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Dresser Rand Group Inc. (NYSE:DRC)

Q4 FY07 Earnings Call

February 27, 2008, 8:30 AM ET

Executives

Stephen A. Riordan - VP - Finance

Vincent R. Volpe Jr. - President and CEO

Mark E. Baldwin - EVP and CFO

Analysts

James West - Lehman Brothers

Kevin G. Pollard - J. P. Morgan Securities Inc.

J. David Anderson - UBS

Geoff Kieburtz - Citigroup

Glenn W. Primack - Broadview

Operator

Good day everyone, welcome to today's Dresser-Rand Fourth Quarter and Year End 2007 Earnings Conference Call. My name is Melissa, and I will be your coordinator for today's call. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference call. [Operator Instructions].

As a reminder, this conference call is being recorded for replay purposes. After Dresser-Rand's comments today, I will instruct you on the procedures for asking your questions. And now at this time, I would like to turn the call over to Mr. Steve Riordan. Please go ahead sir.

Stephen A. Riordan - Vice President of Finance

Thank you Melissa. Good morning. My name is Steve Riordan and I will be sitting in today for Blaise Derrico. This call is open to the public, is being webcast simultaneously at www.dresser-rand.com and will be temporarily archived for reply. A copy of the news release we issued yesterday is available on our web site, as are the slides that we use today during our presentation. We’ll let you know when to advance the slides as we deliver our prepared remarks.

Please turn to slide number 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 Vincent R. Volpe Jr., President and CEO.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Thank you for joining us today, and welcome to Dresser-Rand's earnings conference call. With me are Mark Baldwin, Vice President and Chief Financial Officer and Steve Riordan, our Vice President of Finance. Today, I will start with a few opening comments and Mark will follow with a detailed discussion of the fourth quarter results.

Please turn to slide 3. 2007 was another big year for our company. Much of our continued success is the direct result of the hard work and dedication of approximately 6000 Dresser-Rand employees worldwide. I am proud of our employees and the progress we have made this past year. I will mention a few of the highlights for 2007. Bookings increased 19% to record $2.2 billion and included Applied Technology bookings of $80 million, which is an increase of 54% over 2006. Backlog grew to a record level of $1.9 billion. Revenues increased 11% to $1.7 billion. Operating income increased 12% to $197 million and if adjusted for the impact of the Painted Post strike and certain other unusual items, operating income on a non-GAAP basis would have increased 28% to $241 million. Operating cash flow totaled $216 million. Total debt was reduced by $137 million. The first commercial order for Integrated Compression System or ICS was received. We acquired the Gimpel Valve business, all material weaknesses have now been eliminated and total shareholder returns for the year was 60%. Despite these successes, we also encountered some challenges. More significant of which included a work stoppage at our facility in Painted Post, New York, and a slowdown in aftermarket bookings during the first three quarters of the year.

Please turn to slide 4. As mentioned earlier, GAAP operating income for 2007 was $197.1 million, there were a number of unusual items to reduce the operating income, which on a pro forma basis would have been approximately $241 million. The key differences between GAAP operating income and this pro forma amount are shown on this slide. We estimate that the work stoppage at Painted Post reduced operating income by approximately $34 million, which includes approximately $20 million higher-costs, principally for temporary workers and under absorbed overhead, and $14 million in margin related to deferred sales. Additionally, we incurred several previously disclosed unusual items totaling $10.1 million. Including a litigation expense of $4.4 million to settle a claim for a project that was delivered in 1998 at the time of a plant closure. Service unit expense of $3.4 million associated with the sale by first reserve of its remaining ownership interest in Dresser-Rand and a legacy charge of approximately $2.3 million from the Ingersoll-Rand relating to prior year was workers compensation claims previously administered by them one our behalf.

Please turn to slide 5. At Painted Post, we never wavered in our result to achieve a new contemporary labor agreement. We endured a labor action of nearly 17 weeks, while steadfastly focusing on our objective or uninterrupted service to our clients. The work stoppage has ended and most of the bargaining unit employees have returned to work under the terms of the last offer we made to the union. Although we do not have a signed agreement, we have effectively achieved our objectives. Today, Painted Post is operating at full strength with employment slightly above the pre-strike levels. Going forward, it is our intent to continue to engage in good faith bargaining in the hopes of entering into a collective bargaining agreement with the union.

