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National Oilwell Varco Inc. (NYSE:NOV)

Q3 2009 Earnings Call

October 26, 2009; 10:00 am ET

Executives

Pete Miller Jr. - Chairman, President & Chief Executive Officer

Clay Williams - Senior Vice President & Chief Financial Officer

Analysts

Marshall Adkins - Raymond James

Geoff Kieburtz - Weeden & Co

Robin Shoemaker - Citigroup

Bill Herbert - Simmons & Company International

Operator

Good morning ladies and gentlemen and welcome to the National Oilwell Varco third quarter 2009 earnings conference call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded.

I will now turn the call over to Mr. Pete Miller, Mr. Miller, you may begin.

Pete Miller

Thanks Hilda and good morning and welcome to the National Oilwell Varco third quarter 2009 earnings conference call. I am Pete Miller, CEO with National Oilwell Varco and with me on the call today is Clay Williams, our Chief Financial Officer. Loren Singletary who is normally on the call is currently traveling overseas on business and will not be with us today.

Earlier today we announced earnings in the third quarter of $385 million or $0.92 a share on revenues of $3.1 billion. This compares to earnings of $1.31 a share on revenue of $3.6 billion in Q3 2008, and $0.53 a share on revenues of $3 billion last quarter. We are very pleased with the excellent work put forth by our employees in this challenging time to achieve these results.

Additionally, we announced a quarter ending backlog of $7.3 billion, down from $8.7 billion at the end of the second quarter. I will expand on both operations and backlog later in this call, and discuss some opportunities that look very promising and exciting over the near term for [Inaudible].

At this time I would like to turn the call over to Clay to give you some color on our quarterly results.

Clay Williams

All right, thank you Pete. Before we begin this discussion of National Oilwell Varco’s financial results for its third quarter ended September 30, 2009, please note that some of the statements we make during this call may contain forecast, projections and estimates, including but not limited to comments about our outlook for the company’s business. These are forward-looking statements within the meaning of the Federal Securities Laws based on limited information as of today, which is subject to change.

They are subject to risks and uncertainties and actual results may differ materially. No one should assume that these forward-looking statements remain valid later in the year. I refer you to the latest forms 10K and 10Q National Oilwell Varco has on file with the Securities and Exchange Commission for a more detailed discussion of the major risk factors affecting our business.

Further information regarding these, as well as supplemental financial and operating information maybe found within our press release on our website at www.nov.com or in our filings with the SEC. Later on this call Pete and will answer your questions. We ask that you limit your questions to two in order to permit more participation.

National Oilwell Varco earned $385 million or $0.92 per fully diluted share on $3.1 billion in revenue in its third quarter ended September 30, 2009. Once again, National Oilwell Varco benefited from outstanding execution by the Rig Technology Group, which posted record margins during the third quarter, while our activity driven petroleum services and supplies, and distribution services groups continued to skillfully navigate the choppy waters of low rig counts and high pricing pressures, producing good results in view of a very tough market.

Third quarter consolidated revenues improved 3% from the second quarter, but fell 15% from the third quarter of 2008, when the worldwide rig count was 39% higher. Operating profit was $618 million excluding $17 million in pretax transaction and restructuring charges in the third quarter. Operating margins were 20%, up slightly from the second quarter pro forma results excluding charges and down 270 basis points from year ago levels.

Operating leverage or flow through was up 38% from the second quarter to the third, and down 38% from the prior year quarter. Our backlog for capital equipment sales within our Rig Technology Group declined 15% to $7.3 billion at September 30th from its June 30th levels.

Gross orders were $333 million, which included some jack up equipment, but no floaters. Orders were partly offset by total cancellations out of backlog of $72 million including some small capital equipment items, but mostly due to reductions of scope on a few large offshore projects. Specifically, we agreed to permit a shipyard to execute lower margin in their direction work to improve project efficiency.

Overall, we view approximately $334 million of our backlog, about 5% as being in arrears and at risk, and I have seen a total of $306 million cancelled over the past 12 months, about 3% of our peak backlog of $11.8 billion a year ago. This compares to gross orders of a little over $2 billion during the past 12 months.

Needless to say, recent orders have been frustratingly slow. Long awaited tenders from Brazil have proven more languid than we expected when we started the year, stumbling through very tough credit markets and rising local content stipulations despite a high level of result by Petrobras following their spectacular deep-water discoveries in the Santos Basin.

But we have good news to report. In mid September the executive board of Petrobras formally approved the company’s strategy to build up to 28 new ultra deep-water rigs and tenders were finally issued for these a week ago Friday. Specifically, seven drill ships and two semi-submersible tenders provided to Brazilian shipyard for rigs to be purchased and owned by Petrobras.

Additionally, tenders were new floaters to be purchased and owned by drilling contractors were also send to 15 companies for new rigs to be predominantly constructed in Brazil. Bids on these were due back to Petrobras late in the first quarter of 2010, and we expect that NOV and/or our competitors will begin to see the first contracts flow into our backlogs for these tender sometime in mid 2010, probably beginning in the third quarter.

Although this is later than we expected and as a result we will fall short of our earlier 2009 order guidance. We are nevertheless very pleased to see concrete progress on this long awaited event. In the meantime we continue to pursue booking a handful of orders for other new deep-water rigs for Brazil from the 12 new rigs awarded term contracts in 2008. But these also continue to face financing challenges. We have seen some progress with these and maybe able to book some or all of these in the fourth quarter this year and we’ll let you know on an update again in our next call.

