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KBR, Inc. (NYSE:KBR)

Q2 2009 Earnings Call

July 30, 2009 11:00 am ET

Executives

Rob Kukla - Investor Relations

Bill Utt - Chief Executive Officer

Kevin DeNicola - Chief Financial Officer

Analysts

Andy Kaplowitz - Barclays Capital

Jamie Cook - Credit Suisse

Martin Malloy - Johnson Rice

Barry Bannister - Stifel Nicolaus

Daniel Pickering - Tudor, Pickering, Holt

Steven Fisher - UBS

Will Gabrielski - Broadpoint

Vance Edelson - Morgan Stanley

Operator

Welcome to the KBR 2009 second quarter earnings call hosted by KBR. (Operator Instructions).

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

Rob Kukla

Good morning and welcome to the KBR second quarter 2009 Earnings Call. Today's call is also being webcast and a replay will be available on KBR's website for seven days. The press release announcing the second quarter results is also available on KBR's website.

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

Before turning the call over to Bill, I would like to remind our audience that today's comments may include forward-looking statements reflecting KBR's views about future events and their potential impact on performance. These matters involve risks and uncertainties that could impact operations and financial results and cause our actual results to differ from our forward-looking statements. These risks are discussed in KBR's Form 10-K for the year ended December 31, 2008, KBR's quarterly reports on Forms 10-Q and KBR's current reports on Form 8-K.

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

Bill Utt

Let me start by discussing the operational highlights of the business. Overall, I am pleased with KBR's second quarter results. With respect to our upstream business unit, the Skikda LNG project continues to proceed very well, and at the end of the second quarter was 49% complete. At the end of the quarter, the Tangguh LNG project was 99% complete and the Yemen LNG project was 98% complete.

In regards to the Tangguh LNG project, earlier this month our customer announced the first cargo of liquefied natural gas from the Tangguh facility had been shipped to a regasification terminal in South Korea. This initiates the start-up of the project and marks a successful milestone in the culmination of planning, engineering, design, procurement and construction for KBR and our customer.

For the Gorgon LNG project, the customer has publicly stated that they are expecting a final investment decision in the second half of 2009. KBR continues to perform post-FEED early engineering and procurement services on the project, as well as final development of project execution and logistics planning.

The highly complex and integrated Pearl GTL project is also progressing well, with engineering and procurement services completed and construction progress over 50% complete.

In our Oil & Gas business, we continue to support the Jack/St. Malo semi-submersible project, with extended pre-FEED work on the hull and mooring. We look forward to potentially expanding our opportunities on this world-class project.

Our FEED work on the drilling platform for the Chirag Oil project and an FPSO for the West of Shetland's project are also proceeding well, with expectations of expanded detailed engineering opportunities over the next 12 months.

KBR continues to refine our strategies to capitalize on the significant opportunities in Brazil and also in Kazakhstan, where we have the PMC role on the Kashagan project.

During the second quarter, our Eos Joint Venture with WorleyParsons was awarded an umbrella or enabling agreement covering project services for the PNG LNG Project by Esso Highlands Limited. The agreement supports requests from Esso Highlands to provide engineering, training, in-country support services and integrated project team services for construction and project management. It maintained Eos' engagement in the upstream component of the proposed PNG LNG development, following the completion of Eos' current FEED services contract. The agreement commenced in March 2009 and extends to the end of 2014.

For our government and infrastructure business, it was recently announced that KBR was unsuccessful in securing either of the two large Afghanistan task orders under LOGCAP IV. We recently met with the customer for debrief on the selection criteria and the decision metrics for these awards. After debrief, we decided that KBR will not protest the outcome of the awards. At this time, we don't know the details or the timing of the transition plan, but our current expectations for the transition are anywhere between three to six months. Kevin will provide further details in his comments on the financial impacts related to our work in Afghanistan.

In regards to the transition from LOGCAP III to LOGCAP IV in Iraq, we have received preliminary request for proposals on portions of the Iraq work under LOGCAP IV. Although the timing for the issuance of the final RFP is still a moving target, we currently anticipate bid and awards at the end of this year or early next year.

Over the past six years, KBR has gained valuable experience in providing logistical and life support services, obtained through our support of the US Army in Iraq and Afghanistan. In the past, I have discussed KBR's strategic approach to utilizing this expertise to expand our opportunities geographically, including to other branches of the US Military, departments of the US government and non-US governments. We are currently pursuing a number of major logistical and life support programs, including several field logistical support contracts in the continental US.

Internationally, we are awaiting award on a state department multiple award task order contract for logistics, engineering and life support services in Africa called AFRICAP, and pursuing a logistics support program for the National Science Foundation in Antarctica. The US Air Force manages a logistics umbrella as well, AFCAP, where we are pursuing LOGCAP type work in Kuwait.

In regards to non-US governments, we are seeking to expand services provided to the UK Ministry of Defense for new infrastructure projects in Afghanistan, and globally with an integrated fuel supplies management program. In the Gulf region, we are concluding work on the initial construction phase of expeditionary headquarters facilities for the Australian Defense Force, while pursuing follow-on program management and construction management opportunities.

Relative to many of the lawsuits that have been filed against KBR related to our LOGCAP work, on June 30, 2009 the Eleventh Circuit Court of Appeals affirmed that the political question doctrine bars a plaintiff's suit alleging KBR is responsible for civil liability related to its activities as a contractor to the US Military under the LOGCAP contract.

