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McDermott International Inc. (MDR)

Q2 2007 Earnings Call

August 8, 2007, 9:00 AM ET

Executives

John E. Roueche - VP of IR

Michael S. Taff - Sr. VP and CFO

Bruce W. Wilkinson - Chairman of the Board and CEO

Analysts

Jamie Cook - Credit Suisse

Joe Agular - Johnson Rice

Roger Read - Natexis

Dean Barber - Deutsche Asset Management

Brad Handler - Wachovia Capital Markets

Brent Thielman - DA Davidson

Presentation

Operator

Ladies and gentlemen, thank you for standing by, and welcome to McDermott International Second Quarter 2007 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later in the call, we will conduct a question-and-answer session and instructions will be given at that time.

I would now like to turn the conference over to our host, Mr. Jay Roueche, McDermott's Vice President of investor relations. Please go ahead, sir.

John E. Roueche - Vice President of Investor Relations

Thanks, Minoshia, and good morning, everyone. We appreciate you joining us today to discuss McDermott's second quarter 2007 financial results, which we reported yesterday.

Participating on the call with me this morning are Bruce Wilkinson, Chairman and CEO of McDermott, and Mike Taff, Senior Vice President and Chief Financial Officer. Mike will review the financial information of our quarterly results and Bruce will follow with an overview of our operations.

After our prepared remarks, we'll open the lines up for your questions.

Before turning it over to Mike, let me remind that this call is being recorded and a replay of it will be available for a limited time on our website. Also, some of today's comments include forward-looking statements and estimates that are subject to various risks and uncertainties.

Please refer to our filings with the SEC, which are available on our website, including our Form 10-K for the year ended December 31, 2006, for a discussion of the factors that may cause actual results to differ from management's projections, forecasts, estimates and expectations.

With that, I'll turn the call over to Mike Taff, Chief Financial Officer of McDermott.

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

Thanks, Jay, and good morning, everyone. For the second quarter of 2007, McDermott reported net income of $149.4 million, or $1.31 per diluted share, compared to $47 million, or $0.41 per share in last year's second quarter. The increase was primarily due to improved results at our Offshore Oil and Gas Construction and Power Generation segments.

In most quarters McDermott has certain identified amounts that we highlight to investors so that they can better understand our results and this quarter is no exception. I'll discuss most of these later when I discuss our respective segments.

However, let me remind you now that a year ago in the second quarter of 2006, our financial results included a $49 million loss related to the early retirement of J. Ray's debt, which was partially offset by $0.12 a share of income from discontinued operations.

Let me begin with our top line. Revenues in the quarter exceeded $1.4 billion, approximately 35% above the 2006 quarter. The year-over-year increase was primarily attributable to a 45% increase from our Offshore Oil and Gas Construction segment and a 37% increase at our Power Generation segment. McDermott's operating income was approximately $181.8 million in the second quarter of 2007, an improvement of $69 million from the prior year.

Our Offshore Oil and Gas Construction and Power Generation Systems segments led the way, increasing $25.6 million, and $50.1 million respectively. Partially offsetting these improvements, McDermott's unallocated corporate expenses were $14.3 million in the 2007 second quarter, about $5.5 million above last year.

The increase was primarily related to higher stock-based compensation expense that is subject to mark-to-market accounting, higher accounting fees, as well as other increased general corporate expenses. We believe going forward that a better run rate for this expense is about 7% to 9%... $7 million to $9 million per quarter.

The other income and expense line item improved over $60 million compared to a year ago. In the second quarter of 2007, we generated other income of $9.5 million compared to other expense of $50.7 million a year ago.

As I just mentioned, a year ago we had the $49 million loss on the early retirement of debt, which represents the bulk of this variance. In addition, net interest income and expense improved about $5.1 million, due to lower levels of debt and higher amounts of cash and investments.

Next, I'll discuss our financial results by segment, starting with Offshore Oil and Gas Construction, which consists of J. Ray McDermott. J. Ray had segment income of $91.1 million compared to $65.5 million in last year's quarter. Including the $121.2 million in segment income from the first quarter, J. Ray at mid year has already exceeded the segment's full year amounts of 2006.

Each major region contributed to the 2007 second quarter improvement, led by increased activities in the Asia-Pacific region. However, I'll add that Morgan City contributed positive results for the second consecutive quarter.

Project closeouts, including change orders and settlements, totaled approximately $20 million in the second quarter of 2007, compared to approximately $5 million in last year's quarter.

I'll remind you that these items are an important aspects of J. Ray's business model, but the amounts recognized in any given quarter can vary widely, causing our reported margins to swing.

However, these results we deliver are hard fought. I commend Bob Deason and his team for the excellent job they have done in capturing this type of income for our shareholders a year ago, J. Ray's second quarter results included a $21 million in profit that had been previously deferred in prior years on a project known as Dolphin.

Excluding this unique contract, operating performance year-over-year at J. Ray was even better than our GAAP results portrayed. As we mentioned in the call in May, J. Ray's business periodically has and will produce margins exceeding our target range of 10% to 12%.

Over the last year, J. Ray's operating… J. Ray's quarterly operating margin has ranged between 10% and 22%. I know this spread makes it difficult to model J. Ray in three-month increments, but that's just the nature of the business. We're proud of this quarter's 15.9% operating margin, yet if you ask us to look out, we continue to suggest a 10% to 12% range would be considered more normalized.

