, yet another record.

Revenue for the third quarter was $159 million, about flat with Q2 but up about 10% from last year’s third quarter. We benefited from record sales in standard and traditional. Many of our large customers continued active dialogue to secure capacity commitments for finished goods and traditional equipments that would be delivered well into 2009.

The segment also benefited from the integration of the Linco acquisition and one month contribution from the acquisition of Connor Sales. The third quarter revenue from the Integrated Engineered Solutions group was up about $6 million sequentially and lower by about $11 million year over year in spite of a 17% increase in bookings during the same comparable period.

Revenue from automation and controls was hurt comparatively by the conclusion of field service work in Kazakhstan and lower sales of control panels coming out above Houston and Harvey which were precipitated by hurricane-related power outages and a number of employee departures in Houston, most of them have now been replaced.

Gross margin percentage for the quarter was 27.3%, about flat with Q2 and down 1.7 points year over year. Of note, IES beat their own record posting a 37.1% gross margin for the quarter on the growing percent of higher margin technologies being deployed successfully to our global markets and their intense focus on execution.

This was about five points better than a year ago and is important to our future as this segment grows and contributes a larger share of earnings. We estimate the hurricanes and higher material cost for our US branch business by about $2 million or two margin points during the quarter. What was an environment of rapidly rising steel cost has now tempered with many suppliers quoting lower prices which feature delivery of [05:46].

Automation and controls gave up margin on revenue mix. Total segment profits for the quarter was $12.9 million after adding back about $2.8 million in expenses related to legal and compliance review cost or about $7 million below last year and $5 million dollars down from Q2 2008.

For the first time, it also reflected an operating loss in automation and controls. It was nonetheless the higher end of our revised guidance. On an as reported basis, segment profits as of percent of revenue was about 6.4% or 8.2% excluding the legal and compliance review costs; a poor showing in any event and below our 10% or better target for the first time in many, many quarters.

This enlarged part reflects the effects of lower revenue recognized from the late bookings, the relative performance in automation and control and higher OPEX. All of which will improve going forward. With respect to net income available to common, we reported $5.6 million or $0.28 per share.

Adding back the legal and compliance review cost would imply an EPS of $0.37 per share compared on a similar basis to Q2 2008 of $0.47 per share and $0.67per share for Q3 2007. The Audit Committee’s review of certain payments made in Kazakhstan as well as its review of certain other foreign jurisdictions in which the Company does business is now complete.

We have kept the DOJ and the FCC informed throughout the review process. While we believe that the sums of questionable payments are immaterial, we cannot predict what actions, if any, the government agencies may choose to take or when they might act.

In the mean time, we have undertaken a number of significant steps to enhance our internal controls over compliance. We have had staffing, restructured our organization, increased training and awareness, and improved communication up and about and across the various parts of our organization.

The Company has taken or is undertaking the necessary steps to assure that record-keeping is compliant with all laws and regulations of the jurisdictions in which we operate.

As I mentioned, during the quarter, we commenced winding down our operations in Kazakhstan. In addition, we have backed several changes within the management structure of our automation and controls group. The employment of Dave Volz formerly Executive Vice President, Automation and Controls and President of TEST and certain other TEST employees terminated in the quarter.

In October, Greg Jean was named to his new position with oversight responsibilities for that segment reporting to Patrick. In addition, we have also named a new segment controller and hired a corporate compliance officer and imposed sanctions on others including the termination of certain personnel. While costly and painful, when this matter gets finally resolved, I am certain that we will have learned from the experience and become an even stronger international Company with a best in class culture and compliance.

At this time, Patrick will discuss the key operating highlights for the quarter. We will take specific segment questions after we wrap up.

Patrick McCarthy

Thank you, John. The award of the [Tangabarrad09:16] cluster, TBC CO2 membrane separation plant for installation offshore Southeast Asia previously recognized as MLTTB was our highest achievement milestone in the third quarter. When the final purchase order is signed, we expect the scope of this project to approximate $125 million, the largest single award in our history.

