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McDermott International (NYSE:MDR)

3Q 2010 Earnings Call

November 9, 2010 10:00 a.m. ET

Executives

Jay Roueche – Treasurer and Vice President of Investor Relations

Steve Johnson – President and Chief Executive Officer

Perry Elders – Senior Vice President and Chief Financial Officer

Analysts

Martin Malloy – Johnson Rice

Jamie Cook – Credit Suisse

Graham Mattison – Lazard Capital Markets

Andy Kaplowitz – Barclays Capital

Steven Fisher – UBS

Roger Read – Natexis

Tahira Afzal – KeyBanc

Will Gabrielski – Gleacher & Company

Operator

Ladies and gentlemen, thank you for standing by, and welcome to McDermott International’s third quarter 2010 earnings conference call. At this time, all participants are in listen-only mode. Following the company’s prepared remarks, we will be conducting a question-and-answer session and instructions will be given at that time.

I would now like to turn the call over to our host for today, Mr. Jay Roueche, McDermott’s Treasurer and Vice President of Investor Relations. Please go ahead, sir.

Jay Roueche

Thank you and good morning everyone. We appreciate you joining us today to discuss McDermott’s third quarter 2010 financial results, which we reported after the markets closed yesterday. Joining me on the call this morning are Steve Johnson, McDermott’s President and Chief Executive Officer; as well as Perry Elders, Senior Vice President and Chief Financial Officer.

Before I turn the call over, let me remind you that this event is being recorded and a replay will be available for a limited time on our website. In addition, some of our comments this morning will include forward-looking statements and estimates. These comments are subject to various risks and uncertainties and they reflect management’s view as of November 9, 2010.

Please refer to our filings with the Securities and Exchange Commission, which are available on our website, including our form 10-K for the year ended December 31, 2009 and our recently filed form 10-Q for a discussion of the factors that may cause actual results to differ from management’s projections, forecasts, estimates and expectations. And please note that, except to the extent required by applicable law, McDermott undertakes no obligation to update any of these forward-looking statements.

Finally, our discussion this morning will include reference to certain non-GAAP metrics. Please review our earnings release which we issued yesterday and is available on our website for the reconciliation of these non-GAAP metrics to the relevant financial measures calculated in accordance with Generally Accepted Accounting Principles.

With that, I will now turn the call over to Steve Johnson, McDermott’s President and CEO, for his opening remarks.

Steve Johnson

Thanks Jay and good morning everybody. We appreciate all of you for joining us today. I will let you know at the outset I am suffering from a bit of a cold, if I pause more than often, that would be the reason.

I am very pleased with the operational results that McDermott delivered in the third quarter of 2010, excluding the non-operational impairments and related costs we disclosed, this was the highest level of operating income for our offshore oil and gas construction business in recent memory, perhaps ever, at almost $128 million. These results were delivered through the significant effort of our employees worldwide and were achieved through ongoing project execution as well as certain project improvements, change orders and closeouts. Essentially, it was delivering on our business model. Later, Perry will go through the details of the numbers, but this was truly an outstanding quarter. However, even during a strong quarter, I must remind investors not to get overly excited in either direction about 90-day results, since there are often sizeable puts and takes in our business. It is just part of being a primarily fixed class contractor in the offshore EPCI business.

In addition to the strong operating results we did have some non-operational, non-cash charges during the quarter. I will spend a couple of minutes here to discuss these items and our thinking behind them. The first item was our decision to suspend our efforts to open a new fabrication facility in the country of Kazakhstan. While there is no doubt that the Kashagan field will ultimately provide for significant opportunities in that region of the world, the simple reality is that progress on this development continues to be delayed and typically each one of these occurrences of delay is measured in years of time. In short, we just do not have confidence in our ability to predict the timing of the opportunity in this region. As I have told the financial community in prior communications, this management team will treat capital as a precious commodity that you have entrusted us with and we will periodically evaluate all of our projects, both those proposed as well as those currently in progress, as was this program.

In my view, we simply could not justify the continued development and the potential for annual rental expense when the major programs we were building the fab yard for kept moving to the right with significant delays. As such, we decided that discontinuing our efforts at this time was the best course of action and thus, we realized the sunk costs as well as associated expenses this quarter. We viewed this action as a much better alternative than proceeding full-bore and spending tens of millions of dollars to create a new facility which would likely sit underutilized or worse, vacant, for a number of years. When it appears that the market can support another facility in Kazakhstan, we will again consider the merits of adding new capacity in that country.

The second major change in our continuing operations was the impairment taken on two of the vessels associated with the 2007 Secunda asset purchase. The impairments were taken on the Bold Endurance and the Agile vessels, which now puts their book value in line with current estimated market values. Of course, accounting rules require us to mark vessels down during periods of weakness, but unfortunately we do not have the opportunity to increase their book values if the market improves in the future.

As we discussed in last quarter’s call, marine-only work has been and currently is experiencing softness in terms of new awards combined with an increase in new vessel capacity over the last few years, which together has resulted in lowered day rates currently and thus, lower market and present value for vessels than just a few years ago. Fortunately, much of our marine work is driven by the larger EPCI contracts, which eliminates some of the volatility. However, we have evaluated our entire fleet of vessels and we believe this is the only impairment required for our ongoing business.

