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McDermott International Inc. (NYSE:MDR)

Q1 2009 Earnings Call

May 12, 2009 10:00 am ET

Executives

Jay Roueche – Vice President of Investor Relations

John A. Fees – Chief Executive Officer

Michael S. Taff – Senior Vice President and Chief Financial Officer

Analysts

Andy Kaplowitz - Barclays Capital

Graham Mattison - Lazard Capital Markets

Jamie Cook - Credit Suisse

Martin Malloy - John Rice & Company

Will Gabrielski - Broadpoint AmTech

Tahira Afzal - Keybanc Capital Markets

Roger Read - Natixis Bleichroeder

Steven Fisher - UBS

Stephen Gengaro - Jefferies & Co.

Operator

Ladies and gentlemen, thank you for standing by and welcome to the 2009 first quarter earnings conference call of McDermott International. (Operator Instructions)

I would now like to turn the conference over to your host, Mr. Jay Roueche, McDermott’s Vice President of Investor Relations. Please go ahead.

Jay Roueche

Thank you [Eric], and good morning everyone. We appreciate you joining us today to discuss McDermott’s financial results for the first quarter of 2009 which we reported yesterday afternoon and is available on our website.

Joining me on the call this morning are John Fees, McDermott’s Chief Executive Officer and Mike Taff, Senior Vice President and Chief Financial Officer.

Before we discuss the quarter, let me remind you that today’s event is being recorded and a replay will be available for a limited time on our website. In addition some of the comments today will include forward-looking statements and estimates. These comments are subject to various risks and uncertainties. Please refer to our filings with the Securities and Exchange Commission which are available on our website for a discussion of the factors that may cause actual results to differ from management’s projections, forecasts, estimates and expectations.

With that I’ll now turn the call over to John.

John A. Fees

Thanks Jay. I would like to wish everyone a good morning. While I’ll let Mike cover the financials before I come back to discuss our operations in the business environment, let me start off by indicating how pleased I am with McDermott’s results this quarter. In total it exceeded our earlier expectations. Additionally, consolidated backlog grew to about $10 billion and we made some good progress on the lease pipeline projects in the Power business although it is still the segment most affected by the global economic slowdown. It was able to produce another quarter of exceptional results from its backlog as well as with its recurring business.

From a corporate perspective, Steve Johnson joined McDermott as the Chief Operating Officer. He’s an experienced executive who I’ve known for years and will be an outstanding addition to our management team. And we will benefit by the two new members who were recently appointed to our board of directors whose experience and insight will provide very beneficial.

But before I really get going let me turn the call over to Mike to take you through the financials.

Michael S. Taff

Thanks John, and good morning everyone. Starting with the income statement, total revenues were almost $1.5 billion, up 3% compared to Q1 a year ago. The revenue growth in the Offshore Oil and Gas Construction and Government Operations segments more than offset the decline in Power Generation Systems.

McDermott’s consolidated operating income of over $131 million in the 2009 first quarter compares to about $157 million a year ago. The majority of the decline is explained in two items. The $21.8 million increase in pension expense which is predominantly non-cash. This is an explanation you’ll hear from us throughout the year, as a result of the decline in the value associated with our pension plan assets during 2008. The other item is that in last year’s quarter we benefited from an $11.4 million gain on asset sales compared to a $1 million loss on sales and impairments in the 2009 quarter. We are pleased that excluding these items operating income otherwise would have increased year-over-year.

Below operating income, our results this quarter were also impacted by a $16 million swing in other income and expense line item compared to the first quarter a year ago. Net interest income declined by $8.6 million, primarily due to lower rates earned on our cash investments coupled with a lower balance, which more than offset the benefit from lower interest expense. In addition the other other expense worsened by about $7.5 million primarily due to non-cash charges related to foreign currency hedging activities we established for the construction of a new vessel, which will be offset by lower capital costs and thus depreciation in the future. As a result, pretax income declined by $42 million as compared to the 2008 quarter. But due to the mix in tax jurisdictions where our income and losses are derived our provision for income taxes actually increased by approximately $3.5 million. As most of you know, our tax rate varies quarter-to-quarter and year-to-year, dependent upon which taxing jurisdictions we are working in and the respective profit and losses incurred in those regions.

Now taking it all to the bottom line, McDermott reported net income of $77.7 million or $0.33 per diluted share in the 2009 first quarter compared to last year’s quarter of $123 million or $0.54 per share. We are pleased that the company’s consolidated backlog remains strong at nearly $10 billion, up sequentially and close to our all time high achieved a year ago.

Now looking at each of the business segments, Offshore Oil and Gas Construction reported segment income exceeding $45 million in the first quarter of 2009, including a loss of $2 million on asset sales and in equity income. Each of its major operating regions were profitable this quarter with the Middle East leading the way with its heavy level of work. Project closeouts and change orders had the Americas and Caspian regions profitable despite a modest level of ongoing work. And a soft marine campaign in the Asia-Pacific market dampened otherwise strong contract performance, but this region contributed as well.

Government Operations had another very good quarter with segment income of nearly $46 million. Considering we incurred a $8 million increase in pension expense and a doubling of depreciation and amortization expense, this segment’s operations were even stronger. Our site management activities and the nuclear components work continued their historical strong performance. Also this was the first quarter with our NFS acquisition consolidated, which largely drove the segment’s top line increase by adding about two-thirds of that growth.

