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Dresser Rand Group Inc. (NYSE:DRC)

Q3 2007 Earnings Call

October 31, 2007 8:30 AM ET

Executives

Blaise Derrico - IR Director

Vince Volpe - President, CEO

Mark Baldwin - CFO

Analysts

Geoff Kieburtz - Citigroup

Ole Slorer - Morgan Stanley

Kevin Pollard – JP Morgan

James West - Lehman Brothers

Robin Shoemaker - Bear Stearns

David Anderson - UBS

Roger Read - Natexis Bleichroeder

Thad Vayda - Stifel Nicolaus

Glenn Primack - Broadview Advisors

Operator

Good morning, ladies and gentlemen and welcome to the Dresser-Rand third quarter 2007 earnings conference call. (Operator Instructions) I will now turn the conference over to Blaise Derrico, Director of Investor Relations.

Blaise Derrico

Good morning, all. This call is open to the public. It is being webcast simultaneously at www.Dresser-Rand.com and will be temporary archived for replay. A copy of the news release we issued yesterday is available our website, as are the slides we will be using today during our presentation. We will let you know when to advance the slides as we deliver our prepared remarks.

Please turn to slide 2. The statements made during this conference call that are not historical facts may be forward-looking statements. Forward-looking statements involve risks and uncertainties that may cause actual results or events to differ materially from those expressed or implied in such statements.

In addition, this conference call contains time-sensitive information that reflects management's best judgment only as of the date of the live call. Dresser-Rand does not undertake any ongoing obligation, other than that imposed by law, to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after this call.

Further information concerning issues that could materially affect forward-looking statements, including our financial performance, can be found in Dresser-Rand's periodic filings with the SEC.

Now, I will turn the call over to Vince Volpe, President and CEO.

Vince Volpe

Good morning. Thank you for joining us today and welcome to Dresser-Rand's earnings conference call. With me today are Mark Baldwin, our Chief Financial Officer; and Blaise Derrico, Director of Investor Relations. Today, I will start with a few opening comments and Mark will follow me with a detailed discussion of our third quarter results.

Please turn to slide 3. Our net income for the third quarter was about $21 million or $0.25 per share. Consistent with our prerelease on October 3, there are two items which affected our third quarter results.

First, the work stoppage at our Painted Post facility in New York State reduced our net income by approximately $13 million after tax, or $0.15 per share. On August 3, 2007, the represented employees at our Painted Post facility in New York State imposed a work stoppage as a result of our being unsuccessful in reaching a new agreement.

As the work stoppage persists, we continue to execute successfully our contingency plan. This plan includes a complement of temporary workers, augmented by newly hired permanent workers, employees from the union who have chosen to return to work, and extended subcontracting. As the number of temporary workers declines, our costs will reduce to the point that should the work stoppage persists through 2008, we believe the results for the year will not be materially impacted.

The second item which affected our third quarter results was that aftermarket parts sales did not recover as quickly as had been previously forecast. This was principally due to the continuing slow pace of orders from two national oil company clients. Recently, we've begun to see signs of recovery. I will have more to say about this situation in a moment.

Please turn to slide 4. As to other third quarter performance metrics, I will mention a few. Sales increased 25% compared to the corresponding period last year. Bookings were 3% higher than last year's third quarter. Our backlog grew 48% to a record level of approximately $1.7 billion. Our operating income was $36 million, including the impact of Painted Post work stoppage, which we estimate reduced our operating income in the quarter by about $20 million and margins by about 400 basis points. Our operating cash flow for the first nine months of the year was $188 million, which was more than double that of the corresponding nine-month period last year.

We are also pleased to report on a couple of other positive developments that occurred earlier this month of October. Next slide, please. First, we signed an alliance agreement with Repsol YPF, one of the world's ten largest private oil enterprises. Repsol has operations in 29 countries with the bulk of its assets located in Spain and Argentina. The agreement covers sales of all Dresser-Rand products and services. We estimate the value of the agreement over the next two years of be approximately $100 million.

Under this alliance agreement, we have been awarded an order in August for the Tarragona refinery worth approximately $13 million, and in October, we secured two orders valued at approximately $20 million for the Petronor expansion at the Bilbao, Spain refinery.

Repsol's planned refinery expansion reflects the continued strength of the refinery market globally, particularly as it relates to expansion in the European sector. There are more planned refinery projects where we believe we are well positioned to supply mission-critical rotating equipment.

Next slide, please. Second, in October we booked an order in excess of $46 million for compression equipment to be supplied on an offshore platform in Asia Pacific. We will supply two DATUM turbo compressor trains for export gas and pipeline service. This is continued evidence of the strength in the new unit market for upstream Over the past 12 months, bookings for projects in the upstream market have represented nearly a third of our total bookings for all markets.

Next slide, please. Total bookings for the last 12 months were approximately $2.1 billion or 26% higher than the same period a year ago and 60% higher than two years ago. Approximately 50% of our bookings in the last year were for downstream applications, principally in refining. New unit bookings were especially strong and totaled $1.3 billion, an increase of 46% compared to the 12 months ended September 30, 2006. Aftermarket bookings were up 4%.

As previously mentioned, aftermarket bookings in 2007 have been temporarily impacted by changes in the procurement process and the delay in budget appropriations for certain national oil company clients.

Turn to our next slide, please. The bar chart in the upper left-hand corner of this slide shows the bookings trends for the two national oil company clients that have slowed their order patterns due to process changes. As you can see, bookings for the first nine months of 2007 were approximately $43 million lower than the corresponding period in 2006.

As previously reported, at one of the national oil companies which we've labeled NOCA, budget issues have impacted their ability to place orders. At the other, which we've labeled NOCB, process changes have increased the time from request for quotation to purchase order from weeks to months, due to the additional approvals that are now required and the additional office locations involved in the process.

At the time of our second quarter conference call, we had said that we expected to see both national oil companies return to more normal booking and shipment levels. While this was not the case, bookings for these two national oil companies started to improve in the third quarter, totaling about $20 million, up from $14 million in the first half of the year, so we have seen some recovery in the order trend. We continue to believe that these shortfalls in aftermarket bookings involving these two national oil companies are just timing delays and not lost market share.

