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Baker Hughes Inc. (BHI)

Q2 2007 Earnings Call

July 27, 2007 8:30 am ET

Executives

Gary Flaharty - IR

Chad Deaton - CEO, Chairman

Rod Clark - President, COO

Peter Ragauss - CFO

Analysts

Dan Pickering - Pickering Energy Partners

Jim Crandell - Lehman Brothers

Robin Shoemaker - Bear Stearns

Geoff Kieburtz - Citigroup

Kurt Hallead - RBC Capital Markets

Ken Sill - Credit Suisse

Michael LaMotte - JPMorgan

Brad Handler - Wachovia

Alan Laws - Merrill Lynch

James Stone - Cambridge Investments

Presentation

Operator

I would like to welcome everyone to the Baker Hughes Second Quarter 2007 earnings conference call. (Operator Instructions) I'll now turn the conference over to Mr. Gary Flaharty, Director of Investor Relations. Sir, you may proceed.

Gary Flaharty

Thank you, Luanne. Good morning, everyone. Welcome to the Baker Hughes second quarter 2007 earnings conference call. Here with me this morning are Chad Deaton, Baker Hughes' Chief Executive Officer and Chairman; Rod Clark, Baker Hughes' President and Chief Operating Officer’ and Peter Ragauss, Baker Hughes' Senior Vice President and Chief Financial Officer. Following managements comments we'll open the line for your questions.

Reconciliation of operating profits and non-GAAP measures to GAAP results for periods referenced in today's news release and for historic periods can be found on our website at www.bakerhughes.com in the investor relations section under financial information.

Last, I caution you that any company outlooks discussed this morning are subject to various risk factors. We'll try to highlight these risk factors as we make any forward-looking statements, however, the format of the call prevents a thorough discussion of these risk factors. For a full discussion of these risk factors, please refer to our annual report 10-K, 10-Q, and in particular the forward-looking disclosure in this morning's news release.

With that I'll conclude our discussion of the administrative details and turn the call over to Chad Deaton.

Chad Deaton

Thank you, Gary and good morning, everyone. This morning we reported income from continuing operations for the second quarter of 2007 at $349 million or $1.09 per share. This $1.09 per share is down $0.08 or 7% from the $1.17 we reported in the first quarter in '07, and is up $0.02 or 2% from the $1.07 we reported for the second quarter of 2006, which is on a 500-basis point higher tax rate.

Revenue is $2.5 billion, up $334 million or 15% from the second quarter of '06 and was up $65 million or 3% sequentially. Non-North American revenue was up 21% compared to a year ago and was up 6% sequentially. Our incremental profit from U.S. land and international operations was not sufficient to offset the sequential decline of profitability from Canada and the impact of our softer activity in the Gulf of Mexico.

I want to further comment on the second quarter and how this quarter fits with the changes we've made over the last two years and our strategic direction as we move forward. I do believe and continue to believe that we're in the midst of a multi-year expansion for this industry. We are several years into one of the strongest cycles that we have seen. International activity is strong and is providing significant growth opportunities and long term it's also apparent that North American activity must increase if our industry is going to offset the high decline rates for natural gas production.

Given this environment, I firmly believe the strategic plan that we are implementing is the right one. As we've said in the past, we continue to invest in people, in technology, and in our infrastructure. We've continued to increase our R&D spending and the rollout of new technologies to maximize new product revenues, which deliver preferential margins.

These investments are paying off. We've targeted specific countries for growth and we've made excellent progress in expanding our presence in share in such areas as the Middle East, particularly Saudi Arabia and Qatar. We have tangible evidence that these investments are delivering growth. In the second quarter, we had significant revenue expansion in many of our targeted countries. Revenue more than doubled from the year-ago quarter in Equatorial Guinea, in India, in Malaysia, and Russia, and revenue increased greater than 40% in Qatar, Brazil, Libya, Egypt, and Columbia.

In Russia, our revenue base is more diversified and our Russian revenue is expected to increase more than 70% this year. We're working with all the Russian majors, including Gazprom, LUKOil, Rosneftegaz, Surgut Natural Gas and TNKBP.

However, as I think about the successes we're having, I'm not satisfied with the margins we're delivering. As we said before, we look for incremental profits to meet or exceed 30% and in quarter 2 we fell short of that goal. We're therefore undertaking a number of initiatives to continue to improve our profitability. Clearly, some of these must be to improve on pricing gains and decrease deficiency and productivity, but we're also taking a very hard look at our overall cost structure, and I believe we have an opportunity to further rationalize our support functions and eliminate some costs. This will be done in a manner that does not hinder our ability to grow.

We are managing our largest cost driver, which is headcount, in order to meet market conditions. Year on year, our total headcount is up 4,200 net. Sequentially, we've reduced our North American employee base. In addition, we have frozen global G&A headcount. However, for the second half of the year, you'll see us continue to recruit, hire, and train direct employees -- those that are directly related to revenue-generating positions -- and this is particularly true for overseas locations. At the same time, we'll also continue our focus on execution, marketing, and portfolio and product mix to ensure that our top line growth fully reflects the market potential we see in years to come.

I'll now turn it over to Rod and Peter to address some of the operational and financial highlights.