Finally, we also exclude the discontinued operations line as we evaluate our results. There are two major components of our discontinued operations. The first, which is the same as what it was in the last quarter, is the Babcock & Wilcox Company, which was spun off to shareholders at the end of July of this year. In addition, this quarter we added the Chartered Marine business associated with Secunda. For several years now we have indicated that these vessels were not core to our operations and we would evaluate a disposition of them. However, we did not move as quickly as I would require. Since I view capital as highly valuable, I do not want it tied up in assets that we simply do not see as core. Divesting this business at market value has become a priority and we would expect the sale to occur within the coming year.

With that as a backdrop, let’s talk about the quarter. Revenues in the third quarter were $732 million, down substantially from a year ago, but up sequentially. Clearly, these revenues were higher in quality as reported operating income was down only $13 million despite $44 million of non-cash impairments. Excluding these costs our non-GAAP EPS of $0.44 per share was truly exceptional, in my view. In terms of activities levels, our major construction facilities worked a total of about 4.5 million hours during the quarter. This was down from the second quarter of 2010 by about 9%, but up by about 15% compared to the third quarter a year ago. This type of quarter to quarter change is fairly normal for our business, as we said before, as projects move through the EPCI sequence. Virtually all of the fab work took place in our Middle East and Asia Pac locations, while the Caspian and Atlantic remained underutilized similar to the last few years.

As we mentioned previously, keeping our construction vessels working has been a challenge this year as a result of soft award cycles in 2008 and 2009. Utilization did improve during the third quarter as our eight major construction vessels worked a little over 350 days. Although this level is still only about 70% of what we would consider full utilization, it was the highest of the year and was an increase of about 20% in days worked compared to the 2010 second quarter. We are still well below the 570 days worked in the 2009 third quarter. Rather than just sitting by, waiting on the market, we made a decision to take one of the vessels, the DB50 from the Atlantic region and move it temporarily to the Asia Pacific region. There are two main reasons for this move. First, we believe there is an opportunity to obtain its upcoming dry dock, which has been previously planned, at lowered costs. Second, we see more opportunity to increase 2011 work in the Asia Pacific region versus the Atlantic. While it will take about 90 days to move the vessel, we are already actively marking it for the Asia Pacific region. We believe this will improve its economics for 2011, although, there will be no work in the near-term during its transit. I would note that we will begin transit the first week of December.

At September 30, our backlog of work stood at $3.6 billion. This was down from June 30 levels as a result of the good level of revenues in the third quarter combined with like new bookings and the exclusion of about $80 million of backlog associated with the Chartered Marine business, which as I mentioned earlier is now categorized as discontinued operations.

As we look at major goals, certainly our near-term focus continues on winning profitable new work for 2011 and beyond. During the third quarter, bookings were approximately $160 million. The vast majority of which were change orders and scope growth on existing projects. Ordinarily, we would be more concerned with such a small amount, but as we indicated in our press release yesterday, during the month of October we booked about $1.2 billion worth of new work and we are optimistic that there may be more awards coming during the remainder of this fourth quarter. As recent months demonstrate, new awards are generally lumpy on a quarterly basis. Virtually all of the October work is for the Middle East and Asia Pacific segments with around $500 million and $700 million respectively.

In terms of revenue recognition, our September 30th backlog is expected to generate just under $700 million of revenue in the fourth quarter and about $2 billion for the full year of 2011. If you add the roll off characteristics of the October bookings, the 2007 roll off expectations would increase by about $500 million, bringing 2011 to a total of about $2.5 billion and obviously, we expect to add new work and grow backlog projects. In that regard, we are reasonably optimistic. At September 30th, we had about $3.7 billion of bids and change orders outstanding, including some of which that became the October bookings. Beyond bids, there are also a sizeable number of projects on the horizon that we see coming to market over the next few months. We have a category identified as Target Projects that exceeds $10 billion in total, which we believe will be bid over the next five quarters and our focus list would be even higher than that number. Competition remains tough in every market that we operate in, but the market remains strong overall, and we just need to win our fair share.

Looking more at our daily operations, let me cover some items of interest here. While I do not normally spend much time talking about safety with the financial community, let me assure you that this company and our management team view the safety of our people and our assets as our most important duty. As you know, the projects we construct are very large and very complex onshore and then we install them in the water. Either activity can be potentially hazardous if not done correctly. Our standing with our customers, our local communities, and our employees can be dramatically affected by our safety culture and our safety statistics. For this reason, I am very proud that McDermott was recognized as Chevron’s Contractor of the Year as a result of our work on the Platong Gas Project for the Gulf of Thailand, where we recently completed over 10 million man hours on the project without a single lost-time incident. It was quite an accomplishment.

I am also pleased to report that we have recently taken over operations or the North Ocean 102 vessel and it is working on the Koran Project in Saudi Arabian waters as we speak. Its sister ship, the 105, is now under construction in Spain and should be completed for our use in 2012. Both are important parts of our vessel strategy.