As we have professed many times on past calls, our membrane product is a proven technology having a performance record dating back 20 to 25 years. The SACROC separation plant is where everything commenced and continues to advance. We have demonstrated quality and consistent operating results to offshore operators in Southeast Asia starting with the Unocal Pailin now Chevron started up in 1998. Follow on awards included CTOC phase one and two and CPOC between 2001 and 2006.

[Tangabarrad 10:21] cluster was a technology award that we are extremely proud to win. The two letters of intent we have announced will convert into a full contract award by the end of this quarter. In the Integrated Engineered Solution segment, our third quarter bookings included the second LOI of $28 million for TBC. Twenty-one million dollars of refinery oil desalters, $14 million of oil field dehydrators, and $10 million for a sulfate removal membrane water reinjection project offshore of West Africa.

The $87 million of bookings for IES in the quarter is our third consecutive quarter to book at least $80 million of new orders. The resulting ending backlog of $215 million reflects these bookings’ consistency. Expecting the balance of TBC, approximately, $90 million in the fourth quarter, we look forward to completing 2008 with another outstanding quarterly booking within IES and a strong backlog onward to 2009.

The standard and traditional business unit had a robust performance in the third quarter reflecting growth in equipment and after market parts and service sales. Bookings in the United States exceeded $100 million and Canada had twelve and a half million dollars including a $10 million award for oil sands electrostatic equipment.

In the United States, quarterly, year over a year, part sales were up 13%, service was up 26%, standard equipment excluding Connor, our most recent acquisition was up 19%, and traditional equipment sales were up to 60%. Margins were up 6% for parts and 7% for service. Standard equipment margins were flat and traditional equipment margins down by 15%. The use of material pricing; we have adjustments to all material pricing and presently the market for steel is slowly softening.

As we fulfilled prior commitments with our suppliers during the fourth quarter, we are in conversation with our vendors to reduce cost in 2009. Recently, we have reorganized our supply chain management organization to improve the communication and integration between our S&T execution group and external suppliers.

As strong as the third quarter was, we like others, expect changes in market demands. However, as our traditional equipment bookings increased in the quarter, we continued to have major integrated E&P companies request quotations for US-based on-shore gas programs having planned production profiles extending over several years. There will be more clarity in the gas market as we finished the fourth quarter and enter 2009.

According to the American Petroleum Institute, the number oil wells completed in the quarter exceeded 6,200 and this is 34% more than a year ago. Our acquisition of Connor Sales in Williston, North Dakota in the quarter will allow as to leverage oil field equipment sales with parts and service through the integration of our existing branch business. Oil price drives the Bakken as we go into 2009 and presently this market represents a growth model for us.

In Canada, we added to our previous successes with approximately $10 million of bookings for another oil sands project. Our Canadian business unit has a strong backlog of oil sands equipment orders which will provide the bulk of our 2009 revenue.

We booked $3.8 million with Pemex to outfit and debottleneck existing offshore production separators in the Cantrell oil field. This will be our fiftieth quarter test revolution for installation offshore Mexico for either two-phase or three-phase separation debottlenecking.

Throughout the third quarter, we continued with several, several previously mentioned joint development programs within our technology research units. At our lab in Tulsa where we test oils from all global areas to determine what electrostatic technology is best suited to treat a production profile, we are working with Petrobas to enhance our compact electrostatic separator.

We have been successful in the lab to demonstrate a significant reduction through a compact-sized vessel having inlet conditions of 40 plus % water to an outlet of less than 3% water. This will not only represent a breakthrough technology advance for surface separation but ultimately, subsea as well. The compact separation technology will be field tested in the second half of 2009 as part of the JDP.

Also at the Tulsa lab, we have started the production flow loop awarded in the first quarter of this year from a major integrated E&P company. Using the flow loop to emulate field conditions, we are able to test out technology such as electrostatics and cyclonic separation devices to evaluate applications to meet our customers’ requirements and specifications.