The Court affirmed in this case that the Military, not civilian contractors, decides and directs the activities of contractors in battlefield situation and the political question doctrine, "Excludes from judicial review those controversies which revolve around policy choices and value determinations, constitutionally committed for resolution to the halls of Congress or the confines of the Executive Branch."

In this case, the Eleventh Circuit held that adjudicating the plaintiff's claims would require reexamination and second-guessing surrounding the conduct of a military operation during a wartime environment. Contractors facing these types of suits now have a useful Appellate Court precedent, which affirms that significant protection exists where contractors are executing military directed missions.

Further, previously we announced that KBR has been dismissed from two lawsuits arising from an electrocution incident that resulted in the unfortunate death of Sergeant Chris Everett. The dismissal orders were issued by the United States District Courts in the Southern District of Texas and the Eastern District of Louisiana.

Regarding KBR's government and defense business in the United Kingdom, in June, KBR was recognized by the British Ministry of Defense as the Department's top key supplier. KBR's government and infrastructure business unit currently works on a number of high profile projects with the MoD, delivering infrastructure and other support services to the British Military, including contractor logistics support, Afghanistan infrastructure support and Temporary Deployable Accommodation programs. During the performance reviews of 29 key suppliers, which were conducted between April 2008 and March 2009, KBR was awarded a score of 8.2 out of 10, making us the first key supplier to receive a score above 8.

As we look at our major infrastructure projects, the Qatar-Bahrain Causeway project was a nice contributor to the quarter's results, as our work providing design management, project management and construction management services for the first phase of this project has ramped up and is progressing well. We are expecting to build on initial successes and be a valuable partner with the customer on the next phase of the project.

Also, our project management for the Das Island project in Abu Dhabi is progressing very well. The overall project encompasses a Formula One racetrack, the Ferrari World Exhibition Center, a marina, a golf course and other surrounding infrastructure. The project is on schedule for the first Formula One race to be held on November 1 of this year with the completion of the track and surrounding infrastructure, including the marina and hotels.

KBR services business also continues to perform well. Last quarter I mentioned that the Shell Scotford Upgrader project was being slowed by the customer to enable engineering and materials supplied by others to catch up with the construction demand. Services job income during the second quarter of 2009 continued to be impacted. However, during the period, the staff levels were increased considerably and we continue to increase staff on this project. We expect the work to continue to increase during the second half of 2009. The project is currently 46% complete and still has about a year's worth of work remaining on the project.

In the Canadian oil sands area, we're currently seeing more bidding activity than we have over the past six months, as the market continues to reposition its cost structure under the current economic environment. Last quarter I mentioned that services had seen an increase in bidding activity around power-related projects and we expect this to continue through the second half of the 2009.

In early April, 2009, we were awarded a power contract by Progress Energy Carolinas, Inc. to provide construction services for a new natural gas-fired combined cycle unit at the Richmond County Energy Complex located near Hamlet, North Carolina. This award reinforces KBR as a key provider of construction services for the domestic power industry.

For industrial services, owners of facilities are using the market conditions to execute refining and mill turnaround projects, as well as consolidate services provided on these facilities. KBR sees this as an opportunity to expand our industrial services market share.

For our downstream business unit, the Ras Tanura and Yanbu export refinery projects in Saudi Arabia notably contributed to the second quarter's results. As I discussed during last quarter's call, we continue to expect to see increased levels of activity and contributions from these projects over the remainder of 2009 and beyond.

In July, 2009, KBR received authorization for an additional $130 million in work, covering much of our work scope through the end of 2010. Also during the second quarter, KBR also had a sizable work releases issued on the Yanbu export refinery project. The FEED and site development work for Sonangol's 200,000 barrel per day refinery is progressing well and contributed positively to downstream's second quarter results.

In regards to the EBIC ammonia project, last week we successfully completed the reliability testing by producing in excess of 115,000 tons of ammonia within the 60-day testing period. This milestone achieves substantial completion of the project and we expect to receive official notification from the client in August.

However, in the second quarter of 2009, we did incur additional repair costs during the performance testing, some of which may be potentially offset in the future by insurance claims or supplier warranties. All that remains on the project are warranty items. Although, we could incur additional costs based on these items, I am comfortable with the current cost forecast for the project. I would like to congratulate the EBIC team on the successful completion of this project.

Also, during the second quarter of 2009, downstream was awarded a FEED project for a coal-gasification facility, utilizing KBR's proprietary TRIG gasification technology. However, at this time the client has asked for confidentiality surrounding this project and we can offer no further details at this time. However, we are excited to continue to develop and strengthen our position in the power business through the applications of proprietary technology.

After Kevin's comments, I will comment in more detail on the market outlook for our business before turning the call over to questions.

Kevin DeNicola

Okay. Thanks Bill. I'll review KBR's consolidated second quarter 2009 results, which primarily focuses on year-over-year comparisons. Consolidated KBR revenue totaled $3.1 billion, that was up 17% from the $2.7 billion for the second quarter of 2008, led by the Services business unit revenue increase of 356% year-over-year due largely to the BE&K acquisition.

The services business unit was followed by a 23% increase for downstream and 13% increase for upstream. The technology business unit revenue was flat over this period, with government and infrastructure revenue down 8%.