During the strike, the union filed the 11 unfair labor practice claims seeking a ruling that the strike was an unfair labor practices strike rather than an economic strike. After many months, union negotiating committee made an unconditional offer to return to work under the terms of the expired contract. We did not accept the unions offer and instead engaged in a lockout that lasted less than one week. On November 29th, we implemented the terms of our last offer after reaching impasse in the negotiations. Lifted the lockout once our terms have been implemented and represented employees agreed to an unconditional return to work. On December 21st, Region Three of the National Labor Relations Board informed us that the work stoppage was indeed an economic strike not an unfair labor practice strike as originally alleged by the union negotiating committee.

The unfair labor practice claims were filed to be insufficient to give rise to any company obligation to provide back pay to striking workers. And additionally allowed us to retain newly hired permanent replacement workers. The union has appealed the decision by Region Three of the NLRB and while we do not yet have a decision on the appeal, we continue to believe that we have engaged in good faith and legal bargaining practices throughout this process. After the union’s unconditional offer to return to work, the union on December 31st, 2007 filed additional unfair practice charges, the most significant of which alleged that company prematurely declared impasse and implemented its last offer. We have submitted a response to the NLRB's regional office, which we believe fully addresses the allegations.

We continue to believe we engaged in good faith bargaining and declared impasse legally. While the cost of the work stoppage is estimated to be approximately $34 million. We believe the benefit derived from liberating capacity to more flexible work rules, better productivity and a contemporary healthcare program makes the investment worthwhile. As previously reported, we had expected to be able to record a curtailment gains in connection with the elimination of retiring healthcare benefits for certain future retirees of the painted post facility. It has however been determined that the benefit change is implemented represents a planned amendment. Therefore, the resulting reduction in the recorded obligation of approximately $18.6 million will be amortized income over 36 months beginning in January 2008.

Please turn to slide six. As mentioned earlier, total bookings for 2007 were approximately $2.2 billion or 19% higher from those of 2006. They were also 52% higher than two years ago, approximately 38% of 2007 bookings were for upstream applications, 12% for midstream, 42% for downstream and approximately 8% for applications in general industry in the U.S. Navy. New unit bookings were especially strong and totaled $1.3 billion, an increase of 32% compared to 2006.

Turn to the next slide please. In the fourth quarter, we booked a $44 million order to supply advanced thermal machinery for floating production storage and offloading vessel or FPSO for the Pazflor Field offshore Angola. We're very excited about the floating production market, which is strategically important to Dresser-Rand. This award is representative of the value DATUM technology adds by reducing the weight and footprint of the compression system, as fewer casings are required. It also maximizes gas throughput compared to competitor offerings as a result of the high efficiency of the compressors. We believe ongoing activity and our share in the floating production market will remain strong.

Next slide please. As to the aftermarket segment, bookings in 2007 were up 4.4% compared to 2006. This reflects a considerably lower growth rate than what we had expected going into the year. As previously reported aftermarket bookings have been temporarily impacted by changes in the procurement process and a delay in budget appropriations for certain of our national oil company clients.

Turn to slide 9 please. The good news is that the aftermarket bookings had a strong quarter and recovery in the fourth quarter totaling approximately $265 million, which was some 16% higher than the fourth quarter of 2006. Unfortunately, 45% of the fourth quarter bookings came in December, thus preventing us from shipping within the quarter and moving as closer to the lower end of the range of the guidance previously provided. Let me repeat, approximately 45% of the fourth quarter bookings came in December, thus preventing us shipping within the quarter and moving as closer to the lower end of the range of the guidance previously provided.

Turn to the next slide please. This slide shows the aftermarket bookings trend over the last eight quarters for the two national oil company clients we've been talking about for the past couple of quarters. The dark green bars represent 2006 bookings, which averaged approximately $25 million per quarter. In the first half of 2007, bookings averaged approximately $8 million per quarter, but recovered during the latter half of the year with second half bookings up 280% over the first half of 2007 and fourth quarter bookings up 58% as compared to the fourth quarter of 2006. As previously reported, we signed a $50 million blanket order with PEMEX in December. Moreover, as none of the aftermarket offers orders received in the fourth quarter were booked under this new agreement, the entire facility is still intact and bodes well for 2008 bookings. We continue to expect to achieve high single-digit growth in the aftermarket segment for the foreseeable future.