Power Generation Systems continued to make the most of its backlog in recurring parts and service business, delivering another strong quarter. This time with over $58 million of segment income which again exceeded our expectations, particularly its double-digit margins. All in all, it’s a good start to the year.

Now turning to the balance sheet. Our liquidity remained at the $1 billion level for cash investments compared to only $10 million of funded debt and our working capital position improved over $120 million this quarter. McDermott’s liquidity remains a strength of the company. In addition to our solid cash investments position, we have a couple of years on average left on our existing credit facilities. While we continue to monitor the financial markets, we expect to begin the process of renewing these in the near future.

That pretty well covers the financials. I’ll now turn the call back over to John for his comments on our operations and business environment.

Jay Roueche

Thanks Mike. As I mentioned earlier we are clearly satisfied with our results for the first quarter. It’s a good start out of the blocks which will motivate our management team as we look forward to the remainder of the year. However, there still remain some warning signs on the road ahead which we are mindful of. The global economic climate remains somewhat uncertain and fragile, no clear path forward exists on CO2 as of yet, customers remain cautious on their large projects, credit’s tight, natural gas prices are still soft. While we believe McDermott is better positioned for these realities than most in our space, it would be disingenuous to suggest that we have perfect visibility at this time.

I do like our significant backlog which is proceeding with virtually no delay or cancellation and our liquidity remains very strong, both of which provide for a solid foundation in this environment.

Let me share a few additional specifics on each one of our segments. The Offshore Oil and Gas Construction segment results improved significantly this quarter compared to the prior two sequential periods which were negatively affected by expected cost increases, predominantly on the three Middle East projects. But we have made significant progress on this front. We’ve completed all the pipelines associated with the Ross Gas [Two] project which was one of three pipeline projects in Qatar that proved to be problematic. So it’s positive that we have this work behind us now. Ross Gas was the longest and largest of the three jobs. We resumed our work on the second project in April, the [Cutter] Gas [Three] and [Four] pipelines and have completed one of the pipelines and are well underway on the second. We expect to complete that second Cutter Gas pipeline around mid-summer.

During the quarter we took about $5 million of additional net charges, primarily on the third project, the Shell GTL job. Since the Shell pipeline has only just begun, the additional monies relate to the welding simulation, that would be pipe cycling and testing which we performed onshore, to better perfect our processes and approach before we get into the water without modifying our forward-looking contract estimates. We expect this investment to payoff when the project hits stride during the second quarter. Fortunately, the Shell job is the shortest in length and the smallest in pipe diameter of the three. Looking at all of these projects together, we’re now over 60% physically complete on the pipelines based upon the number of joints that have already been laid.

The weather in the Middle East has been erratic this year, but with the two remaining jobs largely being worked on during the traditional better weather months of the summer combined with our more conservative estimates which we took in the fourth quarter, we should complete the remaining scope within or better than our plan. Despite the progress made on these jobs we had about $215 million of revenue from projects that have little or no gross profit associated with them during the first quarter. And we still have about $850 million in revenue left to recognize, virtually all of which is expected to be recognized during the remainder of this year.

Regarding liquidated damages no new charges were incurred during the quarter, and we continue to believe that the potential for LDs are not probable to be incurred. We have ongoing discussions with our customers, in some cases with trigger dates modified so we believe that we will achieve a successful resolution that is satisfactory to all the parties.

While these projects have received most of the air time for the last few quarters it’s positive that generally the rest of the portfolio has performed more in line with history, with a few puts and takes but reasonably within our expectations.

During the first quarter we received probably the largest award this segment has ever booked with one order which was the Karan project for Saudi Aramco. We are pleased to be selected for this award by a valued customer and it was the key driver behind our backlog growing which now exceeds $5 billion in the segment at quarter end.

As Mike highlighted the Power Generation Systems segment had an outstanding earnings quarter despite $90 million less revenue. We benefited from a number of timing issues in the quarter including having a large customer hire us to replace a competitor [run] environmental retrofit project. This segment has done an exceptional job of squeezing the most out of its backlog and an ongoing differentiating factor for McDermott versus the peer group is our recurring parts and service business, which was largely in line with our expectations.

Considering the Power business is more sensitive to the global economic and credit issues than our other businesses, and our backlog and revenue burn rate have softened as of late, our expectations for this segment in near term are more moderated than this quarter’s results. On the other hand, I also realize that I have said this generally, this same line for several quarters now. We’ve continued to exceed our own expectations.

Also of interest we recently shipped our first thermal solar generating unit and booked a second order. While the dollar value of just two units was modest we do expect more work of the same nature as thermal solar power progresses.

The Government Operations segment started the year well with over 20% income growth even though it had a lot on its plate. The integration of the NFS acquisition has gone reasonably smooth in this the first full quarter as part of our consolidated income statement. Also we should benefit somewhat from the recently announced $6 billion commitment from the Department of Energy for additional site management work over the next few years and are working with the DOE on the specifics. As a reminder, we are a participant in a number of key sites including Pantex and Y-12, our two largest facilities, as well as Los Alamos, Lawrence Livermore, Savannah River, Idaho and a number of others, all on a nuclear site. Plus we are part of the consortium running the strategic petroleum reserve on the fossil side.