During the quarter we cut steel on our second PEMEX project in our Mexican fabrication yard at Altamira. As we continue to credentialize this facility.

Finally, management is actively engaged with our Atlantic segment. We are building a more focused strategy and business plan that will deliver improved results as we enter 2011 and go beyond.

To give a few comments on our markets, the Middle East remains active with new developments as well as numerous upgrade projects. In fact, we are looking to expand our footprint with some additional fabrication capacity. In the Asia Pacific segment, Australia remains the hot market, but we also see significant opportunity throughout Southeast Asia, in particular, Vietnam and Malaysia.

In the Atlantic region, we are starting to see the industry commence projects and I believe our Altamira fabrication facility will be the long-term response to meet the demands of the western hemisphere offshore construction market and our new focus here should incrementally add to this segment’s results.

That pretty well completes my prepared remarks on operations. To summarize, we are very pleased with our quarterly results and continue to believe that 2010 will be one of our better years financially. We carry on with our efforts to book EPCI projects for future years and in the short-term, we are trying to fill as many as the available marine days as possible. Just based on where we are today, the fourth quarter should prove to be a strong period for new awards. We remain steadfast on the excellent execution of our projects, as well. The company has a strong balance sheet with financial flexibility provided by our available liquidity. With that, I will turn the call over to Perry to go into the details of the financial results for the quarter. Perry.

Perry Elders

Thanks Steve and good morning everyone. Starting at the top, as Steve mentioned, total revenues for the third quarter of 2010 were $732 million, which is up about 13% sequentially, but down about $280 million from a year ago. The decline was primarily due to a lower level of activities in the Middle East segment compared to the third quarter a year ago when we had substantially more marine days as we were very active in the Cutter project marine campaign.

Our gross margins were solid again this quarter at almost 23%, which were hampered by the $20 million charge we recorded for the discontinued Kazakhstan facility. However, even with this one-off expense, our gross margin this quarter was up sharply from the 15.5% recorded a year ago when a portion of our revenues were generating no profit.

SG&A expense was up modestly on a sequential basis, as we indicated on the last call, but it was down about $3.1 million from a year ago as a result of a lower post-spin cost structure. Consolidated operating income of $84.3 million was, this quarter, generated an operating margin of 11.5%, at the upper end of our 10% to 12% range that we think of as the norm. However, if you excluded the $43.9 million of combined impairment expenses related to the vessel write-downs and the fabrication facility, operating income was at a record level of $128.1 million. The results of the third quarter compared to operating income of $97.6 million with an operating margin of 9.6% a year ago. The strength of the 2010 third quarter was, once again, in the Middle East segment, where strong operating performance, change orders, and cost savings combined to generate the stellar result, including about $36 million of recovery on the Cutter projects, which we worked very hard to deliver.

Below operating income, the other expense of $3.5 million compared to about $300,000.00 that was reported in the 2009 third quarter. The $3.2 million swing was largely driven by lower interest income, higher interest expense, and an increase in foreign currency exchange expense in the 2010 third quarter.

With virtually all of McDermott’s pro-forma income being generated from our foreign operations, our provision for income tax this quarter was only $10.1 million, or about 12.5% of pre-tax income, compared to a tax provision of $19.3 million or almost 20% in the 2009 third quarter. As has always been the case with McDermott, our effective tax rate will vary quarter to quarter dependent upon the jurisdictions where we are operating. We believe our Panamanian domicile is a structural advantage that benefits shareholders despite the quarterly lumpiness. However, I would continue to suggest you to expect mid-teens to low twenty’s tax rate over the next year.

Net income attributable to non-controlling interest, primarily our minority interest partner in Southeast Asia and the North Ocean 102, was $9.8 million, which was a significant increase compared to a year ago and several million dollars higher than what we would normally expect as this quarter, the joint venture partner as well as we benefitted on the project closeout.

At the bottom line, the reported net income attributable to McDermott from continuing operations was $60.8 million for the quarter or $0.26 which includes approximately $44 million of impairment and related expenses. Excluding these expenses, non-GAAP net income was $104.7 million or $0.44 per share. All in all, an outstanding quarter.

Briefly to mention, the items in discontinued operations, Babcock & Wilcox had a net loss during the month of July. In addition, we had about $5 million in spend related costs which we believe are finished. We mark to market the Secunda Charter vessel held for sale which was perfectly offset by the Charter income and a small net tax benefit. In total these items sum to $40 million.

Looking forward, we continue to anticipate operating margins in the 10% to 12% range, which now includes the corporate costs that we had absorbed as part of the spin that were previously excluded from the target range.

There are opportunities and risks to be outside this range, as we have demonstrated in the past, but we strive to realize the opportunities and eliminate or mitigate the risks. We also expect SG&A will hover around the $60 million level in the coming quarters, but we are working to keep it as low as feasible.

As covered in the 10-Q, we are applying our deferred profit recognition policy to the Papa Terra contract in the Atlantic segment. All in all, McDermott has delivered very strong performance thus far in 2010 and we believe we will deliver another good year.