The bar chart in the lower lefthand corner of this slide shows bookings for the first nine months of 2007 compared to the corresponding period in 2006, excluding the two national oil company clients. The point of this bar chart is that if you were to adjust for these two clients, bookings for all other clients are actually up 8% year over year.

Turn to slide 9, please. We do have some good news concerning one of these national oil company clients. We're currently negotiating a three-year blanket purchase agreement initially valued at approximately $50 million. The agreement would cover all aftermarket parts and services and would help streamline transacting business. We expect to sign the agreement this quarter. In light of these developments, we believe that aftermarket sales shortfall will be at least partially recovered in the fourth quarter.

Turn to slide 10, please. Our backlog at the end of September was at a record level of $1.7 billion or 48% higher than the year earlier period and 101% higher than two years ago.

Breaking it down into our two business segments, new unit backlog of $1.5 billion is up 62% versus a year ago, and the aftermarket backlog is up about 4% to $294 million. Our strong backlog gives us very good momentum going into the fourth quarter and next year. I will have more to say about outlook in a moment.

First, I'd like to turn the our call over to Mark Baldwin for some more details about our third quarter financial results.

Mark Baldwin

Thank you, Vince, and good morning, everyone. Please turn to slide 11. Sales for the third quarter of 2007 of $389 million were about 25% higher than the third quarter of 2006. New unit sales of $194 million were higher than the third quarter of '06 by about $80 million, reflecting the shipment of a few large orders, including turbo compressors installed on a large FPSO vessel.

Aftermarket sales of $195 million or essentially flat with the corresponding period last year. Sales were lower than what we had anticipated earlier in the quarter, due in part to the slower than expected pace of orders from two of our national oil company clients, as Vince has recently discussed.

Turn to the next slide, please. As Vince mentioned earlier, we reported net income for the third quarter of $21 million or $0.25 per diluted share. However, as you can see on this slide, if you were to adjust our GAAP net income for the estimated impact of the Painted Post work stoppage, adjusted non-GAAP net income would have been approximately $34 million or $0.40 per diluted share.

Turn to Slide 13, please. Operating income for the third quarter of 2007 was $36 million, including the impact of the work stoppage, which we estimate reduced operating income by approximately $20 million.

There are two components of this estimated $20 million impact. First, there are higher costs of approximately $10 million, which principally relates to the use of temporary replacement workers. Second, we estimate that there was about $10 million of margin related to sales that have been deferred.

As you can see on this slide, if you were to adjust our operating income for the impact of the work stoppage, adjusted non-GAAP operating income would have been approximately $56 million compared to $48 million for the corresponding period in '06.

Turn to slide 14, please. Again, if you were to adjust for the impact of the work stoppage, the adjusted non-GAAP operating margin of 13.3% compares to 15.6% for the corresponding period in '06. This 230 basis point decrease was principally due to lower margin new units representing a higher portion of total revenues in '07 compared to '06. New unit revenues increased to nearly 50% of total revenues compared to only 37% in 2006.

Next slide, please. Our new unit operating margin decreased nearly 380 basis points to 6.2%. The decrease in operating margin was principally attributable to the work stoppage at the Painted Post facility, which we estimate reduced margins by approximately 300 to 350 basis points.

Next slide, please. Our aftermarket operating margin decreased 430 basis points to 22.1%. The decrease in the segment's operating margin was primarily attributable to the impact of the work stoppage at the Painted Post facility, which we estimate reduced margins by approximately 400 to 450 basis points.

Turn to Slide 17, please. In August of 2007, we amended our revolving credit facility. The amendment increased the size of the facility by $150 million to $500 million. It lowered the borrowing costs 50 basis points, and extended the maturity date by approximately three years.

At the end of the third quarter, our liquidity was approximately $491 million and consisted of about $184 million in cash and $307 million of available borrowings under our bank credit arrangements.

Next slide, please. Net cash provided by operating activities for the first nine months of the year was about $188 million. This compares to $92 million in the first nine months of '06. The increase of approximately $96 million was principally from favorable changes in working capital and higher operating earnings.

With respect to the working capital changes, the change in accounts receivable since year-end provided cash of approximately $77 million in the first nine months of 2007, compared to $44 million in the first nine months of 2006. Inventories, net of progress payments, grew $53 million in the period as our business continued to grow. Inventories grew nearly $43 million in the first nine months of '06. Customer advances increased approximately $72 million in the period, compared to an increase of approximately $12 million in the first nine months of 2006.

Turn to Slide 19, please. As you can see on this slide, net working capital has been reduced by more than $100 million to a negative number over the past 12 months, despite higher business volume. This improvement in our net working capital reflects our diligence in collecting progress payments and advances from customers, consistent with the terms of our contracts. The timing of billing and collection of these advances has improved. For example, the sum of progress payments and customer advances increased to 94% of our gross inventory value at the end of September of '07, compared to 74% at the end of '06.

Next slide, please. While we anticipate sustaining some level of this improvement in net working capital, quarterly fluctuations in our business may at some point drive us back to the 5% of sales target in the future, depending upon the growth and timing of new unit bookings. As you can see on this slide, net working capital in the range of 5% of sales is a more normal level for our business.

Next slide, please. In terms of investing activities, we used approximately $18 million of cash for the first nine months of '07, $10 million for capital expenditures and $8 million for the acquisition of the Gimpel valve business in April. This compares to investing activities using $13 million in the first nine months of '06 for capital expenditures. We also used $140 million of cash in the first nine months of 2007, principally to pay down long-term debt.

Turn to slide 22, please. You can see on this slide the significant reduction in our total debt. Since the end of 2004, we've reduced total debt by a little more than $450 million. Next slide, please. We ended the third quarter with a net debt to capital ratio of approximately 17%, and net debt to our last 12 months' adjusted EBITDA was less than 1 times.

As you know, our growth strategy includes acquisitions. While we have nothing to report at this time, we are continuously evaluating potential targets. For more information about our results for the third quarter, please refer to our 10-Q which we filed last night with the SEC.

With that, I will now turn the call back to Vince for some closing comments and to moderate our Q&A session.