Many of these locations are receiving some DOE stimulus money. Also as a reminder we don’t record the value of our M&O contracts in our reported backlog numbers.

Finally we were also pleased that the defense budget that Secretary Gates revealed pretty well matched our prior expectations, specifically with the commitment to two Virginia Class submarines per year which continues our good work for our nuclear components and fuel activities.

Overall we’re a little cautious on the near term. A word outlook, I think customers are still feeling their way on new projects, particularly as it relates to large new awards and more specifically on the power side. A number of customers are using this opportunity to lower their cost on projects, specifically through procured items. You know we’re actively working with them to help them achieve these savings.

During the quarter McDermott booked about $1.6 billion in new awards exceeding the revenue burn. The Karan project I mentioned earlier in Offshore Construction was clearly the largest award providing the backlog addition, so the segment led the way in backlog growth. As most of you know by now we tend to have three quarters of backlog decline in the Government Operations, then we receive a grouping of awards at year end that coincide with the federal budgeting process.

Power had a soft quarter for new awards but we think it should increase some in the coming periods as we booked a good scrubber project after the quarter’s close, which is an encouraging sign in the economic climate we’re currently in. All in all, the projects are still there for our business. It’s only really a question of timing.

That wraps up my prepared remarks for our operations and summary. McDermott’s backlog remains at record levels. We have a solid balance sheet and we continue to make progress on our work. The first quarter was a good start to the year and our ongoing mission is to focus on project execution.

We’re heading to New York later this week for Calyon’s conference and will be there again the first week in June for three conferences in a row. I believe the host firms are Lazard, Credit Suisse and Macquarie. I hope to see many of you over the next month at one of these venues.

With that, Operator, we’ll now open the call for questions and comments.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Andy Kaplowitz - Barclays Capital.

Andy Kaplowitz - Barclays Capital

Can you talk about, you had an impressive quarter in Power and Government especially in terms of margins. You know, I get over 14% margins in Government with significant pension and headwind, you know, some depreciation headwind. And so what kind of things are you doing in those two divisions in terms of getting costs down? Because clearly it looks like you’re doing something there.

John A. Fees

Andy, I would say we’re doing a number of things. One is that we started an initiative back in 2007 to more broadly put our approach towards process improvements, six sigma approaches that we developed and perfected under our Government Operations across the entire B&W organization. We have a dedicated team focused on that and they’re producing excellent results in terms of improving the efficiency of our operations and helping us focus on costs and cost management.

On top of that, we have been thinking harder about across the board synergies that we might be able to get in G&A. Not only just on the Power side and the Government side, but also at the J. Ray side. And we’ve made some traction there. I still think there’s a little bit more work to do, but we have made pretty good traction across the board on those particular matters. And I think we’re starting to see evidence of that showing up in the operating results.

Andy Kaplowitz - Barclays Capital

John I didn’t see any unusual items in those two segments and so I guess my question is assuming there isn’t anything unusual, you know, how sustainable for instance is that Government margin, you know, against this pension headwind as we go forward? I mean I know it’s variable and lumpy, you know, but is this a decent run rate going forward?

Michael S. Taff

Andy, its Mike. I would say that, you know, we’re certainly pleased with this run rate. We had a few things we pulled forward on the Government side but, you know, I think you know that business is pretty consistent and we’re pleased with where we are there.

John A. Fees

Yes, I think we’re going to continue to see good opportunities on margin moving forward but I would not really change our overall thinking at this point in time about the long term run rate of margins in that business. But I think there are margin opportunities that exist.

Andy Kaplowitz - Barclays Capital

And one more question. John you gave, you know, comments on new awards that, you know, they’re out there and customers are taking their time. And, you know, when we look at the quarter Karan is definitely a nice award. It looks like there wasn’t much else in J. Ray, you know, not too many small to mid-size projects in there. So I guess my question is, you know, how is sort of the bread and butter stuff going? You know, should we get a ramp up in the small to mid-size projects as we go throughout the year? And then, you know, what are your customers telling you about these larger projects? Are they, you know, maybe getting more excited as [ample] costs are coming down and maybe the global economy looks better? Any visibility there at all would be helpful.

John A. Fees

I think right now Andy we’re, a lot of the bread and butter ties into a lot of our marine assets. And right now our marine assets are fairly busy. We have bid a number of good opportunities. I think that will continue to extend that busyness throughout the year and potentially into next year. So I think some of those opportunities are good and exist. We have a good list of focus projects that we’re continuing to go down. That has not really changed much. As you may remember, we do a lot of work for the super majors and the international oil companies. The spending levels in that area, you know, hadn’t moderated as much as the balance of the industry so, you know, we’re continuing to see a lot of projects that we would have fundamental interest in. And so I would expect to have a decent run rate this year on being able to capture some pretty good work in the area of which we would call bread and butter.

I was very encouraged, if I can change venues a bit. I was very encouraged by the scrubber award we recently got on the Power side. We’ll be providing more details. That happened after the quarter closed, but we’ll provide some more details in the near future. And it was one of these events that I wouldn’t necessarily call a major trend. But, you know, a trend starts at one data point and it’s good to see some of that break loose, which is the, with the first indications that we’re getting coming out of the credit crisis and where we’ve been on a major Power project such as that. So we were rather excited about seeing that and seeing that moving forward. And again I wouldn’t necessarily identify it as a trend at this point, but we considered it to be an encouraging sign in the environment that we’re situated.