At our CO2 membrane lab in Pittsburg, California, the JDP with Petronas is progressing testing various membrane fibers. The next test facility within our lab permits simulating different compositions flowing through fibers that will ultimately be field tested at our SACROC plant.

In fact, the 30-inch membrane that has successful demonstrated separation and mechanical properties at the SACROC facility for three years, we recently installed one on the CPOC platform in a Southeast Asia fabrication yard. CPOC separation plant is designed using 16-inch membranes to meet productions specifications. The 130-inch membrane will be incorporated in the operation and field data collected. CPOC is scheduled to start up in the third quarter of 2009.

As an update, our Saudi Arabia NATCO Al Rushaid joint venture fabrication facility is scheduled to open at the end of the second quarter in 2009. We are presently interviewing for staff in line positions and we will begin training personnel in the first quarter of next year.

Even with a slowdown in ARAMCO’s large capital programs, the Saudi market represents a significant opportunity to grow all NATCO products and technologies such as dual frequency electrostatics to enhance throughput within existing GOSP facility. Our automation and control system segment experienced a disruptive quarter with the mobilization and demobilization of staff from a certain Gulf of Mexico platforms caused by hurricanes Gustav and Ike.

In addition to the two hurricanes, we had personnel turnover in the segments during the quarter and because of this, we have announced management changes through promotions within our organization. Greg Jean has been promoted to Senior Vice President to head this segment. Greg is a 10-year NATCO employee that we promoted in January of 2008 to Vice President of Automation and Control.

Prior to the move, he was General Manager of NATCO Canada. He was instrumental in leading NATCO to the forefront of capturing the majority of awarded oil trading equipment for Canadian oil sands operators. With Greg’s experience and leadership skills, we look forward to growing the business segment around our relationships with the Gulf of Mexico customers and certain international and national oil companies and major integrated E&P’s.

As John mentioned, we are closing our exiting Kazakhstan operations. We will explore a new and expanded NATCO product offering into the Caspian region in 2009. Our core competencies and technologies offer services and solutions to the customer base in this region.

Entering the fourth quarter with the passing of two hurricanes, we are adding staff to accommodate Gulf of Mexico operators with their restoration of production facilities. We envision a ramp up to build slowly, peak in the first quarter of 2009, and return to a seasonal market condition in the second quarter of 2009. Also our contract work in Angola with Chevron has maintained a steadily growing headcount through this year with expectations to add staff in 2009. Thank you. Brad?

Bradley Farnsworth

Thanks, Patrick. John and Patrick have covered much of the segment financial results as well as market conditions. I will address some income statement items and also highlight several balance sheet items.

Total operating expense for the quarter was thirty-two and a half million dollars which includes $2.8 million related to certain legal and compliance review cost. As noted in the press release, this amount is recorded in SG&A and allocated through our business segments as follows: Integrated Engineered Solutions, $1.5 million, Standard and Traditional, $ 1 million, and Automation and Controls, $ 300,000.

As we have mentioned on earlier calls, we were deploying additional resources in the certain areas of the Company to facilitate and support our continued growth. At this point, our normalized SG&A run rate is about $29 million per quarter. Reasons for the increase on operating expense between years are largely to support costs for the higher current year business activity level, additional engineering, project management, and procurement support, higher support level for international growth initiatives, general costs increases related to wages, employee benefits and other services, higher compensation costs associated with Company’s long-term incentive programs, and expenses related to our enterprise resource planning system initiative and M&A activities.

Depreciation and amortization expense for the quarter was $2.3 million. This amount increased over the prior year by $700,000 due to the increase in capital investment over the past year to support future growth and the amortization of intangible assets related to acquisitions.

Interest income for the quarter was $204,000. Our cash on hand was $15.7 million as of September 30 with $13.6 million of this amount invested in highly liquid instruments carrying a weighted average interest rate of 2.3%. Invested balances have declined from $60.9 million at December 31 primarily due to using cash to acquire Linco as of January 31 and Connor Sales as of August 31.