Looking at the balance sheet, our financial position remains strong. Our cash position, which includes cash and equivalents as well as investments, ended September at $720 million. In addition, we had about $650 million currently available under our credit facilities.

Looking beyond cash and credit capacity, our working capital, which is current assets less current liabilities, was strong at around $430 million and total equity was 63% of total assets. We essentially have an unleveraged balance sheet as our debt is $54 million.

To switch gears to our investor relations activity, we were very busy during the third quarter participating in conferences and visiting with investors both on the road and here in Houston. With third quarter earnings reported, we will start IR activities back up for the rest of the year. Next week we will participate in both the Barclay’s Energy and ENC conference in Dallas as well as the KeyBanc Engineering Construction and Utilities conference in New York. In December, we will present at the Capital One Energy conference in New Orleans and at Jeffrey’s Energy conference here in Houston. With several regions to choose from on the near-term itinerary, we hope to see many of you at one of these venues before year end. This concludes our prepared comments, but following the Q&A session, if you have any additional questions regarding the quarter or the company, I encourage you to call Jay or Robbie in our investor relations department and with that, we will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Looks like our fist question comes from the line of Martin Malloy with Johnson Rice. Please proceed, sir.

Martin Malloy – Johnson Rice

Good morning. Congratulations on the quarter.

Steve Johnson

Thanks Marty.

Martin Malloy – Johnson Rice

Could you talk a little bit about your strategy in the Atlantic region, the Gulf of Mexico and there are a number of bids that are apparently coming out for top sides in that area and how the Altamira yard factors in to your strategy there?

Steve Johnson

Yes, Marty, I would be happy to. This is Steve. There are a number of factors underlying our strategy on a going-forward basis for the Atlantic region. Let me first note to your last point and that is the Altamira fabrication facility. As you know, we have done some work in the yard before and we are doing our second job for PEMEX, as I said in my prepared remarks.

The long-term goal for the Altamira fabrication yard is to become the western hemisphere’s fabrication yard, both for deep-water and conventional. The characteristics of that yard are to be such that we can reach both of those markets. We have more investment to do before we can reach that, but we are timing our investment to the opportunities that we see in front of us. More to that point, if we can find an opportunity to have an award in hand before we make the next stage of investment, that is what we shall do. In a macro sense, in the Atlantic region, we are sticking our stake in the ground.

Over the long-term, the opportunities there are significantly robust, they are matched to our capability both deep-water and conventional, and we plan to grow the Atlantic region. For the short-term, the watchword is focus. We need to pursue the work and pursue the opportunity that we can win and we need to execute the work in a fashion that returns better financial results than we have seen in recent times.

I will not comment on recent awards, but I will say to you that today we have been somewhat disadvantaged in deep-water, with our current fabrication facilities, but over the long-term and the interim-term, the Altamira facility will solve that problem for us. That really relates to heavy lift capability, Marty.

Martin Malloy – Johnson Rice

On the Qatar Projects, how much is left to still work off there? I think it was around $110 million at the end of 2Q.

Perry Elders

Marty, we worked most of it off. There are a few remaining kind of project closeouts and final items with the customer that we anticipate we will finish up in Q4. It is really, as you know, not about the remaining revenue and backlog as it is about the project closeout related to that. There is not a lot left, but there is a little bit left.

Martin Malloy – Johnson Rice

Thank you.

Operator

Our next question comes from the line of Jamie Cook with Credit Suisse. Please proceed.

Jamie Cook – Credit Suisse

Hi. Good morning. A couple of questions. One, Steve, you mentioned several times in the prepared remarks, it looks like you feel optimistic of more awards coming in Q4. If you could give any more color or quantify, just given the $1.2 billion that you already got. I guess my next question is, when I think about, based on your backlog today and the $1.2 billion of additional work you got and what is to come, how do I think about—I am trying to think about 2010—how do I think about margins in that business or utilization and mix based on what you know today?

Steve Johnson

Very good Jamie. Thanks very much. On the first question, remainder of Q4, I would first characterize the $1.2 billion that we are calling the October awards as follows; they are predominantly EPCI projects, Jamie, they fit our business model pretty well. Between the Middle East and Asia Pacific, heavily skewed towards EPCI, although, there are some transportation and installation-only and a fab-only project in there. There are other projects that we have some indication that we will be the selected bidder, but we do not have definitive understanding about that and we expect those to be later this month or in December. I would say that those are generally T&I to EPCI projects. Certainly cannot announce those, but I feel pretty comfortable about some additional awards which would boost that $1.2 billion, in a meaningful way for the rest of the quarter.

As to margins, Perry why don’t we let you handle that as we think about going forward. I think Jamie’s question was around 2011.

Perry Elders

Obviously, Jamie, we are sticking with our guidance around 10% to 12%, but just to give you some color in that. That is based on our view of the roll off, and as Steve mentioned in his earlier comments, the roll off of the revenue and backlog at September as well as these October bookings, and as we look at the margins on those projects, and as you know, on the $1.2 billion, in particular, we are looking at the as-bid margins. Although we do work hard to brighten that over time, that is what we have visibility to at this stage.