Vince Volpe

Thank you, Mark. Turn to slide 24, please. I will wrap up our prepared remarks with a few comments about our business outlook. Demand for our products and services continues to be strong. Our backlog is extended into 2008 with more than $1.1 billion of our September 30, 2007 backlog scheduled to ship beyond this year.

As for our earnings outlook, we expect the fourth quarter operating income to be in the range of $85 million to $105 million, including a potential curtailment gain of between $8 million and $12 million. We currently estimate that the impact of the work stoppage on fourth quarter results will be approximately three-quarters of the third quarter impact. This is due to ongoing reduction in our dependence on the relatively high cost temporary work force due to hiring of permanent replacement workers and extended subcontracting.

With respect to earnings per share in the fourth quarter, we currently estimate that it will be in the range of $0.58 to $0.73 per share. This assumes interest expense of approximately $8 million and an effective tax rate of 36.5%. These fourth quarter results should bring the full year 2007 operating income to a range of $205 million to $225 million, including the curtailment gain of $8 million to $12 million.

The curtailment gain would essentially offset certain other unusual charges recorded this year of approximately $10.2 million, including a provision for the Maersk litigation, service unit expenses, and workers' compensation expenses related to previous years' payment information provided to us by Ingersoll-Rand earlier this year.

Turn to the next slide, please. As to our outlook for 2008, we currently expect significant improvement compared to 2007. While we have not completed our 2008 plan, our current thinking is that consolidated revenues should increase on a percentage basis by 15% to 20%. New unit revenues should increase on a percentage basis by 25% to 30%. Consistent with previous guidance, operating margins should be in the low double-digit percent of sales.

Aftermarket revenues should increase on a percentage basis by high single-digits, consistent with the growth we've experienced in the aftermarket over the past six years. Operating income should increase approximately 40% over 2007 operating income guidance range of $205 million to $225 million, reflecting the continuing benefit of operating leverage, cost control and no material impact of the work stoppage, should it continue into next year.

Interest expense is expected to be approximately $32 million. We are now estimating our effective tax rate for 2008 to be approximately 35% to 36%. Finally, diluted shares outstanding are expected to be approximately $86 million.

Next slide, please. As mentioned during my opening remarks, I will now comment on the status of the work stoppage at our Painted Post facility in New York. We are into the 13th week of the work stoppage involving approximately 400 represented employees. Since work stoppage commenced on August 4, 2007 the parties have met on several occasions with the assistance of a federal mediator from the United States Federal Mediation and Conciliation Service, and there has been virtually no change in either parties' pre-strike position on any of the major areas of disagreement which lead to the work stoppage.

As a result, we've been implementing a contingency plan which includes hiring permanent replacement workers, substantially increasing subcontracting of components and parts, and reducing costs associated with the work stoppage. Our contingency plan, though somewhat higher in cost than originally planned is, we believe, working effectively as designed. As to the current status of the plan, we currently have working in the plant approximately 180 temporary replacement workers consisting of skilled machinists, assemblers and support personnel provided through a firm that specializes in replacement workers during strikes.

We've begun the process of hiring permanent replacements. The number of permanent replacements and bargaining unit employees who have chosen to return to work currently stands at 75. Additionally, another 25 applicants have been offered employment and are expected to begin training in early November, bringing the total in-plant permanent work force to approximately 100. We expect to further increase the permanent replacement workers with continuous recruiting. Throughout this recruiting process, we've maintained a strict adherence to our high quality standards for new employees. Those standards are focused on safety, quality, professional behavior, productivity and customer responsiveness.

We continue to extend subcontracting to our supply base with agreements being negotiated. Currently, we've subcontracting approximately 35% of our labor hours. By year end 2007, we estimate that the supply chain will have replaced the work of approximately 150 people.

We are producing products to our high-quality standards and have met most of our new unit delivery commitments to date. Production capacity will ramp up as we continue to execute our contingency plan and increasingly shift from temporary employees supplied by the replacement company to permanent replacements and short-term subcontracting to long-term supply chain agreements for the purpose of shortening delivery cycle times.

In the event that the work stoppage continues into 2008, our current best view is that over time, we will turn to our pre-strike cost levels and therefore, we do not expect a material impact on our full year results.

Before we open this to question-and-answer, I will take a moment to put the Painted Post situation into perspective. For many years, the legacy contract language and benefits in Painted Post have increasingly diverged from what has occurred in mainstream corporate America and indeed within most of Dresser-Rand.

Said differently, over the past several years, the management and union negotiating teams have not dealt proactively with the changes necessary for an improved operation needed for long-term, global growth. During the past two years, the company has attempted to work with the union to effect the appropriate changes in a way that would be win-win for both employees and the company, including an offer to avoid the necessary strike preparation and split the savings among the employees in the form of a bonus for everyone. The union rejected this and all other suggestions we made.

This company is not seeking a contract which creates the lowest-cost labor force in the industry. If we were, we would have made the decision to vacate our principal places of manufacturing in New York State. In fact, it could be argued that we should be spending money and resources on doing just that rather than enduring this strike.

The fact is, however, that with an improved, modern contract, we believe that we can compete effectively as a company, make strong returns for our shareholders, and maintain a significant manufacturing footprint here in the United States. We will persist in implementing the needed changes in all of our facilities.

Last year, we negotiated two competitive contracts: one in our Wellsville, New York facility and one in out Burlington, Iowa facility. These contracts contained a great deal of change. As a result, over the past year we have launched significant investments in both facilities, including added manufacturing capacity and investing in new equipment.

The Burlington, Iowa plant has increased its employment by 12%, and the company is making new investments in the facility. In Wellsville, we have moved new products into the plant and increased the workforce by almost 40%, from 285 when the contract was settled to over 400 folks today.

While the increased workload has brought its share of challenges, our employees are focused on improving these operations for the long term. This is a good example of what is still possible in the United States with a modern, effective, efficient and forward-looking working labor contract.

We continue to be firm in our commitment to achieve the changes identified for Painted Post and for all of our facilities to operate effectively in today's global business environment. We believe we're doing the right thing for our shareholders, for our employees, for our customers, and for the communities in which we do business.