Rod Clark

Thanks, Chad. In Q2, Baker Hughes' quarterly revenue exceeded $2.5 billion for the first time ever. Revenue was up $334 million or 15% compared to the second quarter of 2006 and was up $65 million or 3% sequentially. North American revenue was up 8% year over year. U.S. revenue increased 11% year on year compared to a rig count that was down 1%. U.S. land revenue was up 16% year on year. Revenue growth in U.S. land was particularly strong for INTEQ, Centrilift, and Baker Hughes Drilling Fluids.

U.S. offshore revenue was down 4% year on year compared to the offshore rig count, which fell 20% from the year-ago quarter. Canadian revenue was down 12% year on year compared to a rig count down 50%. As expected, less favorable economics for Canadian natural gas projects continue to impact activity, particularly for businesses in our Drilling and Evaluation segment. Within D&E, revenue declines were greatest in Hughes Christensen and INTEQ due to their high correlation to the rig count. Our completion of production segment demonstrated resilient with nice year-on-year revenue gains in all regions, even Canada, where our 2% year-on-year revenue gain ran counter to activity declines that affected our D&E segment.

North American revenue was down 2% sequentially compared to a 16% decline in the rig count. U.S. revenue was up 4% sequentially, as higher revenue in U.S. land operations served to offset declines in U.S. offshore. Canadian revenue was down 34% sequentially, whereas the rig count declined 72%. Latin America revenue was up 20% year on year compared to a rig count up 8%. INTEQ's revenue was up 81% year on year, driven by share gains in Brazil, and Baker Oil Tools delivered solid revenue growth in Venezuela and Mexico. Latin American revenue was up 2% sequentially, led by Baker Oil Tools in Venezuela and Brazil.

Revenue for the Europe, Africa, Russia, and Caspian region was up 27% year on year. Revenue increases in Europe were led by INTEQ in the UK and Baker Hughes in Norway. Revenue in Africa was up 26% despite a 7% drop in the rig count. Our significant revenue gain year on year in Russia CIS was led by Centrilift, INTEQ, Baker Atlas, and Baker Oil Tools. Revenue for the [ERC] region was up 9% sequentially, with strong revenue growth in Russia Caspian and Europe offset by decline in revenue in Africa. The decline in Africa revenue is due to the impact of a particularly strong Q1 result in Equatorial Guinea

. Middle East Asia Pacific revenue was up 14% year on year. Revenue growth was strong for Baker Oil Tools in Qatar, INTEQ in India, Egypt, and Saudi Arabia, and for Baker Atlas in Malaysia. Revenue for the Middle East Asia-Pacific region was up 4% sequentially as Baker Oil Tools and INTEQ had strong revenue growth in Qatar and in China.

Turning now to segment review for D&E, revenue for the segment was up 14% year on year and down 1% sequentially. D&E's operating margin in the second quarter was 25.7%, down 280 basis points from the first quarter and essentially flat for the second quarter of 2006. The margin degradation resulted from lower Canadian activity, unfavorable product mix at Baker Hughes Drilling Fluids, and the impact of higher repair and maintenance costs at INTEQ, which I'll talk about shortly.

Within D&E, Hughes Christensen continued to have the highest operating margin and it remained Baker Hughes' most profitable division. Hughes Christensen 's operating margin was down year on year and sequentially, due principally to lower activity and reduced profitability in Canada, which is traditionally a high margin market for our bit business. However, pricing remained under pressure in the second quarter as multiple competitors worked to gain market share with lower pricing while Hughes Christensen continued to put share at risk to maintain pricing in the quarter.

INTEQ's operating margin increased compared to the second quarter of 2006 but declined from Q1 due to lower Canadian activity and higher repair of maintenance expenses. Roughly half of the incremental R&M costs at INTEQ in the quarter is nonrecurring as it relates to scrapping of old parts and reliability upgrades to our fleet. The balance is due to higher R&M costs on newly released, more advanced, and more complex formation evaluation technology. INTEQ remains the second-most profitable division within Baker Hughes.

Baker Atlas operating margin in the second quarter was up year on year and slightly down from Q1. Strong international performance, both revenue growth and incrementals was offset by weakness in Canada and U.S. offshore.

Baker Hughes' Drilling Fluids operating margin remained under pressure due to unfavorable product mix and continued delays for a number of deepwater rigs, which provide high margin work. We anticipate higher levels of deepwater work in the second half of the year and we expect a more favorable product mix as we continue to roll out our newer products such as Microwash and Rheo Logic.

Due to the impact of lower Canadian activity, higher repair and maintenance costs at INTEQ, and unfavorable product and activity mix at Baker Hughes Drilling Fluids, D&E's year on year incremental margin declined to 24%. However, both INTEQ and Baker Atlas had year on year incremental margins greater than 30%.

Turning now to our Completion and Production segment, revenue for the C&P segment was up 16% year on year and up 6% sequentially. The decline of billing activity in Canada had left an impact on these production-oriented business. Baker Petrolite's Canada revenue was essentially flat for the first quarter and although Centrilift was down sequentially, the issue was primarily the deferral of some orders to Q3 due to inclement weather in June. C&P's operating margin for the second quarter was up slightly at 21%.