Consolidated operating income was $137 million in the second quarter of 2009, compared to operating income of $90 million in the second quarter of 2008. Net income, attributable to KBR, for the second quarter of 2009, was $67 million or $0.42 per diluted share, compared to $48 million or $0.28 per diluted share for the prior year's second quarter. Recall that the second quarter of 2008, included a $40 million of pre-tax charge related to an unfavorable jury verdict from litigation with a subcontractor on the LOGCAP III contract and a $24 million pre-tax reduction in KBR's share of the estimated profits on an LNG project.

Upstream revenue was $787 million in the second quarter of 2009, that's up $88 million or 13% from the second quarter of 2008. Business unit income was $65 million in the second quarter of 2009 compared to $39 million reported in the second quarter of 2008. Business unit income in the second quarter of 2008 included $24 million reduction in KBR's share of the estimated profits on an LNG project, which, as you recall, was offset by a gain of $24 million on a change order on the same LNG project in the fourth quarter of 2008.

The increase in business unit income for the second quarter of 2009 was driven by the second quarter of 2008 profit reduction on the LNG project, increases on the Skikda LNG and the Gorgon LNG projects, incentive fees on the Escravos GTL project and an engineering and procurement services project in Azerbaijan, as well as the absence of the second quarter of 2008 profit reduction on an LNG project. Partially offsetting this increase was lower activity on the Pearl GTL project and lower activity on another LNG project due to schedule delays.

Government and infrastructure revenue in the second quarter of 2009 was $1.6 billion, compared to $1.7 billion for the prior second quarter. Business unit income was $80 million in the second quarter of 2009, compared to $63 million in the second quarter of 2008, which included a $40 million charge related to an unfavorable jury verdict from litigation with a subcontractor on the LOGCAP III contract dating back to 2003, and a $3 million charge on the US Embassy project in Macedonia.

Taking into account the second quarter of 2008 items, the decrease in business unit income was primarily related to lower LOGCAP award fee accrual rates, lower activity on the Allenby & Connaught project and the completion of several engineering projects in Australia and a facilities management project in the US. Partially offsetting this decrease was work on the CENTCOM project, a public school project in Georgia and a causeway project in Qatar.

I'd like to make one additional comment in regards to our LOGCAP Afghanistan work and the recent announcement that we were unsuccessful on our LOGCAP IV Afghanistan pursuit. We continue to perform a great service to the US Army in Iraq and Afghanistan. To put this in perspective, our G&I Middle East revenue related to LOGCAP III for the full year of 2008 was almost $5.5 billion, of which the Afghanistan work under LOGCAP III represented $616 million, about 11%.

Services revenue was $588 million in the second quarter of 2009, up from $129 million in the second quarter of 2008. Business unit income was $29 million, compared to $17 million for the prior year's second quarter. The increase was primarily due to the addition of BE&K projects, including an activated carbon project in Louisiana and power projects in Georgia and Texas. Also contributing to the increase was our offshore vessels in the Gulf of Mexico. Partially offsetting this increase was lower activity on the Shell Scotford Upgrader project in Canada.

Downstream revenue was $124 million in the second quarter of 2009, compared to $101 million for the second quarter of 2008. Business unit income was $14 million in the second quarter of 2009 compared to $14 million in the second quarter of 2008. The business unit income increase was due to the Lobito refinery FEED, the Yanbu export refinery project, the Ras Tanura integrated project and several BE&K projects. Offsetting this increase were unexpected costs related to additional repairs during the performance test on the EBIC ammonia project in Egypt.

Technology revenue for the second quarter of 2009 was $23 million, flat compared to the second quarter of 2008. Business unit income in the second quarter of 2009 was $5 million compared to $7 million for the prior year's second quarter. The decrease primarily relates to the completion of a basic engineering and design technology project and slightly higher overhead costs associated with a sales initiative. Partially offsetting this decline were new syngas projects, including several ammonia projects in South America and one project in India.

Now, let's review some other financial items. The general and administrative expenses for the second quarter of 2009 were $54 million, slightly up by $2 million from the second quarter of 2008. We've been able to maintain relatively flat general and administrative expenses, although, we had a 17% growth in revenue in the second quarter of 2009 from the second quarter of 2008, again primarily related to the BE&K acquisition. The G&A expenses as a percentage of revenue were 1.7% in the second quarter of 2009, 2% in the second quarter of 2008.

The corporate G&A for the first six months of 2009 was $103 million, that's tracking lower than our previously updated estimate of approximately $230 million for the full year of 2009. We're continuing to pursue further cost savings and believe we will successfully achieve results lower than this full year estimate.

Our effective tax rate in the second quarter of 2009 was 37%, that's flat compared to the first quarter of 2009, and we now expect the full year 2009 effective tax rate will be approximately 37%.

Let me take a moment to discuss backlog. Total backlog was $12.3 billion at the end of June 2009 quarter, that's down 2% from the second quarter of 2008 and down 3% sequentially from the March 2009 quarter. We had no material project cancellations in the backlog portfolio during the second quarter. The sequential decline was primarily related to lower Middle East backlog and normal project work-off.

During the second quarter of 2009 Technology's backlog was up 16% sequentially, driven by a SUPERFLEX award in China and several technology packages to be provided on a refinery in Angola.