Thank you for your attention. At this point, we will open the line for questions.

Question-and-Answer Session

Operator

Your first question comes from Geoff Kieburtz - Citigroup.

Geoff Kieburtz - Citigroup

Could you explain a little bit the other income line in the results today?

Mark Baldwin

Other income for the third quarter was $5.6 million. $5.2 million of that is the gains we had on our cash that is held in affiliates offshore. The weak dollar creates a gain when we're holding that cash offshore. Almost all of that $5.6 million is the result of currency gains.

Geoff Kieburtz - Citigroup

As a consequence, not really something we could forecast very effectively?

Mark Baldwin

If you can forecast the dollar, you can, Geoff.

Vince Volpe

Let us know how that goes, Geoff. That's why we normally focus our comments on the operating income line.

Geoff Kieburtz - Citigroup

But a little seriously, if the dollar were to weaken in future periods by a similar amount to what it did this past period, is this the kind of impact we can expect?

Mark Baldwin

Geoff, we are actually looking at trying to bring some more of that money home, despite the prognosis that the dollar may weaken more. So, I would not expect, even if the dollar were to continue this decline, to have that. We do want to bring more of it home. We are a dollar-based company and if the dollar does get stronger, it could go the other way. There are accounting implications to that, Treasury implications to that. I don't want to get into that at this point in time.

Geoff Kieburtz - Citigroup

On the fourth quarter guidance of $85 million to $105 million operating profit, if I understood you correctly, Vince, that's inclusive of $8 million to $12 million in FAS 106 gains?

Vince Volpe

Correct.

Geoff Kieburtz - Citigroup

So if we excluded that effect, because it didn't sound from your comments that that was a really high probability scenario, correct?

Vince Volpe

No, we believe that we will incur that gain this quarter, Geoff.

Geoff Kieburtz - Citigroup

Oh, you do?

Vince Volpe

Yes, but we're not 100% sure, and so we want to make sure that we keep it on everyone's screen so that if it does move out, we will let you know and you'll understand the effect of that.

Geoff Kieburtz - Citigroup

My original question was, if we took the gain out of the picture, should we interpret the guidance as $85 million to $93 million of operating profit?

Vince Volpe

That sounds like the right math.

Geoff Kieburtz - Citigroup

What triggers the FAS 106 gain?

Vince Volpe

There's a long answer to that. It is complex and I can't speculate on all the different pieces of it, but as I said before, we believe that is something that will occur in Q4.

Geoff Kieburtz - Citigroup

I think I heard you say that in your '08 outlook you continue to believe that new unit margins should be in the low double-digits. Is that correct?

Vince Volpe

Yes. We've been saying this for the last couple of years, Geoff, that we thought we would get to high single-digits this year and then crossover in 2008 into the low double-digit range. That looks now, with a lot of our backlog now in place that looks like the case. I think even on the last quarter call, I alluded to the fact that we would have more information for you on this call because we just have a better view on our backlog next year.

Geoff Kieburtz - Citigroup

That's really what's driving it, is pricing improvement in the backlog?

Vince Volpe

Yes, There are three things that go on, so however you do the math, the way that it fundamentally works out is we try and focus our material gains on offsetting inflation, material productivity gains, which allows the pricing to flow through.

Geoff Kieburtz - Citigroup

You mentioned a couple of contract wins there, on the Repsol contract specifically. Could you tell us how much of that is incremental business from Repsol, and how does it breakdown between aftermarket and new unit?

Vince Volpe

This is mostly new units. What we've booked so far is mostly new units, all but probably about $3 million we think would be new units. Now, the way to think about Repsol is this is terrific for us. Repsol has been a good customer in the past but they just haven't been all that active, and so you've been from one year to the next on the new unit side, in a zero to $10 million mode. Maybe there was a year where it was more but on average I would say it was probably less than $10 million. So now, you can see that there's a significant step up in terms of what we've already booked.

Now, just to be clear on this, we booked that first tranche in August of about $13 million. That's actually steam turbine business, so that is in our backlog as you look at 9/30. The other about $20 million, we booked this month of October, so you actually haven't seen it show up yet. That is for the turbo compressor business and reciprocating compressor business.

By the way, reciprocating compressor is that will be built at Painted Post.

Geoff Kieburtz - Citigroup

You do expect $100 million of orders over two years?

Vince Volpe

Correct, that's correct.

Operator

Your next question comes from Ole Slorer - Morgan Stanley.

Ole Slorer - Morgan Stanley

Just going back on the fourth quarter guidance again, so if I understand you correctly, we take out the gain from the high end, the loss from the low end to get to a gain-free guidance. That would imply a midpoint in that type of guidance in the low 60s per share, versus current expectations of 58, so marginally ahead. Would that be the right way to look at it?

Mark Baldwin

The right way to look at I, the operating income guidance was $85 million to $105 million with the curtailment gain. If you take the midpoint of that curtailment gain, the operating income would be $75 million to $95 million. Then just work down.

Ole Slorer - Morgan Stanley

Sorry, I misunderstood your previous comment. So on that basis, the midpoint in the guidance, excluding the curtailment gain, is the same as the First Call estimate, right?

Mark Baldwin

I'm not sure what the First Call number is right now. I am talking operating income, Ole.

Ole Slorer - Morgan Stanley

But translate that through to EPS.

Mark Baldwin

Then that is what it works out to, because the operating income guidance, without the curtailment gain, is $75 million to $95 million.

Ole Slorer - Morgan Stanley

So you knock off the midpoint in the operating income.

Mark Baldwin

And with all the other guidance, that should give you the right EPS. I have not done that math though.

Ole Slorer - Morgan Stanley

I think it works out at 59 or so, above expectations. So looking at the $10 million of deferred revenues, up to $20 million, when would we expect to recover that? Is that all coming back in the fourth quarter, or is some of that also delayed beyond that?

Vince Volpe

Well, I think the way to look at it, Ole, is a fair amount of it is going to come back, okay? In total, whether it all comes back from the Painted Post piece or whatever or it's because of the aftermarket increase in the bookings and our oil company clients, if you look at the total year, if you adjust for the strike, you will see that we are getting pretty darned close on a total year guidance to what was sort of at the low end of our range but pretty darned close to the range that we originally provided at the beginning of the year. That should give you a sense that a significant portion, we believe, of the aftermarket shortfall will actually be recovered.