As has been the case recently, superior project execution, substantial change orders, harvesting of contingencies, combined with a high level of work, provide the upside to our target range. We continue to have these opportunities going forward, but these items will help form the quarter-to-quarter variability in our margins.

Turning to our Government Operations segment, BWXT generated segment income of about $29.7 million for the 2007 second quarter, compared to $30.8 million in last year's quarter. The decrease was primarily due to a $1.1 million gain on an asset sale recognized in the second quarter of 2006.

Excluding this, segment income was relatively consistent with the prior-year's quarter. I'll let Bruce cover the exciting news of our government business, an acquisition, a new M&O contract, and a management that's focused on expanding commercial nuclear products and services.

Wrapping up the segment discussion with Power Generation Systems, where B&W resides it, reported segment income in the quarter of $75.4 million, compared to $25.2 million in last year's quarter.

This substantial improvement was primarily the result of approximately $50 million resulting from contract terminations and a variety of settlements. Again, this type of income doesn't just fall in our laps.

Our employees worked hard to deliver these results and John Fees, Brandon Bethards, and their teams should be commended. However, with our target margin in this business in the 6% to 8% range, we would expect near-term results to be more in line with this range than had quarter's 11.2%.

I'll wrap up my comments with a few balance sheet items and discuss a few events subsequent to June 30th. As we discussed on the call… as we discussed on the last call, we received a $272 million refund from the IRS early in the second quarter, which we used to retire the $250 million term loan portion of B&W's credit facility.

As of June 30th, McDermott is virtually debt free. Our working capital is positive, at around $130 million, including about $1.4 billion in cash and investments. During the quarter, we completed the MMC acquisition for about $75 million, and in July, we completed a $260 million asset purchase, both of which we funded with cash on hand. McDermott will continue to pursue smart growth that is intended to improve net income and increase shareholder value.

Similar to the acquisitions that Bruce will discuss in more detail, we continue to pursue financially attractive bolt-on opportunities. In addition, we are investing in our core businesses, both existing and new markets. We have approved a robust capital spending program to support our organic growth. We are also planning to contribute around $115 million towards our underfunded pension position in 2007. All of these initiatives are intended to be accretive to our shareholders.

During the summer, we received credit rating upgrades from the major rating agencies. We appreciate their recognition that McDermott and our subsidiaries have an improved risk profile. The improved ratings helped enable us to complete amendments to J. Ray's and B&W's credit facilities in July.

There were a number of modifications to these facilities, including lower margins on borrowings and letters of credit. The savings is between 50 and 150 basis points annually, which should work out to be about $5 million per year pre-tax, based on current LC levels.

We truly appreciate the support of our lenders and look forward to working with them throughout terms of these facilities. Their confidence in us helps support our growth objectives. And finally, yesterday we announced that the board of directors has approved a two-for-one stock split.

This decision reflects the board's confidence in McDermott's current and future performance and our long-term outlook. It should improve the liquidity of our shares and will result in a new entry price that is more attractive to a broader base of investors.

I'll now ask Bruce to provide his business and operational update.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thanks, Mike, and good morning, everyone. McDermott delivered outstanding performance again this quarter. All of our business segments posted solid numbers and backlog was up sequentially across the board.

As Mike indicated, there are numerous puts and takes again in this quarter that make it difficult to annualize our results, but the Company continued to deliver substantial income from our shareholders. This quarter's superior results reflects extraordinary effort across all our businesses.

Our entire management team is to be commended. McDermott's consolidated backlog at the end of the second quarter was $8.9 billion, up about $1.3 billion from year end, $1 billion from a year ago and about $900 million from last quarter, and each segment reported sequential backlog improvement.

Like our reported results, backlog can be somewhat choppy, but this quarter's growth is a clear indication that our core energy ENC markets remain strong.

Turning now to each segment for a little more detail, let me begin with Offshore Oil and Gas Construction. Segment revenues grew sequentially in year-over-year to about $580 million, which is up nearly 45% versus a year ago.

However, the revenues were a little less than expected, as a few projects that were scheduled to commence got pushed out a bit and some others didn't complete as much work during the three months as we originally thought.

It's nothing that we consider an issue, since our focus is always more on what we earn, and as Mike covered, J. Ray did well in that regard. During the 2007 second quarter, J. Ray had bookings of about $1 billion, bringing its June 30 backlog to $4.6 billion.

The bulk of the new awards came from the Middle East, but the Americas and Asia-Pacific also each reported over $100 million in new awards. At Morgan City, the large award in the quarter was the poinsettia project in Trinidad that J. Ray is performing in a consortia led by Fluor. Worldwide bids outstanding at J. Ray remain strong at approximately $3.2 billion.

Considering our backlog in this settlement… in this segment is up over 40% from a year ago, the bidding activity remains exceptionally robust. As we announced yesterday, J. Ray was just awarded the long-term agreement from Saudi Aramco.

The first phase of this contract alone is one of the largest that J. Ray has won in many years and the several hundred million dollars that we'll initially book in the third quarter is a fraction of what this award can ultimately be. Several years ago, when times at J. Ray weren't quite as good, we began emphasizing to our investors that we should remain selective on the projects we pursued and that we didn't bid work that didn't fit our criteria for risk and return.