For services, the second quarter of 2009, revenue was $588 million, while the backlog only declined $279 million over the same period. Although we announced the Progress Energy Carolinas power project in early April, the project was booked into backlog in the first quarter of 2009. Although we had no other major awards booked into the second quarter backlog, we continued to capitalize on scope additions on several refining and power construction projects we were embedded on, which is helping to offset the general project work-off.

Gas monetization backlog during the quarter was essentially flat, with scope additions on several projects. For downstream, additional work orders were released on the Yanbu export refinery, and a FEED award utilizing KBR's TRIG technology for a coal-gasification facility that drove the sequential increase in backlog.

A $230 million reduction in our Middle East backlog was primarily attributed to the timing of the funding of task order extensions under LOGCAP III. Subsequent to the second quarter close, KBR received approximately $655 million in additional LOGCAP task order extensions during the month of July. Overall, the backlog portfolio mix at the end of the second quarter was 79% cost reimbursable and 21% fixed price, that's a slight change from the 78%-22% mix we reported for the sequential quarter.

Next I will discuss liquidity in the balance sheet. At the end of June 2009, our balance sheet remained strong with no debt and with cash and cash equivalents of approximately $1.1 billion, which net of cash associated with our consolidated joint ventures and advanced payment related to a contract in progress was approximately $756 million.

Cash flow from operations for the first six months of 2009 used $8 million. However, during the second quarter of 2009, cash flow from operations provided $164 million. That's primarily resulting from general business operations, a net $110 million increase in advanced payments associated with our consolidated joint ventures and a contract in progress and a decrease in accounts receivable.

During the quarter, we repurchased about 234,000 shares for approximately $4 million. For the first six months of 2009, we've repurchased about 1.5 million shares for approximately $20 million. We will continue to repurchase shares periodically in the market to maintain KBR's outstanding share count at approximately $160 million.

Capital expenditures totaled $9 million and depreciation and amortization was $14 million during the second quarter of 2009. We continue to examine ways to prudently reduce capital expenditures during 2009.

Now, I'll turn the call back to Bill for his final remarks. Bill?

Bill Utt

I'd like to conclude our prepared comments by providing KBR's outlook for KBR's three most distinct market segments, North American engineering and construction, military services and global hydrocarbons.

First in the North American E&C market, we are beginning to see an increased level of bidding activity in the North American E&C markets. Levels of activity in power, general industrial services and commercial construction, particularly in education and healthcare, continue to remain reasonably strong. In Canada, we're also beginning to see a pick-up in a bidding activity, as the cost of executing projects has decreased to levels where capital projects appear to be feasible at today's oil price environment.

In the military services area, we still see our LOGCAP III volumes remaining reasonably consistent through the end of 2009. We continue to believe we will have a compelling and competitive offering on the LOGCAP IV bids in Iraq when formal RFPs are finally issued. Our other department of defense and ministry of defense work remain reasonably stable, while our infrastructure business in Australia has slowed down a bit from last year.

With respect to the global hydrocarbon markets, long lead time LNG and offshore projects continue to move forward. For offshore, we are continuing to expand on our capabilities and have been successful on several recent awards, including the ACG award I mentioned earlier. KBR has now been involved on the ACG project with BP for over 13 years.

For LNG, we continue to work on several FEED projects for Gorgon and Inpex. As mentioned earlier, we believe the Gorgon project will move forward to final investment decision in the coming months.

In downstream, where we saw delays on several projects, we now see projects beginning to move forward, as clients seek to take advantage of the declining cost environment. We expect project awards to pick up towards the end of 2009 and into early 2010. Overall, we expect to see a better and more active bidding environment for projects in the second half of 2009, compared to the last 12 months.

Question-and-Answer Session

Operator

(Operator Instructions)

We'll take our first question from Andy Kaplowitz with Barclays Capital.

Andy Kaplowitz - Barclays Capital

Given the size of Gorgon, what I wonder is, let's say you were to win the project, do you have the capacity to handle all three of the trains, do you need to partner up, or can you go at it alone?

Bill Utt

Well, Andy, on the Gorgon project, we're presently in a consortium with JGC and Clough and Hatch contractors in Australia to perform the work. The trains are being sequenced, because of the environmental constraints we find on Barrow Island down there and the limited lay down space we have. We're going to use a lot of modular construction that will allow us to bring in pieces of the facility sequentially and build it certainly in a much more limited footprint than we see in a stick built construction.

This is really one of the benefits KBR brings, because not only do we have the LNG expertise, but because of our offshore capabilities, principally in our Leatherhead UK operation that we're able to bring a lot of value in terms of overseeing the construction of modules, which is a very common practice in the offshore environment.

In terms of resource capabilities, we've obviously been working on this FEED and now in the post-FEED phase with Chevron and its partners for three, four years now. We've got our manpower curves established. We feel very comfortable. As to our ability to staff this project, we will be using engineering resource centers in the UK at our Greenford office and our Leatherhead office, but also looking to find additional support out of our Singapore and Jakarta offices as well. So we think we've got the resources in a pretty good position to execute this project.

Andy Kaplowitz - Barclays Capital

Is it public, the breakdown of the JV in terms of your percentage of the JV or no?

Bill Utt

I believe it is public. We're certainly the leading partner on that. I believe JGC and KBR are each 30% partners and then Clough and Hatch are each 20%.

Andy Kaplowitz - Barclays Capital

Then my follow-up is, at least what I see in your new awards, it looks like international infrastructure actually picked up a bit in the quarter. Could you talk more about the opportunities in that business? You mentioned Australia slowed down versus last year, but I know that's been a priority for you guys to build out that international infrastructure business. What do you see in that environment?