As far as the curtailment gain, by the way, I want to just make sure everybody thinks about this over the course of the year. It's logical for you to make a fourth quarter adjustment of that, but let's not lose sight of the fact that we had about $10.4 million of extraordinary costs in the beginning of the year related to the Maersk litigation from 1998, the workers' comp claim from Ingersoll-Rand which dates back a couple years, and then the exit units, the service units that were part of selling the last tranche of stock to the public markets.

When you add those three things together, you get about $10.4 million, I think, or $10.2 million. You can sort of use that as you think about the curtailment gain which comes back in the other direction and just forget about any adjustments certainly on a full-year basis.

Ole Slorer - Morgan Stanley

I just wanted to understand the math behind it. Looking into next year on your guidance, pretty punchy numbers there in terms of revenues on the new unit side. Can you talk a little bit about the type of pricing power that you think you have, given that you are seeing strong demand from all of your end user areas?

Vince Volpe

Ole, this is not the first time you've asked me the question.

Ole Slorer - Morgan Stanley

Every quarter I suppose. As long as you have 4% or 5% margins net of D&A, then I will continue to ask that question.

Vince Volpe

Yes, it's a fair question. I think it will continue to roll along at the same trajectory we've seen it over the past couple of years. It's a gradual thing in our business because we strive to push pricing from one job to the next, not just on a yearly basis.

Ole Slorer - Morgan Stanley

You're still doing that with all the stuff you are delivering in '08/'09?

Vince Volpe

Yes, you will see continued expansion in the margins.

Ole Slorer - Morgan Stanley

Same rate, 200 basis points?

Vince Volpe

Again, we haven't given you specific numbers at this point. What we've said is we will be in that low double-digit return on sales number for units next year.

Operator

Your next question comes from Kevin Pollard – JP Morgan.

Kevin Pollard - JP Morgan

I had a couple of questions around your new units. First of all, if I look at your ending backlog of a little over $1.4 billion and your number of a little over $1.1 billion that is supposed to ship in '08 and beyond, can I infer from that that you're looking for a big number close to $300 million in the fourth quarter?

Vince Volpe

Yes.

Kevin Pollard - JP Morgan

Quite a bit scheduled to ship there. Then if I look at what's left, relative to go out in '08 and beyond, assume a 14-month lead time. It seems like the revenue guidance up 25% to 30%, while very good for sure, it actually seems a little conservative. Can you walk me through your thinking there?

Vince Volpe

Well, I think there's two pieces of it, Kevin. One is we talked 14 to 16 months is what we've been saying, but there is an issue of mix in there. If you get a couple of projects that have extended testing, full load, full pressure testing, Class 1 type testing, those will extend out beyond that timeframe just because of the testing requirements.

So we give you broad guidance of 14 to 16 months but the actual number moves around depending on the mix of business. So we have taken the actual mix of business that we have. We have obviously more visibility than you do, so we don't need to just use statistics. We actually look at our backlog and looked at the delivery dates, and we think that 25% to 30% is a fairly good number.

All that being said, I would not say, at this point in time, we would be looking to overstate that growth either, though.

Kevin Pollard - JP Morgan

Let me just ask the question this way then. If you experience continued, strong bookings in the early first half of '08, it's certainly possible that number could prove to be conservative.

Vince Volpe

Yes, but unlikely because what happens is by the time you're into '08, anything you're booking that's got a fairly short cycle time, nine months or less, is probably pretty small: single-stage turbines, high-speed separable resets, and they don't really amount to that much in terms of revenue. Any of the big stuff that's going to move the needle in terms of the top line is going to be into '09.

Kevin Pollard - JP Morgan

It seems like I recall the last conference call you said you expected second half of '07 bookings on the new unit side to be in the $500 million to $600 million range. Obviously, you're on track based on what you saw in Q3. Do you still think you are there again in Q4?

Vince Volpe

Yes, I do.

Kevin Pollard - JP Morgan

So, a similar level of bookings?

Vince Volpe

Yes.

Kevin Pollard - JP Morgan

If I can switch over to the strike just will quickly, you've done it sounds like a really good job of replacing a lot of the striking workers and outsourcing. If the strike were to end in before year-end, how do you deal with the 400 striking employees plus the 100 new permanent workers, especially in light of the fact that you've outsourced 150 jobs? How does that all play together?

Vince Volpe

Well, there's a couple of pieces to this. First of all, the people the we've hired as permanent replacement workers stay because we hired them as permanent replacement workers and so, they stay. So that's the first tranche.

The variables that we have, then are what's left. Also, we look at what has been subcontracted. The subcontracting piece, and this is sort of a subtlety that I don't always do a good job making. There's subcontracting and then there's outsourcing, okay? When you make a decision that you're going to outsource something and put it out of the facility forever -- theoretically forever -- you go and you sign long-term supply agreements and that work basically never comes back.

The subcontracting piece you have some flexibility on and so some portion of that, we're going to look at the workforce. We will bring the best performers back first. When we think that we've got the right mix of continued outsourcing and subcontracting and the right mix of good, high-performance employees, then that's what we will do.

The short story is that at this juncture in time, unfortunately there is little expectation that all 400 folks that are out are going to come back.

Kevin Pollard - JP Morgan

In terms of the guidance that you've given on the margin side, does that assume that the strike ends and the new cost structure is in place or would there be some potential upside as that strike gets resolved?

Vince Volpe

Well, I'm not sure that there's much the of a swing either way, I think we would save a little cost. But let me just first of all say one other thing in terms of the answer that I've provided you. What I should have started with is that we have a very clear understanding of the legal requirements around what we've done so far. In fact, our chief negotiator is a labor attorney, okay? So we are very focused on making sure that not only do we do the ethical thing but we also strictly follow the legal requirements in terms of evaluating how and how many folks to bring back.