That statement remains true today, as true today as it did when I first said it. While we're obviously pleased that our offshore construction market is strong, which includes eight quarters now of sequential backlog growth, and that our customers continue to show such confidence in our capabilities, let me assure you that our processes are as stringent as ever.

We continue to believe the real key is to get contracts right on the front end and to keep our costs in line so we can provide quality service to our customers and also earn an acceptable return for our shareholders.

During the second quarter, J. Ray's fabrication utilization continued to be strong, over 150% of its standard. The substantial activity in the Asia-Pacific and Middle East markets led the way.

However, Morgan City was at its standards and achieved profitability for the second quarter in a row, despite half its work load being intercompany, no-profit project for our Middle East region. We believe that our Americas facilities, which includes the new facility in altamira, Mexico, currently under construction, are well positioned, not only for our improving traditional offshore market, but also for modules for the power market refineries and other specialty work.

Longer-term, we believe our Americas business unit will include both the US and Mexico offshore markets. J. Ray's marine vessels were 108% of their standard days during the quarter and the DB-101, which was in dry dock the entire quarter, is now about to return to work in Asia-Pacific, after a long journey from Mexico and about eight months of dry dock for maintenance and upgrades.

We expect J. Ray's marine activity to be fully utilized throughout the remainder of the year. After the quarter, J. Ray completed the asset purchase of Secunda International, including 14 multifunctional vessels, for approximately $260 million in cash.

We're enthusiastic about this purchase and believe it will prove to be a real gem for our shareholders. We based our purchase price on Secunda's existing vessel chartering business, but we think the exceptional value will come from three areas.

First, these vessels should free up capacity for our larger barges, to enable J. Ray to pursue additional large epic jobs. Second, we currently spend tens of millions of dollars a year on charters for similar vessels and the Secunda purchase will now enable us to self perform more work and keep more of the overall project margin.

And finally, this purchase will support the growing subsea market and enhance our existing activities in this area. I personally visited their headquarters, saw some of the vessels and met with their outstanding people.

On a recent trip to Singapore, I also visited the vessel, which we repositioned to the Asia-Pacific market prior to even closing to begin modifications and upgrades. I am pleased to welcome Secunda and its employees to J. Ray McDermott.

Moving on to power system… power generation systems, B&W generated about $670 million in revenues during the quarter. About $150 million of this related to the eight TXU units, with about 80% related to units 4 through 8 covered by the global settlement, which we reached in April.

B&W's backlog in the quarter grew over $500 million sequentially, representing quarterly bookings of over $1 billion, ending June 30 at $2.8 billion. This backlog number does not include the value of the three remaining TXU units on which we are still working.

B&W currently has approximately $2.8 billion of bids outstanding, so the market remains good. Projects we're bidding include new and replacement boiler projects, plus environmental work, such as scrubbers and SCRs. We continued to proceed on three of the TXU units at this time.

There's been some good interest expressed by several utilities in these projects. We're optimistic that we will have some success, but until a definitive purchaser is confirmed and a binding contract signed, this work will remain outside of our backlog.

Should new terms ultimately not be reached with a buyer or buyers, I would expect TXU would likely seek to terminate these units also. As with the units 4 through 8, we would be paid for our costs to date and a fair profit at the time of termination.

Despite a bunch of hand wringing by lawmakers and various misleading and alarming news stories, we continue to be upbeat about the prospects for coal in the power generation market.

It would probably surprise some investors to know that B&W is currently working on about 5.7 gigawatts of coal-fired boiler projects in the United States, including these three TXU units not in backlog. What's more amazing is that while many in the US and Europe ponder CO2 and other issues, the rest of the world keeps growing and growing.

For instance, at B&W's Chinese boiler manufacturing joint venture, they have sold over 5500 megawatts of new boilers since they unexpectedly found themselves with capacity earlier this year after the termination of their TXU subcontract.

The joint venture currently has an astounding 14 gigawatts of coal-fired boiler projects currently in its backlog. While these issues in the US marketplace have caused some in industry to perhaps take their foot off the accelerator temporarily, in the traditional coal markets, the greater Midwest, areas that know coal is clean, efficient and affordable, the business continues.

Likewise, the retail consumer of electricity in these areas typically are paying less for their light bill than in areas totally dependent on gas, such as us here in Texas.

A few key facts remain that everyone should recognize. America needs a sizable amount of new electricity generation over the coming years and decades. Coal is the only fossil fuel where the United States is energy independent and it's proven and cleaner than ever.

However, before utilities start spending their money on CO2 technologies, some reasonable regulations must be implemented. As you know, CO2 is currently not a regulated emission in this country and very few utility CEOs are going to add costs to their megawatts without mandates.

And we believe for a society to make a difference in worldwide CO2 emissions, we must have solutions that address the current plans and not just new ones. B&W has a number of irons in the fire addressing affordable CO2 solutions, continuing our traditions of solving tomorrow's issues today.

Like all environmental issues before it, we believe the current green discussion has a business opportunity for us.

In addition to the oxy coal combustion process that we've discussed in the past, we're also pursuing various scrubbing technologies, using regenerable solvents and enzymes. Two projects we've announced to date using oxy combustion, one a new plant and the other a retro fit, are still in the early phases.