Baker Oil Tools, with the highest operating margin in our Completion and Production segment, inked revenue gains 21% over last year and record operating profit. Significant contract awards were achieved in Kazakhstan, Norway, Ivory Coast, and western U.S., and we're seeing results from the debottlenecking and additions to capacity we previously reported.

Centrilift saw sequential margin improvement in the second quarter. Pricing, while positive, continues to be under pressure and margins continue to be impacted by high-cost commodities, such as copper, nickel, and lead.

Baker Petrolite's operating margin improved slightly compared to the first quarter. Favorable activity and product mix along with some pricing improvement contributed.

C&P's year-over-year incremental margin was 11%. Baker Oil Tools' incrementals, though the highest in the C&P segment, were below our benchmark rate, and Centrilift's incremental margin was impacted by higher prices for raw materials, which are not offset by price increases. Improving incremental margins through pricing improvements and cost control is a primary focus of the C&P business plan going forward.

Now I'll turn it over to Peter Ragauss.

Peter Ragauss

Thanks, Rod. On a fully diluted basis, our operating earnings per share from continuing operations were $1.09 for the quarter. There are a number of factors that had an impact on our second quarter results. The following should help clarify the deltas between this quarter and the prior quarter and the same quarter last year.

Bridging from last quarter's $1.17, subtract $0.03 for the increase in tax rates arising from the disallowance of deductions related to the settlement of our FCPA issues. Subtract $0.01 for higher corporate costs. Subtract $0.02 for the increased repair and maintenance costs at INTEQ. Subtract $0.07 for the impact of lower activity in Canada. Operations excluding Canada added about $0.05, which includes the impact of activity increases, pricing, and raw material costs. This gets us to the $1.09 per share we reported for Q2.

From the $1.07 we reported in Q2 of last year, subtract $0.09 for the significantly higher tax rate this year. Subtract $0.02 for higher corporate spending. Operations added about $0.13, of which $0.07 was from pricing net of labor and raw material inflation. This gets us to the $1.09 per share we are reporting for Q2.

Our balance sheet remains very, very strong. At quarter end we had cash and short-term investments of $840 million. In comparison, our outstanding debt was just under 1.1 billion. Our long-term debt to cap ratio at the end of the second quarter was 15%. With our strong balance sheet, our primary use for capital remains growing our business through capital expenditures for rental tools, machine tools, and global infrastructure.

We intend to return cash in excess of our needs to our shareholders. In that context, the board has authorized a $1 billion addition to our share repurchase program, increasing our total share repurchase authorization to approximately $1.2 billion. It's important to note that even with a share repurchase program in place, the company retains significant financial flexibility to react to market opportunities as they arise.

I will now comment on our guidance for the remainder of 2007. We did not change our guidance for revenue growth outside North America where we are expecting 19% to 21% growth year over year. This includes the impact from our exiting sanctioned countries in 2006.

Corporate and other expenses are expected to be between $235 million and $255 million for the year, and depreciation and amortization expense is expected to be between $500 million and $530 million for the year. We narrowed our range on capital spending to $1.1 billion to $1.2 billion.

Finally, we updated our tax guidance to account for the additional taxes, interest, and penalties we recognized this quarter. The guidance for the third and fourth quarters is unchanged at 32% to 33%, while the tax rate for the full year is now expected to be between 32.5% and 33.5%.

Chad.

Chad Deaton

Thanks, Peter. So in summary, nothing's change and we still see the outlook for our industry, we believe it remains bright. We think we still have a lot of opportunities out there and we're going to continue with our strategy, which has been to continue to increase our R&D investment in introducing the new technologies. We're working on taking our reliability to an even higher level and we're building our international infrastructure in order to support our future growth and we're implementing a regional organization in order to bring decision making closer to our customers around the world.

We have made several significant progress in these areas, yet there's still more to be done. Without impacting our ability to continue to achieve growth, we're going to fine-tune our business process and cost structure in order to improve our profitability. This process is already underway and I'm confident that we're going to be successful and see some improvement in the quarters to come.

Gary, why don't we open it up for questions?

Gary Flaharty

Thank you, Chad. At this point I'll ask Luanne to open the lines to your questions. To give everyone a fair chance to ask a question, we ask that you limit yourself to a single question and a related follow-up. Luanne, can we have the first question, please?

Question-and-Answer Session

Operator

Your first question comes from Dan Pickering - Pickering Energy Partners.

Dan Pickering - Pickering Energy Partners

A couple of product line questions, just to make sure I understand. Could you talk a little bit more about mix in the Fluids business? I assume that means offshore versus land. And then you talked about the INTEQ business. Help me understand there, are we seeing any issues around the reliability in new tools that's raising costs, or is it they're new, they cost more than you thought and you're kind of tweaking that process on the R&M side?

Chad Deaton

It's the latter. Rod's got some stuff to go through that. It's not problems with reliability on the tools. It's the new technologies being added and from what you said on the second part.

As far as INTEQ itself, if you look at the quarter, I think it was more of a mix with INTEQ. We had some shifting of rigs, deepwater, Gulf of Mexico, Petrobras. We're supposed to be up to nine, ten rigs on that. We went up to nine in Q1, we dropped back to six in Q2. Of course, we're geared up to handle ten and as of yesterday morning we were back up on ten. So in the second quarter we saw a little drop-off in rigs as Petrobras moved some of those rigs over to production. Their production has been falling off, they've been talking about, they wanted to get some of that back, but they're moving back to drilling. A little bit of a similar thing in Qatar. Some of the rigs moved over for production, but moving back to the drilling side as well.