In addition, looking at the projects that were in backlog at September, we do not see the same level of opportunity to brighten that like we have had in 2010, particularly on the Cutter projects that we have been talking about. That is what gives us a reason to stick with the 10% to 12% guidance, notwithstanding that we have just had a fantastic 2011.

Jamie Cook – Credit Suisse

But, the actual margins are not lower? There is nothing else impacting margins, like you are not getting a boost this year from lower material costs or anything like that?

Perry Elders

That is correct.

Jamie Cook – Credit Suisse

You are just saying the reason why your margins are going to be lower are because we not going to going to get the benefit from Cutter and you are assuming that you are not counting on postive change orders or closeouts from other projects.

Perry Elders

Not to the same extent. We are assuming that we will achieve some, because it is just a normal part of our business. We believe 2010 has been particularly strong in that regard. If I could comment further, you had asked in your original question about utilization. We see utilization in the fab yards as being a strong year in 2011, probably not as the historic highs that we achieved over the last 12 to 18 months, but very strong in the fab yards, particularly, as Steve mentioned, in the Middle East and Asia Pacific, still underutilized in the Atlantic.

With respect to the vessels, as Steve commented, we saw some improvements in the major work barges this quarter and part of our strategy for moving the DB50 to Asia Pacific is we think there are better opportunities for next year. We do not think we will be at full capacity on the marine fleet next year, but improved certainly from what we saw in the June quarter.

Jamie Cook – Credit Suisse

EPCI margins are higher than T&I, in general?

Steve Johnson

Not necessarily. T&I can be materially higher than EPCI, but they tend to be smaller programs.

Jamie Cook – Credit Suisse

Thanks.

Steve Johnson

Thanks Jamie.

Operator

Our next question comes from the line of Graham Mattison with Lazard Capital Markets. Please proceed.

Graham Mattison – Lazard Capital markets

Hi, good morning guys. If I look at the recent awards that you have gotten in October and also looking at the ones you potentially could be winning later this year, when do see the revenue roll off of the—is the bulk of it going to be recognized in 2011 or more pushed out to 2012?

Perry Elders

On the $1.2 billion, as Steve indicated, about $500 million of that, maybe a little bit more, in 2011 and slightly more in 2012, with not a significant part beyond that. Mostly, kind of split between 2011 and 2012.

Graham Mattison – Lazard Capital markets

Looking at the $3 billion in revenues that you guys talked about on the last call, seems like you are pretty close to that level. Should we look at that as more of a floor for 2011?

Steve Johnson

I would not yet go to that point. I would say that, as I said in my prepared remarks, I can see my way through the $2.5 million fairly readily. I would say that based upon the pipeline of projects that we have in our target list that three is reasonable to achieve. How much greater than that I certainly could not comment on, but I would say that is a possibility.

Graham Mattison – Lazard Capital markets

Great. One follow-up question on the Secunda assets. Is the sale of that expected by the end of this year or within the next 12 months?

Steve Johnson

As we said in the prepared remarks, we are going to give ourselves the appropriate amount of time to get the best price we can, frankly, and what we have indicated is that we are going to take the full year of 2011, if it takes that to get there.

Graham Mattison – Lazard Capital markets

Thank you for that clarification.

Operator

Our next question comes from the line of Andy Kaplowitz with Barclays Capital. Please proceed.

Andy Kaplowitz – Barclays Capital

Good morning guys. If I could just follow up on that last line of questioning. The $1.2 billion in October work, can you tell us how much would be burned in this 4Q?

Perry Elders

Pretty modest, Andy.

Andy Kaplowitz – Barclays Capital

But, a little bit of revenue?

Perry Elders

Not that is going to move the meter much, Andy. Most of that is 2011 and 2012.

Steve Johnson

This is Steve, Andy. I would characterize it as pretty close to a round number. These things are at a point where we are just maturing, just came out of negotiations, just getting the contracts in place and not a lot happens until after the first of the year.

Andy Kaplowitz – Barclays Capital

Steve, there is a lot of potential uses for cash over the next year and you mentioned some of them, maybe Altamira, maybe the Middle East. There have been rumors of other things. Have you guys formed a pecking order of these potential opportunities, yet, that you would care to share with us or is it too early for that?

Steve Johnson

The answer to the question of “have we formed a pecking order?”, the answer is yes. We are continuing to refine that and we had used a process that I am very comfortable with and familiar with that allows us to prioritize those. In more particular fashion, allows us to prioritize those in the view of the balance sheet that we want to have on a going-forward basis.

The second part of the question, “can we share those priorities with you”, we cannot do that at this moment, but I can tell you that we are closing in each month with definitive strategy on moving forward with those priority items. We have category A and category B items, as you might imagine, but we are not ready to announce anything at this juncture.

Andy Kaplowitz – Barclays Capital

I won’t push you on that Steve. One more quick question, you changed the Papa Terra accounting and we know it is a first-of-a-kind project for you. Over the last year on your portfolio projects, but of course, any time I hear first-of-a-kind, I just hope that you guys are doing your homework on the project. If you could update us on Papa Terra and just the risk profile of that contract as you see going forward, any color on that would be appreciated.