Turn to slide 11 please. Backlog at the end of December was at a record level of $1.9 billion or 47% higher than the year earlier period and 110% higher than two years ago. Breaking it down into the two business segments, the new unit backlog of $1.5 billion was up 57% versus the year ago and the aftermarket backlog of $316 million was up about 11%. Strong backlog provides for good momentum going into 2008. I will have more to say about the 2008 outlook in a moment but first, I will turn the call over to Mark to review the fourth quarter financial results.

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

Thank you Vince and good morning to everyone. Please turn to slide 12. Sales for the fourth quarter of 2007 was $520 million or approximately 9% higher than year ago level. New unit sales of $273 million were higher than the fourth quarter of '06 by about 24 million or approximately 10%. Aftermarket sales of $247 million were approximately 9% higher than the corresponding period last year. Turn to the next slide please. As Vince mentioned earlier, we reported net income for the fourth quarter of $44 million or $0.51 per diluted common share. However, as you can see on the slide, if you were to adjust GAAP net income the estimated impact of the Painted Post work stoppage, adjusted non-GAAP net income would have been approximately $53 million or $0.61 per diluted share.

Turn to slide 14 please. Operating income for the fourth quarter 2007 was $78 million including the impact of the work stoppage, which we estimate reduced operating income by approximately $14 million. There are two components of this estimated $14 million impact. First, there are higher cost of approximately $10 million which principally relates to the use of temporary replacement workers and under absorbed overheads. And second, we estimate that there was about $4 million in margin related to sales that have been deferred.

As you can see on this slide, if you were to adjust operating income for the impact of the work stoppage, adjusted non-GAAP operating income would have been approximately $92 million compared to $77 million for the corresponding period in 2006. Adjusted for exit unit expense of approximately $7 million. Turn to slide 15 please. Again if you were to adjust for the impact of the work stoppage, the adjusted non-GAAP operating margin of 17.6% compares to 16.2% for 2006, adjusted for exit unit expense.

The 140 basis point increase was principally due to the higher sales as the mix of new units' and aftermarket sales was essentially unchanged. Next slide please? The new unit operating margins decreased nearly 90 basis points from last year's fourth quarter to 8.2%. The decrease in operating margin was principally attributable to the work stoppage at the Painted Post facility, which we estimate reduced margins by approximately 200 to 220 basis points.

Next slide please. Aftermarket operating margin decreased 340 basis points to 28.5%. The decrease in the segments operating margin was principally attributable to the impact of the work stoppage at the Painted Post facility which we estimate reduced margins by approximately 240 to 260 basis points. Turn to slide 18 please. At the end of the fourth quarter, our liquidity was approximately $479 million and consisted of about $206 million of cash and $273 million of available borrowings under our bank's credit arrangements as $227 million was used for outstanding letters of credits.

Next slide, please. Net cash provided by operating activities for 2007 was about $216 million. This compares to $164 million in 2006. The increase of approximately $52 million was principally from favorable changes in working capital and higher operating earnings. Turn to slide 20, please. As you can see on this slide, net working capital has been reduced by more than $60 million to nearly zero over the past 12 months despite higher business volumes. The improvement in the net working capital reflects our diligence in collecting progress payment and advances from customers consistent with the terms of our contract. The timing of billing and collection of these advances has improved. For example, the sum of progress payments and customer advances increased to 95% of our gross inventory value at the end of December '07 compared to 86% at the end of December '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 it back towards the 5% of sales 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 not unusual for our business.

Next slide please. In terms of investing activities, we used approximately $26 million of cash in 2007. This is the net amount comprised of approximately $24 million for capital expenditures and $8 million for the acquisition of Gimpel Valve business partially offset by $6 million of proceeds principally from the sale of our minority investment in a small electric generating facility. Investing activities used $20 million of cash in 2006 for capital expenditures.

For 2008, we anticipate capital expenditures will be approximately 2% to 2.5% of sales. We roughly used a $141 million of cash in 2007 principally to pay our long-term debt.

Turn to slide number 23 please. You can see on this slide the significant reduction in total debt. Since the end of '04, we reduced total debt by a little more than $450 million to $370 million.

