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Baker Hughes, Inc. (NYSE:BHI)

Q3 2007 Earnings Call

October 26, 2007 8:30 am ET

Executives

Gary Flaharty - Director, IR

Chad Deaton - CEO and Chairman

Rod Clark - President and COO

Peter Ragauss - CFO

Analysts

Jim Crandell - Lehman Brothers

Bill Herbert - Simmons & Company

Ken Sill - Credit Suisse

Dan Pickering - Tudor Pickering

Ole Slorer - Morgan Stanley

Michael LaMotte - JP Morgan

Ben Dell - Bernstein

Robin Shoemaker - Bear Stearns

Geoff Kieburtz – Citi

Operator

Good morning. My name is Luanne and I will be your conference facilitator. At this time, I would like to welcome everyone to the Baker Hughes Third Quarter 2007 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question-and-answer period. (Operator Instructions). Thank you. I'll now turn the conference over to Mr. Gary Flaharty, Director of Investor Relations. Sir, you may proceed.

Gary Flaharty

All right. Thank you, Luanne and good morning everyone. Welcome to the Baker Hughes third 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 management's comments we'll open the line for your questions.

Reconciliation of operating profits and non-GAAP measures to GAAP results 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 these forward-looking statements, however, the format of the call does prevent a more thorough discussion of these risk factors. So 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?

Chad Deaton

Thank you very much, Gary good morning, everyone. This morning we reported income from continuing operations for the third quarter of 2007 of $389 million or $1.22 per share. This $1.22 per share is up $0.13 or 12% from the $1.09 we reported in the second quarter of '07, and the third quarter of '06.

Revenue is up $2.68 billion, which was $2.68 billion, which is up $368 million or 16% from the third quarter of '06 and it was up $140 million or 6% sequentially. Outside of North America, revenue was up 22% compared to a year ago and was up 5% sequentially.

Continued expansion in the international markets with seasonal recovery in Canada, a stable recount in US land and the increases in Gulf of Mexico revenue all contributed to the sequential improvement.

Overall, it was a better quarter as both our Drilling and Evaluation segment and our Completion and Production segment delivered solid revenue growth and improved profitability in the third quarter compared to the second quarter.

The Drilling and Evaluation profits recovered in Canada, as activity improved seasonally and our Completion and Production businesses, which are more geared to production volumes and drilling activity continue to deliver very solid results.

Internationally, we showed good growth in both segments. In the D&E segment the investments we have made at Baker Atlas in people and technology were evident in the improved performance for the quarter.

If we walk around the around world, and look at our regions, North America revenue was up 8% year-on-year and was up 7% sequentially. Looking at US its revenue increased 10% year-on-year compared to a rig count that was up 4%. The land revenue was up 13% year-on-year with strongest growth coming for our D&E group coming out of INTEQ and Hughes Christensen and our C&Ps land revenue was up with strong increases at Centrilift and Baker Oil Tools.

US land revenue was up 4% sequentially, compared to a rig count, which was up a little over 2% with growth strongest in the D&E segment, again led by INTEQ and Hughes Christensen.

US offshore revenue increased 2% year-on-year compared to the rig count, which was down 24% from the year ago quarter, and sequentially, US offshore revenue was up 4% with revenue increases at Baker Hughes Drilling Fluids and Baker Atlas, and this offset the weather related disruption to operator's third quarter drilling activity.

Canadian revenue was down 7% year-on-year, compared to a rig count it was down 29%. The year-on-year revenue decline for the D&E segment mirrored the drop in rig count, while C&P segment revenue actually increased 17%, and that was led by the production driven by Baker Petrolite and Centrilift divisions.

Sequentially, Canadian revenue increased 32% as activity improved seasonally from extremely low levels in Q2, and the Canadian rig count has continued to lag 2006 levels due to ongoing deterioration in economics for natural gas producers. [With] Latin America, its revenue was up 26% year-over-year compared to a 9% growth in the rig count.

D&E was up 40%, 44% year-on-year and that was led by INTEQ's, excuse me, share gains in Brazil, where revenue was nearly doubled by strong revenue growth also at Baker Atlas.

Our C&P segment was up 15% year-on-year led by Baker Oil Tools and Baker Petrolite. Latin America revenue was up 10% sequentially compared to a 1% increase in the rig count. But the D&E sequential revenue gains were led by INTEQ and for C&P sequential revenue gains were led Centrilift and BOT.

Revenue to the Europe, Africa, Russia, Caspian region was up 25% year-on-year and 4% sequentially. In Europe, D&E was up 15% that was led by Baker Atlas and INTEQ in the North Sea and C&P was up 25% year-on-year and that was led by Baker Oil Tools, which was up significantly also in the North Sea. Sequentially D&E was off 9% due primarily to project delays in UK sector while C&P was flat.

In Africa, revenues were up 15% year-on-year doubling the change in the rig count. D&E was down 2% primarily as the result of lower revenue from Nigeria and C&P was up 42% year-on-year led by Baker Oil Tools. Sequentially, Africa revenue was up 4%.

In Russia and the Caspian, revenue was up 58% year-on-year with double-digit contributions from every division. Sequentially, revenues increased 27%. D&E's, INTEQ and C&P's Baker Petrolite and Baker Oil Tools led the sequential and year-over-year improvement.

Russia, excluding Sakhalin Island was up 109% year-on-year. If you recall in late 2005, we highlighted Russia an area a focus for Baker Hughes when we were not happy with the time. We said that due to this dissatisfaction that we had to do something for our growth and performance. We laid out a plan to aggressively grow our share in what we consider a very important market.

We installed seasoned management and we made substantial investments in the country. Today, I am pleased to say that each of our divisions is performing well, and we are well positioned to capture additional business in the years to come.