The project teams on the Saskatchewan power nuc plant have submitted the plan and their recommendations to the board, who is evaluating the go-forward decision. We are confident that they have a real interest in this technology, but the total project costs have risen, so it's possible that the final plant configurations may change somewhat from the current design.

The AEP retro-fit study seems to be on a more accelerated pace. AEP is the largest coal-burning utility in the US and we hope this project progresses to retro fit one of their existing sites for carbon capture.

Construction of the Oxy combustion technology at our 30-megawatt clean environment development facility in eastern Ohio has begun and in fact, we're 97% complete on the site work. The test sequences will begin mid-August and will run about ten weeks.

As part of the site preparation, we've built wet scrubber on site to see how it functions with oxy combustion. We'll test three different coals during the next few months, determining heat transfer rates and combustion parameters with recycled flue gas.

We have a number of facilities as part of the advisory group, all of whom have contributed money and/or payments in kind, such as coal supply. Oxy combustion will be over a 90% CO2 solution and scrubbing technology will likely remove less than 90%.

Which technology ends up winning the day remains to be seen, but we are researching several of them. As we've started addressing new issues, we're spending more on R&D. For instance, we spent about $5 million more on R&D in the 2007 quarter compared to the three months a year ago.

Also unfortunately, we had several construction projects with continued deterioration during the quarter, which left some upside unrealized. We are aggressively managing these projects and feel confident that we've addressed the issues.

Most of these projects are nearing final completion. With the strong quarterly results in this segment, we were able to absorb these increased expenses and still produce superior results. And we do feel good about the progress that's taking place in our power generation segment and the results we're delivering.

Wrapping up with our government operations segment, BWXT's revenues during the quarter were up modestly at $168 million, while segment income was down $1 million, which is essentially equal to last year's gain-on-asset sale.

While the numbers in the segment are pretty steady this quarter, year… this quarter year-over-year, there's a fair amount of activity taking place at the government operations business.

Let me cover a few of these items. During the quarter, we completed our acquisition of Marine Mechanical Corporation. The integration is going well and we think the business is a great fit for BWXT. Adding MMC's backlog more than offset the normal roll-off that typically occurs in the government business during a second quarter.

Shortly after last quarter's call, we announced that our team had won the Lawrence Livermore Lab competition. This is a great victory and in addition our M… and addition to our M&O sites in the US. There are several other bids for additional sites coming up that are on our radar.

Some of the opportunities are large, others are small, but our goal is to add experience to projects, where we will make a difference. We don't bid them all, just the sites where we think we add value.

We continue to be activity… active in the opportunities in the United Kingdom. We were pleased that our team is still in the running for the two major projects we're pursuing, Sellafield, and Atomic Weapons Establishment, which is actually an acquisition of B&G's one-third interest of AWE.

In both of these major projects there, are four qualified teams, including ours. Competition for both of these opportunities will be formidable, but we believe our expertise is well suited, particularly for the AWE, which is similar to the combined missions of Los Alamos, Pantex and the Y-12 facilities in which we operate in the US.

The Sellafield project. where we're partnered with Bechtel and Serco, is likely to be awarded in 2008, whereas AWE is likely a late 2007 opportunity.

Lastly, during the quarter we announced that we have been awarded a commercial nuclear manufacturing project for USEC, or US Enrichment Corporation. BWXT, who will actually be manufacturing the centrifuges, was selected for this work because of its extensive experience in the design and cost-effective manufacturing of nuclear components in classified machinery. Should this project proceed as envisioned through 2012, it will be substantial.

At the moment, we're proceeding in a book-and-bill mode, so there was no backlog impact at this time, but we think it is a great opportunity for us.

This wraps up my prepared remarks. In summary, it was a terrific quarter and continues the making of a great year. There are substantial opportunities ahead in all of our businesses and the energy ENC markets in which we participate continue to be strong.

This is the highest level of backlog in over 30 years or the history of the current McDermott, providing us good visibility for the coming years. Our focus continues to be on execution. In the coming weeks we'll be active on the investor relations front.

We'll be in Chicago next week at the UBS ENC conference, followed by an active September that includes Lehman Brothers energy and power conference in New York, a Midwest road trip, and the Davidson ENC conference in San Francisco.

We hope to see many of you at some of these venues. Following the Q&A questions, if you have additional questions, please call either Jay or Robbie in our investor relations department.

Now we'll open it up… the call for your questions.

Questions and Answers

Operator

[Operator Instructions]

Your first question will come from the line of Jamie Cook of Credit Suisse. Please proceed.

Jamie Cook - Credit Suisse

Hey, good morning and congratulations.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thanks, Jamie.

Jamie Cook - Credit Suisse

I guess my first question, if you look at the margins on the power gen side, back out the $50 million in profits and $150 million in revenues, your margins were 4.8 and you mentioned in your prepared remarks there was some costs as well, so I guess some incremental costs.

So including that, where would margins be and when do we get to the 6% to 8% operating margin target? What do we need to get there?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

I think looking out, I look at it on a kind of a year horizon. Remind everyone that these projects typically are… they span two fiscal years, well, sometimes ten fiscal quarters or more, and at any particular time some perform better than others, and so I think the 6% to 8% is something that we will be achieving.