We are confident that NOV will continue to play an important role in construction of the necessary tools to develop Brazilian deep-water resources and our team is ready to help. We are working to expand our in-country presence through a combination of acquisitions and green field expansions to supplement our existing capabilities, which include our technical colleges in Marques, where we train Brazilian professionals to maintain and repair sophisticated NOV drilling equipment.

We are confident that we will be able to achieve the local content goals of our customers on these projects, which escalate from 20% to 50% for the progression of the new program. We also continue to pursue new offshore rig construction opportunities outside of Brazil, for additional floaters, jack ups, well intervention vessels and FPSOs.

Urgency around these projects is considerably less than we enjoyed over the past few years, but we expect the orders to begin to flow at some point. Despite some falling in credit, our customers continue to face steep headwinds in securing structured financing. Specifically, we see banks requiring much higher levels of equity in projects typically 25% to 30%.

An export and trade financing agencies and many governments are now requiring term contracts from oil and gas companies before issuing guarantees on new rig construction projects. The recovery of the credit markets is proceeding at a decidedly glacial pace, so we nevertheless do see progress.

Land rig inquiries remain low, at least outside of the Middle East. We are very pleased with the performance of our new Drake rig design in the Marcellus shale and more broadly with a gradual recognition by oil and gas companies at the superior performance of modern AC rigs that we have delivered.

Generally higher utilization and day rates for newer land rigs, vis-à-vis older rigs, confirm a growing market preference for the safety and efficiency of modern technology. Nevertheless, we have seen scarce few domestic land rig buyers, although a few domestic tire kickers have checked in with us, just bouncing the possibility of a 2010 North American recovery.

Our backlog continues to give us great visibility into coming quarters. We expect Q4 shipments out of backlog to total about $1.3 billion, down from Q3, which would bring our full year revenues out of backlog to about $6 billion.

As of September 30, we had orders scheduled to shift in 2010, totaling about $4.7 billion and another $1.3 billion scheduled to go out in 2011. 89% of our backlog is offshore equipment and 11% is land, which tends to turn much more quickly since it is not gated by whole construction schedules in a shipyard. 93% is for international locations and only 7% is for the US.

Execution of the backlog has been outstanding and led to exceptional margin performance for our rig technology group in the third quarter. The execution of projects benefited from two distinct factors this quarter.

First, we are now well up the learning curve on building and commissioning rigs, replicating those bills earlier in the cycle. Repeat work enables us to apply lessons learned and produce increasingly better efficiencies. Second, we have benefited from deflation in certain inputs and somewhat better FX movements producing our estimated costs to complete these projects. As we update our cost estimates on these each month we’ve seen continual improvements through 2009.

Softer demand has produced mounting pricing pressures for rig equipment and we have seen pricing decline 10% to 15% for offshore equipment and 15% to 20% for land rigs compared to last year. Thankfully though, better execution and cost experience has enabled us to offset some, but not all, of the recent pricing pressures.

Our service business has faced tough market conditions but are generally holding up well due to prudent cost productions and smart decisions by the experienced NOV managers, we are grateful to have at the helms of these businesses.

Pricing pressures continued through the third quarter despite a modest bounce in North American rig counts and most product lines have seen pricing fall by 30% or more since last year. Our distribution services group continues to squeak out good margins, considering the market due to a high level of commitment and energy to service the needs of our customers.

Our petroleum services and supplies group manufactures and sales many of the critical consumables into drilling operations, but with the worldwide rig count down nearly 1400 rigs from last year, our customers are generally sitting on more than adequate supplies of these.

Several businesses within petroleum services and supplies carry backlogs into the year, and have drifted down as customers had redeployed consumables and drilled pipe from idle rigs, or turned in rental equipment to us in lieu of utilizing fleets of equipment that they already own.

Business has become much more hand to mouth as we’ve moved through the year. However, most product lines seem to find a bottom on pricing during the third quarter, generally leading to a little more arching stability as we enter the fourth quarter.

The worldwide oil and gas machine eats equipment everyday. Growth for our petroleum services and supplies manufacturing businesses will come when either, A, the grind of day to day consumptions steadily cuts inventory overhangs, or B, a broad recovery of drilling activity accelerates the rate at which the machine is eating.

Recent improvements in North American gas prices and amazingly high oil prices off late, certainly increased the possibility of scenario B, if prices are sustained, but we remain cautious in our outlook owing to the possibility of further broad economic weakness. We don’t know precisely how much excess supply our customers have, but we believe most oil field consumables probably need at least a few more quarters of current activity levels to dissipate.

In the meantime, quietly at work in the background is the steady application of new technologies to both conventional plays and non-conventional shales. It is highly noteworthy that the horizontal and directional drilling now accounts for 62% of the US rig count, compared to only 38% five years ago.

Bending the drill string around a 90 degree angle places dramatically higher stresses on the downhole tools and tends to wear them out at a much faster rate. Bits, drilling motors, non-magnetic drill collars, drill pipe, coil tubing, all hardware in which NOV has quietly built leading positions bear the brunt of this, but are also the necessary hardware required to apply these new technologies. The result is a well that may cost two or three times more than a vertical well, but it can deliver three to five times more oil and gas.