Andy Kaplowitz - Barclays Capital

John do you see other scrubber awards out there, you know, after this one?

John A. Fees

There are other projects that are out there, that are active that are good opportunities for us and I would not consider that market anywhere close to that.

Operator

Your next question comes from Graham Mattison - Lazard Capital Markets.

Graham Mattison - Lazard Capital Markets

Just a follow up on the margin question there. Looking at the biz you have outstanding on the J. Ray side do you still see a sort of 10 to 12% margin as the appropriate range or the range that you’re looking at?

John A. Fees

We believe that. We think that that’s the appropriate way to think about it. One thing that we are seeing that, you know, is an opportunity is there is a good buying environment right now on the commodity side. And although we’re working very closely with our clients who want to really try and capture some of this cost savings, you know, we’ll continue to try to, you know, use that as an opportunity for margin benefit as well. But right now at this point in time I would not change that general feeling about the new awards going into the backlog providing the 10 to 12% margin run rate into the future.

Michael S. Taff

Yes, and Graham just to remind you as we kind of indicated last year we’ve still got, you know, a fair amount of these jobs to work through the pipeline this year at zero margins. So really when you’re saying 10 to 12 that’s really out into ‘010, ’11 and the jobs we’re looking at today.

John A. Fees

And that would be new jobs coming into the backlog as opposed to we indicated in our comments earlier that we had a little over $800 million worth of zero margin work associated with these three problem projects that we still need to get through the snake in the balance of the year.

Graham Mattison - Lazard Capital Markets

And then just looking on the acquisition front, I mean have you seen any change in terms of the terms that you’re seeing on vessel acquisitions, pricing moving around on that front? Have prices come down there given the change in the environment?

John A. Fees

I would say there’s some pressure in that environment. We are seeing some downward pricing pressure on vessel charters for example which is totally different than a situation we were in 12 months ago. And we’re seeing a number of under utilized vessels, stressed vessels that are in construction and we’re evaluating all those possibilities as opportunities for the company.

Operator

Your next question comes from Jamie Cook - Credit Suisse.

Jamie Cook - Credit Suisse

Just a follow up question on the J. Ray margins. This is the, you know, third quarter that we’ve seen improvements since the third quarter of 2008. And I understand we have about $800 million more revenue we need to burn through, but, you know, Mike or John as you look at it do you think the first quarter is sort of the bottom when you think about margins on the J. Ray side? You know, because I don’t think there was anything else unusual in there and you sort of alluded to we could start to see some benefit on the procurement side. So if you can help me think about that. And then I guess just my follow up question, unless I missed it in the prepared remarks, I think last time you reiterated it in the analysts range out there for 2009 and given the strong performance we had in the first quarter I was just hoping you could update us on that.

John A. Fees

Let me go back to the J. Ray question first. What we had indicated prior is that we thought that with the combination of work that we were doing and the combined with the zero margin projects, we had an expectation that margins were probably fluctuating in a 6 to 8% range for 2009. And we really haven’t changed our thinking about that. Now with that 6 to 8 just so that everybody is on the same page with us, consider, didn’t consider, it considered that we would not be imposed with liquidated damages on any of the contracts of which we may have some exposure. We have worked with our clients. We do not think that is a probable event at this point in time based upon the discussions with them and the progress that we’re making on the projects and how those projects fit into the balance of the infrastructure that they’re trying to develop. So fundamentally, we do not believe that to be a question or an issue at this time.

On the other side, we have not incorporated in it any claw back of contingency nor recovery of claims. And so we also feel that we have a little bit of a positive potential that is not really reflected in our thinking on a 6 to 8% range. And so that’s how I would characterize that in terms of J. Ray margins, the expectation for the year, and I think we would expect to turn into a more typical run rate on margins in 2010 which is, we’ve indicated to you in the past.

Let me reflect for a minute on this question about the comment that we made relative to the analysts estimates that were out there. We felt that there was a tremendous amount of uncertainty relative to questions that we were receiving from the market of what the expectations should be for the company in light of the economic conditions and combined with the problems that we were seeing in the Middle East. We felt that it was prudent to provide some amount of comment relative to what we thought the path forward may look like.

And as you all know we have historically not given guidance and really do not have a plan to initiate giving guidance. But we felt that it was prudent to try to provide some perspective looking forward on what may occur as we go into the future and therefore we did what we did at the point that we had that particular release. And we don’t really plan to continuing to comment on that going into the future, but we felt that it was more of a point in time perspective and we thought it was important to get everybody closer to where we thought we were heading as a company.

As you know the NC business is rather lumpy and it gets a little lumpier when you get into a higher percentage of lump sum related projects. And so we really don’t think it would be prudent or would be wise to give any type of structured guidance on an ongoing basis.

Operator

Your next question comes from Martin Malloy - John Rice & Company.

Martin Malloy - John Rice & Company

Could you talk a little bit more about what you’re seeing on the bidding opportunities at J. Ray, geographically and also bids outstanding?

John A. Fees

To throw the bids outstanding number out first, we were looking at about $3.2 billion at the end of the quarter. It was down slightly from the sequential period but that’s what you would expect when you receive a $1 billion plus award.