And frankly, you can parse every line of a construction company and take out the good or add back the bad and draw all kinds of conclusions. But realistically, I think it's typical in the construction industry to have some that over perform and some that underperform.

So I'm not particularly concerned about the 4.5 that you're looking at there. I think it has to do with the timing of some projects, but as an ongoing proposition, I feel every reason to believe that we can achieve the 6% to 8%.

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

Also, Jamie, I think you just have to think of it in terms of, as we have contract settlements, that's a normal part of our business. We see that much more active on the J. Ray side, but as the B&W business continues to grow and with backlog at the $2.8 billion range, I think you'll continue to see that within that business as well.

So we just happened to point that out to the, to our investors and the investment community, but we do feel that contract settlements and change orders are a normal recurring part of the ENC business.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

It's a little more pronounced now, Jamie, too. Back before you followed us, and certainly before we were reconsolidated, if you go back three or four years ago, it was probably 70% parts, service, after markets, small projects in B&W, and the rest larger OEM jobs.

As you evolve to the larger OEM jobs, the profile of the backlog starts looking more like the J. Ray backlog and less of the smaller, steady state stuff, so you would have… there was probably somewhat less volatility then than there is now because the nature of the backlog has changed dramatically.

Jamie Cook - Credit Suisse

Okay, and then just a follow up, Bruce, after listening to Fluor's conference call last night and some of the comment you made within the power gen business, you mentioned that outside of those three boilers on TXU, there could be other things to come on the coal new generation side, and that's despite… articles you read in the Wall Street Journal, et cetera, that coal's never going to happen.

So I guess as you talk to your customers today, what do you think the chances are that we could… that there could be some new coal-fire power plants going ahead to be built in 2008?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

I think the ones that we… that the Journal has written about and we think about, are very, very high profile. Clearly TXU, the activity down in Florida recently close to large population areas where it's been high profile. I think we continue to work on a number of smaller ones in, I call it the greater Midwest.

They're areas where coal is still not a bad word because they're going on. I think there's… and as my remarks also alluded to, for a huge surge going forward that some have been anticipating, I think we have to have regulatory certainty underlying that in order to have some bow waves of very large effect. And so it is possible we could have a little bit of a period of waiting for that.

But in fact, the ongoing smaller market, or many of the smaller projects, are going forward. We in fact, I think… we remind people back before the TXU event, meaning… and the first event being when we were awarded it, that our own internal plans projected five to six gigawatts a year, if you will, and that was the market we were shooting at hoping to get our share of it.

And so currently working on effectively five gigawatts or more does include three of the TXU units, but even if you take that out and say they went away, you would still be… we would be hitting the mid point of the target market that we identified.

So I think, I think there is a market that will continue. There are some major utilities that are going to wait for regulatory certainty, but you have certain REAs, municipals, other places that are working on a different theme.

Jamie Cook - Credit Suisse

All right. Well, congratulations. And I'll leave it to someone else to beat you up on the fact that your J. Ray margin assumptions are probably too low. Congratulations.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thank you, I'm sure that's coming.

Operator

And your next question will come from the line of Joe Agular of Johnson Rice.

Joe Agular - Johnson Rice

Thank you. Good morning.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Hi, Joe.

Joe Agular - Johnson Rice

First on J. Ray, the contract that you all announced yesterday has been in the press somewhat and there was some estimates that the size ultimately could range up to $2 billion. Is that something you would comment on?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

I would say there's been press speculation in the industry regs about the Saudi LTA project for some time. I've seen different orders of magnitude, including the one you mentioned. It… you know, it… the fact is it's a seven-year contract with two three-year renewal options, so if it goes the ultimate fruition of 13 years, who knows?

I think your number… it, could certainly be that, it could be larger. What's interesting is that the… right now it's targeting four offshore fields, and so a significant amount of the Saudi maintain potential, or if you will, maintaining its productive capacity to keep the world topped up when it's needed, is now dependent on fully developing the offshore sector.

And that's been good for us, because if you go back the last 30, 40 years, it's been much more of an onshore thing, where the larger beneficiary of the business has gone.

Joe Agular - Johnson Rice

Well, Bruce, when you booked the first part of the award in the third quarter, how does that… and with the other projects you have in that yard, how are you in terms of capacity over whatever, the next year or two?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Well, it's tight, but I'm pleased to say that we've invested in a new rolling mill. By then we're going to have a significant new paint facility. We have a considerable amount of material handling equipment that… these trailers that are much more efficient than using the big cranes.

So we're putting a lot more through the yard than we ever thought possible in the past, we're doing it well, But also, the thing about these Aramco projects is they are highly repetitive. I mean these are not huge well head structures. They are not huge jackets. These… it's relatively shallow water and it's something we've been doing for years.

So you really can have the efficiencies of a pretty good assembly line there. So I think we'll be able to handle it, and realistically, the whole negotiation is about deliverability. I mean that's really what the Saudi Aramco wants. They are not stupid. They don't want to put everything in a place that can't do it. So I think we'll… it'll be tight, but we think we can do it.