Next slide please. We ended the third quarter with a net debt to capital ratio of approximately 14% and net debt to the last 12 months adjusted EBITDA was less than one time. As you know, our growth strategy includes acquisition. While we have nothing to report at this time, we are continuously evaluating potential targets.

Next slide please. Before turning the call back to Vince for some closing remarks, I am pleased to report that we have concluded that the company's internal control over our financial reporting as of December 31st, 2007 was effective. Eliminating all our material weaknesses is a great milestone and reflects the hard work, an excellent team effort of many of our employees across the entire worldwide organization. For more information about our results please refer to our 10-K which we filed last evening with the SEC.

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

Vincent R. Volpe Jr. - President and Chief Executive Officer

Thank you, Mark. Turn to slide number 26 please. I will wrap up our prepared remarks with a few comments about the business outlook. Demand for products and services continues to be strong. Backlog is extended into 2008 with more than 400 million of the December 2007 backlog scheduled to ship beyond this year. In 2008 we expect significant improvement compared to 2007. New unit revenue should increase on a percentage basis by 30% to 40% and consistent with previous guidance, operating margin should be in the low double-digit percent of sales. Aftermarket revenue should increase on a percentage basis by 8% to 10% consistent with growth we've experienced in the aftermarket over the past six years. Consistent with previous guidance, we expect operating income to be in the range of $285 million to $315 million. Interest expense is expected to be approximately $30 million to $32 million. We are now estimating the effective tax rate for 2008 to be approximately 36% and diluted shares outstanding are expected to be approximately $86 million.

Thanks for your attention. At this point we will open the line for questions. Operator, begin the Q&A session.

Question and Answer

Operator

Thank you. The question-and-answer session will be conducted electronically. [Operator Instructions]. And we will take our first question from James West with Lehman Brothers.

James West - Lehman Brothers

Hi. Good morning, guys.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Good morning, James.

James West - Lehman Brothers

Vince, during the quarter you booked pretty solid order for the FPSO at Pazflor. Two questions about that, one what do you estimate as your market share in the FPSO piece of the business and then what should we expect to be the average size of awards of these type of projects going forward?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, I would say without divulging too much change that, let's call it mid 20s in terms of share. Okay.

James West - Lehman Brothers

Okay.

Vincent R. Volpe Jr. - President and Chief Executive Officer

So as good as sort of our general business and I think that that will only get stronger as people focus more on the value proposition like we had on Pazflor where we had fewer casings, okay, than our competitors. The size of the... the size of these opportunities really goes back to the guidance that we provided earlier on a per equivalent barrel basis and so they are going to be all over the map, a range... they ranged anywhere from $20 million per floater up to we saw BP scarp at $154 million, okay. So there really is a wide... there is a wide swing, but it's approximately $200,000 of equipment per million standard cubic foot of gas production. So that's the way I gauge in and I think there is... we're looking at probably a hundred or so of these being contacted over the next, say, five years, whether they can get them all done in five years is another question, but I think if you look at that number and then you sort of figure on an average size it will get you to the math. So let's call it Pazflor is probably right in the middle of the opportunity band. I guess if you are looking for a number to multiplied by another number, Pazflor is probably as highest as any.

James West - Lehman Brothers

Okay. That’s great detail. And then one last question, we just finished up with a work stoppage at your Painted Post facility, which seems to be mostly resolved or at least in the final stages of being resolved. I think your collective bargaining agreement at the Olean facility expires in June. Are there any of the same issues with your bargaining agreement or the negotiations at that facility as they were at Painted Post?