Michael S. Taff

And Marty I mean and I think the bids outstanding we’re seeing is pretty consistent with kind of the allocation of where the current backlog is. I mean still good opportunities exist in the Middle East and Asia-Pacific regions. We are seeing an uptick in opportunities recently in the Caspian region, a lot of activity that’s going on there. And then more limited activity I’d say in the Gulf of Mexico market, both on the U.S. side and the Mexican side.

John A. Fees

I’d say, Marty, the Caspian was a little bit of a surprise to us. We saw some bid opportunities arrive there a little bit earlier than we expected. And that was a pleasant surprise. But I would say that about half of the focused projects that we’re really looking at are concentrated in the Middle East and a balance of them are probably evenly spread between Asia and the Caspian with a smaller piece in the Gulf of Mexico.

Martin Malloy - John Rice & Company

And that focused project number still $15 billion type range?

John A. Fees

It adds up to right at $15 billion right now. So that’s the list that we have and that’s what we’re running down and chasing.

Martin Malloy - John Rice & Company

Could you talk about the modular nuclear product offering that you discussed a little bit in your annual report and the timing of when we might find out some additional information there?

John A. Fees

Yes, I’ll give you a little bit of insight there. You know, we felt that it was important to go off and to consider that as an option for the industry. The industry, I think, is suffering a lot of movement to the right in delays and I think that it’s related to the difficulty of wrapping your mind around a total cost and the certainty around that cost. We felt we had a good capability in the company to bring our own design forward and to be able to supply on a modular basis factory built reactor assemblies. And so we’ve done evaluation of that. We have done considerable, had considerable discussions with the utilities. We’ve had a lot of interest on the part of the utilities. We’ve been to the NRC to discuss this with the NRC. And right now we’re at a point where we’re trying to take it from that early stage of development to plot our path forward.

There’s still a fairly long way to go, but I think the big wave on nuclear’s moved to the right and I’m not sure that we, I don’t think we’ve missed it. I think we have an opportunity here to be able to capture this opportunity and move it forward. Certainly the enthusiasm is there on our part and on the part of the utilities to consider what we’re looking at developing going forward, but I would say that we’re in the earlier stages of a concept that probably wouldn’t start delivering megawatts to the grid until later in the next decade. So that would be the perspective I would leave you with this morning. We may have a few announcements coming out in the future. I’d say stay tuned.

Operator

Your next question comes from Will Gabrielski - Broadpoint AmTech.

Will Gabrielski - Broadpoint AmTech

Your last quarter you guys made a comment about the Power business and how it’s performed in past recessions. Do you still comfortable with that flat to down 5% number you’d given?

John A. Fees

I would say that right now I’m a little more uncertain and, you know, we certainly had a good quarter this quarter. And it was within our expectations what we would have seen there. And I’m saying that on the basis of the parts and service business. I would say that I think I need to see a little bit more openness on the capital budgets relative to the utilities to continue to feel that way. I don’t have any reason not to feel that way at this point in time, but I’m just a little more uncertain until I see a little bit more movement on the part of the utilities relative to their capital spend. You know, we’ve booked a decent amount of work. We had a lot of book and burn in the quarter. It’s behaving about the way that we would expect it to behave. But, you know, we’re seeing some unprecedented things, you know. For the first time in the history of us tracking Power Generation there’s actually been a decline in demand and output. And that’s very unusual. And it’s things like that and that make me moderate a little bit more in my thinking about where this could go. Right now I don’t have any reason to think differently than that but I would say that I’m a little bit more cautious.

Will Gabrielski - Broadpoint AmTech

In terms of what a recovery might look like in Power and the environmental side, can you talk a little bit about it? Any type of visibility that you’re getting from customers about when they may want to obviously get back into some of these environmental programs and what that recovery might look like?

John A. Fees

I think it’s hard to speculate. You know, we certainly felt that it was a good sign booking a scrubber here recently. We have a number of projects that we’ve got great technology and a great competitive position with that I think will absolutely have to be done. If we see some increase in power demand, if we see a continuing freeing up of the credit markets and a little bit more certainty about the economy, we could start seeing some activity there later this year. If those events don’t transpire that way, some of those projects could actually move out into the ’10 timeframe before we would actually start to see any reasonable level of booking activity. So I think it’s dependent upon those events, but I don’t think it’s out of the cards to continue to see more of that work later this year.

Michael S. Taff

And certainly getting a replacement ruling for the CARE Act could be a strong catalyst for the environmental market as well.

Will Gabrielski - Broadpoint AmTech

On the L&G market, I’m not sure how granular you’re willing to get there but in terms of opportunities that you see over the next 12 to 18 months, how material is the L&G markets for what you’re looking to do in Oil and Gas and any detail you could provide around that?

Michael S. Taff

Well there’s an awful lot of work coming in Australia which probably John can elaborate on.

John A. Fees

Yes, you know there’s a fairly large project off the coast of Australia that we have had a tremendous interest in building the modules associated with the onshore development. You know, Chevron has a lot of interest and activity out in that particular region. We’re staying very, very close to those opportunities. Right now we have not seen a lack of interest on those opportunities. We have turned in some bids on a variety of projects and we’re following the market. Again it’s on our focus list, it’s what we’re following and we think it could be a good opportunity for us.

Michael S. Taff

And L&G really gives us a twofold opportunity. Not only can we pursue our traditional field development work to actually get the gas reserves to the L&G plant, we can also do the modular fabrication and build those facilities in our yards and ship them over to onshore destination.