Joe Agular - Johnson Rice

Good. On the B&W side, I was wondering if you could maybe help us understand… the last year, ex TXU, your backlog has really started to grow very nicely on the B&W side, and--

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Yes, that's what I… I think that every… the TXU is what everybody wants to talk about, but if you… the largest backlog that B&W ever had was $3.1 billion, more or less a year ago, about now, after we added TXU. $1.1 billion of that was TXU.

Six months later, $1.1 billion came out of the backlog, so it's back to $2.8 billion today and I commented that we're still working on three projects for TXU that's not in the backlog. And so when you… it's sort of like $1.1 billion went away, but we've effectively replaced it.

And so… and we have about $2.8 billion to $3 billion in bids currently outstanding. So it's still… there is still a good market that we're shooting at out there, not just… it's not all about new build boilers. It's still about scrubbers and SCRs and all the other things that we do well.

Joe Agular - Johnson Rice

My question on that also was that I guess that some of the settlement gain that you had in the quarter obviously over the last year, you all have devoted a lot of your resources to TXU.

And just to what extent does the settlement reflect some of the potential earnings power that you might have had, had some of these contracts gone through to completion and therefore what implications that has for the backlog that you're adding now?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Well, it has had some impact. I mentioned we feared a much worse impact on the Chinese operation than in fact has happened, but that's one of the rare places where you can just go book another 5000 megawatts and never miss a heartbeat. Can't do that here.

But there were some projects including one that's been in the press recently for Duke, that at the time we could not bid. We were fully constrained by TXU and it was subsequently announced as being awarded to others and will go forward, and so we've had some of those impacts, too.

But I look at the whole settlement issue 4 through 8. I think it's erroneous to get all wrapped around the axle about it being a one-off event. In reality, if all those projects were still going forward, we would be earning pro rata on all of these things.

There'd be eight units going forward and we'd still be earning and everybody would call it normalized earnings. So to some extent, settling some of these things the way we did, I think it's to the credit of our team. They did a good job, and that's what contractors are supposed to do when extraordinary events like sudden cancellation occurs to you.

Joe Agular - Johnson Rice

Okay, thank you.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thank you.

Operator

And your next question will come from the line of Roger Read of Natexis.

Roger Read - Natexis

Good morning, gentlemen.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Hey, Roger, how are you doing?

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

Good morning.

Roger Read - Natexis

Quick question for you, following up on the backlog of B&W. You touched on it a couple times already, but if you were looking at the breakdown of your backlog, SOX, NOX-related issues, a year and a half, two years ago, Bruce, you would have said that that business looked like it was flattening out in terms of the part driven by regulations.

Does that appear to still be the case, or have you seen any uptick there?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

I'm trying to recall what… I had a note that had to do with the present backlog.

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

Yes, I think if you look at… Roger, if you look at the current backlog, we kind of break it down. It's about 15% of it's related to boilers, about 40% is related to environmental work, and 35% of it's related to our parts and service business.

Roger Read - Natexis

Okay, that's helpful.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

That would indicate that that market isn't over, by any stretch. No, I think… I think the environmental side of the business is still… still has a future. I think most people have dissected the install base out there and that which has already been scrubbed and that which remains to be scrubbed, but within that… those other parameters, I think the business is still strong.

Roger Read - Natexis

Okay. Your comment about the backlog in China, 14 gigawatts, given the accounting for that comes through as an equity line, I'm presuming there's no impact on your stated B&W backlog for that?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

That's correct. It's not in the backlog, and you'll have… you'll have some of that as equity income and depending on which type of project and where it is, there can also be license fee or royalty income. Most of that is in China. I believe of that backlog, there's at least one project destined for Indonesia, and I believe one for India.

Roger Read - Natexis

Okay, and then what would be the timeframe for them to monetize that backlog, actually how long do they get all those orders out?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Well, I think they are like here. Those are probably 30-month start-to-finish duration, so what it implies is at least a two-year horizon of very strong results over there would be my guess.

Roger Read - Natexis

Okay. And my last question, switching gears back to J. Ray, I'm not going to beat you up about the margins. I took my swing last time and you certainly did well with this quarter. Capacity issues, you mentioned the beginning with the exception, I believe, of Morgan City and Altamira, which is not yet online, 150% of capacity.

Now, I know there's rated numbers, there's clearly a learning curve that allows you to do more. Do you feel with two very significant Saudi awards here recently, is there a need in the Middle East, Asia, et cetera, to add either shipyard… fab yard capacity, or ships… vessels themselves beyond the Secunda acquisition?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Let me say first about Secunda, it will be a great facilitator for our marine business, because we… as you know, we operate seven marine barges, construction pipe lay barges and then a couple that we don't own in the Caspian.

And we use those barges for… basically their main purpose, and also for some purposes where it's too much equipment at too high a cost for part of the project that can be done by these MSVs, DSVs, and these vessels that we got from Secunda.

So I think we all believe that over the next several years, assuming this high utilization in Asia and the Mid East, that we… that these vessels will give us some breathing room between projects for our major work barges and allow them to take on maybe an extra large epic contract or two every year or two.

And if they do, that's like… it's almost like free capacity. It's… there are only so many days in a year, but if we can have productive use of the DB 30, the DB 27, for instance, as opposed to a lot of time when it's being utilized, but for less than its intended purpose, that will be a great facilitator.