Bill Utt

Well, I think being part of the government and infrastructure business, a lot of our work that's being performed all over the world has been somewhat in the shadows compared to LOGCAP. We're taking steps to examine, how do we bring that to a greater level of focus within KBR and probably we'll have some comments either at the end of the third quarter or at the end of the year about how we expect to get a better visibility.

We are the fifth largest engineer in Australia and we've done a lot of work in terms of roads, bridges, railroads, water, water treatment and other infrastructure projects. We think it's a good launching point for us to look at continuing to build on the successes we've had in the Middle East, but also look in the other Pacific and Indian Ocean regions to build that business, where I think the capability sets that we have in Australia can be leveraged very nicely into those markets. So, I think you'll hear us talking more about infrastructure as time progresses and I think you'll see a continuing greater degree of visibility in our discussions on that market over time.

Andy Kaplowitz - Barclays Capital

Has the pace of that market increased in terms of bidding overall?

Bill Utt

I think it changes. Obviously, we got a couple of really nice awards in the Middle East, but I think everybody would say compared to a year ago, the Middle East is a little bit slower. Australia, our volumes are down, but there is going to be some stimulus spending in Australia, certainly not to the degree we see in the US, but it will be, we think it will allow us to continue to maintain a very compelling presence in the Asia market.

Operator

Our next question comes from Jamie Cook with Credit Suisse.

Jamie Cook - Credit Suisse

Bill, you mentioned in your prepared remarks that you decided not to protest LOGCAP IV based on your debriefing. I was just wondering if you could give a little more color around that and how you think that positions you to win the Iraqi part? Then my second question, I'm encouraged by your comments on some of the big projects moving forward at the same time and we've seen evidence of that, but at the same time we've seen or heard of contractors winning on fixed price terms or on unfavorable, and essentially low bidding to win those contracts. So, I'm just wondering what you're hearing, what you're seeing in the market, as it relates to pricing and low bidding on fixed price contractors with less work moving forward?

Bill Utt

With respect to LOGCAP IV, we did have an extensive debrief and what we did learn is the evaluation criteria used by the military for the Afghanistan business covered the technical performance and proposed execution plans, it covered past performance and it covered pricing, and certainly it gave a lot of latitude to the military in terms of how they wanted to segregate that work.

We all know that there has been a lot of pressure on the Department of Defense to diversify the contractor base and certainly that's the reason we have a LOGCAP IV. These were the first two major task orders that were being issued under the LOGCAP IV program. The prior four task orders were reasonably small.

We think the military wanted to get a diversity of contractors. In fact, on one of the bids, one of the successful proposers had a higher cost offering than KBR had, but there were a lot of other considerations that went into their decisions and we don't think there would be much to gain for KBR to lodge a protest. It is certainly within the Department of Defenses purview to deal with how they want to bring additional capabilities from the contractor community into LOGCAP, and so, we're prepared to bid very aggressively and offer very compelling value propositions on future LOGCAP IV work.

We don't think, based on what we heard, that there is a trend we can extrapolate in Afghanistan that directly correlates to Iraq, but we continue to feel we have a very compelling value proposition to the US Military on our LOGCAP activities.

Regarding the big projects, I think we've spoken several times about the discipline that our new Management team has brought to KBR in terms of the big projects, really all projects, and I think we're seeing that manifested in a more predictable level of financial performance for the company. I'm very pleased by some of the observations raised by you and others as to the consistency that KBR now is generating in our performance.

We're looking at these bids. We do bid fixed price, but we do very much look at what is acceptable fixed price for us. The Gorgon project with its size and in our discussions with the customer is it going to be a reimbursable project. So, while we do look for fixed price, we're not going to deviate from the discipline that we've established here. We're seeing opportunities to bid fixed price, but if others wish to buy market share by low bidding in the fixed price or taking on series of risks that really don't make sense to us, we're happy to let them have the work.

Clearly, there was a pretty aggressive bidding on some of the recent activities in Jubail and some articles are written by it, but we're generally very confident there will be enough work out there for us to execute as KBR, some of it will be fixed price, some of it will be reimbursable, but we'll be able to achieve that within the discipline framework that we've established here.

Operator

The next question comes from Martin Malloy with Johnson Rice.

Martin Malloy - Johnson Rice

Could you talk a little bit more about your comments on the oil sands, are the increase in bidding activities mainly for upgrades to existing projects or are there new projects?

Bill Utt

Well, there were a series of projects, Marty, that were deferred when actually the market got overheated and we saw that in terms of equipment pricing that was really a global phenomenon. We saw that in terms of the quality of engineering in the market, because everybody was really stretched in terms of all the projects they were undertaking. So quality of engineering and timeliness of drawings were tough. The construction marketplace also got overheated and you saw a lot of per diems and other adders to the cost of construction being injected into the cost of projects. All of these elements have in our view been relaxed and we're seeing the ability to get construction labor at lower rates, with better work rules and better productivities.

We are seeing maybe better timing and quality on the engineering drawings and certainly the equipment market has come down as well. So, that's what we are seeing up in Canada, and this has resulted in a decline in the cost of executing projects, which in terms of our observations have brought the cost of executing capital projects back into the envelope at today's oil prices that we are seeing in a way that people are now talking about taking projects forward.