Now, far as the strike is concerned, if we were to settle -- which based on what has happened so far, I've got to tell you is unlikely -- but if we were to settle here miraculously short term, say by the end of the year, and we were able to bring everybody back, there would basically be some cost avoidance around the temporary workforce that we have today.

The temp workers are the once that are most expensive, the ones that we've hired through this outside firm. So that might make a change, but it's really not going to move the needle that much one way or another, which is why we basically represented that we don't think that there's going to be any real material cost impact on 2008.

What will be different is how we get the work done. So, I wouldn't look for too much upside any more than we're looking for much downside, if it doesn't get resolved.

Operator

Your next question comes from James West - Lehman Brothers.

James West - Lehman Brothers

When we think about the replacement workers and particularly the new 25 that you've made offers to and that will enter training here shortly, how long is the training process? Should we be concerned about, I guess, new labor entering your facilities that weren't union people coming back?

Vince Volpe

Well, a couple of good questions all embedded in that one. First of all, first and foremost, nobody will come into this facility without the proper safety training, (a). (b)The kind of people that we're hiring from the outside are people that have the aptitude or the experience already to do what our folks that were there were doing. We have about a four-week training period, after which we expect these people to be productive.

James, depending on who they are, their level of productivity could go from 50% or 100%, or some other number, from zero to 100%, I guess. What we will see is, in some cases, people after the four weeks are pretty much good to go. In other cases, it will ramp up a little bit more slowly, but we're not talking about years year, okay?

I mean, I don't mean to minimize what our folks in-house have done for us all these years, but the reality is that if you have the aptitude and you are a trained machinist, you will learn how to machine our type of equipment fairly quickly and you will learn the idiosyncrasies of the machine tool you work on and all those other things.

So, there will be a bit of a ramp-up time, but we've baked all of that into the guidance that we've provided. We've also baked in the running down of the cost, if you will and we've done a significant out of work around this before we represented and continued to represent that. We don't think that the impact should the strike persist will be material on our financial results next year.

James West - Lehman Brothers

Switching gears, you announced back I guess a couple weeks ago that you obtained some technology from TransCanada. Could you provide some more details on that technology, how that gives you a competitive edge and what that could mean for your business?

Vince Volpe

What we have is ejector technology in our gas engine business and so the play here, I think it's fundamentally environmental; some efficiency improvements also. I would say that while we are delighted with that, that is not something singularly that's going to move the needle, James. It's just one of those things we have.

If you think about our growth in the aftermarket over the last six years, we've been growing, even with this year and the problems we've had with those two clients, we're growing about 8% a year. The way you do that is by doing all of the things we talked about before, not the least of which is looking at adding or developing a variety or an array of additional aftermarket retrofits and upgrades. This really falls into that category.

So this is not something that's going to be a line item we're going to report about and say oh, wow, this has moved the needle singularly. It's just another one of a cadre of initiatives that we've launched. This one happens to be through a license agreement. Many of these we actually develop ourselves and then others we think will come to us through acquisitions, which we continue to focus on.

James West - Lehman Brothers

So on the acquisition front, how is the hunt going for additional aftermarket acquisitions?

Vince Volpe

Well, the hunt is on. We have a fair amount of targets and we are at different stages in different discussions right now, so until you get to the end and you have a conclusion on any of these, it's hard to provide too much guidance, but we are working at it copiously, James.

Operator

Your next question comes from Robin Shoemaker - Bear Stearns.

Robin Shoemaker - Bear Stearns

Vince, in the past you've articulated an aftermarket strategy of increasing the aftermarket share on your own equipment, and also getting a larger share of the aftermarket on competitors' equipment. I just wondered what kind of progress you've made on those two fronts?

Vince Volpe

Well, I think the guidance that we provided was we thought we would pick up about another 2 percentage points of share this year on our own equipment, plus or minus, Robin. Then as it relates to the applied technology initiative, which is working on other people's equipment, I don't have the number right here to disclose today but I believe that through the nine months of this year, we've already surpassed the bookings of last year for the full year. So it continues to move along nicely. Last year, we booked $52 million on other people's equipment, so that will frame it for you.

Robin Shoemaker - Bear Stearns

On the new unit backlog, I believe you said one-third was upstream. What percentage is mid and downstream, roughly?

Mark Baldwin

Downstream is about between 45% and 50% and then midstream is a little more than 10%, and we have other, which is fundamentally the government business, which is the high single-digits.

Robin Shoemaker - Bear Stearns

Is it still broken out roughly 50% North America and 50% international?

Vince Volpe

I don't have that number right with me, but I will tell you this early that it may be, but it looks like it's starting to move offshore. I mean, if you look at Repsol going forward, if you look at Repsol as a booking coming in October, that's all for Europe.

By the way, as we look at the Repsol business, so far, we are only talking about Spain where we've had bookings and some other assets, including in South America. So we are excited about that.

For 2006, about half of it was North America and on a trailing 12-month basis, it looks like we are in the low 40% now. So it is moving offshore, Robin.

Robin Shoemaker - Bear Stearns

I think on the last conference call you indicated you thought you might book as much as $100 million of new unit orders for LNG projects in '07. Is that likely or are there some delays you are experiencing there?

Vince Volpe

Well, it looks like the delay, we're starting to experience the delays that we were somewhat concerned about, even from last year. so I think this is probably the right time to say that my view has changed from probably to unlikely booking this year.

The good news is we theoretically don't need them to be booked this year. The other good news is that the projects that we are working on or are engaged in, they haven't been decided and they haven't gone elsewhere. So we are still engaged and we're still waiting, and so that is in the category of probably at this point going to move out into next year.

Operator

Your next question comes from David Anderson - UBS.

David Anderson - UBS

Most of the questions have centered around the new unit side. I just want to ask a couple of questions on your aftermarket. If I look at your guidance for next year, you are showing high single-digit growth for aftermarket revenue. It looks like growth has been moderating there over the last couple of years. Can you just articulate maybe a little bit more as to what's going on there? Is there some sort of trend in here that I'm not quite understanding?

I know you talked about the NOCs and the impact. I assume that you're taking that into account there, and so I guess if you could walk me through how you get to that guidance, and also what kind of upside you might be looking at there?