Steve Johnson

That is a fair question Andy. I will give you two kind of categories of responses, the first of which is where the project stands, how is it going. The next is why we characterized it as a first-of-a-kind, which would then draw in our accounting policy on delayed profit recognition. In the first category, I believe the project is going reasonably well. In recent weeks, we completed the feed for that program. The partnership that we have with our partner is beginning to solidify and milestones are being identified. Schedules are being put into place that will allow us to get comfortable that we can measure our progress during detailed engineering, procurement and construction.

We are seeing no surprises at this juncture, I would say, on technology or on procurement or certainly in engineering. I would say it is status quo for this stage of the job, but it is early.

As to the second question, First-of-a-kind, what qualifies this project of a First-of-a-kind in our mind? It is simply the quantum of unique issues. In the first case, the tension leg platform that we are talking about is a first-of-a-kind design for FloaTEC. The use of a Brazilian fabrication yard is a first-of-a-kind for McDermott. The customer, while we have worked for this customer in years past, it has been quite a long time, some 20 or 25 years and just the nature of the venture where we have got two parties and a joint-venture company, that is FloaTEC, tells me that erring on the side of caution is the appropriate thing to do as we think about our investors. I hope those are both responsive to your questions, Andy.

Andy Kaplowitz – Barclays Capital

Yes, that is helpful, Steve.

Operator

Our next question comes from the line of Steven Fisher with UBS. Please proceed.

Steven Fisher – UBS

Hi, good morning. Within the context of a 10% to 12% overall margin framework, do you expect a similar range for each region or is that 10% to 12% the outcome of a wider set of ranges?

Perry Elders

It is the latter, it is the blend, as we saw this quarter, as we have had very strong margins in the Middle East and good margins in Asia Pacific diluted by challenges in the Atlantic.

Steven Fisher – UBS

Is there more normalized, is there anything that would inherently change the margin structure in the region. Is it fixed cost intensity; Morgan City is maybe a bigger fixed cost hurdle?

Perry Elders

It is really—unbundle it—if you think about the three regions, the Middle east, as we indicated earlier, has really benefitted this year from project closeouts and change orders. Particularly Cutter, but others as well, and although we expect that to continue, because it is a normal part of our business, we do not expect it at that magnitude. That is a similar case in Asia Pacific, but not to the same extent. In the Atlantic, the issue is less so about project closeouts, it is about cost management, but it is principally a marine-driven issue and that is what Steve’s comments were directed to earlier with respect to the DB50.

Steven Fisher – UBS

Do you think your engineering staff is the right size for the opportunities you are seeing today? You have about700 engineers?

Steve Johnson

Correct. If it was not the right size, we would be doing something about it. Having said that, I would quickly add that the opportunities that we see today and on the horizon in the future will likely cause us to grow our engineering capabilities in the various regions of the world and, in fact, that is what we are doing. We are out looking for engineering capability today. I think more specific to your question is “is the mix right” in terms of the capabilities that we need as we move to more deep-water and surf markets and is it in the right regions of the world. Part of our thinking as we took over the company here in August was to take a strong look at that Steven, and I will tell you that that is a work in progress, those latter two points.

Steven Fisher – UBS

Any sense of the magnitude as you look out over the next 12 months of where that 700 could go to?

Steve Johnson

I could not comment now. As I said, that is a work in progress. We may add more in the next call.

Steven Fisher – UBS

Lastly, how noticeable will the transit of the DB50 be on margins in Q4 and Q1, and is there any work you can pick up along the way with it?

Perry Elders

As Steve mentioned, it will move from the Gulf of Mexico in early December, just a few weeks away. Obviously, it will not be generating revenue while in mobe for 90 days. You really should expect Q4 as well as most of Q1 to not have a lot of utilization with respect to that vessel.

Steve Johnson

I would add to Perry’s comments that we are beginning to get some traction in the Asia Pacific region, when she reaches that region, we believe we may have some work in fairly short order, but nothing we can announce, which would be delightful to have her land in that region and go to work within the first month.

Steven Fisher – UBS

Thanks a lot.

Operator

Our next question comes from the line of Roger Reid with Natexis. Please proceed.

Roger Read – Natexis

Good morning. A little bit more on the vessel side, you talked about the number of days that you worked during the quarter, I think 350 was the right number and you had run 570 before. Can you refresh us, as you look at your fleet today—as constructed, assuming no significant mobe’s and all that—how many days you could conceivably work in a quarter if you were at budget and the number that is peak and how that compares to the 350 that we saw in Q3?

Perry Elders

Just to kind of ground you, our standard for those eight major work barges is right around 500 days a quarter. We were at, I believe, 290 in the June quarter, 350 in the September quarter, and with the comments we just made with respect to the DB50, which was working for a good chunk of the September quarter, you can envision that we will not have that in the March or December, the next two quarters.

In the past, the 570 that we mentioned was at a historic high level, when we were doing those Cutter projects. We do not see getting back to 100% or more utilization in the near-term.