John A. Fees

And then Will you may recall, you know, from a year or so ago we certainly had a good project, our initial project into that field with the Woodside train, five modules that we built out of our facility outside of Singapore and in Asia. So we’ve got some experience there and the clients know our expertise there.

Michael S. Taff

Yes, the only cautionary note that I would give in there is we are not in a strong gas market right now. And so I think the drivers to really put L&G on the ocean are, have dissipated considerably. But there is still a lot of interest in L&G in Asia, and we’re continuing to follow those developments.

Will Gabrielski - Broadpoint AmTech

But have you guys seen any sort of material shift in sort of some of these target dates that we all track for a final investment decision on some of the projects, Papua, New Guinea, Australia, etc.?

John A. Fees

If you’re talking about the New Guinea project and the Gorgan we have not really seen a change in those dates.

Operator

Your next question comes from Tahira Afzal - Keybanc Capital Markets.

Tahira Afzal - Keybanc Capital Markets

I just wanted to start off with asking you about the J. Ray bookings. Obviously Karan was the leading portion there. Outside of Karan could you give me a sense of how much you booked?

Michael S. Taff

Right now it would probably end up backing into the exact value of the Karan project so we’ll probably hedge a little bit on that. But suffice it to say Karan was the major component of our bookings in the Offshore Construction segment.

Tahira Afzal - Keybanc Capital Markets

So I mean let’s assume that the rest was around, you know, $200 million or so. You know, what kind of normalized, you know, as you pointed out and John talked about, a normalized rate outside of mid-size and large size projects? Really the activities to keep your moving fleet busy. Would that be around $200 plus million dollars in size on a quarterly basis?

Michael S. Taff

You know, Tahira, that’s probably not a bad number, you know, to think about. But that’s obviously it’s going to fluctuate quarter-to-quarter just depending on what comes in and all. But that’s not a kind of a bad number to think of.

John A. Fees

But you’ve got to be careful because you’ve got to moderate, you know, what project work we used. You know, we’re a EPCI contractor so we do take things all the way through installation, so you’ve really got to moderate your thinking about what kind of bread and butter marine work comes in opposite of what we dedicate our vessels to and what project work we’re associated with. I mean our customers rely on us heavily to continue to maintain and upgrade and work on their installed infrastructure, but fundamentally we’re an EPCI contractor and we’ve got to kind of balance that mix opposite of our major project list and what we’re working on going forward. So it may moderate. You may see a few big projects come in that may capitalize on the fleet, and it may decrease the amount of that kind of work that we would actually accomplish.

Michael S. Taff

And you’re also, you know, going to get some change orders that occur. And we had some of that that we benefited from this quarter as well. And again that’s just, those are lumpy in nature but, you know, historically we were in the, you know, with [Jay Hunter] million dollar range or something like that for, you know, per quarter on the change orders and all that we saw coming through.

Tahira Afzal - Keybanc Capital Markets

Secondly I just wanted to ask about the mix. The news coming out of this seems to be that you’re finally sitting down with some of the international oil companies and might actually formalize an alliance, probably by the end of this year. Are you hearing any buzz around the Gulf of Mexico space in regards to Penex?

Michael S. Taff

We have some opportunities with them that we’re proceeding with and we’re pursuing and we would consider them to be a great client and we look forward to doing some work with them. I really can’t comment on their internal structural alliance activities, but we have good capability for them. We’ve got our yard down in Altamira. We have excellent vessels in the Gulf of Mexico that can do service with them and we have opportunities with them that we intend to pursue.

John A. Fees

And I would add that we certainly hope that, you know, the expectation was that, you know, they’re several years behind what had been forecasted for the level of work that’s in that region of the world. So we’re certainly hope that what you’ve indicated is true and we’re ready to serve them.

Tahira Afzal - Keybanc Capital Markets

If I was to look at today was it last quarter when you spoke, would you be incrementally neutral, you know, at the same place in terms of your opportunities there? Or are you feeling a little more positive?

Michael S. Taff

With Penex?

Tahira Afzal - Keybanc Capital Markets

Yes.

Michael S. Taff

I’d say a little more positive.

Tahira Afzal - Keybanc Capital Markets

And then in terms of your government work, I know it might be a little early to ask but what really happens once all these Virginia submarines are rolled out? Do you have a longer term strategy in mind? Is there anything else? Does the government need more submarines after that? How should we be looking out a few years out from now?

Michael S. Taff

Well, you’ve got a combination of submarines and aircraft carriers that are in the mix. And we would expect there to be an ongoing piece of work with us for some period of time. And then the other question would be renewal of the ballistic missile submarine force and we have an expectation that the government would likely renew that force going into the future. And that’s a fairly large fleet. I’d say it’s a very vital part of our strategic deterrent and we would have an expectation that as we go into the near term future that renewal of that part of the fleet would be a possibility.

Tahira Afzal - Keybanc Capital Markets

And then if you look at the DoD plan that came out, it seems to be more focused on keeping shipyards busy and unionized labor within those busy. Does McDermott benefit at any level from that?

Michael S. Taff

We don’t run any naval shipyards but, you know, we are a key element in terms of the ability of those, of nuclear vessels to go to sea. So in terms of whatever structurally happens to sustain the workload in those particular areas would have a residual benefit associated with us.