Interest expense for the quarter was $199,000. During the quarter, we borrowed $10 million to fund the portion of the Connor Sales acquisition which appears on the balance sheet as long-term debt. Our effective tax rate for the quarter is 35.3%. This rate reflects our combined Federal and State statutory rates and at this point we are projecting a tax rate of approximately 35.3% for the full year of 2008.

As the quarter end, our networking capital position was $81.8 million as compared to $110.3 million as of December 31, 2007. This lower level of working capital is due to the decrease in cash of approximately $48 million related to funding acquisitions, increases in accounts receivable, inventory and prepaid expenses totaling [$24.3] million, all of which were due to the acquisitions Linco and Connor Sales.

A net decrease in accounts payable accrued expenses, and taxes of $8.5 million, and an increase in advance billings, and payments from customers of $10.7 million. Capital expenditures for the quarter were approximately $5.6 million. These were broken down as follows, maintenance, $1.5, growth and productivity enhancement, and $4.1 million.

Capital expenditures for 2008 are expected to be in the $21 million to $23 million range with maintenance-type projects representing about $6 million of that amount. Goodwill and intangible assets have increased since year-end by $52.2 million due to the acquisitions of Linco and Connor Sales. Our balance sheet remains very strong and gives us a great deal of financial flexibility to operate the business and take advantage of future growth opportunities that may require capital outlays. Our available liquidity at quarter end was $130 million.

Recently, we issued a press release announcing the $25 million stock buyback program. We believed that repurchasing shares at the current market levels represents an attractive investment. Now, I will turn it back over to John for the wrap-up.

John Clarke

Thanks Brad. Let me conclude by addressing a couple of key points as we look to the future. I will discuss the financial underpinnings which give us a reasonable degree of confidence as we look ahead. Proactive and reactive measures we would implement with changing market conditions and evolving organization and infrastructure build out plan.

With respect to financial underpinnings, in many ways NATCO is a unique oil services company and was not immune in the changes of the fundamentals, we are perhaps better able to weather a storm. On the strength of our technology, we have a significant backlog in hand in many large global projects pending which will remain viable given their maturity and an oil price strip still well above the economic threshold.

In the $336 million backlog referenced earlier is nearly $215 million of IES project work which will be recognized over the next four to six quarters. We expect to bring a backlog at year-end 2008 of approximately $400 million in the next year including the remaining amount expected to be incorporated into that backlog from citing the final purchase order to the recently announced CO2 projects in Southeast Asia.

I would emphasize that much of this backlog represent new orders, work just getting started as opposed to riding off a large tail of earlier awards. We also have new sources of incremental revenue. We will start up manufacturing operations in Saudi Arabia for the first time by midyear bringing retrofit and new build revenue opportunities originating from the most economically attracted energy market in the world.

Closer to home, we have redeployed excess cash into earning assets via acquisitions. In fact, in this year alone, we have invested upwards to $65 million in three acquisitions generating approximately $90 million in projected revenue and $12.5 dollars in EBITDA annualized for 2008. This will help future comparisons to prior periods as well.

Our North American business is cost effective and our assets, our people, service, and delivery are flexible enough to direct our resources to where the capital spending ultimately goes.

As the supplier to the production end of the value chain, we have excellent visibility with respect to drilling activity and we will have plenty of early warning of any dampening effect of production spending; signals that we will ultimately drive our revenues and cost structure. And importantly, from a financial stability standpoint, we have our CO2 processing facility in SACROC which will provide added cash flow and earnings from higher throughput after plan, expansions, and compression are completed by year-end.

Throughout North America, many of our larger customers continue to advance alliance-type arrangements which will shore up capacity utilizations, cover fixed cost, and better assure their timely deliveries which is still a major priority.

Finally, we expect to have minimal debt at year end and to throw off sizable free cash flow next year to ride out the storm or to fund the organic growth acquisitions and potential share repurchases. We will be very careful on how we use this financial flexibility. Now, the things that we are watching and our range of responses. Rate count in North America can be expected to contract during 2009 as a result of lower expected gas prices and the potential for lack of finances and especially for higher risk, higher cost projects.