The Middle East and Asia-Pac revenue was up 17% year-on-year compared to a rig count which was up 9%, and the Middle East revenues were up 11% over the same quarter last year and a 9% increase in the rig count and that was led by the impact in Hughes Christensen.

Revenue for the Asia-Pacific region increased 24% year-on-year. D&E was up 21% led by Baker Atlas and INTEQ and C&P was up 30% and that was led by Baker Oil Tools and Centrilift.

With that, I will now turn the call over to Rod, who is going to address the segment and division operational highlights for the quarter. Rod?

Rod Clark

Thanks Chad, and good morning. As Chad said, third quarter revenue was $2.68 billion up $368 million or 16% compared to the same quarter last year, and up $140 million or 6% sequentially. Revenue for the Drilling and Evaluation segment was up 13% year-on-year and up 6% sequentially.

D&E's operating margin in the third quarter was 26.5% up 80 basis points from the second quarter and essentially flat for the year-ago quarter. Within D&E, Hughes Christensen continues to have the highest operating margin. Hughes Christensen's operating margin decreased slightly from the third quarter of '06, but increased sequentially as Canadian activity and profitability recovered from Q2 lows.

INTEQ's operating margin decreased compared to both third quarter of '06 and the second quarter of '07 due to delay of high margin work in the UK and lower activity in Nigeria.

INTEQ continues to have the second highest operating margin in the company. Baker Atlas operating margin improved both sequentially and year-on-year due to activity increases and strong incrementals from international markets.

Baker Hughes Drilling Fluids operating margin rebounded sequentially due principally to improve product mix resulting from increased deepwater rig activity in the Gulf of Mexico. The division operated on seven deepwater rigs in Q3 up from two rigs in the second quarter.

Incremental margins for the D&E segment increased on both the year-on-year and sequential basis with year-on-year incrementals of 25% and sequentially incremental margins of 40%.

Baker Atlas is throwing off nice returns on recent investments with incrementals both sequentially and year-on-year in excess of 50%.

Turning now to our Completion and Production segment, revenue for the segment was up 20% year-on-year and up 5% from the second quarter. C&P's operating profit was up 20% year-on-year and 8% sequentially.

Baker Oil Tools operating profit margin improved sequentially and year-on-year. A recent third-party survey by Spears & Associates recognized Baker Oil Tools recent market share gains, which are reflected in their 20% year-on-year growth.

Centrilift saw sequential margin improvement in the third quarter driven by revenue growth and good profitability in Canada, Latin America and Asia Pacific. Although, margins improved on a sequential basis, year-on-year margin erosion reflects continued commodity price pressure.

Baker Petrolite's performance remains steady with operating margins in the mid to high teens. C&P's year-over-year incremental margin was 22% and the sequential incremental margin was 35%.

I'll now turn it over to Peter Ragauss. Peter?

Peter Ragauss

Thanks, Rod. On a fully diluted basis, our operating earnings per share from continuing operations were $1.22 for the quarter. There are a number of factors that had an impact on our third quarter results.

The following should help clarify the difference between this quarter and the prior quarter and the same quarter last year.

Bridging sequentially from last quarter is $1.09 at $0.50 with the impact of share repurchases netted against reduced interest income at about $0.03 for the impact of a lower comparative effective tax rate in this quarter.

We tracked about $1.50 for increased compliance-related corporate spending. Finally at $0.11 from operations, we posted 38% incremental profit on a revenue increase of $140 million. This kept us to $1.22 per share we recorded for Q3. The year-over-year from $1.09 we reported in Q3 of 2006 add about $0.01 for the impact of share repurchases netted against reduced interest income reflect about $0.03 for the impact of a higher comparative effective tax rate in this quarter, reflect about $3.50 for increased compliance-related corporate spending.

Finally, at $0.185 from operations, we posted 23% incremental profit on revenue increase of $368 million. This improvement was driven by higher revenue in the US and international markets, partially offset by weaker activity in Canada and includes about $0.04 of price improvement, net of raw material and labor inflation. This kept us to $1.22 per share we reported for Q3.

Our balance sheet just gets stronger. At quarter end, we had cash in short-term investments of $908 million. In comparison, our outstanding debt was just under $1.1 billion. Our long-term debt-to-cap ratio at the end of the third quarter was 15%.

Our primary use of capital continues to be growth in our business through investment in rental tools, manufacturing equipments and global infrastructure.

Our intent is to return cash in excess of our needs to our shareholders. As we disclosed last quarter, our Board authorized a $1 billion addition to our share repurchase program.

During the third quarter, we repurchased 2.3 million shares of common stock at an average price of $80 per share for total of $181 million. At quarter end, we had authorization remaining to repurchase up to $1.1 billion of common stock.

I'll now comment on our guidance for the remainder of 2007. Our outlook for international revenue growth for full year 2007 over 2006 is 20% to 21%. Corporate and other expenses are expected to be between $245 million and $255 million for the year. This implies an increase of around $10 million or about $0.02 per share in compliance related corporate expense in the fourth quarter relative to the third quarter.

While this activity impacts our quarterly results, the attention to compliance and logistics has quickly become an industry-wide issue.

Depreciation and amortization expense is expected to be between $515 million and $525 million for the year. We expect our capital spending for 2007 to be approximately $1.1 billion.

Our tax guidance remains unchanged, 32% to 33% for the fourth quarter and between 32.5% and 33.5% for the year.

Lastly, I want to comment on our year-on-year incremental margins. Last quarter, we said we were not satisfied with our margin performance. Our Q3 results show that we have clearly made progress. We expect this trend to continue with year-over-year incremental margins improving to around 25% in the near-term.

I'll now turn it back over to, Chad.