Operator

Your next question comes from Roger Read - Natixis Bleichroeder.

Roger Read - Natixis Bleichroeder

I guess a couple of questions starting on the Power Gen segment. Obviously, you know, things are looking a little weaker there as we see across the large part of the economy. But how would you break down how the Q1 results were in terms of delivering out of backlog versus your services related business?

Michael S. Taff

I’m not sure I understand the question. Could you give me that a little more?

Roger Read - Natixis Bleichroeder

Well, let’s say capital equipment deliveries versus your just general services business, the turnarounds or the selling of spare parts as opposed to selling new equipment for a specific order.

Michael S. Taff

Yes, I think it was actually a combination of a lot of those aspects, Roger. I mean I think if you’d kind of break it down, and we don’t generally get this granular, but if you look at the way we break down our business between OEM, environmental and parts and service and then our construction company, we really saw, you know, good activity in all of those. And I think the key to the Power Generation this quarter was if I could say one word it would be project execution, or two words. They did very well in kind of getting the most out of their backlog on our OEM projects and in our environmental projects. We did see a decent amount of volume coming through on the parts and service business. And then our construction company that actually the guys in the field erecting our components had a good quarter as well.

John A. Fees

Yes. I would just say that, you know, if you want to just think about it in some relative terms if you compare it to about the same time last year, everything produced about the volume that we would have expected plus or minus a normal run rate against the first quarter of last year with the exception of the new equipment business which produced roughly about 70% of the volume. So if you want to think about it from a revenue basis, that would be the way. So the mix changed a little bit and became a little bit heavier in construction, parts and services and things like that because of the relative change in the volume there, which was predominantly in the heavy equipment side of the business.

Roger Read - Natixis Bleichroeder

So as we see that equipment business probably slow down a little bit more the rest of this year and into 2010 we don’t necessarily have to see a margin impact as well?

Michael S. Taff

Actually you know it’s kind of interesting. If we do our job right which is to manage our costs properly, you can actually get to the point where your margins go up on lower volume because of the heavier mix of higher margin work in parts and services and construction. And so you can have a tendency to see it go in the other direction. We could have increasing margins with slightly lower volume.

Roger Read - Natixis Bleichroeder

Looking at the offshore oil and gas, the J. Ray piece, if I did the math right back out the $215 million of zero margin or low margin business you did about 9% on the remaining part of your business?

Michael S. Taff

That’s about right. We’re in the kind of 9 to 10% range if you kind of normalize that. I think your math’s right on.

Roger Read - Natixis Bleichroeder

Then if I look at the backlog runoff for the remainder of the year in that business looking at the Q last night I think it said $2.3 billion so you’d be expecting $3 billion of revenue out of J. Ray this year?

Michael S. Taff

I’ll trust your math.

John A. Fees

Yes.

Roger Read - Natixis Bleichroeder

When you look at the stuff you’re bidding on, the awards you have remaining for 2011, excuse me 2010, J. Ray ought to be able to stay flat over the next 18 months plus?

Michael S. Taff

I think that’s not an unreasonable expectation. It just depends on, you know, I think we could be flat to somewhat up. It just depends on opportunities and our success rate in bids and, you know, how active we are and are there any changes in the environment? But I don’t think it’s an unreasonable expectation for it to be flat to maybe up a little.

Roger Read - Natixis Bleichroeder

Final question along those same lines, more so J. Ray I think than the other segments, certainly not the government segments since they’re spending money crazily. Customers putting price pressures on you, is that anything that you find or you believe that you’ll find too difficult to manage in terms of you’re talking about procurement savings going forward. Does that match pretty well with what the customers are asking you to do, you know, or do you see an opportunity to either gain or lose margin as you deal with those issues?

Michael S. Taff

You know our objective is not to lose margin over that question. I mean we make money on procurement. It’s part of the value added that we give to our clients and so from our perspective if there is an opportunity out there to save the client money by aggressively pursuing procurement we’re going to work with the client and make sure that that value gets passed on as part of the equation. At the same time, we are keeping our bidding discipline together to get the margins that we think we just generally deserve as part of the work that we’re doing and we’re pursuing. So we really are trying to stay very disciplined about it and focus on delivering the value through the, the value that we give to our clients through our procurement management and not really effect our overall margins or our opportunities that we might have in executing our projects.

So, you know, we do this on a lump sum or a combination, partial reimbursable lump sum basis and we think there is a deserved margin for that risk as well as the investment that we have in infrastructure to execute the business. And so that’s, we continue to stay very focused and disciplined on that as well as our project executions.

Roger Read - Natixis Bleichroeder

My final question, acquisitions, obviously earlier you spoke about vessel prices probably coming down as vessel utilizations dropping globally, did a lot of stuff in the back half of last year. Anything else or any particular segment we should expect you to focus on over the next, you know, let’s say the remainder of ’09?

John A. Fees

Well, you know, we don’t have anything really to comment on. We usually don’t comment on these things as appropriately until we would get to the point where we would have something that would be able to share. You know we have a process internally that we are working through, looking at all available opportunities whether it’s a vessel or some type of built-on or other strategic acquisition. We have a team that that’s what they do. We are trying to be very guarded. We think that opportunities in this environment should have high returns and so we’re really not going to invest in a technology, whether it be internal or vessel or a business that we would go off and pursue without getting a very strong return in this environment. We’re being very guarded about making the strong balance sheet. You know we ended the quarter with our very nice cash balance and we think we enjoy that. And we’re trying not to be too cavalier with how hard we worked to earn that and the value that that creates for our shareholders in terms of stability of this company.