Roger Read – Natexis

My second question for you, as you talked about in your fabrication yards, being somewhat hampered in bidding for deep-water projects, historically, due to a lack of heavy lift. As you look at these deep-water projects and integrate fabrication with the vessel fleet, clearly the market, in general, is a little bit softer for vessels, yours or anyone else’s, anything you want to do additionally on the vessel acquisition side? I know the vessel that is under construction, but anything else that you would like to add or would make your fleet complete, as you look at various projects around the globe over the next several years?

Steve Johnson

Roger, his is Steve. As we think about deep-water, let’s all think about it in terms of the Atlantic Basin including the Gulf of Mexico and we think about the fabrication facility. We believe we have a solution from a fabrication standpoint, as I talked about earlier. As you think about the marine fleet, the two new reel-lay vessels, one of which is working in the North Ocean 102 and the 105 coming in 2012, are targeted at deeper water and risers, umbilicals, flow lines for deep water. That is one comment I can make.

I would say to you and you can read this in media reports and industry publications that the company is looking at a construction vessel that would have heavy lift capability and we are evaluating that now. We are trying to determine the appropriate timing and if the timing presents itself, then how we would go about doing that. I would say that we would look at potentially adding a deep-water construction vessel with a heavier crane associated with it. I would not stop there, I would say that there could be additional marine assets that we would want to deploy, depending on how the market develops and the pace at which it develops.

All of those are on our capital list. I would say that many of the A category—we will just call them A and B category, for conversational purposes--deal with deep-water and moving into deep water and surf.

Roger Read – Natexis

Just a follow-up on the margin so I can understand—we just had two quarters in a row with very impressive margin performance and I recognize a few years ago we had a couple of quarters of considerably less than impressive margin performance and that is part of why we are getting this in the change orders and the project completion—but, for so many years I have heard guidance of 10% to 12% and barring that one set of pipe-lay projects in the Middle East, it seems like, over and over, you do better than that. What is it that is keeping you from being more optimistic about your long-term margin potential at this point?

Steve Johnson

Let me try my way of thinking about it, the first of which, Roger, is I have been in this seat for a few months, my focus is primarily around execution, as you would imagine and want our focus to be, so that if we do not eliminate, we mitigate the issues of the past. I would quickly add, as you added, that this is a business that has in its nature and in its underpinnings the potential to have an occasional derailment on these projects.

With that as a backdrop, let me say that I am not ready to indicate any change until I have a better understanding of the pipeline of projects coming forward, our ability to execute them, and that we have the assets available to respond to them.

Lastly, this business is largely around managing the marine fleet. If the utilization of the marine fleet continues to have some softness, as both Perry and I have talked about, it is a concerning matter for us. We need to figure out how we can better utilize that fleet, which is why we put in a new organization for the company, the Global Marine Organization, to help us get at that issue.

All said and summing up what I commented on there, it is too early, if at all, for me to go to different-margin land, until I get a better understanding of how our new marine organization can function, a; b, until I understand how much more robust our execution protocols, procedure, and disciplines are, and; c, until I understand what the nature of and the complexity of the future projects are. And I hope that is helpful, that is about all I can do at this juncture to your very good question.

Roger Read – Natexis

I am just trying to understand framework and that definitely puts a frame on it. Thank you.

Operator

Our next question comes from the line of Tahira Afzal with KeyBanc. Please proceed.

Tahira Afzal – KeyBanc

Morning Gentlemen and congratulations. I just have one question, if you look at your remaining outstanding bids, target projects and focus list, which you have indicated is more—could you talk about number one, as you look at the third quarter and the $1.2 billion you have won subsequently, what your win-rate has been? For the target projects and the focus list, if you could please perhaps touch on the competitive landscape, is that really the first and type of projects you want?

Perry Elders

I will take the first one and Steve will take the competitive landscape question. The bid list is comparable in both size and quality to what we saw at June and by quality, what I mean is both the composition from a profile standpoint, geographic as well as being principally EPCI work, also, quality in terms of the risk level and the margins that we anticipate. Our conversion rate has been consistent this year, as to what Jay has been saying for a number of years, which is that is ranges around a quarter to a third. We have not seen anything that would change our view about our conversion rate. I would want to make sure that you guys picked up on the clarification that Steve gave in his remarks about what we are calling targets. That is maybe a different term than you have heard before. It is a portion of the focus projects that we have discussed in the past, but it is an important distinction because these are projects that we expect to bid in the next 15 months. They are in our scope, they are in the geographies where we believe we have a realistic opportunity and we are investing money on the bid. It is maybe a higher quality number than the more broader focus list. In terms of how we have seen the market, there has been no real change. We are just getting a sharper pencil to the buckets that we are putting on the revenue pipeline.

Tahira Afzal – KeyBanc

Thank you. Quick follow-up on that, could you elaborate on the focus list? The last quarter is was $14 billion.