Chad Deaton

All right. Thank you, Peter. And closing our comments on our outlook. Our industry is going to continue to be challenged to meet projections for worldwide oil and natural gas demand without some kind of increase in spending and order supports the higher exploration and development activity.

We're going to continue to invest in growth in our international markets, to provide our customers with the best technology and of course the execution for their projects that they have outlined.

The near-term outlook for North America activity is less clear. The rig count in Canada has recovered from low levels in the second quarter, however, there is no clear catalyst in sight to accelerate activity and the Canadian producers continue to be hindered by less favorable economics for natural gas.

While US land activity has been sustained at a high level, growth in US land rig count is effectively stalled due to concerns over the continued build in natural gas inventories. And we've seen weaker activity in rig counts in the US offshore markets.

With natural gas inventories approaching historically higher levels, the near-term direction for North American natural gas activity will be determined by a number of in-related variables, which includes demand, weather patterns, US and Canadian production volumes, LNG imports, depletion rates, natural gas prices, and of course our clients or the producers are going to respond to all of these changing variables.

As a company, we remain committed to improving our margins and profitability. We have several key initiatives that we've introduced that are intended to enhance profitability. And perhaps the most important of these initiatives is proper investment and deployment of new technology.

Last week I kicked-off our annual Baker Hughes Technology Conference. And once a year, we gather approximately 1250 of our scientists and engineers from our global R&D centers in order to bring them together to exchange ideas, to share technical papers and to identify cost, divisional solutions and opportunities to satisfy many of our customers' top technical challenges.

During the conference, I spent time talking to several of our R&D engineers about the serious technical challenges that our clients face in completing and producing many of the deep extreme high-pressured, high temperature wells that are planned for the Gulf of Mexico and other areas of the world. These wells are going to present technical challenges that our industry has never been faced with before. Temperatures in some wells will approach 500 degrees Fahrenheit, and in other areas wells will exceed bottom-hole pressures of 25,000 PSI.

Traditional metals, elastomers and electronics will not survive in this environment. Especially when you consider that these wells are been in need to be able to produce for 15 to 20 years. Research and new product development in the areas of metallurgy, electronics and metal-to-metal sealing technology will be critical for the successful completion of these wells.

Now, we think it actually bottled-up the excitement and enthusiasm that I saw this last week and be able to share with you, but obviously that's not going to be possible. But what I can tell you is that I can't wait for that confidence, [that conference] is so confident that this is going to be the company that is going to provide the answers to these completions in production challenges.

Of course another initiative is to make sure we improve profitability to not only build these tools, but make sure that we are delivering best-in-class quality and reliability. And make sure we get a fair price for this technology in our well side execution.

And finally, we have initiative to make sure that we manage our cost and improved productivity and efficiency, and this includes keeping a very close watch on the North American cost structure all these next couple of quarters.

We are beginning to see some very positive advancements on our infrastructure spend over these last 18 months. The operation center in Maceio, Brazil open this quarter and in December of this year, we'll open Phase I for our Center for Technology and Innovation, which is there to design and develop some of these high temperature tools, I just talked about. And also in December, we are going to be moving into our Dubai regional headquarters and training facility.

These and the other investments that we are making to position Baker Hughes to benefit from increased E&P spending around the world. The international markets continue to provide strong growth potential and we will staff accordingly. The opportunities continue to look plentiful. We are currently tracking in excess of 10.5 billion of the integrated opportunities for our type of services and products.

And finally, just on a personalized note, I just want to take a minute and recognize Rod Clark. This will be Rod's last call, as he is going to be retiring in January of '08. Rod has made a tremendous contribution to Baker Hughes over these last eight years and I think I can speak for all of 36,000 employees in Baker Hughes that what we are going to miss about Rod. We're going to miss his positive attitude. His great sense of humor, and of course, his insight to this business and we all very much appreciate what you've done for Baker Hughes, Rod.

Rod Clark

Thanks Chad.

Chad Deaton

So, with that Gary, let's open it up for question.

Gary Flaharty

All right. 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 question. Luanne, can we have the first question, please?

Question-and-Answer Session

Operator

Your first question comes from Jim Crandell with Lehman Brothers.

Gary Flaharty

Good morning.

Jim Crandell - Lehman Brothers

Good morning, everyone and Rod congratulations on your retirement. You have done a great job over the years.

Rod Clark

Thank you, Jim.

Jim Crandell - Lehman Brothers

Well, my question is about the revenue side, first on the product line basis and then on a country basis. On a product line basis what I consider to be your three fastest growth divisions showed the lowest quarter-to-quarter growth this past quarter and I think I heard some explanations why that was true with INTEQ. But I was wondering if those three divisions, could you expand on a little bit more? Is it a function of geography, capacity constraints and what if anything should we read into it?

Chad Deaton

Well, you mentioned INTEQ. I assume you are probably talking of Baker Oil Tools for another one and Hughes Christensen or Atlas?

Jim Crandell - Lehman Brothers

Yes, Atlas, your three lowest growth ones this quarter on the revenue side I would have thought, at least I think speculate they should be your three fastest ones.

Chad Deaton

Yeah. Well, INTEQ had to do some shift in the UK. I mean, there are just some project delays and other things. And also Nigeria, obviously some issues going on in Nigeria. Logistics issues, getting tools in and other things which all has been taken place there in the news over the last while. Elsewhere, INTEQ was up very solidly in Latin America, that Brazil continues to ramp up. I think we're 48% share there now and over 50 years we would continue to ramp. So, I don't see any issue in INTEQ that has been any concerned on quarter-to-quarter.

Atlas, North America we mentioned in the last second quarter we had lost some share in North America and Atlas in the third quarter did very nicely, the Gulf of Mexico got back quite a bit. In fact, it was up significantly in the US sector.