The company continue to reduce cost through the third quarter with SG&A declining another 3% following the 10% drop in the second quarter despite higher revenues. As the year has unfolded, we have been able to reduce personnel expense, travel and outside service cost by about a $140 million a quarter.

About half of the $17 million in third quarter transaction and restructuring charges relates to the restructuring of our manufacturing base reflective of our desire to use this downturn to continue to become more efficient and productive across all of our plants.

Finally, we’ve continued to energetically pursue corporate transactions through the third quarter, having signed two acquisitions, which are expected to close during Q4, in addition to some smaller transactions and have five letters of intent to acquire smaller businesses as well.

In particular, we were very pleased to close our joint venture with Schlumberger on our proprietary and IntelliServ technology, which extends high speed two way broadband communications downhole through wired drill pipe, replacing rickety Morse code, MWD Mud Pulse telemetry systems with a new information super highway. We are delighted with our new partnership and anxious to get to work.

NOV remains exceptionally well positioned and well capitalized with $3.2 billion in cash at September 30th, a $2 billion revolving line of credit and a wealth of practical integration experience owned over many years and dozens and dozens of acquisitions to tackle the extraordinary opportunities that are arising during this time.

2009 continues to be a challenging year with no clear recovery in sight, but we are grateful to work every day with smart decisive experienced leaders to deliver solid results through all kinds of weather.

Now, let me turn to our segment operating results. Rig technology posted revenues of $2 billion in the third quarter, up 4% both sequentially and year over year. Operating profit was $579 million yielding operating margins for the group of 29%.

Incremental leverage or flow through was 52% from the second quarter and a 105% from the third quarter of last year. Revenue out of backlog of $1.6 billion increased 12% sequentially and 17% year over year. Third quarter after market sales and services, which accounts for about 17% of the group’s mix were flat with the second quarter but small capital equipment sales fell sharply from the second quarter to the third. Approximately 2/3rd of the groups after market revenues were derived from offshore markets and 1/3rd from land.

The group produced great results in the quarter. Seven new offshore rigs were delivered brining our total to 66 delivered so far this cycle, National Oilwell Varco has nearly 600 professionals rigging up a total of 33 new offshore rigs presently in 14 different shipyards. We continue to see favorable cost variances on projects as they were closed out due to efficiency and learning curve effects, and cost estimate revisions on projects and progress contributed to the strong results.

Pricing pressures are mounting and day to day expenditures on both CapEx and OpEx for rigs still remains very tight. Lower demand has reduced production volumes in many our factories compared to the high levels of last year. Many are running 50% to 70% of 2008 levels prompting the group to redouble its efforts to improve efficiency through lean manufacturing and QRM techniques to drive further products standardization and to end source to utilize slack NOV machine time to approve absorption.

Demand for pressure pumping and coil tubing equipment in North America remains weak, but a handful of international markets like North Africa, India and China appear to be picking up albeit at lower pricing.

Wireline equipment demand has remained steady for international markets; the group is bidding a number of North Sea platform upgrades and FDSO projects for cranes rise or pull systems offloading and mooring equipment, although we don’t expect many of these orders to be placed until 2010.

Looking into the fourth quarter, we expect rig technology revenues to decline in the high single digit percent range at higher decrementals producing operating margins in the mid 20s. The petroleum services and supply segment generated total sales of $882 million in the third quarter of 2009, down 3% from the second quarter and down 33% from the third quarter of 2008. Operating profit was $86 million excluding transaction and restructuring charges down $10 million from the second quarter on the same basis.

Third quarter operating margins dropped to 9.8%, down 70 basis points from the second quarter. Sequential to decremental leverage or flow through was 32% and year over year decrementals ran 57% excluding charges reflected by the significant year over year discounting in the group’s business.

Almost all product lines within petroleum services and supplies posted low single digit sales declines in the third quarter as compared to the second quarter. As customer spending remain subdued. Sales of bits and downhole tools improved in North America, but international demand for these fell in the third quarter in Saudi Arabia and Europe, driving sequentially lower results.

Drop pipe revenues were roughly flat with the second quarter but margins improved due to more favorable mix of premium pipe for new offshore rigs and lower steel costs. Drill pipe backlog in sales are expected to continue to decline due to the current over supply, which is not likely to turn around before the second half of 2010.

Lower drill pipe demand also reduced drill pipe coding and inspection services at decremental margins. Well site services and coil tubing posted slightly lower margins on lower salt control equipment and spring sales and increased discounting.

Overall, the petroleum services and supplies group generated approximately 42% of its total revenue from North American markets and 58% from international markets. Within the international portion declining sales to Europe and Russia were offset by growth in the Middle East, Africa and Latin America.

Looking into the fourth quarter 2009, we expect petroleum services and supplies to decline modestly again, as improvements in downhole tools, coil tubing and other modest product sales increases fail to fully offset expected declines in drill pipe revenues. We expect margins to stabilize in the high single digit range.

Sales and distribution services totaled $306 million for the third quarter, about flat with the second quarter and down 39% from the third quarter of 2008. Operating profit was $7 million down $3 million from the second quarter and operating margins were 2.3% down a 100 basis points from the second quarter. The sequential decline in profitability arose from lower pricing, a decrease in supplier rebase on following annual sales volumes and lower margins on industrial products and artificial lift.

Compared to the third quarter of 2008, decremental third quarter leverage was 19% on the 38% sales decline. Domestic sales roughly flat sequentially but Canada increased nicely emerging from seasonal breakup at good incrementals. Total North American revenue mix grew slightly overall sequentially to 71% and international sales declined sequentially and accounted for 29% of the group’s third quarter revenue.