Martin Malloy - Johnson Rice

Relative to your significant cash balances can you give us an update on what you are seeing out there on the potential acquisition front?

Kevin DeNicola

Well, I mean we haven't changed our position on anything. I think it's one of the elements that we would consider using cash for, if the right opportunities came along. We are not seeking anything in particular. We are not trying to repeat things that we did in previous year, but we certainly, as we look at some of these other market segments that we are focusing on, if we think that there is an opportunity to do something that makes sense to push us forward in a certain area, we might entertain that, but we don't have anything. It's just one of the other aspects of what we look at it for our cash balance.

Operator

Our next question comes from Barry Bannister with Stifel Nicolaus.

Barry Bannister - Stifel Nicolaus

A lot of the focus is on G&I Middle East, but G&I International operation sales and margins really moved the needle for the entire company's profits. Could you give us an outlook on G&I International where margins have held in, but sales have been declining as we look to second half and maybe into 2010, especially given recent ratings?

Bill Utt

G&I International encompasses primarily our UK government and defense business, the infrastructure work we are doing in the Middle East, as well as our infrastructure business in Australia. We've seen a very consistent level of margins in the Australian civil engineering business that we have, the consulting engineering, and that has held firm even as volumes have declined. Really the Australian market was so overheated, we were selling a lot of work in Australia and executing a lot of it in our Jakarta office, because of the supply/demand imbalance between work in Australia and engineering resources. That continues to become more imbalance as some of the volumes have reduced.

The work we picked up in the Middle East has been PMC kind of work. It's a consistent work that reflects the high value of services that we are providing in helping our clients execute their projects. While volumes maybe down there, the margins typically stay pretty consistent. Then we've had just a wonderful track record of performance in the United Kingdom on our government and defense business. It does in theater the same thing for the ministry of defense that we do for the US government through our US business. The margins are better. These are bid contracts. They are typically smaller in scale. In many ways it resembles a lot of the LOGCAP IV business that we see going forward where we've commented previously that the margins for LOGCAP IV should return more closely to traditional government work compared to the very low margins we have on LOGCAP III. We are trying to look in each of those areas and figure out how we can get those volumes back up, because they are very compelling businesses certainly as evidenced by our UK award from the Ministry of Defense as number one supplier, and we want to continue to drive that. It's very similar to the comment I made earlier that a lot of these very good businesses have, for sometime, been overshadowed by LOGCAP, but we are trying to give them a little more sunlight and a little more emphasis for growth.

Barry Bannister - Stifel Nicolaus

Then before the Afghani award, the margin had been a little below the 2008 level for LOGCAP III task orders and that you had said that possibly in '10 we'd be down about 40% year-over-year as troop drawdowns blended with Afghan wins. Now, that Afghanistan has other engineering firms, are we looking at about a run rate in the mid-4s for operating margin, trying to balance the higher LOGCAP IV, with the potential that the task orders are split up in Iraq and for lack of Afghanistan within the revenue mix, are we looking at about half the level of profit in '10 versus '09 or can you give that granular?

Bill Utt

A lot of the aspect of what our volumes would be will go to the troop counts and certainly the US government has moved the troops out of the cities to the enduring bases. Again, this is what we hear in the public, so we don't have any non-pubic proprietary information regarding troop plans, but it's our expectation from what we've assimilated in the media that, once Iraq gets through their elections in January that we would see troops start to come out of Iraq and with that eventually get to a point some months later where we have a much smaller enduring force in Iraq that would be largely there to assist in the training of the Iraqi security forces and be a much smaller presence than we have today.

Certainly that has a direct impact to us, but the indirect impact that we can't estimate at this time is when you start leaving the basis, you start having to remediate sites, takedown equipment, get it cleaned up, shipped, restored to various marshalling positions across the globe and how much, what kind and the duration of that work is really too hard for us to estimate. We do expect that the troops will come down, and we've always held to the belief that our work will lag the troop withdrawals because of this camp remediation. That's about all we can comment on to get into the precision of what that means to 2010. I just don't think we have the visibility right now on that Barry.

Operator

Our next question comes from Daniel Pickering, Tudor, Pickering, Holt.

Daniel Pickering - Tudor, Pickering, Holt

Following on the question around Afghanistan. Kevin, I think, you mentioned that it was $620 million in '08 revenues. Do you have a rough idea of where that's going to be in '09, I'm just trying to figure out if the other government project wins might offset Afghanistan's decline?

Kevin DeNicola

We gave you a couple of pieces there. We talked about these short duration projects that keep coming along on the LOGCAP III. The only reason we try to give you the other is to look at what percentage it really was of the total. So it isn't as significant as some people might have thought. Where that goes? We don't know, as far as the timing is concerned on some of these things. It really all depends on how these troops move as Bill just said.

Daniel Pickering - Tudor, Pickering, Holt

Well, I guess if we were $620 million of $5.5 billion in 2008 right, so around 10%.

Kevin DeNicola

Correct.

Daniel Pickering - Tudor, Pickering, Holt

'09 is going to be roughly the same levels we think?

Kevin DeNicola

Well, I don't know what's going to happen in Afghanistan. I don't know what that could grow to for somebody else. I'm just saying it wasn't a significant piece for us whether we kept it or lost it.