If you look at Atlas year-on-year outside North America it's growing in excess of 30% year-on-year. So, as Rod said in his comments, we've paid a lot of attention to Atlas over these last year, year and a half. We've put in some significant investments and we're quite pleased with where Atlas is going in that area.

And Baker Oil Tools, again, year-on-year is up over 20%, which globally you look at that was our biggest growth area. Outside North America, year-on-year it was up 30%. So, this is sequential 2%. Again, we get a big shipment of $40 million and it makes the next quarter look great.

And actually if you go back over the last three years, Jim, this is the first third quarter that showed sequential gain out of four years. In the previous three years Baker Oil Tools always had a third quarter that showed a drop in the second quarter. So, I think and as Rod said, BOT just recently speared the show that they are gaining market share. So, we've kind of turned the corner and showing it going up. So, we are happy with the results we are getting out of all three of those.

Jim Crandell - Lehman Brothers

Okay. Thank you, and my follow up is though a geographical question. Chad, with both Russia and Saudi now surging into the $500 million to $600 million revenue range for you, what kind of growth here from these levels, you expect out of those countries in '08 and maybe '09.

Chad Deaton

I don't see anything stopping Russia and its really Russian/CIS, (inaudible) group that. But, I don't see anything stopping Russia. We're this quarter 109% in Russia over a year ago and we continue to see good success with our Russian clients. They are really taking to technology.

Saudi, obviously, is reaching its 130 rigs and Manifa has not been awarded yet, Manifa will have some effect on Hughes data, obviously, but there is still going to be a lot of activity in Saudi. I don't think we're going to see -- nobody will see the growth that they've seen in '05 and early '06 in Saudi's as they went from 35 rigs to 130 rigs. But, Saudi is going to be a good, steady revenue generator. Saudi will probably in time look more like a UK, Norway, little better in terms of growth, but not like Russia.

Jim Crandell - Lehman Brothers

Got you. Okay, thank you very much.

Chad Deaton

You bet.

Operator

Your next question comes Bill Herbert with Simmons & Company

Bill Herbert - Simmons & Company

Thanks, good morning Guys.

Chad Deaton

Hi, Bill.

Peter Ragauss

Hi, Bill.

Bill Herbert - Simmons & Company

Chad, continuing with the international refrain. In 2008, and again, I have recognized that you haven't completed your budgeting process what have your. But, conceptually sort of paint a roadmap for us with respect to which international markets, not for the industry, but for Baker Hughes look to demonstrate the greatest rate of change?

Rod Clark

Our '08 over '07?

Bill Herbert - Simmons & Company

Yes, sir.

Rod Clark

Well, I think.

Bill Herbert - Simmons & Company

And that would be positive way of change.

Chad Deaton

I think there is some interesting things in Venezuela just starting Latin America, could be some potential there depending on what happens in Venezuela. Mexico is going to show some real activity. We are not strong in Mexico as you all know, but we've been spending a lot of time and discussing and they clearly want us in there right now. Brazil is going to be strong again in '08. We should, we're seeing in Brazil, which is really encouraging as that, it was an INTEQ driver that won that contract. But we are seeing nice gains in our sister companies on the pull through.

Bill Herbert - Simmons & Company

And when you say strong again, that means demonstrating the same rate of year-over-year rev?

Chad Deaton

Well, I don't how much. We're up 62% in Brazil, year-on-year.

Bill Herbert - Simmons & Company

Okay.

Chad Deaton

It's going to be 62% probably not [above] it.

Bill Herbert - Simmons & Company

Sure.

Chad Deaton

I think Libya, we are up 45%, Libya year-on-year. Libya is starting to get a little full on some competition but we did have a big market share there and the clients are accepting us there with some open arms. So, I think we have an opportunity in Libya.

Bill Herbert - Simmons & Company

Right.

Chad Deaton

I think Algeria will do well. Russia, we talked about, I don't see anything stopping Russia. I think that will probably be still one of our strongest growth areas. And the good thing is there, it is a very big area, lot of potential there. I think Egypt we will show that it's going to have potential for next year. Kuwait is getting better. I think Malaysia is still going to be strong, but again we are up 83%, Malaysia year-on-year. So, it's going to be little hard to match that. I think we'll probably see some countries that are just starting to pop up, that could be good that we need to watch. We did not have necessarily a good year in Indonesia and usually these things sometimes swing back and forth. So, we could be better in Indonesia next year.

Bill Herbert - Simmons & Company

So, it sounds like a combination of continued strong rates of growth in some countries where you have been both performing well and a couple of notable examples such as Mexico, which could be big wonders as well for you.

Rod Clark

Yeah. And then India is another one that I failed to mention but India has got some good potential too.

Bill Herbert - Simmons & Company

Okay. And then secondly, and then I am done the comment on the incrementals approaching 25% near-term, define near-term? And then secondly, on that front in an environment, I mean, none of us know what's going to happen in North America but in an environment of stagnating drilling activity, as a potential scenario for 2008 and perhaps, the leading pricing in that environment, is it realistic to expect overall incrementals to expand in that environment?

Rod Clark

Well, first, 25% is near-term is, next quarter.

Bill Herbert - Simmons & Company

Good.

Rod Clark

And in terms of expanding incrementals, I think it's going to be difficult for North America to do that.

Bill Herbert - Simmons & Company

Right.

Rod Clark

And I think what we have to do is, like we said in the prepared remarks, I think what we have to do in North America it's still a very good market to stabilize at a high level. We just have to watch our costs.

Chad Deaton

And then internationally, we got to, there we have the opportunity to continue to work on incrementals and continue to improve those blended and that's why we are saying 25%.

Bill Herbert - Simmons & Company

Okay, great. Thank you very much.

Chad Deaton

All right.