Vincent R. Volpe Jr. - President and Chief Executive Officer

There are some similarities but probably the most marked difference is the tenure of the relationship and what I would say to you is first of all let me just do a little bit of clean-up as far as Painted Post is concerned. I think we've disclosed here that we've got what you would... we have to consider as for NLRB issues that are being dealt with. But as far as the workforce is concerned, I was there last week and they are engaged and excited and we are all very pleased that everyone is back to work. Heads are up and I couldn't be happier. We are back at full strength. Even a little bit higher employment levels than we were before. So, I toured the facility with together in fact with the two ranking union officials who are on site and it was very positive and so I think from an operations stand point or an operating standpoint, we are in better... we are better than ever. And we will let NLRB actions run their course as sort of a separate... a whole separate process if you will and fundamentally being driven by someone who is not even working in our facility to be quite blunt about it. As far as OEM is concerned, our contract is up in June. We have in the past had a very open dialogue, the folks there have not been resistant to change as long as we've been able to convince them that it makes sense and the company equally has always maintained the attitude that we need to negotiate in good faith and bargain in good faith, which we believe we have. And so, there are no guarantees in like [ph] change but I'm guardedly optimistic that we will come through the OEM negotiations with what we both consider... both we and the union, the steel workers consider a successful outcome. That being said. We are taking all the steps that we need to that we have a responsibility to take to be prepared for work stoppage and so if we are confronted with that, we'll deal with it and we will provide uninterrupted service to our clients as we did in the case of Painted Post. And I think one other anecdote again just to come back to Painted Post if I could, about 4 days or 5 days after the work stoppage was over and the folks came back to work. One of our very large international oil company clients had been contemplating for giving us an order and we're concerned about the situation up there. And so, we all went together up to the factory and they were so delighted with the pace of the work what was going on up there, the demeanor of the employees... we spent a full day up there that literally at the end of the day they gave us an order for $12 million. So I think that's probably the best testimonial that you need to just look through some of the white noise you see in the press, what's going on the ground up there is very positive and as I said, I couldn't be happier.

James West - Lehman Brothers

Okay. That's great detail. Thanks Vince.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Thank you.

Operator

We will go next to Kevin Pollard with JPMorgan.

Kevin G. Pollard - J. P. Morgan Securities Inc.

Thanks. Good morning guys.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Good morning, Kevin.

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

Good morning.

Kevin G. Pollard - J. P. Morgan Securities Inc.

I... my first question I guess is with regard to your Q1 guidance the 10% to 12% of full-year operating income on percentage terms, which is in all fairness in the normal range historically if we sort of exclude the strike here. But I'm wondering based on your comments on the aftermarket aside with all the bookings that came so late in the year why that might not push up the higher percentage than normal?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes. That's a very good question. We are on this journey and we're chipping away or trying to make... trying to get 25% of this per quarter. I don't know if we will ever get there but what I can tell you is... the short story is that our sales... total sales will be a higher percentage of the total year in the first quarter of this year compared to first quarter of last year. And so, last year was somewhere around 18%, we'll be North of 20% this year, okay. So in terms of production and the productivity and the throughput of the facilities, we are actually moving closer to our goal not further away from it. That being said, what we have basically Kevin is an issue of mix. We are looking at a modest improvement in the aftermarket but a huge improvement in new units. And so that temporarily or at least for Q1, skews the percentage down a little bit versus what we’ve done in previous years. It really is a mix… it is a mix issue not, that we are not making progress in terms of overall throughput.

Kevin G. Pollard - J. P. Morgan Securities Inc.

Okay. All right. Thanks.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Does that do it for you?

Kevin G. Pollard - J. P. Morgan Securities Inc.

Yes. Actually, that's helpful. Thank you. And if I could switch over to the new unit side, I wanted to talk about the margins a little bit. In the past you've kind of guided us to a 250 basis point, 300 basis point, year-over-year improvement. I am wondering if we sort of take the strike out of the equation in ‘07, you were kind of in that 9% range. Is that... so if we use that as a starting point in '08 as we look forward, what kind of an improvement do you think you can do off of that number, given the pretty significant increase in volumes going through that segment?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, the trend continues Kevin. And so... and the trend being that we sort of press price one day after the next and so we have this continual and gradually sort of sloping up effect. And so what we've guided to... I think we reiterate is, we think we'll get to a low double-digits on new unit margins for the full year. And you should hopefully see steady progress on a year-over-year basis by each quarter, okay.

Kevin G. Pollard - J. P. Morgan Securities Inc.

Okay. And then if I could just ask one last question, your CapEx if I heard you right you said 2% to 2.5% of sales?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes.

Kevin G. Pollard - J. P. Morgan Securities Inc.