I think we believe there is still… with good investment, there's still capacity to expand beyond what we're doing at the Batam yard, and here… back here in the Gulf of Mexico, of course, where it's not as robust, we think the offshore market is indeed coming back.

It's probably still two years out. It's '09 probably when you have significant fabrication work starting for a lot of the deep water developments that have already been made. So that's why we think then the key will be to have both Morgan City rolling and Altamira being effective.

So I think there's, there is some additional capacity in these, but certainly not infinite. We are looking at other things still, waiting for the market. We have talked in the past about Casicstan.

It's still something we intend to do, but it's a market that's slow to develop and so we're not going to get ahead of ourselves there, and we've explored some other alternatives for capacity in Asia, including China. So we're still thinking about how to grow beyond the present footprint if the market gets that large.

Roger Read - Natexis

Okay. Thank you.

Operator

[Operator Instructions]

Your next question will come from the line of Dean Barber of Deutsche Asset Management. Please proceed.

Dean Barber - Deutsche Asset Management

Hi, guys. How are you doing? It's actually Dean Barber. Just a question on you Secunda assets, I wanted to get a little bit more detail there from you guys in terms of when do you expect those assets to be fully integrated into the business and really running at full steam?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Let me back up and say that of the, I believe, 14 vessels or so, we, we look at them in three categories, those of highest potential to us, those that are DP 2, another group that are DP 1, and then some others that are more utility vessels, and so we… for us, the key is getting the right ones into our system, as soon as possible.

I believe that looking at when the charters roll off and the planning that's going on now, my recollection is that we believe that by mid '08, we'll have probably four of them… at least four, maybe one more in the Mid East and/or Asia, and that's pretty good.

That's actually ahead of our earlier expectation. And there were some that had charters… were subject to charters that had a renewal option that we are still looking at, because, you know, we're not totally determining whether the renewal happens or not.

But, but the… it's clearly our desire to get them into our system sooner rather than later. The strategy of Secunda, as you know, is a chartering business. We're not in that business, and we feel that they have great people, great assets, and what we're trying to do is really translated into a value-added use with the vessels, not just chartering income.

Dean Barber - Deutsche Asset Management

Okay, thanks. And then one more question, just on the cash perspective, can you just walk through the priorities in terms of use of cash at this point? I mean you paid down… obviously you paid down the debt.

You have no more debt on the balance sheet. There's some liabilities and you've just done the Secunda deal. Can you just walk through the priorities for us?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Yes, we… this… looking back at… or looking back and still forward in this year, there's been about $115 million that has been targeted that will go to fund pension plans. We have, or expect to expend about $116 million CapEx… or I think we have spent $116 million, primarily in J. Ray, $263 at Secunda, $75 million Marine Mechanical. What else, Mike?

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

Yes, and I think overall, I think you'll continue to see a very robust capital spending program, as Bruce mentioned. I think we've invested about $120 million or so during the first half of the year and I think you would… could project a similar number that will fund the underfunded pension position.

And also, I think we would be remiss in not telling you that just analyzing our balance sheet, our working capital is positive at around $130 million, so we have to factor that in, as well as some liabilities that are on the books.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

But effectively, what we're… we're very pleased at investing in what we already have and expanding what we do to other geographies first. Funding the pension plan, we have talked about uses beyond that.

There's been discussion. We haven't ruled out stock buybacks, that sort of thing, but there's really been no formal activity by the board to authorize it at this time, because we still believe that we have a lot of growth and there's room and reason to make… continue to make some of these acquisitions that really facilitate our main businesses beyond the present footprint.

I mean we think, frankly, if you look, we go back to… we serve oil and gas, coal and nuclear, the big three, and when you come around to the nuclear side, that is an area where we are just beginning to stake out our position, organize the business unit itself to be operable in '08, and that's yet a full suite of services and products. And so we're looking at acquisition alternatives that could expand that sector as well.

Dean Barber - Deutsche Asset Management

Well, great. Thanks, guys. Congrats on another great quarter.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thank you.

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

Thank you.

Operator

Thank you. Your next question is from the line of Brad Handler of Wachovia Capital Markets.

Brad Handler - Wachovia Capital Markets

Thanks. Good morning.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Good morning, Brad.

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

Good morning, Brad.

Brad Handler - Wachovia Capital Markets

In discussing the long-term agreement… and maybe it's going back to the trade press… but there was talk about building a yard in Saudi. Is that, is that still part of the mix in some way?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Yes. As, as originally conceived and as requested for bid, it involved a long-term agreement that contemplated both out-of-kingdom, as they call it, services and in-kingdom services, and the in-kingdom services included investing in building or setting up a fabrication yard to do offshore work. Such a yard does not currently exist in Saudi.

There is a lot of fabrication that goes on there, but it's been directed to refining petrochemical and other markets. And so as originally conceived, it was going to be a winner-take-all, if you will, doing both.

But in all cases, our analysis suggested that the larger part of it would be out-of-kingdom work, because for instance, out-of-kingdom in all cases, included the marine work, where you're setting jackets, top sides, or laying pipe.

So… but in the end, Saudi Aramco decided to split it and there will be another award that will go to the so called in-kingdom, that the odds are will have somebody else's name on it than ours. But I don't know that that decision's been made, but what we know is that we are the winner of the out-of-kingdom part.