Rod, you have some comments on the R&M?

Rod Clark

Yes, it's definitely not a reliability issue. It's rather an extension of a concerted plan that we unfolded at INTEQ about nine months ago. We've taken a view that step change reliability is a game changer in this area as we continue to see migration from wire to pipe, and increasing complexity of not only well geometries, but also the increased horsepower by the advent of PDCs and the ever-rising shock that's being introduced in the assembly.

We're trying to think out of the box a bit here, Dan, to what's it's going to take to take truly dramatic improvements and reliability going forward. We went outside the industry to, actually to GE, the aircraft engine group, and recruited an expert in engine reliability and brought him in-house, and we conducted over the period of the last nine months a very extensive review of all of our practices, procedures, everything from fault tolerant designs in our upfront engineering and design of the tools down through real time diagnostics, mission life requirements, part and tool upgrades of our existing fleet and so on.

Really this quarter is the culmination of some decisions we've made to do a couple things. One is to go through our spare parts inventory and eliminate and scrap service parts that no longer meet our service life cycle requirements. We've upgraded selective products in recognition of the more demanding service environments that I talked about. We've also beefed up our preventative maintenance process, by which I mean we have very much standardized them with very much more rigor across the globe.

Combined with that, and that's a strategic initiative we have underway. We've also found it necessary to bite the bullet and extend an older generation AutoTrak design through one more R&M cycle just to meet activity, principally in Latin America. That is an older vintage will higher R&M costs just inherently in the design. So you're seeing a combination of a couple things occurring at the same time.

The bulk of which really stems from a program headed to, we think, breakthrough reliability upgrade, generally, across our fleet. Of course, as the tools get more complex, we have introduced a series of new, much more complex imaging and formation evaluation FE tools. You're going to see by, just as a direct function of their complexity, more R&M expense when they do come in for their repair cycle.

Dan Pickering - Pickering Energy Partners

That's helpful. On the C&P division, incrementals were I think you indicated below your benchmark targets. How do you see that playing out for the next couple quarters as you deal with cost increases and the various dynamics in the business segments there?

Rod Clark

Well, inevitably, a function of that, and I have to be square with you, is the pricing environment, which we are seeing to be comparably softer than it was in the previous quarter. I assume you're talking about the year-over-year incrementals?

Dan Pickering - Pickering Energy Partners

Yes.

Rod Clark

That's a feature. We have a big part of the C&P group, of course, is our production chemicals business, which has performed stellar, but we have the incrementals, year over year, still in the 25.7% range. So all in all, it's a reasonably good performance. Notwithstanding the generally lower margins we see from our production chemicals business, which is not an insignificant contributor in terms of revenue volume to the overall segment.

I vowed not to use the lumpy word in this conference call with Baker Oil Tools, though I do see encouraging results from some of the capacity changes and debottlenecking we've talked about in previous conference calls, and I foresee a good second half there at Baker Oil Tools.

Operator

Your next question comes from Jim Crandell - Lehman Brothers.

Jim Crandell - Lehman Brothers

Chad, where do you think you still need to make investments, both in terms of international expansion and geography-wise? You certainly invested a lot here in the last 18 months and we're beginning to see some strong revenue growth coming out of some of the developing countries. Where do you see the most investments here going forward?

Chad Deaton

Well, I hate to signal my competitors where we may go next, Jim, but let me just look at where I think we've built up to a point where we can now refocus a little bit. Brazil, the new base will open the end of this year; that will be able to handle all the activity increase in Brazil, so we're pretty well built out there. That will be done.

Russia is an area where you're going to continue to see us build out. With the success we're having with Gazprom, Rosneft and the others, we're looking at Eastern Siberia. We've got some projects working with them in those areas coping up. So Russia is going to be a continual build out.

India, we should be built out by the end of this year, early next year, but we can see India will probably require a little bit more. Saudi, we started the second facility in Saudi. That should be done by mid-next year. Mexico is one that you'll see that we'll be focusing on. So we'll be doing some things in Mexico. Then in general, Asia itself, I think we've now positioned ourselves very strongly in the Middle East and that's working well for us. Now we need to move a little further east and take a look at some key areas there. Malaysia has been very strong for us.

Latin America in general, we're in good shape. So we don't need much there. West Africa, and again, Angola, you'll probably see in the next couple years some things happening for us in Angola regarding infrastructure build. I think those are the key areas.

Jim Crandell - Lehman Brothers

By product line, Chad, would you see it being primarily focused on INTEQ and Atlas?

Chad Deaton

Well, I think, INTEQ, Atlas, BOT. I think that one as well is going to be strong. I think, if you look at Atlas, Jim, year on year outside North America, Atlas did not have a good quarter in North America, but outside North America, Atlas has grown significantly. In fact, year-on-year growth outside North America was 34%.