Okay. So that would suggest $40 million to $50 million based on your revenue guidance, which is I guess nearly double what you have been running. Can you tell us what was driving that increase, and where the money is going to be spent?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, we're not building any new factories, okay. I don't know that we'll actually spend all that much money, but I think we feel like CapEx is so modest that we probably wanted to give ourselves a little bit more room. Now we've got a couple of little projects here and there that we haven't announced yet. So it will probably move it up north for the 1.5%, which has kind of been our run rate. And so we thought we'd... I wouldn't read too much into what I guess is a short story. We just... if we didn't want to feel like we were going to be constrained if we ended up at 1.6% or 1.7%. we didn't want you all to feel like we weren't forecasting accurately and it's... since it's such a modest number anyway, we though what the heck let's push it up a little bit so that we're pretty confident, we're going to stay inside of that. So, nothing really significant in terms of new factory openings or huge capacity increases. We continue to debottleneck what we basically have and if you look at... if you look at the run rate of the fourth quarter, we shipped about $520 million worth of goods and services. And so if you extend that run rate for a full year, you can start to see where it looks like we've liberated enough capacity both internal and external, to hit the kind of numbers that we're guiding to in terms of an overall sales... overall sales number. Are you following me?

Kevin G. Pollard - J. P. Morgan Securities Inc.

I am. Yes.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Okay. Is that covered? You bet.

Kevin G. Pollard - J. P. Morgan Securities Inc.

I think it's all. Thank you.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Thank you.

Operator

We will take our next question from Jeff Siddle [ph] with Natexis Bleichroeder

Unidentified Analyst

Good morning gentlemen. Vince if we could touch one more time on the labor situation. Am I understanding correctly that in terms of an incremental cost in Q1 where pretty much that's behind us at this point?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes. That's right Jeff.

Unidentified Analyst

Okay. And then moving over to the aftermarket segment, can we talk I guess a little bit about where you think margins could go there for 2008 relative to what they were on a normalized basis in 07?

Vincent R. Volpe Jr. - President and Chief Executive Officer

I think they are going to be fairly flat. Our view is that the aftermarket margins... margin expansion in the aftermarket is not an objective per se. The objective in the aftermarket is in growth and volume. We like the margins where they are and we always are concerned that if we start to press too much in areas of price that we may encourage a little demand destruction or erosion of share and so we think that we'll continue to push for inflation plus where we can get it in some specific families of parts. But I would suspect that it's going to be fairly flat year-over-year.

Unidentified Analyst

Okay. Great, and just one more on the balance sheet, could you give us an idea of plans regarding debt reduction for 2008 and if there is some available to reduce in the near-term?

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

Yes, Jeff, this is Mark Baldwin.

Unidentified Analyst

Hi, Mark.

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

The debt that we have outstanding right now is our senior sub notes and they are really what I call good quiet debt, low covenants and a good coupon. So we are not right now thinking about buying that back. We do continue to look at different Bolt-on acquisitions that make sense either from a product or geography standpoint and while we don't have anything to announce right now, we are looking at several of them again bolt-on acquisitions that I think would make sense, be accretive but right now we don't have any immediate plans to pay down any more debt.

Unidentified Analyst

Okay. And I guess that strategy of pursuing acquisitions would be your preference versus share repurchases at this point?

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

Yes, I think the ones that we are contemplating would make good sense there kind of right… in our core business and are accretive, so that's our preference at this point.

Unidentified Analyst

Okay. Thanks very much gentlemen, I appreciate it.

Operator

We will take our next question from David Anderson with UBS.

J. David Anderson - UBS

Good morning, Vince.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Hi, Dave.

J. David Anderson - UBS

I think I ask you this question every quarter, but just in terms of your inbound orders, can you just kind of give me the breakdown of the inbound in terms of say, upstream or finding mid stream?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Right. About 38% were upstream David, 12 were midstream and 42% were downstream and then the remaining 8 was basically U.S. Government, navy and some industrial.

J. David Anderson - UBS

So the mix is going to come down a little bit on the refining side, I recall you have been kind of at about a 50% number for last several quarters?

Vincent R. Volpe Jr. - President and Chief Executive Officer

That's correct.

J. David Anderson - UBS

So, I was wondering how does that relate in terms of the seasonality. You talked about the mix have been kind of a mix shift is required in order to kind of smooth out the seasonality issue. What has to happen in terms of that mix for that seasonality to kind of spread out little bit more?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, it's a mix between aftermarket and units right. It's not just the… between upstream, midstream and downstream there is really no fundamental margin difference in terms of the units.