Bill Utt

There is also a transition that's undefined at this point as to how quickly the other ones will come in and take over the work and the military has never ever quite done a transition from one contractor to two, and I'm sure there is a lot of seams type issues that remain to be identified and not only addressed.

Daniel Pickering - Tudor, Pickering, Holt

It would seem like given the LOGCAP III to IV experience in Iraq that transitions tend to take longer. On the upstream side of the business just looking at second quarter levels, revenue and margin, as you look at the back part of the year as your project work-off goes through, would you anticipate that those sorts of revenue and margin levels are sustainable given your outlook at this point?

Bill Utt

I would say, Dan, the work that we're bringing in, I mean when you talk about our upstream work and you talk about net of overhead, I think we're seeing it reasonably constant. A wildcard for us in part is how much might we get on scope extensions on Skikda, because the construction project part of that is reimbursable at no margin. We expect to see additional Gorgon work and that's got a nice margin to it. Yes, it's a little bit bifurcated, but there's a base margin that we think is a fair base margin, but there is a series of incentives that if we perform in terms of schedule, cost and safety could be very positive not only for the owners of the project in terms of our performance, but they have agreed to share parts of those benefits with the contractor. Those may be realized later than we might see in the second half of '09. Overall, as you look at the portfolio, as the construction on Skikda winds down, as Escravos winds down, you're going to see some low margin projects digest out of the portfolio and the overall performance on some of the new work we're seeing should be better, Gorgon as an example, than what we saw from the legacy projects that were contracted back in the 2004-2005 timeframe.

Operator

Our next question comes from Steven Fisher with UBS.

Steven Fisher - UBS

Kevin, you talked about SG&A. I wonder if you can comment on the status of SG&A reductions, what targets you have and what areas you're trying to attack to bring costs down.

Kevin DeNicola

I think we've done a very good job there. We've really just focused on a lot of things. We were looking at what it takes to actually do some of the work, the productivity issues and seeing what we can do there as well to try to get some efficiencies out of it. So that's an important area there. I can't comment on just any particular area, because it's a broad range of things that we're trying to work on.

We've gone through an approach to anticipate that business conditions might decrease and we actually so far have been fortunate that they have not, but nevertheless we've taken some of the steps as if it had. The approach we have taken is sort of a tiered approach, what I call Tier 1, 2, and 3, some of the things that are just no-brainers to do probably to reduce some of your costs, little things like travel or whatever you want to say. Other things that will have a little bit more impact on the business on a Tier 2 basis that you might temporarily reduce head counts or certain things like that, but might come back and bring those back in later on. Then further reductions if you see significant changes in the business. So what we've done essentially is put a plan in place. It's already on the shelf. Some of it's been executed. In fact, all of our Tier 1 has actually been executed, some of our Tier 2 cost reductions and we're working along those lines there. So we feel pretty good about that.

You're seeing it on the G&A, but you also would see it if you looked at the overheads on the business areas as well, which are sort of above the line. So it's actually broad across all that. I don't distinguish between sort of how we look at overhead, whether it's above or below the operating line. We're working broadly across the company.

Bill Utt

Steve, I would comment that Kevin's been with us for a year and certainly one of the hopes we had when Kevin joined us was his ability to bring his experience of being part of a very large commodity chemicals operation and their focus on overheads. I'm very pleased with the results that he has led us towards in the first year of his tenure here. I think I'd underscore that we hope we'll find some other areas that we haven't yet identified, where we could make more progress, but I think that what we've achieved over the last 12 months is a good testimony to Kevin's leadership with our Management team in really running this business efficiently.

Steven Fisher - UBS

Related to Iraq, how likely is an award fee evaluation result in the second half, and what do you think the chances are that it's above your accrual rate, which I think is about 72%?

Bill Utt

We believe that we'll see one in the second half. The evaluations we have coming out of theater, these are the informal evaluations that we get from the team. We've correlated them against prior awards and we think we're accruing based on the data we're getting out of theater. We should be pretty accurate if history is a guide to future performance. So no, I'm not expecting any unusual upsides from that.

Operator

Our next question comes from Will Gabrielski with Broadpoint.

Will Gabrielski - Broadpoint

Couple of questions. First, just on the uses of cash now, I guess you said that the net number, the cash flow cash number is around $750 million. Can you walk through what some of your plans may be besides just keeping the share count flat at $160 million?

Kevin DeNicola

Well, let's just say it's nice to have the cash balances there to support the work that's coming along that we have, the swings in the working capital that we see intra-quarter, that's important. We are focusing more and more of our effort on improving shortening the cash cycle. So we're trying to collect faster, better, which I think you're starting to see some of the benefits of that as well, which means we have options looking forward. We've already touched on the possibilities. There's always a possibility that there would be an acquisition that we'd like to see and do. Again, I'm talking more of the smaller type of things that would make some sense there.

Obviously, we're sweeping up shares. Under the current revolver, we're still constrained on that. Until we renew that revolver and hopefully release that constraint, we really can't spend much more on the combination of dividend and/or share repurchase. So we're kind of stuck to about what we're doing right now until that's done there. So I don't have a lot of answers.

I think the point is that we have a lot of flexibility here to take advantage of opportunities that come along. From a customer standpoint, we look strong which is very important, which is how we can take on the additional work that's coming along and other additional work that may come along when people start asking whether or not you have capacity. We have financial capacity, we have people capacity. We've talked about that before. So I look at it as considerable flexibility.