We will direct our efforts, equipment sales, service, after market support to those areas of highest value and best economics. We are not dependent upon anything of resource play or player and of course have a very strong position in the North American oil markets including the shale plays in Canadian oil sands. We will watch completions as perhaps the better barometer of our business in North America as rig count declines will be led by the most inefficient rigs getting laid down first. Multiple completions from higher efficiency rigs, however, have led to increased equipment sales even when rig counts have been flat or down.

Given the current price expectations, global oil project economics still makes sense in long lead times to first production. We will require the national and international oil companies to stay the course on projects in the pipeline. Much focus has been given to demand destruction due to global recessionary pressures but we must also remember that with our continued spending, supply destruction is real and perhaps longer lasting.

Margins thus far are holding throughout the North America and around the world. Softening steel prices, remember that material cost make up about 60% of our cost, should release some upward cost pressures on our customers and allow us to maintain pricing discipline in our markets. No doubt, in the market where it seems to be developing, our customers will be looking closely at all cost to assure themselves that their suppliers are as competitive as possible.

On the cost side, as you know, we have invested heavily this year in infrastructure and additional resources to manage an expanding scope of global business, one we are seeing materialize for 2009. A portion of this spending is discretionary which could be deferred as factors in the market dictate that a change in timing is appropriate.

We will continue to stay focused on managing working capital. Fortunately, our larger project work is cash flow neutral to positive because we utilized progress billings and advance payments to finance the bulk of our build-to-order projects. We would not expect to encounter credit availability issues on our committed bank line as we look to future growth and/or funding smart acquisitions or share repurchases.

So in closing, we remain confident in our plans but certainly aware of potential changing conditions in the industry and in the financial market. I would like to add because of that uncertainly, we will provide 2009 financial guidance in mid-December when we finish our profit plan. In the meantime, we expect segment profits for the full year 2008 to be between $73 million and $75 million excluding the legal and compliance review cost on revenue estimated between $640 million and $650 million. This would support normalized earnings per share number of $2.03 to $2.08. With that, we will be happy to take your questions. Operator?

Question-and-Answer Session

Operator

Thank you, Mr. Clarke. (Operator Instructions). Our first question comes from Byron Pope from Tudor, Pickering, Holt and Co.

Byron Pope - Tudor, Pickering, Holt and Co.

Good morning guys. John I wanted to get your thoughts for the IES segment for the two big and CO2 membrane systems project that you guys have LOIs for. Could you just give us a ballpark for the milestones that we should be looking for and then to try to think through how that will flow through in the income statement over the next couple of years? Again, I am just trying to look for the major milestones as it relates to those two big projects.

John Clarke

Sure. Byron, to be clear, it is one project that right now is supported by two initial LOIs. The first one was to allow us to begin some of the engineering works that was necessary and then the second was to allow us to begin the purchase of some of the long lead items.

As Patrick said, we believed when all is said and done that this project will be somewhere in the $125 million size award which of course will be the largest one that we have ever signed up. If you look at how that revenue is likely to run off assuming that the project is signed up in total by the end of the year, we will expect somewhere around 75% of that amount of money to be run off during 2009 and as we have discussed before, it is sort of a Bell curve where you get the bulk of it in the middle quarters. I guess for 2009, it would be sort of two, three, and four with ramp up in Q1 and finishing it in as we get towards the end of 2009.

Byron Pope - Tudor, Pickering, Holt and Co.

Okay. That is very helpful. And then the second question that relates to the new implied Q4 guidance and it is a big step up versus Q3 and so, could you just help us with the moving pieces from a top line and from a margin perspective and are we going to get a big step up in margin and yet again I am just trying to think through the Q4 deltas as it relates to implied guidance there.

John Clarke

Well, I will let Andy give you some detail to it but the fundamental driver of Q4 is the reality that finally bookings have hit and we will begin to see meaningful run off of revenue associated with the book of business in IES. We have also thought on the previous call that we have had in the bag a large membrane replacement order that we booked in I think, Q1 that we will not deliver until Q4 which of course does not generate a lot of revenues but is a very profitable piece of business for us.