Pricing pressure appeared to stabilizing across North America but many operators are bidding out much of their work, which has enabled the group to win some incremental MRO contracts during the quarter. Not surprisingly, unconventional shale plays in the Marcellus Haynesville and Balkan are some of the most active North American markets and the group continues to expand its presence in these areas as well as expand in Russia.

Artificial lift sales into Mexico are expected to pickup in Q4 after a third quarter pause. Activity in Argentina was ended by labor issues, which affected both distribution and petroleum services and supplies in the third quarter. For the fourth quarter we expect distribution services revenues to improve in a low single digit percent range at modestly better margins.

Turning to national, Oilwell Varco’s consolidated third quarter income statement overall gross margin were flat with the second quarter 29.1%. SG&A declined $9 million sequentially to 9.1% of revenues compared to 9.6% in the second quarter. Equity income and our Voest-Alpine joint venture declined $15 million sequentially to $1 million on sharply lower OCTG volumes and pricing, and we expect the equity earnings from this unconsolidated entity to slip to a small loss in the fourth quarter.

Other expense improved $25 million on lower FX expense, which was a $6 million debit in the third quarter in addition to bank fees and other items on this line totaling about $7 million in Q3. The tax rate for the third quarter was 33.2% slightly above our guidance of 32% due to prior year return to provision adjustments in other discrete items. We expect the tax rate in the 32% to 33% in the fourth quarter.

Unallocated expenses and eliminations on our supplemental segment schedule was $54 million in the third quarter roughly flat with prior periods. Depreciation and amortization was $126 million in the third quarter, up $4 million from the second quarter, and CapEx declined again to $43 million, down another $21 million sequentially.

We continue to guide our CapEx downward for the full year and expect to end up below $250 million for 2009. EBITDA was $734 million in the quarter, excluding transaction and restructuring charges up about 7% sequentially. NOV September 30, 2009 balance sheet employed working capital, excluding cash and debt of $2.2 billion, down $230 million from June 30. The working capital on this basis equaled 17.8% of annualized revenue, down from the second quarter.

Customer financing on projects in the form of prepayments and billings in excess of cost, less cost in excess of billings was $1.4 billion at September 30th, down about $600 million sequentially, due to the increase in revenues out of backlog during the third quarter.

Cash flow from operations for the third quarter was $684 million, and less CapEx of $43 million yielded free cash flow for the quarter of $641 million. Year-to-date cash flow from operations is $1.969 billion. Now, let me turn it back to Pete.

Pete Miller

Thanks Clay. I would like to take this opportunity to just make a few brief remarks about our operations, some of the things going on around the world and our market perspective. First off on our operational aspect of things, the key for us is geographic flexibility.

As you look at our distribution folks we have been able to follow our customers, get into the shell plays where needed, most recently we have opened up a few new facilities on the Marcellus which we think is going to expand dramatically over the next couple of years, and the deep-water plays are finally starting to come to fruition in places and especially in the Gulf of Mexico and of course you will see that expand around the world as we deliver many more of these deep-water rigs that we are currently building.

So, the key for us in distribution is to be able to maintain following our customers geographically, maintain variable costs at the highest level, fixed cost at the lowest level and be able to give our customers what they need.

On the PS&S side, and on our petroleum services and supplies, it’s really about new product development, and it’s about providing the services and tools that our customers need. I think you are seeing us do that, and as you see, some of the folks are talking about 2010 being a more robust year, we hear the drilling contractors talking about having a little bit more optimism, and as those customers and our other service customers like Schlumberger and the other service companies expand their role in this drilling philosophy, we will be able absolutely add equipment to that, but the big thing for that is new product development.

This quarter we are opening up our new drill pipe research facility, that’s going to be located here in Houston, we continue to push the envelop on product development because that really is going to be the key to anything, I don’t care if you are talking about a drilling rig, a distribution services concepts, or our petroleum services and supplies products, I think having those new products out there, being able to enhance the efficiency of these shale wells, and also being able to enhance the efficacy of the deep-water wells is really what’s going to be critical for us in that and we are pushing ahead quite well on those areas.

In our rig equipment, it’s really about execution, and I think you should take a look and you see the numbers that we have talked about here this morning, our rig folks do not execute. We have been able to take stuff on a backlog at very good prices and very good margins.

If you look at this anybody can put anything in the backlog, you can take stuff at almost no margin put it in the backlog. It’s the execution of getting it after backlog profitably that makes all the difference, and I think you can see from the results that we have been telling you about that our folks in our rig technology group have done a phenomenal job of not only obtaining backlog, but making sure that they monetize that backlog appropriately.

So for that we are very, very pleased, but that’s really kind of the state of our operations, our folks are working very, very well, we feel very good about our position in the market and our ability to execute and deliver to our customers.

Let me talk just a moment about our market perspective, and again, we are cautiously optimistic. Listening to a lot of the drilling contractors conferences calls this past quarter, and of course with my visit with them, I mean they are feeling a little bit better about the jack up market and some other areas, and of course our customers are feeling better, quite frankly, we are feeling better.

So, I think we are cautiously optimistic about things, specifically of the Gulf of Mexico, looks like it might pick up and especially in some of the smaller jack up arenas, and as that happens that really helps us in both the PS&S services side of the business. So, I think you could see some improvement there.