So Atlas, INTEQ, BOT. The other thing we're going, those, these bases are joint facilities. It's not like three years ago where we were building individual. Libya, built out facility, all divisions will be in there. Same thing we're looking at in Russia, Dubai, Saudi. We're going to get a little help in that area as well.

Jim Crandell - Lehman Brothers

Rod, could you talk to pricing trends for your different product lines in the U.S. market over the quarter and how things have changed for the first few months of the year?

Rod Clark

Well, you probably know the answers, Jim, you follow this pretty closely. North America has been somewhat a mixed bag across the divisions although certainly we're facing headwinds as operators delay projects hoping for lower pricing in future periods. We are seeing the realities, as I mentioned, for example, the bit business where there's been some share swings arising from people who are willing to push the pedal on price before we have been.

On a year-over-year basis though, INTEQ's pricing in North America is almost just shy of double-digits. Hughes' is about half of that. Atlas is nearly 6. So for the D&E group, excluding Baker Hughes Drilling Fluids, you're looking probably gross numbers, by the way, you're looking at 7% kind of numbers, whereas in the Completion and Production segment, it's about half that; I'm talking North America overall.

Operator

Your next question comes from Robin Shoemaker - Bear Stearns.

Robin Shoemaker - Bear Stearns

In other conference calls, we've heard some venture an outlook on Canada. I just wanted to see what your take is on the situation there, and when we might see the next change, if there is one, in the demand for Canadian services or for all of your products?

Chad Deaton

Well, Robin, this is Chad. I think we're already seeing Canada come back. I think in Q1 it was 540 rigs got down to 70 rigs or whatever, it's back up to 377. Our outlook for Q3 is to probably stay in that range, so it's obviously not bouncing back to the same level. And then we see another step change in Q4, but again, not back as high as Q1.

Canada hurt us, obviously. The detrimentals in Canada were tough, it's a pretty big area for us. So that will help us as this thing comes back. We're seeing in Canada as well, not as much gas was used for some of the heavy oil projects. There's a little bit of a gas build there. Canada, we just have to assume it's going to have a second half that will be okay, but it's going to be a little soft compared to previous year.

What we've done there, Rob, and as we've already adjusted some of the product lines, INTEQ shipped some people, Hughes Christensen took some action, we've got people overseas that shipped out to either Nam or to Brazil and other places. We're sizing Canada what we think the rest of the year will be.

Robin Shoemaker - Bear Stearns

When you said that some operators are delaying projects to see if they can get better pricing, are you referring to all of North America in that statement?

Chad Deaton

I think it's primarily Canada. We're not seeing a lot of softness in the lower U.S. Pricing is holding in the U.S. The exception would probably be, and I think Rod mentioned it, Hughes Christensen . There's been a little bit of a nibbling around there in terms of market share on Hughes Christensen . The other one is Drilling Fluids. Drilling Fluids has had some pressure on pricing, all other divisions are holding up. In fact, INTEQ got a little bit of a price improvement. So the pricing in the U.S. is hanging in there, with those exceptions.

Operator

Your next question comes from Geoff Kieburtz - Citigroup.

Geoff Kieburtz - Citigroup

As Peter said, most of your guidance comments were unchanged or at least only refined from what you had said last quarter with the exception of North America comments, which were omitted. You've said in the press release, you see things continuing at the current level, but as you just discussed, Canada looks like it's getting better. Are you thinking U.S. declines to offset the sequential improvement in Canada, or could you help us understand what you do see at this point?

Chad Deaton

Well, we still see the U.S., second half, with slight growth. And we see Canada what I just described, so not coming back as strong as the year before, but the U.S. year on year will be up over 2006, slightly. I think the reason why you're hearing the guidance the way you're hearing it, Geoff, is I don't think anybody is really comfortable to layout on the U.S. with a basically flat to slightly up rig count and it's almost beginning to sound like last year. We all start talking about the weather and everything else.

Geoff Kieburtz - Citigroup

No, I appreciate that. Just interested to understand, I could see several different interpretations of what you've said and I think you've clarified that with that.

Come back on maybe a slightly re-worded question in terms of the pricing. Outside of North America, are you seeing pricing pressures?

Chad Deaton

No. Spot markets. There's been a couple places where we've picked up some rigs and a competitor here and there has come back in to talk to the customer about a discount if they get a rig. The isolated thing, but in general, if you look, no, we're not.

Geoff Kieburtz - Citigroup

Okay. So in the context of the dissatisfaction with the incremental margins, the two things we've heard is pricing and cost control. Can we assume, then, that the primary focus of the efforts to raise incrementals is on the cost control side?

Peter Ragauss

Yes. I think that's fair. I think what we have to do is go back and look at what we've been doing for the last 18 months. Part of that was the shift in order to strengthen these four regions around the world, as I said, to get closer to where our customers are and where the action is. Now we've built those areas out. I think, now what we're doing is looking at it and now let's rationalize some of those support costs and other things and get focused back on some of the business.

The other thing, Geoff, that clearly for the last couple years, we have been focused in this area of the build out of our compliance team and making sure that we strengthen that. We've now settled with, as you know, the DOJ, SEC, we've got the teams in place. There's quite a bit of build out, there are costs that come with that. It's, clearly, it's an increasing focus in the oil field service sector, as you've seen recently in the press.