And as you look at S&T, that business continues to have pretty good winds at its back given the amount of business that, you know, we know is in our shops right know. And I would hope and as the year wraps up, we will see some straightening in the automation and controls groups which of course bled heavily in Q3. Andy?

Andy Smith

Yes. Byron, just sequentially over Q3, if you look at the implied revenue increase going in the fourth quarter, about $6 million of that is the membrane order that John talked about which again is higher margin stuffs and will positively affect margins in the IES group and the bulk of the remainder is going to be increased project runoff in the IES group in Q4. Again, at good margins, with what we have had in our backlog right now, we are looking at margins on our backlog of work, in the, I think mid 30 range.

Operator

Our next question comes from Collin Gerry of Raymond James.

Collin Gerry - Raymond James & Associates

Hey, good morning. So back to backlog. Clearly, that has been one of the stronger points this year is the big growth you have seen there. As we look forward and you look at the timing of that given the economic concerns just around the world, any fears of project delays on your customer side or somebody else getting delayed in the overall scope of a big project that could push that revenue back and maybe on that same note, what is the security or as far as cancellations in that backlog number?

John Clarke

Okay, if you write down the backlog, obviously the backlog in the runoff, those are for projects that obviously we have purchase order signed and they are being worked on. So I think that it is less likely that that type of work gets delayed meaningfully.

Now, if you look at the prospect pipeline, there is always the risk that projects will slide to the right you know, from following us that predicting when and how jobs booked is one of our principal challenges in everything that we did. But again, I go back to the fundamentals that if you look at the global oil markets where most of these projects are situated, it is very hard to back off the development programs especially with projects that had been in the queue for a while and they have been largely based on economics that have been well below where current prices are. And to the extent that the operators get any relief on supply material cost that should help build momentum around those things progressing.

In terms of contract terms within our purchase orders and order booked, there are cancellation provisions in most of these agreements but if they are cancelled, then we obviously recover all of our cost plus any margins on work that has been completed or on material that has been ordered. You want to add anything to that?

Collin Gerry - Raymond James & Associates

Okay, so, but it sounds like based on your comments earlier that in your eyes and based on what you are hearing from your customers, you do not perceive that as a huge risk at this point in time?

John Clarke

We do not. I think based on commentary for instance, at Saudi Aramco and others no doubt have made, they are going to have very sharp pencils and they are going to want to get the advantage of what appears to be for instance, softening steel prices. That will be, a big help for their project cost but again, I think that is mostly going to affect new work that would be considered.

Andy Smith

Hey Collin. This is Andy. I will make one point because of the fact that there is a little bit this quarter, we in a lot of areas; we do not necessarily manufacture our projects. We will subcontract that work out and for many quarter to quarter, our subcontractors can be further along or not as far along as we would have expected within the quarter. It is a purely timing issue and it is short-term in nature but it is something to keep your -- to be aware of I guess that you know where we are as of September 30 versus October 10 can be drastically different just depending upon where our subcontractors are.

John Clarke

And that would impact, of course, revenue recognition.

Andy Smith

Revenue recognition and profit.

Collin Gerry - Raymond James & Associates

Okay. Well, that makes sense. And then I guess just on a smaller note, we have seen some pretty wild swings on the currency side, does that affect you guys in any material way?

John Clarke

Well, it can as the dollar is weakening last year, I am sure as you recall, and we did have FX losses that were generated. This year so far, you will see in our other net line, those have flipped around with the strengthening of the dollar so we are riding the benefit right now. But over a period of time Collin, it really tends to work out to be fairly neutral.

Operator

Our next question comes from Steve Ferazani from Sidoti & Co. Your line is open, Sir.

Steve Ferazani - Sidoti & Co.