What we are seeing around the world that’s very positive is a lot of the financing that’s being done to help us and help some of our customers with these major products in particular is DAC, which is the Norwegian financing group, you have the EXIM bank in the United States, the China Development Bank, and the Korean Development Bank, these are all banks that are actively trying to finance projects as long as a lot of the manufacturing has done within the compounds of those countries.

Quite frankly the neat thing for us is we are in all those counties and we’ve got facilities that can hit the local content rules and be able to position ourselves to competitively take advantage of these projects and put ourselves in great competitive position.

The biggest risk for us of course is going to be the worldwide economy. I think we have seen what’s happened in the past year, last October was very disastrous; we have been pulling out of this for the last year.

I think the speed with which the GDPs on every country that’s out there pulls out of it will dictate what happens to the marketplace in the long run, but we are cautiously optimistic, we do think that we probably hit bottom, but I will say that especially as we trough, and things like our petroleum services and supplies and distribution, that doesn’t mean you are bouncing up, it just means you are troughed out. So that’s kind of where we are in the market.

Let me take you around the world just a little bit, tell you what we are seeing and I will start with South and Central America. Brazil as matter of fact as Clay mentioned earlier, some of the great opportunities we see down there. But I will also kind of expand a little bit. The other thing we are doing is we continue to make sure that our presence in Brazil is significant.

Currently, we have over 700 employees in the country. We just recently purchased some land in Recife that’s very close to Atlantico Sul, which is one of the larger shipyards in the area, and we will continue to expand our presence in Brazil because we think not only is that going to be a good environment for capital equipment to expenditures, but it’s also going to be a place where we are going to be supporting the offshore industry for the next 30 years, and with their intend to drill so many deep pre-salt wells and other deep-water wells out there, having a great footprint there makes a lot of sense, so we see Brazil as a great area.

Mexico continues to be very positive where it’s just counter pack or the [Berguou’s] basin, we have facilities there throughout all of our operations to take advantage and support our customers, to take advantage of the business environment and support our customers, and we feel very comfortable that those two markets are going to be positive in the near term.

The Middle East is pretty steady. I think with the oil price increasing, we have had some positive things in Kuwait. We are expanding our operations in Kuwait, we are actually using that as a jump off point to take care some of the operations that are ongoing in Iraq.

We think that North Africa, Algeria, Libya and Egypt continue to have projects and continue to need, especially in the services side of the business a lot of those things that we have. And I think the natural gas is coming out of those areas, and their ability to hopefully be able to build pipelines that will go into Southern Europe with that natural gas will be very interesting in the long run.

Another one that’s kind of cropped up on our scope here recently has been India. And India has been very positive, they have, I think much like Brazil, they really want to develop a little bit of their own internal oil and gas business, a lot of the international contractor is drilling in the offshore arena. We are seeing and more and more opportunities for land rigs in those areas. Today we currently have some manufacturing in India, but we continue to expand our footprint in those areas to be able to take advantage of what’s going on.

Russia, we are going to open up a facility in [East Navarktaz] this quarter. It’s a little slower, but again it kind of comes back to potential element there. We have some good operations out in the [Sukkwan] Island, and of course as over the next year or so we will be delivering some of the larger rigs that are going to be going into the Barren Sea to drill some of the Artic environment up there.

China, again a very exciting arena for us. I think the shipyards there will stay reasonably active, and especially trying to develop a little bit more of their internal oil and gas structure. Of course we have some great facilities in China and I think you see the Chinese moving around the world today, trying to take up a lot of the oil capacity and they want to do as much as they can locally also, and so we are positioned to be able to take advantage of that.

Then finally, it kind of comes back to North America. I think when you get into North America its tough game, and it’s the natural gas business. I am probably not telling anything to anybody in this call it’s pretty tough right now with the pricing and things, but we believe that natural gas can play heck of an important role.

I think in the energy security of this country, when you start talking about carbon, I think natural gas is a wonderful antidote to some of the carbon issue. So we are cautiously optimistic that you will see more and more positive things happening with natural gas, and then with our abilities to be able to drill these shales, we think it’s going to be something that will be exciting as we extend out into the future.

So that’s really kind of where we are in the world. Just a couple of other quick notes to make. We are excited about the opportunities in Brazil; we are excited about some other opportunities around the world, whether it’s in the Artic areas and some other things. So it’s not a one trick pony at this point in time. There are other opportunities out there and we are pursuing it very aggressively and we like where we are in the business.

Then finally, we completed as Clay mentioned earlier, our JV on IntelliServ this quarter with Schlumberger and we are really excited about this. I think that this technology can really do some very, very unique things in the industry, and the speed with which it can get information, both going down the hole and coming back up the hole is pretty incredible. So we are excited about it, and we have kicked it off. The management team is in place and we push forward from here and we think it’s going to be pretty exciting.

So that’s just some quick comments on operations and what we see around the world, the market perspective, and at this time Hilda, I would like to turn it over to any questions that any of our listeners might have.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from Marshall Adkins - Raymond James.

Marshall Adkins - Raymond James

I am going to leave it up to the next five guys to ask you about your backlog, ten different ways. I want to hear about your M&A stuff. It seems to me this is going to be a key part of the story going forward. I mean, you had phenomenal free cash flow, I would expect you guys obviously to put that to work through acquisitions.