So we’re trying to really balance our desires to keep strength in the balance sheet off of a lot of opportunities that seem to be emerging opposite of high return expectations for those opportunities. And we’re working through that process. It is not an inactive activity inside the company.

Roger Read - Natixis Bleichroeder

Maybe just a slightly different way to ask that, are you more or less likely do you think to do an acquisition in ’09 than you have been in prior years?

John A. Fees

I don’t see any change.

Michael S. Taff

Roger, the way I would answer that question is we’ve done I think if I count it right five acquisitions or so over the last 18 months or so. And we’ve done acquisitions in each of the disciplines. We’ve done some, you know, the Canadian acquisition vessels up for J. Ray, M&C for the Government group and as well as NFS and then a couple of smaller acquisitions on the Power side. And so we’re actually still pursuing, you know, different candidates on each of those business units.

John A. Fees

Recognize that with the constraints that I mentioned, you know, you could get to the point where a lot passes your screen and nothing passes your screen. And so I don’t want to create a false expectation either. You know we have a very vigorous disciplined process that we’re pursuing relative to this question.

Operator

Your next question comes from Steven Fisher – UBS.

Steven Fisher – UBS

A question for Mike on the accounting for pipeline projects. They’re going to be finished in stages. It sounds like three out of the six are already done. Just wondering are the contingencies that you assign to them are they assigned to the specific unit such that you reverse them as you go along if the performance on that unit was good? Or would it be reversed all at the end? I mean it sounds like it’s going to be all at the end but just wondering.

Michael S. Taff

Oh no it’s actually more assigned to each, you know, if you want to call it unit but really to each job. I mean the way we structure that is we have a process called the PROM process or our project risk and opportunity management system and so we basically assign the risk and assign the contingencies associated with that risk. It’s not necessarily pulled down proportionately because certainly certain phases of the job may be higher risk than in the earlier phases of the job. But as we complete the job, the contingency would be drawn down. I’d say the user would be drawn down as that job is completed.

Steven Fisher - UBS

Was that a help to the first quarter margins as you finished up the?

Michael S. Taff

No, I’d say overall, you know, we’re, first quarter was pretty much the way I’d define it is right on schedule. You know we had reforecast our lay rate, reforecasted our weather down time and now I’d say we ended March right where we had forecasted. We did a very good job of forecasting at the fourth quarter and we really hit the marks there.

Steven Fisher – UBS

And then on the government side of things. Last quarter you had mentioned that you thought 10 to 20% increase in revenues for the Government segment this year would be a reasonable range. Certainly the first quarter was off to a much better start than that. I’m wondering if you think that 10 to 20% is now looking conservative or is there anything we should be aware of for the rest of the year?

John A. Fees

I think that’s still a pretty good number. I mean I think we’ll come in and, you know, maybe closer to the higher end of that range but it’s still a good estimate.

Operator

Your next question comes from Stephen Gengaro - Jefferies & Co.

Stephen Gengaro - Jefferies & Co.

Just a couple of housekeeping items. I know you mentioned these in some detail in the opening remarks, but the corporate line which was about $17.7 million in the quarter was up dramatically sequentially. How should we think about that going forward?

John A. Fees

I would say, Stephen, it’s probably, you know, a pretty good quarterly run rate in that, you know, $16 to $17 million range. A large piece of that increase was due to our increase in pensions. About, I think about $4 million of that. And then the other $3 million kind of quarter over quarter related to, you know, some systems projects we’re working on in the middle of a large SAP project with an HCM so that’s incurring some costs as well.

Stephen Gengaro - Jefferies & Co.

And then when we look at again the other other line should that revert back to a much more normalized level going forward?

John A. Fees

I certainly hope so. Yes.

Michael S. Taff

It’s a tough line to forecast.

John A. Fees

But no it should revert back to a more normal line.

Stephen Gengaro - Jefferies & Co.

Just my final question gets back, I’m sorry, but back to the J. Ray margins. When you book a large project like you did in the first quarter at J. Ray is it safe to say that that project fits within your parameters of sort of 10 to 12% margin range?

John A. Fees

You know I think that, you know, not necessarily talking projects specific. I mean I still, when we say 10 to 12% range we’re talking about the whole portfolio of projects and not just one project in general. So not to talk specifically about that one project, so when we think of 10 to 12 we’re thinking about, you know, longer term what those margins would be for the J. Ray portfolio of projects and for, you know, kind of the margins of what we’re bidding and all still would result in net result would be in that range for the, you know, 10, 11 timeframe.

Operator

That is all the time we have for questions. At this time I would like to turn the call over to Jay Roueche for closing remarks.

Jay Roueche

Thank you Eric, and thank you all again for joining us today. A quick reminder that the call included forward-looking statements. For more information on these I encourage you to see our SEC filings. Please call Robby or me if you have any follow up questions or need any clarification and we look forward to seeing many of you in New York over the coming month. Eric, this concludes the call.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You all may disconnect and have a good day.

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Source: McDermott International Inc. Q1 2009 Earnings Call Transcript
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