J. David Anderson - UBS

Okay. I understand. And then I guess what I was also wondering is in terms of your capacity, you talked about with the strike being through that you can kind of improve your capacity a little bit on that side. What are the... can you help us... kind of identify some of these bottlenecks and you had also mention your run rate about $525 million in the fourth quarter, insured capacity and your ability get throughput through... is there kind of linked to the seasonality. In other words if you can get the seasonality spread out more... you could kind of maybe achieve $500 million run rate per quarter?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes, that's...

J. David Anderson - UBS

Is that what you are trying to get here... and is that the main bottleneck I guess?

Vincent R. Volpe Jr. - President and Chief Executive Officer

No. No. The issue is when we... when do we get the backlog? Okay. I think what we were, we have been able to demonstrate here is that not withstanding the problem we had in Painted Post, we have been able to meet the requirements of the market, okay, with what we have in terms of internal capacity and also our supply chain. And so I think we've got what we fundamentally need Dave. Now when I talk about the bottlenecking what I am really talking about is there are a couple of different areas where you can have pinch points, where you can't go either to subcontracting or you don't have enough internal from one month to the next enough internal capacity. So, like one of those areas is test, okay? And so we look at the test facilities and we say do we [inaudible] here or there, because that's something particularly in the turbo business, the clients very much insist on. Every unit is basically performance and mechanical tested. So, that's a little bit of where the CapEx could go. The fundamental machining operations, there's a lot of capacity out there. We've identified more capacity in what we think we can possibly need on the outside, our supply chain organization is now put into place. So, I think we're okay in terms of machining, assembly, I think we're fine on. We have bottlenecks in engineering, we've added significant engineering resources and capacity. And by the way, part of what you see in the S&A growth is getting ready to take more orders and getting ready to execute more orders in advance of getting them, that's kind of the… that’s part of the answer why the S&A has grown so much. So, look, I think inside of the CapEx budget that we've got, we feel like we're going to be able to either create or liberate enough capacity. This certainly meet the 2 billion plus that we're talking about shipping this year. And I don't see in our longer range where even with continued significant growth, we're going to need to make a step change in our CapEx.

J. David Anderson - UBS

That's very helpful. In terms of LNG, I think last year you were talking about… targeting about 100 million in awards in kind of some of these smaller LNG projects. How did you... where did you shake out if you don't mind, I'm asking on the year, and what's your expectations for '08?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, Dave, we booked a couple of small orders, which we didn't publicize because they weren't big enough sort of to be world-class plants. So, I missed my estimate again this year in terms of booking sort of 100 million worth of world-class equipment. The good news is, other than the fact that it's somewhat embarrassing that I missed two years in a row now. The good news is that it [inaudible] and I think it will be this year. But beyond that, and not needing to be tongue and cheek, what has really happened is the projects have moved out. From our standpoint that's actually excellent news. You can see that we have no shortfall of new unit bookings. So it wasn't like we were dying for these orders right now anyway and basically what has happened is we've gone through our internal testing program, we have done a lot of publicizing of what we've been able to achieve, the results have been good. We spent a lot of time with clients that basically a year ago, had their projects gone forward, they would have sold source to one of our competitors. So, time is actually working in our favor. And while these projects are being delayed and you know as well as I do what's going on with some of these major world-class projects. I didn't structurally to believe it’s still very strong that these, many of if not all, many of these projects will go forward and I actually think that our share of our participation will be higher than what we've previously indicated. So, I am not ready to change guidance, okay? Since we still haven't booked what we said, we were going to hopefully book two years ago. So, I think you need to bear with us a little bit on this. But I do think that we will... we're in a position this year to get some commitments. And I believe that we'll be able to move past that $100 million mark in terms of commitments this year. Now, remember when they actually show off [ph] official bookings and when they show off the sales, it will be sometime in the future. But I believe we have a good chance to secure commitments this year that will meet or exceed the targets that we have talk about last year and the previous year.

J. David Anderson - UBS

Great. And one last final question. You mentioned, you had highlighted kind of your first commercial work for ICS. Should we expect to see more of that this year and I guess my other kind of real question here is what's the optimal application for this technology, you talked about the Campos filed, is that the type of application this is good for... you got a lot of people out there, a lot of your... a lot of other companies are looking at this type of technology as well.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Right, but nobody has got a separator on the front end of a compressor, Dave.