Operator

Your next question comes from Ken Sill with Credit Suisse.

Ken Sill - Credit Suisse

Yeah, good morning guys.

Chad Deaton

Good morning, Ken.

Ken Sill - Credit Suisse

I do believe my congratulations towards Rod also. On those incrementals just looking at it, the 21% growth internationally is kind of in line with what we were expecting kind of a notable lack of guidance on North America in this short run. Could you kind of walk through how that's going to play out sequentially anyway in the Gulf of Mexico and on shore where, on shore seems stable? Gulf, you had some evacuations but you guys were surprisingly strong there, how are you thinking North America is placed at Q3, Q4?

Rod Clark

Land, well North America let's split it. So Canada, we show Canada to be a little better in Q4 than Q3, but clearly not as -- not where it was a year ago Q4 and Canada we don't see as we said any real catalyst there again things come back, I don't see it and well into 2008, what's going on up there. US land I think it seems kind of stabilized where the rig count level is today. It's holding in there I think that will continue, through the quarter.

We are starting to see a few rigs comeback in active into the fourth quarter in the Gulf. And you know these things, they finish drilling and switch over and sometimes it's your rig and sometimes it's not. We did well in the third quarter in the Gulf. We are very happy with our results there considering whatever was going on there and we think we should do okay again in the fourth quarter in the Gulf, but its not going jump back up to the same rig count that was on the second quarter.

Ken Sill - Credit Suisse

Okay, and then following up on the incremental margins, 25% blended for this quarter with a little bit of top line growth looks like the [street] might be a bit high where they are on estimates but I guess the key here is this international build out and international infrastructure going in should eventually start leading to much higher international incrementals as the revenues flow through.

I don't want to kind of get ahead of the game, but could you give us kind of your expectation for how incremental margins play out as we move through '08?

Chad Deaton

Yeah. Like I said, we see that we have room to improve our international incrementals in the other three regions as we go thorough '08. So, we know that's going to be the push to get those up to offset flat growth in a very big market like North America.

You made the comment about revenue and revenue growth versus others and where we are. It's all over the map, when you start talking about what revenue growth is going to be for next year and it's anywhere from -- I heard one competitor say, mid to upper teens, and I heard another one say 40%. And so, we have to just look at where we think we are going to grow in which countries. I mean, you take Denmark, UK and Norway and we do more in those three countries in a year, when one of our competitors does in the entire Europe, West African CIS countries.

So, obviously, UK, Norway and Denmark, it's not going to grow 30% or 40%. They grew this year at about 16% to 17%. And that does blend obviously with the countries that I talked about where we grow 80% or 90%, in Russia and et cetera. So, you blend all that. You look at it globally and that's where 23% growth on a quarter and we break it down by country and look at it. We are pretty comfortable with what we see in response from our people.

Ken Sill - Credit Suisse

And I understand that it's easier to grow from a smaller base and that seems to clearly be happening with some of the companies not named Schlumberger. But should we expect in our models to be seeing any kind of dramatic expansion and incremental margins as you move through '08 and some of this infrastructure in CapEx starts translating into earnings. Where do you think it's going to be more of a steady progression on incremental margin improvement internationally?

Chad Deaton

I think it's going to be a steady progression, Jim, because we are not done investing. We continue to see, like I said, we are chasing $10.5 billion worth of contracts and opportunities around the world, and where we have made our choices to move in like Brazil, like India, like Saudi, these areas over the last couple or three years. We are very happy with what we see in our market share that we are getting there. And we still think we have other opportunities to do the same thing. So, we want to just have a continued improvement in incremental margins around the world and just keep margins grow over there.

Ken Sill - Credit Suisse

Okay. And then I just wanted to confirm what Jim had said that, what is Russian there on an annual run-rate for Baker, price wise?

Chad Deaton

Russia itself is $400 million.

Ken Sill - Credit Suisse

$400, like what you would call the CIS?

Chad Deaton

No, we exclude Sakhalin because we will manage that out of our Asia Pacific region for logistic reasons.

Ken Sill - Credit Suisse

Okay. All right. Thank you.

Operator

Your next question comes from Dan Pickering with Tudor Pickering.

Dan Pickering - Tudor Pickering

Good morning, guys.

Chad Deaton

Hey, Dan.

Dan Pickering - Tudor Pickering

Chad, you mentioned the $10.5 billion in backlog and I just was hoping for some perspective where that would have been six months ago. I mean, is that number increasing and I assume Manifa will be in those numbers?

Chad Deaton

Manifa would have been in both numbers. And you are right, it is increasing. Dan, I don't know the number. But we just had a review from our integrated group the other day and that's the highest number we've seen from the previous quarter. I can't remember what the number was. I think $8 billion or something like that. But, yeah, it's increasing.

I think one of the things that we are seeing out there clearly is that there are some very big packages that three years ago, these things weren't happening. So, the international clients were tending to go to big packages for longer term duration. And it's like Brazil last year, and what we are just saying in Manifa, and what's going on in Norway, Statoil heat drill the Angola project. Those are in Mexico. And so, you just start adding those up around the world and it gives you some pretty good visibility what's out there.

Dan Pickering - Tudor Pickering

Chad, are those projects kind of an integrated projected management type of opportunities, where the customer is asking for basically a big company to come in and provide almost a turnkey result? Or are these product line-specific opportunities?

Chad Deaton

There are a couple of places where it's a turnkey. But for the most part, it's more of an integrated, we don't like to use the word bundling, but a group of your service is coming together and providing that. That's most of it. In Mexico, as obviously you are involved in trying to build locations and roads. But that's really the exception. Most other places, you are seeing and where they want you to do more logistics and bring more of your services in, like Manifa.