So, we feel we're in very good shape, we've got those people in a place out there and we can focus now in terms of good activities and now let's work on our margins.

Operator

Your next question comes from Kurt Hallead - RBC Capital Markets.

Kurt Hallead - RBC Capital Markets

A couple of your competitors, obviously reported within the past week and discuss their viewpoints on the drill bit market. Obviously, neither of the other companies had suggested any pricing pressures in drill bits. Can you kind of help us sort out this competitive landscape and is this a competitive issue, primarily? You may have referenced it earlier, if I missed it, I apologize. Is this primarily North American issue on drill bits?

Chad Deaton

Yes. It's totally North America, stronger in Canada, it's there in the U.S., and we do see it. I don't know if they see it, but we do see the pricing pressure, it's happening.

Operator

Your next question comes from Ken Sill - Credit Suisse.

Ken Sill - Credit Suisse

Chad, you guys have been doing the build out internationally. When you speak and when we go to meetings, you guys seem very confident about the contract awards and the wins and how much business is coming. I'm wondering if there's just an issue here of the timing between when you're getting these awards and talking about them and when we're putting them in our models or when investors expect them?

Could you talk about how the lag between the investment and the flow through to revenue and what you see may be evolving over the next four to six quarters? Because you've been sitting here with flat earnings for a year now, and there are obviously different reasons for it, but how should we look at that going forward?

Chad Deaton

I agree with you, we probably talk about them and you guys plug them in a model and the problem is some of these big contracts take six, eight, nine months, a year in order to get them beefed up and built up to the point we're actually on the rigs. Brazil to me is a perfect example. We started talking about winning Brazil last October, even before that when we first won it. I think in October is actually when we started to ramp up to get the people. I don't remember the numbers right now, but it's something like 240 people just for INTEQ in order to get ramped to go from two rigs to ten.

As I said, we got up to nine in the Q1 and we clearly are double loaded when we're doing that, because we had a lot of people from Europe and North America down there as we train Brazilians. I think we hired something like 53 engineers plus all the support people in Brazil. So we got up to the nine rigs and then in Q2 they shifted three or four of those rigs over to their production operation.

If you look at INTEQ, for example, margins Q1 to Q2 got hit in Brazil because we're ramped up to handle nine rigs or ten rigs. Now in the third quarter, they're back over and actually starting to move out. I think it's probably nine months to a year on some of these big, start-up projects that you're going to have upfront costs before you really start seeing some fall through to the bottom. I think you just go out in the world and look at it, whether it's Saudi or Russia or any of the others. I think you can use the same analogy.

Ken Sill - Credit Suisse

I guess, by digging into that another level, we really should start seeing some much better year-over-year numbers, say later this quarter, but really kind of Q4, Q1, from some of this international investment, particularly like Brazil as a specific incident?

Chad Deaton

I think we want to improve the margin percent number, absolutely, but we also want to continue to invest in these countries where we can grow and grow the absolute dollar margin profitability. So if we can get our margins to 24%, 25% up from the 23.5% or 23% that's it's been kind of averaging the last four quarters, and at the same time significantly increase the revenue in these areas…

The other thing that we really want to do is make sure that when we move into these countries, we are ready when we move in. We want the tools ready, we want the people trained, and we don't want to have a failure. We're working on a contract in a country right now where we won 70% of the work and a competitor had won 30%. We just picked up one of their rigs because they don't have the tools in country. That's the kind of thing we're trying to avoid when we move in there. In the end it comes down to execution and service quality and if you start losing that you're going to have problems.

We're moving into a lot of key areas around the world and we want to do it right. We think, it goes back to the point, we think long-term internationally is clearly going to continue to grow and we wanted to have a strong position in those countries and move on to the next one.

Ken Sill - Credit Suisse

Finally, on the bits, I wanted to follow-up on Kurt's question. You had Grant [inaudible] say they were trying to actually push pricing in bits more aggressively than PDC. I know that you don't like to name names, but it would appear that if Grant's trying to push price and you're trying to push price, is this an issue more of PDC versus Roller Cone, or do you have something like a Halliburton out there that's trying to play some catch-up on market share?

Chad Deaton

You hit it on there, we're not going to go through and name competitors by name. Hughes is a very strong and successful company. Margins are high in Hughes. We believe they're higher than what their competitors are. We think that they've got some room to try to come up. We're trying to stay up as high as where we are. So maybe they're trying to raise prices, but we feel like it's putting pressure on to us try to match them. But this is one product line where we have seen pricing pressure, clearly.

Operator

Your next question comes from Michael LaMotte - JP Morgan.

Michael LaMotte - JP Morgan

First question, Rod, if I could follow-up, I think, on your comments on the Gulf of Mexico, deepwater market in particular and just the volatility there. It seemed to have showed up in your numbers as well as some others, just the mix between development and exploration drilling on the INTEQ side. But can you talk about what that means for BOT, in the second half, and sort of how we can think about that market impacting?

Rod Clark

Yes. I'll tell you. What I feel like is that we've lost share in the deepwater in Atlas and in BOT. And we're very focused on reasserting ourselves to reverse that trend, and we plan on seeing a response to those efforts in the second half of the year. INTEQ's done a nice job. They've actually picked up some share in the deepwater gulf this last quarter. But we've had two disappointments. The rig count has not moved over 80 and we also have seen a share loss in a couple of our very important product lines and that's our backyard, and should be the perfect venue for us to display our capability for both technology and reliability. So we're not happy about it.