So Clay, I know that you mentioned, and you are going pretty fast there, five letters and ten on small companies. But could you spend a little more time walk us through what you have done to staff up in this area, walk us through the opportunities you are seeing, the relative evaluations etc. I don’t need specifics, but just generically how things look. Are you going to have opportunities, are you going to be able to spin the cash you would have on these acquisitions?

Clay Williams

You bet, great question Marshall. This started about a year ago as the financial markets were melting down and Lehman and Bear Stearns and others were facing their problems. We recognize that there were likely to be some pretty extraordinary opportunities come out at this time. And so, as a result about this time last year we increased our staff in this area, we now have a full time staff with four professionals that pursue M&A opportunities.

We also went through their list and sought to high graded to lop off some of the smaller things at the bottom that were less impactful on NOV, and went out to try to act when the future looks very uncertain. And they have been very, very busy and I will stress we have an excellent, excellent team. All four of these folks do a great job and we are very proud of the job that they have done.

It’s an awful lot of work bringing any one of these transactions over the goal line and for everyone that we bring to closure we typically have to queue up about a half a dozen, six or seven statistically, that we look at and do some level of due diligence on, so it’s a lot of effort that goes into this.

Inclusive of deals that we have closed earlier this year plus the two that we signed that we expect to close here in the next few weeks, plus the five letters of intent, we expect to put about $600 million in capital to work through this effort this year.

So it’s a really good effort that’s probably doubled from what we did in 2008 and the returns are very, very good with this application of capital. We are able to kind of the all in run rate EBITDA after cost savings that we think we are buying at is probably just will shade over four times and that equates with the return on capital in the low to mid teens for us. We think a very good application of capital.

The challenge that we face as you point out is that our free cash flow has been so strong and it’s really out paced our effort in this area. So since the beginning of the year we have seen our cash balances grow by about $1.6 billion this year and again expect to put about $600 million to work through this efforts.

So, to kind of increase the pace of point capital in this area we have had a number of discussion with larger companies and probably half a dozen significant sized proposals that we have made on the order of plus or minus $1 billion. So far none of those have come to fruition. So those tend to take much longer, be more competitive and harder to make sure that we execute in a way that’s accretive and a good deal for our shareholders, but we continue to work on getting one or more of those over the gold line in the meantime.

We think NOV is unique, and the fact that we view M&A as full time endeavor, we have a full time staff employed, this is all they do and so it makes them passionate and objective when it comes to looking at opportunities and we are always in the market. We also have a terrific operations staff that has closed and integrated an awful lot of transaction too.

So I think when it comes to actually integrating these acquisitions we have a very high level of competitive advantage there. So this is our preferred application of capital and we hope to see more capital go to work through this pipeline.

Marshall Adkins - Raymond James

Great, one quick follow up the IntelliServ sale on partial sale I guess JV; how much cash did you get in for that and did you book any profit for that?

Clay Williams

Under GAAP rules we did not book any profits related to that, that’s just a change in our additional paid in capital on our balance sheet and we agreed with our partner there that we weren’t going to disclose what was paid for that.

Operator

Your next question comes from Geoff Kieburtz - Weeden.

Geoff Kieburtz - Weeden & Co

I will take the bate and ask you about your backlog. Can you help us understand kind of why things didn’t turn out the way you expected in 2009, I think you did mention that the Petrobras tenders are out based on a board meeting in mid-September, but you are not expecting orders from that to materialize until the third quarter of 2010. So, presumably something else was really behind your expectations for 2009 that didn’t materialize.

Pete Miller

Yes Geoff. I mean I think it’s a combination of factors and what you have in an environment like this, which isn’t really all that uncommon, is you see more and more projects moving to the right. I could name four or five major projects that would look like we are going to come to fruition and in ‘09 it just didn’t, and they moved out.

That’s the bad news but that’s always the difficulty you have on prognosticating about backlog, because if a customer orders it on the 20 of September or the 10of October it didn’t matter to them, but it matters a lot to us because we have a cut off date on the 30 of September. So, you have kind of a date certain, whereas if they kind of move it out it doesn’t matter. What we worry about are project cancellations and we haven’t seen much of that.

We are seeing stuff kind of pushed to the right. There has been some things in the Caspian Sea that probably we thought were going to happen, did not happen in the timeframe with which we thought they were going to happen, were pushed out. We’ve had a couple of projects that we’ve been working very diligently on, that we thought might get signed in September, probably won’t be signed. Well if they didn’t, that’ll be signed in October, November or may be even into January, which at the end of the day doesn’t bother us a whole heck of a lot, other than the fact that you have to report the backlog, when we do the earnings conference call.

Naturally kind of what’s happened has been more of a process of things moving to the right, it’s a guessing game. We get it with our sales folks and we take a look, and we said, “okay, what are the projects you think are coming to fruition here, let’s take a look at different things,” and as we look at it, we kind of put a date on it and that makes us think, “okay, here’s what’s happening” and then if the customer decide to push those out for whatever reason, there’s not much we can do there.

The other thing, I think this is important; our backlog is exceedingly conservative. There’s nothing notional in it, and that’s one of the reasons that you’ve seen a very, very low degree of cancellations. I remember a year ago listening to some people saying “oh, the cancellations are going to be enormous” when in fact they weren’t, and that’s because we make sure before something goes into backlog, that it is fully financed, that we have down payments on it, and that we have the visibility to see that it’s really a deal as opposed to may be just a notional or LOI type deal.