I mean, I think Manifa is a perfect example. It's not truly a project management, where you are building roads and managing rig and doing everything else. You're responsible for your side of the logistics.

Dan Pickering - Tudor Pickering

Okay. My follow up would be, I mean, we're getting close to '08. Now clearly, you are going through your budgeting process. As you look at your spending in '07, it's probably going to be about $1.1 billion. Lots of big international projects out the there, how are you thinking about '08 capital spending?

Chad Deaton

Well, you're right, Dan. We are just going into the process. What I'll tell you, and we'll come back obviously when we get it pen down, when we hear from the divisions and regions around the world. But you can expect that we will spend $200 million to $250 million again next year on infrastructure spend.

So, these are the things we are going to be couple of hundred million this year and a lot of this overlaps and keeps going. And then, we are probably going to be similar to where we were this year and give-or-take some depending on what we see as we roll all this up. It's hard to say because Angola itself, is over $1 billion project and if you win that, you obviously going to need more tools and et cetera, so it's the difference from what I think it was two to three years ago, where you just kind of looked at individual jobs and put your CapEx together and now you could win a big job, it's $1 billion and that changes things.

Dan Pickering - Tudor Pickering

Okay, thank you. And Rod, congrats enjoy your retirement.

Rod Clark

Thank a lot Dan.

Chad Deaton

He is already in shorts and he's got his golf club ready.

Dan Pickering - Tudor Pickering

I like it.

Rod Clark

I still want strokes from you though.

Dan Pickering - Tudor Pickering

No way.

Operator

Next question comes from Ole Slorer with Morgan Stanley.

Ole Slorer - Morgan Stanley

Thank you very much. I wonder whether you could walk us through some of the improvements that you have done at Baker Oil Tools in terms of the bottlenecking the manufacturing over the past 12 months, and sort of where you stand right now in context of having the available capacity for the next two years for the deep water expansion?

Chad Deaton

Yeah, Rod you want to take that one?

Rod Clark

Yeah. We are really happy with what's happened here since we hit the headwinds of our capacity constraints beginning in Q4 last year. We've increased capacity about 20% over last year at this time, Ole. We have mentioned before in conference calls that de-bottlenecking the machine tools here in Houston, the East Kilbride expansion, screen plant going into the meet region. But the affect of this is to couple of things one our lead times are being drawn down as we hit into the backlog and decompress the load on our manufacturing infrastructure.

And secondly, to free up a little bit of flexibility. But we are right now at 90% capacity utilization which gives you enough flexibility to start capturing some high margin short-term, one-off type opportunities that we see in the market. So, we are at that stage now, where we are able to have a little bit more maneuvering room, which we didn't have three quarters ago.

Ole Slorer - Morgan Stanley

Good. Is there more capacity to come on? If you are looking at 90% utilization right now and the border expansion of 70, 80, 90 rigs, and top of that 166 you are running with right now. Do you have the capacity to?

Rod Clark

We are not adding capacity that will significantly move that needle. But the margin, yes or especially needs new products, some high-tech areas that we need some special machining, de-bottlenecking but no big material capacity adds underway.

Ole Slorer - Morgan Stanley

Okay.

Chad Deaton

We will be opening the new manufacturing facility in Dubai, probably first quarter of next year and also we are adding capacity in Saudi, which will relieve some of the screen capacity problems in the US and Europe. So, that's quite a bit of square footage coming on in '08.

Rod Clark

But that's not speculative. We have very sound visibility on the sand control needs of the customer base.

Ole Slorer - Morgan Stanley

And if you were to walk through the same story on INTEQ and Baker Atlas, two other divisions that had some capacity utilization type issues. Where do you stand on those two now? In terms of the reengineering of the INTEQ tools that you've mentioned in the previous conference call, as well as next generation logging tool for Baker Atlas and training?

Chad Deaton

INTEQ providing building tools, we are not getting a crunch on INTEQ for tools. We said last call that in second quarter we had $10 million maintenance thing, that worked its way through or exactly where we said we would be, so that's not an issue for us. Continuing to build new tools because there's quite a demand for some of the high-end inventory tools, so we will continue that will be something you'll see well into next year, continuing to build those tools.

I think probably where we are a little tight right now and its good news it is in the Atlas area. Atlas as I said we're very happy with the way Atlas is growing internationally and the good news is we probably going to have to build some more tools for them, because they are like I said year-on-year roughly over 30%. So, you'll see that in our 2008 CapEx.

Ole Slorer - Morgan Stanley

Okay, well. Thank you very much.

Operator

Your next question comes from Michael LaMotte with JP Morgan

Michael LaMotte - JP Morgan

Thanks guys. I wanted to just follow up on this incremental margin guidance for second and historically I guess you've always targeted low 30s percent, now we are talking 25%. I am wondering is that still a function of the build out on the international side, or is that sort of building in some conservatism for potential price weakness in North America going forward?

Rod Clark

I think it's more of the former. We still feel pretty good about price generally, we're still on an up tick on price. It's not quite as accelerating, quite as fast as it was. As Chad mentioned earlier, it's pretty flat in North America but internationally we are still picking over contracts that are two and three years old and renewing those generally speaking. So there's still positive price momentum globally and when we are still doing the build out internationally in $200 million to $215 million, those are pretty big numbers for Baker Hughes those are numbers you have never seen before.

Michael LaMotte - JP Morgan

Yeah.

Rod Clark

So, it's more the build out really and obviously we are not getting the same price increases we did a year ago, which contributed to 30% and 40% incrementals. So, that plays into factor that, but it's more than build out I'd say.

Michael LaMotte - JP Morgan

In Centrilift, specifically, on the margins, I am kind of curious this is the fastest top-line growth that we have seen in that business in three years. If you look at '07 year-to-date and yet margins are still under pressure, what's the challenge there in terms of getting the inflation put through in price increase in that business.