Vince Volpe

First of all, I think the aftermarket business was flat from 1990 to 2000; compound annual growth rate flat; 0.4% I think was the number. But even inside of those periods, you could see fluctuations anywhere plus or minus $50 million. it still would bounce around and that's because we have a lot of clients. We have close to 8,000 or more discreet order numbers or orders coming in for aftermarket. While we don't have 8,000 clients, this is a very decentralized business, so BP doesn't adopt strategy. It could be Texas City buys a bunch of parts but the North Sea doesn't; so there's a lot movement up and down so when we look at forecasting in the aftermarket we've got to do it on statistics.

So if we look at this year and we bake in the bookings numbers, which clearly are flat based on these two NOCs, our view is that we're going to project a compound annual growth rate consistent with what we've achieved from 2000 to 2007 inclusive, where we did start to grow that business in a systemic fashion and we did it by doing some of the things that we've talked about in the past, creating demand, working on other people's equipment, doing a better job our own market share.

At this juncture in time sitting here at the end of Q3, it is impossible to know what each of these clients is going to do in detail. We've opted for going back to what has statistically been our run rate over the last five or six years, Dave. So, could there be upside to that? Yes, there could be but I couldn't speculate what there is.

You know, there could also be downside to it, right, because you can get that much fluctuation. So we feel like the high single-digit number at this point in time, is the most reasonable guidance to give. I really wouldn't shade it one way or another at this point in time.

David Anderson - UBS

A big chunk of that is on the refining side. We've talk about this a little bit in the past. But have you seen any kind of changes in terms of their maintenance schedules? If I read between the lines a little bit, you are expecting them to go back to more of the historical ordering patterns? I mean, have you seen any change from now to when you look to next year compared to over the last couple of years?

Vince Volpe

Dave, not a heck of a lot. By the way, from one year to the next, the upstream business can actually provide on a percentage basis, even though we have more units installed in refining, on the upstream side oftentimes there is more extensive aftermarket work being done because you are out on a platform; you are in a non-controlled environment in terms of gas properties.

The gas properties coming out of the well are not aggressive dry gas like what you get when you get in a refined process. So actually, I wouldn't focus on refining aftermarket activity as the only thing that drives the aftermarket.

The other thing is that really with respect to the new unit buying patterns, if you don't overhaul your unit every three years, you're going to be “pay me now or pay me later”. We did see that in the past and I can't remember what year it was anymore, but in the late '90s, people tried that and it really didn't work. Then they had sort of catastrophic failures. So instead of putting $200,000 or $100,000 worth of bearings, seals and consumable parts into a machine, they ran it too far and they wrecked the rotor and they were into six or seven times that number easily.

I really don't see a big change in terms of the buying patterns across the spectrum of the aftermarket, which is why we are pegging it at sort of the traditional growth rate we've seen over the last five to six years.

David Anderson - UBS

Looking at the margins, you were talking about the impact of the strike and the NOCs on the margins in the third quarter. If I add that back in, the margins were quite strong on the third quarter. If I look going towards to '08, I heard your comments of a couple hundred basis point improvement on the new unit side. I'm just wondering. If I add that back in on the third quarter of little bit lower numbers, would you expect all-in operating margins to expand in '08? Can you give me kind of a rough sense of how much you're looking at?

Vince Volpe

I can repeat what I said before. You are right. If you adjust on a full-year basis for the strike, you will get something higher than we are reporting. Now, Mark has done the math for you on Q3 and year-to-date. So you'll get a number that is not far from what you were expecting, Dave, for the year way back when, when we talked about it.

The other thing that I supplied you with today so that people didn't get confused adding stuff in and out, I didn't say it was X amount of basis point improvement year over year because I thought I would confuse everyone. What I said was use low double-digit operating margins for '08.

So I'm kind of getting you right to the answer rather than conjecturing on how many basis point you add to an adjusted or a non-adjusted number. I would just reiterate that guidance hasn't changed for two years. You know, it's what we said we were going to do, folks. We said we're going to get to high single-digits in for the full year of '07 and that we would crossover sort of the magic 10% line into '08 and get stronger margins, low double-digits in '08.

Then the other thing I have once again reconfirmed a couple times is that the pricing continues to be strong and I reaffirmed to Ole on his question that we continue to ramp up. I think you've got enough to triangulate.

David Anderson - UBS

No, I understand, but you're just talking about new units though, right?

Vince Volpe

I'm sorry. Was I not clear?

David Anderson - UBS

No, I was asking for both and I guess I was really asking about the aftermarket, is really what was getting at. Are you expecting expansion in aftermarket margins as well?

Vince Volpe

I think that there should be marginal expansion in the aftermarket, Dave. I think principally because the more units that you put through the factories, and we build the parts in the same factory, you're going to get some help there. So we're not on a big pricing crusade on the aftermarket; we are real happy with our margins. We will press where we can, but what will happen to the margins is basically a benefit of the units being a bigger part of the mix.

Operator

Your next question comes from Roger Read - Natexis Bleichroeder.

Roger Read - Natexis Bleichroeder

I'm just trying to understand, in your further commentary on the Painted Post deal, the $10 million of margin related to deferred sales that didn't come through in the third quarter. Is that new units only, or aftermarket only, or a combination of the two? I'm just trying to understand what might have been the lost revenue in the quarter.

Mark Baldwin

In our Q, you will see that we did take a shot at disclosing that $20 million. We didn't break it down in terms of the deferred sales. Of the $20 million, $11 million to $12 million is in the aftermarket area, and $8 million to $9 million was in the new units. Now again, that includes the cost of the temporary workers and the deferred sales.

Roger Read - Natexis Bleichroeder

So, if I am looking at deferred sales and I assumed a 50-50 split, you're talking about maybe somewhere between a $30 million and $50 million loss of revenue in the quarter, or deferred revenue in the quarter?

Mark Baldwin

I would say that's reasonable, but the lower end of that range, though.

Roger Read - Natexis Bleichroeder

In terms of the process of getting through the strike at Painted Post, whether these guys settle or don't settle, what would be the expectation on getting that $30 million back, and also the expectation of how costs may come out?