So that’s kind of where we are Geoff, just things moving to right a little bit on us, but they are going to be there and we feel good about them in the future.

Clay Williams

Yes Geoff, probably also worth adding, when we came into the year, we were very clear that a lot depended on what happened in Brazil and added that to our guidance, and what has happened in Brazil is that the definition of local content requirements and the forms being considered in the way blocks are managed by the federal government ANP in Brazil, I think it has added some delays.

Additionally, the credit market as we have mentioned have been pretty tough, probably worth noting and I think this was in my opening remarks that the banks are requiring higher levels of equity participation by some of the drilling contractors in these projects and if you think about it, it’s one thing to negotiate with the bank and we believe the credit markets are freeing up. But when they add additional requirements for larger equity participations, some of our customers are bringing in partners, and so the discussions take on a whole new set of dynamics.

They have to work out shareholder agreements and prenuptial agreements, so an equity investment is just take a lot longer to bring to fruition. So I think that added headwind, which is a derivative of the state of the credit markets has delayed things a little more than we expected as we came into here.

Geoff Kieburtz - Weeden & Co

I think it kind of addresses in your comment, it doesn’t sound like there was anything on the table in the beginning of the year that has fallen off that’s really material, am I understanding what you comment?

Pete Miller

Absolutely, absolutely. I think as we take a look at this Geoff, there has not been anything that people have said, well, we are just are not going to do it anymore, because most of these projects are pretty viable and especially internationally when you are looking at today’s oil price. So, there really hadn’t been anything that’s fallen off the table, it’s just a question of timing.

Geoff Kieburtz - Weeden & Co

And in terms of the timing, sort of slippage, I am going to guess you are not going to make 2010 order forecast, but.

Pete Miller

That’s a real good guess.

Clay Williams

Oh yes.

Geoff Kieburtz - Weeden & Co

But can you generalize about the slippage? I mean are we talking about a quarter or a year in terms of slippage? Taking into account credit market conditions and everything you’ve already mentioned.

Pete Miller

It almost is slippage that goes on a project by project basis, Geoff. I would have to break it down completely and say, well, here’s one in the Artic that we think is going to happen here, and one here is going to slip out another quarter.

I think the only way just to generalize, there’s going to be slippage, but there’s not really going to be cancellation of these particular projects, they don’t have any order with us, so I don’t want to say cancellation, it sounds weird. But there wont be a compete cancellation of these projects, to go forward at least as best we can see now.

Now if the price of oil goes 20 bucks a barrel, then I’ll bet we are off on that. But I think given the current market environment, there will be some general slippage, but I think it would be very difficult to give you an absolute picture of that.

Clay Williams

Yes. The key thing that you highlighted Geoff is that we are not losing the line, these projects just aren’t being signed, and so, we are confident at some point they are going to be done.

Geoff Kieburtz - Weeden & Co

And lastly, in terms of the local content requirements in Brazil, as they’ve changed and become a little bit clear, are they going to cause NOV to need to make any increased investments in Brazil of significance?

Pete Miller

I think the key is significance. I mean, the fact is we’ve been investing in Brazil for quite some time and we will continue to and you’ll probably see us work at joint venture too that will help us out, note some of the things that we’ve done in China over the years and things that we’ve done in Korea and other places over the years.

So, we will continue to do that. But the bottom line is there is not anything on the content requirements that gives us any pause. We will be able to hit those and hit them very effectively and we are committed to help the Brazilians advance our oil and gas business. So it should work out okay for us.

Operator

Your next question comes from Robin Shoemaker - Citigroup.

Robin Shoemaker - Citigroup

I wanted to ask about kind of directionally operating margins in rig technology and PSNS. Clay, you mentioned that probably you’ll get less delivery from backlog in the fourth quarter, something like 1.3 versus 1.6 this quarter.

I would normally assume that that’s going to have the effect of lowering margins, and as less product is delivered from backlog going forward that would continue to be the case. But you’ve got some cost containment initiatives underway. So, what is your guidance, if any, about this high 20% operating margin you’ve achieved in this segment?

Clay Williams

Robin, the comments that I just gave a second ago, kind of point you in the direction of that moving down in the fourth quarter, closer to the kind of the mid 20% range is what we expect, and it’s as you point out, obviously a big fall in revenue out of backlog from Q3 to Q4 based on what we are looking at now.

Again there’s a possibility of over achieving as we have done last few quarters, but based on what we are looking at now we think $1.3 billion out of backlog is reasonable and that all rolls up to be kind of high single digit decline in that segment in the fourth quarter vis-à-vis the third, and will end up in 25% or may be 26% range, if things hold to what we forecast.

Robin Schumacher - Citigroup

Okay. I think you previously gave a projection for outflow from backlog in 2010 and 2011, and if you gave an update of that I didn’t hear it on this call. Do you have an updated estimate of backlog deliveries?

Clay Williams

Yes, you bet. I can’t recall what I said last time, but right now, based on our September 30, backlog we are expecting $4.7 billion in revenue in 2010, and $1.3 billion in revenue in 2011. So that’s based on projects on the backlog as of September 30. As it’s probably worth pointing out, I know you know this but others may not, as we win orders in the coming fourth quarter and into 2010, some of that can flow as revenue in 2010. So that may have some upward bias in it as the year unfolds.