Good morning. You know, I am thinking about the last sort of drilling downturn and you guys offset it with strong growth of the oil sands revenue. You know, in the last month or so, I have seen some of the operators there talked about reducing CapEx, do you see an impact in ’09 and do you not get necessarily the offset if some of your standard equipment sales will slow with drilling activity?

Patrick McCarthy

This is Patrick. On the North American side of it, we fully expect some reduction of rig counts and we have had some conversation with certain customers and what we looked back to is that when you think about our up to market parts and service business and you look back through the previous downturns, we have continued to grow that business over years. And so we see that is still remaining quite strong and then if there is going to be a weakness, it will be in the standard equipment product line based on those rigs and probably some of the small operators coming offline. The traditional equipment, again, we have more conversation today with larger customers who are talking long range programs and they are not looking at the next six to twelve months. They are looking at several years out and there is more concern in those conversation over capacity than it is about what happens over the next two or three quarters.

Steve Ferazani - Sidoti & Co.

So at this point, given the, you know, the CapEx reductions from the oil sands operators, you have no pull back there at this point?

Patrick McCarthy

No, we have not. Well, in fact it is interesting to me that at least as you look at the Canadian oil sands market; our Canadian operations probably for ’09 are about an 85% of capacity just on work that they got on their own backlog going forward. So, as long as there is not any prolonged weakness beyond that, again, we should be able to bridge that gap.

Steve Ferazani - Sidoti & Co.

Okay. Then on the Saudi Arabian joint venture, does that get pushed back a bit, I thought you are going to start generating revenues beginning of the year, am I wrong about that?

Patrick McCarthy

Well, we have always targeted end of the first quarter and it slid probably a couple or three months just on the construction schedule and permitting and getting things set up and good to go.

Steve Ferazani - Sidoti & Co.

Should we assume that cost will ramp up as you start hiring personnel, so Q2; you probably see a margin dip because you would not be getting the revenues but you will be adding personnel, is that reasonable?

Patrick McCarthy

We will see some cost pick up but those will be mostly picked up in the joint venture itself.

Andy Smith

We will see 50% of the cost ramp.

Steve Ferazani - Sidoti & Co.

And then I know the only guidance you have given on this project previously had been, you were thinking perhaps, $0.25 to the bottom line in ’09, is that no longer valid or any change in what we can think about that?

John Clarke

Well, I am not sure we ever gave a $0.25 number but we have not changed in our perspective of the strength and size of the Saudi market opportunity. In fact we probably feel better about it but it is a question of when it actually comes to fruition in terms of putting throughput through the plans. So, I don’t think that we have backed away from any of that.

Steve Ferazani - Sidoti & Co.

Okay. And then just a couple of quick questions on some line items on the income statement, depreciation spiked the last quarter then we saw it come down a bit here. What was that?

Andy Smith

Yes. Steve this is Andy. There is a little bit of catch up last quarter on some of the depreciation, for some of the amortization associated with the acquisition of Linco in the first quarter. That is what spiked it in the second quarter, there was a little bit of a catch up, and then in the third quarter, normalized a little bit. It will probably go up a little bit in the fourth quarter as we amortize off a little more of the intangibles associated with the Connor acquisition, again, at the end of August.

Steve Ferazani - Sidoti & Co.

Okay. And then on the SG&A was seen sort of, it looks like the ramp up there has slowed a bit. Is this more probably the growth level we are looking at or…

Bradley Farnsworth

Well, yeah. I think that -- this is Brad. I think that what we are going to see is, you know, costs kind of leveling out at this level and as I mentioned during my previous talk that we are at about a $29 million per quarter run rate right now if we exclude the compliance review cost. That is about the level that we would expect going forward.

Steve Ferazani - Sidoti & Co.

Okay. Great. That is it for me. I appreciate it.

Operator

And gentlemen, there are no other questions.

John Clarke

Alright. Well, we appreciate everyone’s time and we look forward to talking to you later in December and talk in a little bit more about how we see 2009 shaping up. Thank you.

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Source: NATCO Group, Inc. Q3 2008 Earnings Call Transcript
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