Will Gabrielski - Broadpoint

To go back to a question that was asked earlier on the call with respect to how well positioned you are from a capacity standpoint to handle Gorgon and then, obviously, working at Inpex and the PNG services contracts and being rumored obviously to be involved and you guys are putting your slides talking about I think Wheatstone, Pluto and some others. In general, I guess from a capacity standpoint, how would you describe maybe the Australian Papua New Guinea labor markets versus the US markets and your expectation around pricing and margins going forward, particularly as we get into 2010 even beyond Gorgon and we start talking about Inpex?

Bill Utt

Well, I think you look at the Asia market. We look at trying to run a global series of offices within KBR. We have managed our resources down about 16% year-to-date and that's allowed us to maintain high levels of chargeability. We certainly have taken a lot of our contractor personnel out first that are really the variable employees we use in executing that work. The areas that we would be looking at the Asia Pacific market, we do have some capacity that we can build in the country or continent of Australia.

Our Jakarta office is down and we believe that the resource base is very available to build that back up and can quickly pick up a lot of work. Singapore has also got some capacity to grow. We've done some preliminary labor studies in the UK at our Greenford and our Leatherhead office, and feel that we can grow those offices back to where some of their peaks have been over the prior years and create a lot of additional capacity.

Similarly, the offices we have in the US, particularly those we picked up from BE&K in Birmingham, Raleigh, North Carolina, Wilmington, Delaware, have good capacity to grow as well as our office here in Houston. So we're comfortable that we can grow the business nicely with this office environment that we've created. We have a lot of capacity and a lot of capability to better utilize our capacities, certainly for the work that we foresee on the horizon.

Will Gabrielski - Broadpoint

Have you reserved any capacities that are related to that PNG upstream Worley deal? Have you guys set aside any capacities to guarantee the client that you have that capacity through 2014? Is there any type of agreement involved there?

Bill Utt

No. The customer pays for us on a variable cost basis, and so we manage our work as variable cost.

Will Gabrielski - Broadpoint

Switching gears really quickly to services business and on the power side specifically seems to be holding up very well and you made a comment about a pretty robust looking pipeline. Can you just a give a little more detail on that and what type of activity and may be some timing and expectations around that?

Bill Utt

Well, we've seen certainly in the last 12 months in the US things just stopped, or didn't stop, but they slowed down dramatically. We're seeing now that activity has started to pick up. While we're not seeing maybe some of the mega projects out there, but there is a new buyer estimation, a very healthy level of medium to large type of projects that we're pursuing. Our bidding activity is very high. Certainly, if you just look at the services business, there was a significant increase in the volume of proposals outstanding from first quarter to second quarter. We think that's evidence of an improving market here in the US and Canada.

Will Gabrielski - Broadpoint

One last one if you guys don't mind, and I'm sorry if you addressed this already, but the direction of legal costs, obviously, there's been the news of some settlements and dismissals and favorable rulings, is that going to decline in any way over the next few quarters or is it going to stay relatively stable?

Bill Utt

I think it's going to stay relatively stable. You've got a series of litigations at various positions in their life cycles. I think the impact that we'll see from the Eleventh Circuit ruling will be felt overtime. It will take time for that to digest itself into these other litigations that we're facing, but we are certainly very pleased with not only the degree at which we're managing the costs on the litigations, which we're doing I think very efficiently, but also the prospect of some of these recent wins that we think may deter some of the what we've considered to be less suits with less merit. I'm not sure how you define less merit, but we think some of them really are pretty frivolous and we think these recent decisions will bode well for us.

Operator

Our final question comes from Vance Edelson with Morgan Stanley.

Vance Edelson - Morgan Stanley

Regarding the debriefing, sounds like diversification was a major factor, if not the major factor. Any sense that the loss there positions you better for opportunities elsewhere, considering you were the incumbent, you likely had the best skills set and perhaps even the Appellate Court ruling works in your favor in terms of any political pressures that existed to diversify given the high profile nature of some of the things you were accused of, so any sense that you've got an advantage now as new opportunities come down the pike?

Bill Utt

Well, I think the situation is a transient. What was the basis for evaluation changes with time. We certainly by being an embedded supplier, in some instances have been dealing with some corrective action requests by the government. Others, who are new or haven't got that were certainly aware that there have been, since the award, we believe there are some corrective action requests that have been made of the other contractors that certainly changed the playing field. Whether it changes it materially or not, that will be in the eyes of the government in its evaluation.

I do believe that there has been just a lot of visibility surrounding just the entire engagement in Iraq and Afghanistan. Will it manifest itself in terms of the contractor? It's really a much broader political issue in terms of administrations, in terms of people's view on the war and why we're there. Like many things, we're just a contractor doing the business, but we become in some respects a lightning rod for criticism. I think getting some diversity of the supplier base does alleviate some of that pressure and there has been some testimony on the Hill recently, as recently as the last 10 days, where people have said that once we step back and take a look at what KBR has done in theater and allow time to pass that people will see what a great job we've done, and that's a fairly nice third-party validation of what we're doing and sometimes that gets lost in the give and take of the rhetoric that goes on in our government.

Rob Kukla

Nikki, I think that will do it for us. I appreciate you getting on the call today. If you have any follow-ups, please don't hesitate to give me a call.

Operator

That does conclude today's conference. Thank you for your participation.

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Source: KBR, Inc. Q2 2009 Earnings Call Transcript
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