Chad Deaton

You just hit it right on the head, Michael, we got to push, we got to get the price up. Lead is up 38% sequentially. We've had issues with copper, that's up very high in nickel. We have not been able to, whereas in INTEQ and some of the others, we have been able to push through the price better and though we haven't had the same success at Centrilift.

Encouragingly, we actually see on the C&P side, Baker Petrolite and Centrilift actually seeing some of our better price improvement that we saw in this last quarter. They haven't pushed as hard as the D&E side, obviously on price, over the last year, year and a half and the clients were little more receptive. So, hopefully we'll be able claw some of this back as we go though the next couple three quartets.

Michael LaMotte - JP Morgan

Is there a backlog lag effect? I mean in terms of sort of a new order price today versus what's flown to the P&L in Q3? So, is deltas there that are potentially meaningful?

Rod Clark

The lead time through our manufacturing facilities at Centrilift are not significant enough really too make that a meaningful consideration in your model.

Michael LaMotte - JP Morgan

Okay.

Rod Clark

That is to some extent, but its not huge.

Michael LaMotte - JP Morgan

Okay, great. And then lastly, Chad appetite for M&A at this point?

Chad Deaton

Well, its getting better. We've, obviously as Peter said, we have a very strong balance sheet. We do have monitor in place now, that's been here three or four months. That actually helps us in terms of getting comfort in terms of what we can do as we look forward to make some acquisition. So, yeah, I think it's getting better for us. We don't have any big on horizon. But, I think we are in much better shape than we were a year ago and that we would be able to look.

Michael LaMotte - JP Morgan

Still thinking reservoir and international as the priorities?

Chad Deaton

Yes, in technology.

Michael LaMotte - JP Morgan

Thank you.

Operator

Your next question comes from Ben Dell with Bernstein.

Ben Dell - Bernstein

Hi, guys.

Chad Deaton

Hi, Ben.

Rod Clark

Morning, Ben.

Ben Dell - Bernstein

I had a couple of questions, first was around Canada, obviously, the changes announced last night. I was wondering if you had any initial thoughts. It looks as though from my perspective the gas changes aren't as bad as people are expecting.

Chad Deaton

I think they are not as bad, whether they are sort of 2 billion and dropped it to 1.4 billion or whatever else, it's still bad. We've been talking to a few of our clients, senior level, and we haven't talked to them obviously since this slight reduction the 2 billion to 1.4 billion. But, basically, what we heard is any type of changes not going to go down favorably with them with the conditions in Canada. So, I don't think that's going to help Canada. I think even that's going to still make Canada pretty week for the next several quarters.

Ben Dell - Bernstein

Okay. And your comments on South America, you didn't mention Argentina. Obviously, there is the elections going on there and there has been a gradual increase in the gas price. Are you seeing any pickup in activity as that sort of coming through?

Chad Deaton

No. In fact, Argentina, there was a strike down there this last quarter which affected us. Argentina was actually down for us for the quarter. I think some of the other competitors had several issues that they have reported. I think one of the issues with Argentina is, they are not actually able to sell their gas or their oil with the price that is on the market. And plus the labor costs are gone out of sight, not only for our people, but the service companies which provide the service to the clients as well.

So, its kind of both sides crashing towards the middle. And I think until they get some of that worked out, Argentina is going to be a little slow. I think it's got great potential. That you would go down and you talk to the clients they are very excited about doing something. They know that the country knows they need the gas and the oil, but I think politically right now it's not going to move until something changes or operation is not going to move until something changes politically.

Ben Dell - Bernstein

Okay. And then just lastly on your CapEx levels in '08, can you give us some indication of what the number will be in terms of the infrastructure spend in '08?

Chad Deaton

You can use between $200 million and $250 million.

Ben Dell - Bernstein

Okay, great. Thank you very much.

Operator

Your next question comes from Robin Shoemaker with Bear Stearns.

Robin Shoemaker - Bear Stearns

Yes, thank you. Chad, I wanted to ask about something you have discussed previously, if you could update us. You have talked about the cost of hiring and training new employees in all divisions and the time lag between that and the revenue generation that comes from that eventually. And these all relates to the kind of incremental margin questions you keep getting asked. Can you describe how that works, again, and where your greatest successes and greatest challenges are on the hiring and training front kind of by geography?

Chad Deaton

Okay. Well again it's depending on product line, it's much different. In Drilling Fluids you can hire an engineer or a new person and have him out on the rig -- basic rig in four months. On Atlas and INTEQ, you are really looking at 18 months by the time you get him out and then it's a very basic rig. We use Brazil for example 10 deepwater rigs, we're getting better but we still have a lot of overlap at year end of the contract and we probably still have some overlap till the next few months, but we'll rotate those the [expats] with the experiences we brought on, these 200 and some Brazilians and that will help bring our costs in line, which therefore helps improve our margins. Doing things like drilling the Maceio base, now we can repair all those tools, level three down in Brazil and not bring them back to Louisiana for repair, so that works on it.

In terms of geographically where we haven't success hiring, really we don't have a problem anywhere being able to find engineers and people a little harder in the US and Europe because then I think lot of it this the Oil industry as not as exciting as you find in the Middle East or in Russia and other places, so its easy to attract engineers and people enter this industry in China and various other places. We don't have trouble, in summary I guess, I'd say we don't have trouble finding and hiring good people. It just it takes sometime to make sure you get him up to speed and get him out of the door so that you can continue to perform and execute on the clients well. Lastly, as you guys well know, you've heard us say, we net -- we hired 8,000 people netted 5,500 people and lot of those have been rolling out and going out on the jobs and [grow] it.