Michael LaMotte - JP Morgan

In terms of that share battle, is that a concession on price? Can you make up margin by getting volume back?

Rod Clark

Well, it's always the case with Oil Tools or any of the manufacturing business that volume helps you absorb the fixed cost of your manufacturing base. But we are trying to lead in price, and inevitably you get to the question of when do you start trading your margin for share? So far, we've not crossed that threshold, based on the belief that, particularly in deepwater, with the rigs coming out, that it's premature to be giving up on activity gains. Although as I had mentioned, 80 rigs in the gulf has been a little bit disappointing.

Michael LaMotte - JP Morgan

Peter, a question for you. Working capital has been a use of cash pretty consistently, 50% to 60% greater than your actual CapEx for the last six quarters or so. When do you see that slowing down and actually seeing some incremental cash yield from working capital? I assume it's to fund growth, but at some point growth is go to decelerate and start generating cash.

Peter Ragauss

Good question. We had 25%, 26% revenue growth last year, and in order to fund all this build out and infrastructure we absorbed a lot in receivables. The issues we had with Baker Oil Tools about a year ago manufacturing started to absorb some inventory. We had a lot of stuff sitting on there but couldn't get shipped out. I think, in fact, we've stemmed the tide this quarter, if you look at our receivables, they're actually down sequentially for the first time in a while. So I think that's a good start. We've put programs into place with our finance people and our collection teams and I think we're getting a lot of traction on the receivables side. Inventories are up a little bit, but nowhere near the build that we've had before. So we are ironing out these manufacturing issues. It's not only showing up in the revenue line, but our inventories aren't growing as fast.

So, making a lot of progress, in fact, this quarter and we'll try to hold it as tight as we can from this point forward. You're right, it has been using up a lot of cash. If we manage that tighter, we have more to distribute to the shareholders in the future. We're working really hard on that.

Operator

Your next question comes from Brad Handler - Wachovia.

Brad Handler - Wachovia

I was hoping you could just delve in another layer with respect to the initiatives at INTEQ. It just seems very interesting. You talk about a step change in reliability, for example. Could you just share some metrics with us around that, perhaps? And in terms of other product lines or other divisions where a similar diagnostic review might be being considered or undertaken?

Chad Deaton

Brad, first off, what we think one of our strengths at INTEQ is our reliability. I think this is one of the reasons why we've won some of the big contracts that we've seen. This is why we have 9 out of 12 of the world's longest extended that are drilled in that area. And we believe that if we can take that to another level with $1 million a day rig rates and everything else, it's just going to really be able to help us provide even further value to the customer and therefore even greater improved pricing.

From that, what we want to do is exactly what you said. We think we can learn from that and we'll be able to take that and apply it across to some of the other product lines, like Atlas, like Baker Oil Tools. So this is a strategy we're looking at. If we can get to the point where we can keep an LWD or a BHA in the hole longer and we can almost predict failure to the client, we think that's a step change. So this is the whole push behind this next level of reliability stage we're going to.

Brad Handler - Wachovia

My guess is that you would say that that's unique in the industry, some of the approaches you're taking from that review perspective? Do you think that's a fair statement?

Chad Deaton

Yes, we do. Some of our people said we shouldn't even discuss it during the call because we think it can be an advantage as time goes on. But we think we're far enough into it and our reliability is strong enough at INTEQ that we think we're ahead on this area right now. So we can even advance it faster now.

Brad Handler - Wachovia

Do you think you have the same edge with respect to reliability in terms of Atlas and Baker and Oil Tools?

Chad Deaton

Yes. I think definitely Oil Tools, without a doubt. I think Atlas has made some very good strides over these last couple years. I think Atlas was more a matter of upgrading tools and updated trucks and things like that and just getting some newer technology out there. I think that was more the issue in Atlas, in order to be able to improve on that. Clearly, you're exactly right. At BOT, we think one out of our strengths is our reliability of down hole completions.

Operator

Your next question comes from Alan Laws - Merrill Lynch.

Alan Laws - Merrill Lynch

I have sort of a follow-up to Jeff's question. Your incremental margin target is 30% and you said that the incrementals are going to be driven mostly by cost reduction. Is that right?

Chad Deaton

No. We said it's a combination of cost reductions, price improvement. Obviously other efficiency gains. You can't put it back to cost.

Alan Laws - Merrill Lynch

But it's your big focus?

Chad Deaton

Yes. It's clearly a focus.

Alan Laws - Merrill Lynch

If you had to rank them, that's the primarily place where you think?

Chad Deaton

It's where you can actually make an impact. Pricing, you can talk about it, but if you just talked about Hughes Christensen , we can say we're going to go improve pricing at Hughes, but if the market's not playing that game, you're not going to do it. So you have to come back to reliability and have the customer pay you more for your tools, via your technology, or your execution. You've got to work on that, you've got to work on the pricing, and you've got to work on just overhead costs in general.