Brad Handler - Wachovia Capital Markets

Okay. Odds are… you have submitted a bid for the in-kingdom piece, it's just you're guessing it winds up getting split?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

It's our belief, from what we've seen, that they felt that it was in their interest to have that split, and you can understand that. This is a huge program and huge numbers, seven years, plus two extensions, if you assume it's a 13… kind of 13-year life to… as they see it already. The fact that there might be two players, one in-kingdom and one outside is not particularly unusual at all.

Brad Handler - Wachovia Capital Markets

That makes sense. Follow-up, I guess sticking with J. Ray, there's starting to be sort of a gathering of steam of new building on the offshore construction vessel side, which may not really hit the market in force until '09 or '10.

But nevertheless it sounds like it's pretty meaningful additions capacity side. Any thoughts on that, please, and then maybe commentary on whether your customers are also seeing that, recognizing you bid differently, vertically integrated and all that, but are there any implications that you're seeing yet in the marketplace related to that?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Not yet. There's been a few new vessels actually entered the market already. I've seen orders of magnitude of up to 50, but that covers a broad array of types of vessels. So in other words there'll be all kinds of… in that number there's all kinds of things that do what we do, don't compete with what we do.

There's one or two very high profile ones that you've read about, hear them and otherwise that would be up in the 10,000-ton lift capacity class, huge things, also kind of beyond us. So, yes, there are a number of things out there, but so far I don't think it's changed dramatically the dynamics of the marketplace.

From my own point of view, I think that what I'm more in favor of from McDermott is I think the model that you see that we did with Secunda is really our preferred approach.

I'm not, one, interested in a three or four-year design construction build program, project financed, hope you get a massive investment out of the shipyard at the right moment for the market, and then spend another year trying to convince the first customer that he ought to be the first customer.

And so to me, when you can buy assets with good people and with management, like we did at Secunda, that's the preferred approach. So I sit and look at the market and think about it that way and if we felt we had to compete in that world, I think you'd see us looking at it that way as opposed to trying to line up a bunch of shipyards to build something brand new.

Brad Handler - Wachovia Capital Markets

Okay, that's very helpful. One more quick one, please. Just in light of how you see the geographical… where your income is coming from in the balance of the year, is it plausible --

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

J. Ray, you mean?

Brad Handler - Wachovia Capital Markets

Yes, presumably that's a driver --

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Yes.

Brad Handler - Wachovia Capital Markets

-- at a good point, but it plausible to think about the low 20s tax rate has being from a modeling standpoint, probably more realistic than mid-20s?

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

I think so, Brad. I think our target, effective tax rate is still around 25% or so, but it… again, that all depends on the mix of business. I think this quarter you saw a 22% tax rate, which, again, I think that 22% to 25% range would be something I think we're more comfortable with.

Brad Handler - Wachovia Capital Markets

Very helpful. Thanks very much, guys.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thank you.

Operator

And your last question will come from the line of Brent Thielman of DA Davidson. Please proceed.

Brent Thielman - DA Davidson

Good morning, and congratulations as well.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thank you.

Brent Thielman - DA Davidson

Just on the J. Ray side, if you look at the first quarter, you had $40 million in closeouts, change orders and settlements, and $20 million in Q2, and I realize these are very difficult to project going forward. Is there any guidance, or should we assume the same, or obviously much less in the second half of the year out of that business?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

I'm sorry, I missed --

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

He asked about changes orders. Brent, I don't think, you know, we can put a definitive number on that. I think as we've always said in this business and with J. Ray's backlog now over $4.5 billion, I think you'll continue to see… quarter-to-quarter, you'll see contract closeouts and change orders, and if we operate official and effectively, recouping some of the contingencies and all that.

But to put a definitive number on that quarter-to-quarter, I think we've always said this business is lumpy and you're going to see variations quarter-to-quarter, but… so we kind of look at this more over a 12-month period versus a three-month period. Also I think it's hard to put a particular number on that.

Brent Thielman - DA Davidson

Okay. And then just a quick follow up… and I apologize if I missed this… but do you have any update on the time line of the UK opportunities?

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Not beyond the prepared comments. I think this AWE thing, which is really… in the end, it's a beauty contest to get down to a select group and then it's actually an acquisition. It's my understanding they're trying to get that done before year end, and that the other opportunity at Sellafield is, I think, the first half of '08, but both a substantial.

These are quite large… either one of them in larger significance than the kind we typically have won, or you see us involved with here in the states. So we're heavily after them. There is competition, but we're staying the course. We think we have a lot to add to those two sites.

Brent Thielman - DA Davidson

Great. Thanks. Congratulations, again.

Bruce W. Wilkinson - Chairman of the Board and Chief Executive Officer

Thank you.

Operator

And that will conclude the question-and-answer session and I would like to turn the call over to Mr. Jay Roueche for closing comments.

John E. Roueche - Vice President of Investor Relations

Thank you, all, again for joining us today. Just a quick reminder that today's call included some forward-looking statements and for more information on these, I'd encourage you to see our SEC filings.

Please call Robbie or me if you have any follow-up questions or need clarification, and we look forward to seeing many of you out on the road in the coming months. This concludes our call. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a wonderful day.

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Source: McDermott Q2 2007 Earnings Call Transcript
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