This year, year-to-date we are about 1,350 or 1,400 people we hired, so we have a little less overhead costs, training as we go through the next couple of quarters, but if we win a couple of these big contracts, we going to be right back into going out and hiring some additional people.

Robin Shoemaker - Bear Stearns

Okay, good also I may have another question, could you update us on cash again in Caspian projects?

Chad Deaton

No [either], I mean it's, it's been a little flat I mean obviously they are trying to work through all other issues over there and we hear some favorable things recently that appears that they may have come to some agreement but it's been basically flat for us over there.

Robin Shoemaker - Bear Stearns

Okay. Thank you.

Gary Flaharty

Okay. Thanks Robin. Luanne at this point do we take one final question please?

Operator

Certainly, sir your last question comes from Geoff Kieburtz with Citi.

Geoff Kieburtz – Citi

Thanks for letting me on.

Chad Deaton

Good morning Geoff.

Geoff Kieburtz – Citi

Good morning. And I am going to be really boring and go back to incremental margin questions again. Just so I am understanding this right now near-term target 25% incremental margins we have segment margins of already 24.2% in the most recent quarter so we are not really looking right now for a big bump up in overall operating margin. Is that correct?

Rod Clark

Well, we said near-term we wanted to get to 25%. We define near-term as -- last quarter.

Geoff Kieburtz – Citi

Okay.

Rod Clark

In long-term we said that we want to continue to push. We haven't given up on our 30% incrementals but as a company but with North America in flat it's been flat for quite some time now. And there's a little bit of pressure in North America on pricing and other things then this is going to be a 30.

We obviously have to carry that in the other three regions and we think that there's potential to continue to improve margins in those three regions and it's going to be hard to hold decent incrementals in North America.

So we haven't given up on that as a number, Geoff. We just said in the near-term, we went from 17% in Q2 to 23% in Q3 and we are saying we wanted to get at least 25% in Q4 and then continue to improve again.

Geoff Kieburtz - Citi

That's helpful I wasn't intending to be critical. I'm just sort of trying to understand whether you're pushing toward 30% incremental goal is kind of a 12 month horizon or is more like a 36 month kind of your target that you're looking at, given that I think we're all pretty much on the same page, North America is going to be a drag one way or the other. It's going to flat or maybe even be a negative contributor?

Chad Deaton

With out a doubt in fact you look around there were quite a few decrementals in North America. I mean we were lucky this time and it swings from quarter-to-quarter, but we have very strong incrementals in North America. But North America is going to be a drag there is no doubt to the whole industry. The good in this is to drag it to very high levels still a very, very good business.

Geoff Kieburtz - Citi

I guess but can you make progress from the 25% level you hope to get to in the fourth quarter towards that 30% level long-term, given what you kind of looks like the'08 outlook is, for right now? And what I'm thinking about is you have different incrementals in different lines of business you got the initiatives underway in terms of your cost efficiency and so on so forth.

And I think Peter said that you are still getting some net price gains internationally. Are we being unrealistic to think that you can move those incrementals up in that environment in '08?

Chad Deaton

I would rather let us get through our budgeting process over this next month and a half. Right now what we're doing is trying to hear what our clients are going to do around the world. And then we also have to factor in, there has been some significant changes taking place over the last few months in the world. You have heard people talk about logistics et cetera, some of these projects are probably -- could possibly be delayed. Getting tools and equipment into some of these countries now, that could slow something down. Right now, we just need to roll these numbers up, Geoff. Look at it outside, try to factor-in, in which projects that we think we're going to win. Take some bets on that, and then I think we can come back with a better answer for you.

Geoff Kieburtz - Citi

Okay. And just related to that, has the logistics become the bottleneck at distributing capacity. Because a year ago, I would have thought that there was a supply chain itself that was getting the equipment, seemed to be you happen to make capital commitments 12 plus months ahead of time. That seems to have been a constraint that's relaxed. But now logistics sounds like, it has maybe become the bigger bottleneck in terms of expanding capacity. Is that correct?

Rod Clark

I think in logistics we are talking about customs clearance and some other things that are talking place out there.

Geoff Kieburtz - Citi

Right. That's what I meant.

Rod Clark

Yeah.

Geoff Kieburtz - Citi

Rather than getting the equipment manufactured.

Rod Clark

Yeah. It's not going to be a shortage of equipment I think for the service sector or for us. We are not getting that manufactured. I think it's more of it. I think what's happening is, this industry is changing significantly. We've been through, as you all know, quite a bit over these last few years, and now it's popping up in a lot of places. And I mean, one good thing, we have lived through it. And like I said, we got a team in place, we have got our controls in place and we've been able to try to work through some of these issues.

So, I just think that the whole industry now is being facing some of these challenges and it's going to slow some things down in certain countries and that's why I think everybody was trying to get a hand on it now.

Geoff Kieburtz - Citi

Great. Thank you and since on the question, Rod, I would also like to say congratulations and good luck.

Rod Clark

Thanks, Geoff. Let's do another ball game. Okay.

Gary Flaharty

All right. Thank you, Geoff and thank you, Chad, Rod and Peter. We'll take this opportunity to thank everyone, all of 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 questions you may have. So, once again, thank you for your participation.

Operator

Thank you for participating in today's Baker Hughes Incorporated conference call. This call will be available for replay beginning at 11:30 am Eastern, 10:30 Central and will available through 6 'O clock pm Eastern Time on Friday, November 9th, 2007. The conference ID number for the replay is 15866175. Again, the conference ID number for the replay is 15866175. The number to dial for the replay is 800-642-1687 in the US or 706-645-9291 International. That's 800-642-1687 in the US or 706-645-9291 International.

Thank you. You may now disconnect.

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Source: Baker Hughes Q3 2007 Earnings Call Transcript
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