The margins were weak in Q2. I think some of the regions, clearly, Canada, I think INTEQ's been a very, very strong performer for the last 11 quarter, and because of some of these rig delays that Rod talked about and I talked about and some other issues, the incremental wasn't as strong in INTEQ. I have no doubt in Q3, Q4, it will be back. But we just think we've reached a level now we can start fine tuning the organization and bring some additional cost to the bottom line.

Alan Laws - Merrill Lynch

So you still see upside here for mix and kind of real price increases?

Chad Deaton

Yes.

Alan Laws - Merrill Lynch

All right. So this doesn't suggest that your refocused or stepped up efforts on internal costs doesn't suggest that pricing power is waning or that you've reached or nearing limits for margin expansion on your product lines because of, say, cost escalation? Because today everyone's really said, cost escalations have been met with price increases. Are we seeing the first signs of this slowing?

Chad Deaton

I think in North America you are. North America pricing has slowed. If you look at the four regions, clearly we're doing much better in Europe, Africa where we see pricing improvement taking place. I think we just need to watch North America, see what happens, and at the same time, we're watching overhead costs everywhere in the world, because we've built out these regions and now we need to watch those, but we are still hiring direct people. Again, those people that are out there on the rigs earning money, and we're continuing with our training and development programs in those areas.

Alan Laws - Merrill Lynch

There seems to be more than a few quarters of growth in these markets. Because your Brazil comments would suggest that in certain markets your ramp to handle current business or maybe in certain quarters over ramped from time to time. Is that fair?

Rod Clark

One other point to bring out here is that you mentioned mix. And that's definitely something we would expect to rebalance as we've tried to feature heavily is the performance of our drilling and evaluation segment this quarter arising, in large part, out of Canada. We also had some mix issues through the business that affected both C&P and B&E.

The second point is, that we do have a portfolio of new product technologies that are ready at various stages in the product development pipeline, but are ready to come out, including, for example, Baker Hughes Drilling Fluids, which was by far and away our weakest performer this quarter. So, we have both mix and mix compounded by new technologies which leveraged the opportunity to extract higher price than legacy technologies.

Alan Laws - Merrill Lynch

You are high grading your product mix?

Rod Clark

Exactly.

Alan Laws - Merrill Lynch

But do you think that this cost issue, because you're the first to mention it, is this specific to you or do you think you're just the first to kind of hit the wall on this or that you're the first to go after this as an incremental margin accelerator?

Chad Deaton

I don't think by any means at all we're the only ones that have mentioned it or we're the only ones taking a look at it. We've heard a couple of our different competitors make comments about headcount getting up there, especially in North America on activities.

I think everybody is looking at it. You get the growth, you've got to ramp up to do it, and with that comes overhead costs and training costs and everything else and you do reach a point after you've done it for 18 months or two years, or so, you say, okay, I think we've got enough infrastructure in place, now let's leverage it or expand the direct people and watch the overhead costs.

Operator

Your final question comes from James Stone - Cambridge Investments.

James Stone - Cambridge Investments

Good morning, guys. I hear what you're saying about focusing on margins and efficiencies in the quarter, but I guess what struck me is outside of North America, if I compare your growth across the space to what everybody else has reported, you guys, both on a sequential and year-over-year basis, kind of fall down at the bottom of the range.

I'm just a little surprised to see that given all the investments that you have made and all the effort that you've made over the last couple of years to really ramp that up. I'm wondering, as you look at that and look at your competitor's growth, where do you think you're missing and where do you think that gap is coming from?

Chad Deaton

Jamie, I don't want this to sound like an excuse, and maybe it will as I go through it. If we look at it, for one thing, we're kind of comparing company to company and none of us have the same portfolio mix. We're growing at, last year, 25%, 26% internationally, we said we're going to grow at 19% to 21% this year.

If you look at our D&E product line, a couple of our product lines. For example, one of them is up 34% in growth, another one is up 27%. But if you look at Petrolite, which is a very steady, on going business that generates, almost like a dividend every quarter, its growth is 16%. I'm talking international growth now. So blended it puts us at 21%, individual product line, which we kind of try to compare to and our competitors look at, anywhere from 27% to 34%.

I go back to this point. We've tried to target our countries as we go into them, and where we target those countries, we're in excess of anywhere from 40% to triple-digit growth in some of those countries. It goes back to making sure we establish ourselves, get our facilities in place, and the people and go target another country so that we don't end up having some issues out there.

So I don't know if that answers your question, but that's how we kind of look at it.

James Stone - Cambridge Investments

So I guess what you're saying is it is more a structural thing, in terms of the mix of your business, as you compare yourselves to your competitors than a competitive issue?

Chad Deaton

Yes. You just can't look at company to company and try to compare it. I think, to me, you have to look at product line by product line. We don't compare Petrolite to one of our traditional Halliburton, we try to look at what Petrolite's competitors are and what they're doing on an international growth. Same thing with Atlas or INTEQ or BOT and try to break it down and see how they're doing.

Gary Flaharty

Thank you, Jamie. Thank you, Chad, Rod, and Peter. I want to thank everyone, all our participants this morning for your time and your thoughtful questions. Following the conclusion of today's call, both Gene and I will be available to answer any additional calls that you may have. Once again, thank you for your participation.

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Source: Baker Hughes Inc. Q2 2007 Earnings Call Transcript
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