Robin Shoemaker - Citigroup

Okay. Lastly on this, the after market I presume will now become a little more of higher percentage of rig technology revenue compared to what it has been. So, I think you said 17% in the third quarter.

Clay Williams

Yes.

Robin Shoemaker - Citigroup

So, have you got a sense now with the new generation of deep-water rigs, drill ships and semi-submersibles, as to the kind of after market opportunity that each of those types of rigs represents on an annual basis for NOV?

Pete Miller

Robin, we don’t have that yet, and one of the reasons is a lot of them that we put out are running very, very well. We kind of match that up with warranty reserves that we make, and we look at the way that some of these are running. We think in the long term it’s probably going to be a pretty decent number, simply because the equipment that we are putting on these things is so much more complex, but we have been reluctant to take a stand and give a number on that, simply because these new generation of rigs they are so new and they are so technically advanced that we just don’t have a real handle yet on what that after market is going to look like.

Operator

Your next question comes from Bill Herbert - Simmons & Company.

Bill Herbert - Simmons & Company International

Pete, trying look out a little bit here and contemplating the floater world ex-Petrobras, and once E&P companies, IOCs and select NOCs, begin to believe that essentially $70, $80 crude is not assembled and frankly could be conservative. What do you think is a reasonable normalized environment for floater related orders going forward? I mean clearly, we are not seeing anything now. We were in an environment of four to six per quarter. What do you think normalized going forward is?

Pete Miller

That’s always going to be a tough answer Bill, simply because, I think if you could say the price of oil was going to be in the $85 or $90 range and not [fremrol] as you say. I think you could probably come up with a pretty decent handle, unfortunately it moves pretty dramatically.

I think that, if you were to tell me, okay, it’s going to be pretty close to $80, $85, $90 the entire time, then I would tell you two to three coming on a quarterly basis would not be abnormal. And I know a lot of people look at that number and they kind of go, gosh, that seems like a lot but look at the amount of water that you have around the world.

I think especially as IOCs and some of the others want to really increase our own exploration efforts, I think the world needs a lot more of the deep-water rigs. And then given the timeframe to build these things, whether it’s two and a half or three years or three to four years, I think having a normalized rate like that would make sense.

Now, having said that, let me put caveat on it, I mean it’s just all based upon the price of oil or where you think the price of oil and gas is going.

Bill Herbert - Simmons & Company International

Right, and I guess where I am trying to go is this. I mean, Petrobras has come out and again approved, if you will, of the additional 28 rigs that it’s going to build. Assuming you get your call it 50% market share plus with regard to those it’s probably, I don’t know, something approaching five Petrobras floaters per year. Let’s be conservative and assume you get one additional floater outside of Petrobras per quarter.

So call that four per year, you have got your, call it run rate of $300 to $350 million in non-floater related orders per quarter that probably moves higher as well. In other words, getting to an environment where you are generating normalized orders call it $3.5 billion per year, that’s not necessarily illogical, is it?

Pete Miller

No, not at all. As a matter of fact I think we will look back, I mean this has been an abnormal year and it has been abnormal not so much because of the oil and gas business as much as worldwide economy. And I think if you look to the future I think looking at numbers like that is not abnormal. And I think you would start to throw in land rigs and you start to think about the technological advances on land rigs, right?

Bill Herbert - Simmons & Company International

Yes

Pete Miller

You start to take a look at the fact the clock keeps ticking on rust. We have said this for a long time and we are adamant about it and I think you are going to see more jack up rigs that are going to be needed. We sold jack up equipment this quarter and the fact of the matter is that those are not I think abnormal numbers at all to project into the future.

Bill Herbert - Simmons & Company International

Right, and Clay, when you distill that into an earnings number with PSS improving as well, conservatively, I don’t know, 350 a year in earnings per share, free cash flow north of a $1.5 billion per year or something like that?

Clay Williams

Yes, the nice thing about it is, we spend a lot of time sort of mesmerized by this backlog. But the truth is the business is actually much smoother than that. Orders are volatile, as Pete mentioned, are subject to cut off. If you look at our earnings and our cash flow, because in particular you see water rigs are built over two or three or four years, the earnings performance is actually quite leveled and that makes it a much easier business to run.

Bill, also, I think worth noting with regards to the deep-water environment, a couple of things. First, Petrobras has done an amazing job steering how to drill through a lot of salt.

Bill Herbert - Simmons & Company International

Right.

Clay Williams

And as the world’s population of wells that have successfully penetrated 6000 feet of salt and rocks as they continue to drill down there, I think that technology is going to find its way into other basins, so you are effectively opening up new frontiers with that technology.

Secondly, as deep-water development progresses you build out infrastructure, you build out gathering system, such that the incremental cost of new fields in that basin, the economics look that much better because they are not having to carry the expense of laying a pipeline all the way to the beach.

So, I think those two things along with other technological advancements in this space mean you are likely to see sort of an acceleration over the coming decade plus of interest in these deep-water environments and that requires a lot of rigs and that’s what we are here for.

Operator

This concludes today’s call. I will now like to turn it over to Mr. Miller for closing remarks.

Pete Miller

Thank you Hilda. And we appreciate everybody calling in today and we look forward to talking to you next year when we report on our final results for the year and the fourth quarter. Thank you very much.

Operator

Thank you ladies and gentlemen. This concludes today’s conference. Thank you for participating, you may now disconnect.

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Source: National Oilwell Varco Inc. Q3 Earnings Call Transcript
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