Steve Johnson

I think, based on what you have heard Perry speak to, the target projects are those that fit our capability and that we decided to bid or planned to bid and they are a subset of that focus list, that $14 billion that we talked about before. We think it is more useful to talk about the bids outstanding and the target lists, rather than talk about and speak to the focus list. The target list is over the next five quarters, the focus list was a little sloppy, to be honest with you. It had some numbers in it that would have found themselves in the other two categories and it did not really have a timeline associated with it that I thought was crisp enough. I do not have a new number to replace the $14 billion with. I would say that it is not a weakening market. It is a strengthening market, if you will allow me to leave it at that.

On to competition, Tahira you had asked in the first instance, I will tell you that as you think about our core business model of being EPCI. We have a very disciplined set of competitors and I am happy about that. I would much rather have competitors that understand risk, that have a pricing discipline that is similar to ours so that we do not have a condition where one tries to follow the other down and we get into some unique situations, which is just not good for shareholders.

The second thing I observe for you is the regional competition is somewhat more of an undisciplined group and we are very cautious about that. We maintain our margin, our contingency, our scoping and our pricing disciplines around both EPCI and regional competition.

As I think about change, am I seeing significant change? I would have to say no, not much, but I would say that competition is strong everywhere in the world where we bid. We have to sharpen our pencil and we have to use our engineering capability and our creativity to provide a marine or fabrication or installation solution, which is a better idea than the next person in order to win. That is the goal of our marketing and sales force, to figure out what the unmet needs of the customers are and to find a technical or fabrication solution to respond to it.

Tahira Afzal – KeyBanc

That is very helpful. Thank you very much.

Operator

Our next question comes from the line of Will Gabrielski with Gleacher & Company. Please proceed.

Will Gabrielski – Gleacher & Company

Thanks. Good afternoon, good morning guys. Congrats on a good quarter. A few small questions. One, on Papa Terra, in terms of the impact to the equity income line from what actually flows to the joint venture. Has that started to contribute, if not, when will it, and can you quantify what you are expecting there?

Perry Elders

Will, it is Perry, thanks. The same deferred profit policy that we are applying to the McDermott scope, which is about 20% of the project, is also being applied by FloaTEC, the joint venture, as well. We have not experienced and do not expect to experience P&L, if you will, from the project either in our direct scope or through the JV. There are some overhead costs of the JV that hit our equity and earnings line, but it is not huge.

Will Gabrielski – Gleacher & Company

And how would you describe the progress you are making in China, with your joint venture there in the FPSO opportunity?

Steve Johnson

Will, I think we are making very good progress as we have indicated in the past. Next year, 2011, sometime in the third quarter of next year, we should be ready for our first program there. There is much to be done in terms of training the construction workforce. The assets are getting in place. I would say to you, over the long-term that appears to me to be a very good strategic decision for the company, for FPSO, top sides and whole, with our joint venture partner in China. I would say, in two or three quarters time, we will have a better sense of the opportunity for the first projects and programs, but it is going along as planned in terms of the development of the facility today.

Will Gabrielski – Gleacher & Company

One last question, if you go back to the end of June and look at what you laid out as 2010 backlog for revenue in 2010, it was $1.5 billion. If you look at what you burned this quarter and what it implies for Q4 burn in the quarter, it seems that there is virtually not drive-by work and you are just burning backlog right now, am I missing something? Can you talk about the drive-by work that you guys normally talk about in any given year and what that looks like for 2011?

Perry Elders

By drive-by, I think you are talking about what we call book-and-burn. It is true that the majority of what we recognized in Q3 and what we expect to recognize in Q4 is in backlog. We are not anticipating a lot of book-and-burn. The exception to that was what I referenced in terms of the DB50. We did pick up some work for that vessel in the Gulf of Mexico in Q3 and we did not expect to do so in Q4 given our mobilization plans. You are right, virtually all of the revenue in 2010, second-half, is coming out of backlog. Not a lot of book-and-burn.

Will Gabrielski – Gleacher & Company

One last question, you guys obviously are giving a lot more disclosure right now in terms of utilization and just more detail on the business. Is there any way to quantify this or when you look at your fab capacity and you think about Altamira ramping up and you think about Morgan City. Strategically, how important—are there opportunities here for you to maybe rationalize your own fleet? Is that something you are thinking about in certain regions? Or, is the opportunity set still big enough to support your entire fab base as it stands today?

Steve Johnson

As we think about ramping up Altamira we also want to continue doing work in Morgan City. It is the right thing to do until we have Altamira up and running and that is our current plan. I do not know if you were speaking about the marine fleet more than the fabrication side of the business, Will, but as it relates to the marine fleet, I would say we are thinking of being more additive than deductive as you think about the marine fleet.

Will Gabrielski – Gleacher & Company

That is helpful. I appreciate it. Thanks again.

Operator

Ladies and gentlemen, this concludes the question-and-answer portion of the call. I would now like to turn the presentation over to Mr. Jay Roueche for closing remarks.

Jay Roueche

Thank you all again for your participation and interest today. I want to remind you that the call included some forward looking statements as well as some non-GAAP items and I encourage you to see our SEC filings and press release for more information on these. If you have any follow-up questions or need any clarification, please give us a call and we look forward to seeing many of you over the coming month. This concludes our call.

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Source: McDermott International 3Q 2010 Earnings Call Transcript

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