I mean Vince, you said from an '08 basis for the full year not a material impact, but clearly you would expect to have a declining but material impact Q1, maybe even Q2 before you would be on maybe a full run rate with whatever settlement you get in the back half of '08?

Vince Volpe

Let me help you understand a little bit the trend here, Roger, and these are legitimate questions. We have not disclosed what I am going to tell you here. We have disclosed about a $20 million impact so far. We said that would be reduced by about 25% in the fourth quarter, so that starts to give you a sense of the size of the problem for the year.

If we look at out-of-pocket costs and deferred costs for the quarter, it was about 50-50. When we look at the fourth quarter that will shift so you're going to see about the same one-time costs between Q3 and Q4. But don't forget, Q3 was only two months of strike; Q4 is three months. So on a per-month basis, that number is starting to come down. So you start to see the one-time ramp down.

On the deferred side, when we look at the loss or the deferred impact, if you will, we think that $10 million will come down by perhaps more than a factor of three. So what that means is you are improving your throughput in terms of the impact on the sales side of the equation already and you can see how the costs are starting to ramp down.

Beginning in the first quarter, Roger, we're going to still have temporary workforce people, and they will ramp down and somewhere in the second quarter I think we probably get to zero. So it will continue to ramp down, but that number is not really a material number when you look at the big picture and everything else we're doing in the business.

So yes, there will be some impact in the first of the year, principally in Q1, due to the temporary work force, and that will ramp down.

Roger Read - Natexis Bleichroeder

Following on some of the questions you guys have had about acquisitions, if you don't find substantial acquisitions, you're paying down a lot of you debt, building some cash here. Vince, how do you ultimately look at the potential for a dividend, share repurchase, something along those lines?

Vince Volpe

Well, I don't think a dividend would be something we would consider at this point in our history. We feel like it may be too early to do that, and fundamentally, what we want to do is reinvest in our business because we think that will give us the greatest shareholder value. Good acquisitions are the best way to do that and another way to do that to create shareholder value is clearly to buy back stock.

So I would now rule that out, Roger. We just haven't gotten to that point yet. No decision has been made and so we need to leave it in limbo now, but I should tell you that it is something we would consider.

Operator

Your next question comes from Thad Vayda - Stifel Nicolaus.

Thad Vayda - Stifel Nicolaus

Just a quick one on these procurement agreements. What level of comfort do you have that there really hasn't been any demand destruction associated with the time it has taken to renegotiate these? I mean, what are the NOCs using now to satisfy their aftermarket requirements?

Vince Volpe

Thad, could you repeat your question, please? The volume was a little low on us, sorry.

Thad Vayda - Stifel Nicolaus

Regarding these procurement agreements with NOCs, what gives you comfort that there has actually not been an element of demand destruction associated with the time it has taken to renegotiate these?

Vince Volpe

I understand the question. Because they need these parts, they are not buying stuff just to have it; they are buying it because they need it. These are aftermarket parts. So it wouldn't be how you think about traditional demand destruction where it gets so expensive to build a facility that the economics are gone. This is equipment that's already running, needs to continue to run. They need these parts; they come to the OEM. That's us. So we believe it's fundamentally a question of timing. They are not going and buying these parts from anybody else.

Thad Vayda - Stifel Nicolaus

That was my question, not demand destruction, just sort of market share loss.

Vince Volpe

Right, right.

Thad Vayda - Stifel Nicolaus

The guidance range for the fourth quarter, what is the single largest variable between the low end and the high end?

Vince Volpe

I would say it's swing in aftermarket sales because that's where most of the margin is. We've got our new unit equipment booked in there. If a unit gets pulled in or gets slipped out, it's not going to matter all that much probably to the overall earnings side. I think we've got to ship our parts into our services work. They are still book-and-ship; we still have to get orders and turn them around and ship them. They're always is in a quarter. What I would say is the levels that we are forecasting are very similar to what we achieved last year. So it looks like doable numbers.

Operator

Your final question comes from Glenn Primack - Broadview Advisors.

Glenn Primack - Broadview Advisors

If we go back to the D-R Avenue project and the growth that you've seen so far in applied technology bookings, do you think as you move out, are you comfortable putting a growth rate on just that piece over the next three to five years? Because it seems like you've made incredible progress and if I look into '08, potentially north of 10% of aftermarket could come from just that Applied Technology piece.

Vince Volpe

obviously internally we do, but we don't put a growth rate, we don't publish a growth rate on Applied Technology, other than to say that we believe we have the organizational structure and that we are continuing to build that structure, by the way, which you'll see. A big part of our SG&A increases have been around building that structure. It's a great investment, though.

Glenn, we're going to continue to drive that business. It wouldn't surprise me for you to be able to draw a straight line through the last couple of points here. You have them already, and we ought to see that kind of growth in applied technology. That will not be enough to continue to grow at the rate that we've indicated, though. We need to also work on our upgrades and retrofit business; we need to look at entering the kind of agreements we have with TCPL on the ejector technology. We have to look at maybe small bolt-on service acquisitions.

I'm comfortable that we can continue to grow at the same rate we have over the last six years or so on an annual average basis in the aftermarket, but it will take more than just applied technology. There will be some years where we do better than that growth rate and others where it may be a little less. I mean, I know it's a steadier business than the new units, but it's still got bumps in it; they are just smaller bumps.

Glenn Primack - Broadview Advisors

Just going back over the past decade where you hovered right around anywhere between $450 million and $500 million, and now it seems like you've got yourself a potential step-up as you look out a few years, so it is a new level of recurring, higher margin revenue.

Vince Volpe

Yes. In fact, I wouldn't even say it's a new level. I think it's a new trajectory. That's the way we think about it, Glenn, to be honest with you. It's not a new plateau that we're going to then oscillate around. We believe that arithmetically going forward, we ought to be able to continue to grow at the same rate we have been growing over the last five or six years, and that's the guidance that we provided for '08.

Blaise Derrico

We're going to wrap up the call. I want to thank everybody for joining us this morning. If you have questions, you can call me. My phone number is shown on the news release that we issued last evening. Everybody have a great day. Thank you.

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Source: Dresser-Rand Group Q3 2007 Earnings Call Transcript
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