J. David Anderson - UBS

Agreed.

Vincent R. Volpe Jr. - President and Chief Executive Officer

That is...that's the huge differentiator for us. Now, we're going to work on educating the investment community through the course of this year, because we're starting to get close enough now to the beginning of the industrialization period as I call it, but it's worth talking about. I just didn't want to over hype this thing in the past but, Campos is a great application, it's on platform above... it's a surface application, it basically had no room left on the platform to put traditional skit in, so they're putting this compact design in, which has basically got a cooler and a separator and a compressor all in the same package. We think that there is a lot of interest out there in the market, we believe that we've got a good opportunity for at least one other order this year... a similar type of application with a different customer, may be later on this year. And I think what we're going to see Dave is this is the subsea compressor by the way to be completely open and clear here. It is exactly the same machine, not a reasonable facsimile, it is the same machine minus [inaudible], so basically we are medically sealed. But the package itself is what's going to go on the bottom of the ocean. So, where we are is right now there are surface applications, where there is more pressure required because of the depleting reservoir pressures and so the pressure is required on the platform in very tight spaces. Over time this will all move subsea and we're going to work closely with the investment community and with some of the subsea packagers to see how we get from surface applications to subsea, and that step will probably will take us a couple of more 2 years to 3 more years anyway. So, I think before you really start seeing these things, orders for these things on the bottom of the ocean, we're probably talking about three years. But between now and then I think you're going to see a nice ramp up in the applications for surface existing platform applications.

J. David Anderson - UBS

It's great. Thanks Vince.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Thanks, Dave.

Operator

We'll take your next question form Geoff Kieburtz with Citigroup.

Geoff Kieburtz - Citigroup

Good morning.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Good morning, Geoff.

Geoff Kieburtz - Citigroup

Coming back to the new unit margin question. From your earlier comments it sounded like pricing is the primary driver of your expectation of continuing... couple of 100 basis point improvement in margins for new units going forward. Is that correct?

Vincent R. Volpe Jr. - President and Chief Executive Officer

It is. And...we are looking at productivity and the gains that we are trying to pick up there basically to offset cost increases and inflation.

Geoff Kieburtz - Citigroup

Does the mix... different market segments does that really make any difference? Are you getting the same traction in terms of pricing improvements kind of across all the market segments?

Vincent R. Volpe Jr. - President and Chief Executive Officer

We are Geoff. These customers are either national oil companies who have lots of assets upstream, midstream, and downstream or international oil companies that buy again throughout the space. The competitive landscape is at least the top two 2 or 3 competitors are serving all three of those markets, and so the macroeconomic pressure is there that the margins are... they're fairly constant across three different streams.

Geoff Kieburtz - Citigroup`

And out of the roughly $1.5 of backlog, do you expect to ship how much of that in '08?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Mark it's about $1.2 billion. Do you have that number?

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

I think what we said was about $400 million. They're scheduled to go...out

Geoff Kieburtz - Citigroup

$400 million is beyond '08, okay.

Vincent R. Volpe Jr. - President and Chief Executive Officer

So, let's back that out. $1.1 billion, I guess.

Geoff Kieburtz - Citigroup

So you've got a very good degree of visibility on your margin and backlog.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes, we got... that's right. We have basically all of our backlogs for new units as our... all of our new unit sales are basically in backlog now.

Geoff Kieburtz - Citigroup

Right, okay.

Vincent R. Volpe Jr. - President and Chief Executive Officer

So, we have a good feel for the margins and the reliability of those forecast are pretty good because for the most part when book the order we've got our supply chain tied in on a cost standpoint. The question mark for us is around how much booking shipped we get in the aftermarket and even if you look at this year, we are just delighted with the 16% increase year-over-year and the fourth quarter but equally disappointed that we didn't get more of it actually shipped in the fourth quarter, and as a result we came at the lower end of our range, and it's because just under 45% of what we booked in Q4 was in December. So...

Geoff Kieburtz - Citigroup

I was going to ask about that because I mean you did post a 9% year-over-year aftermarket revenue and you really emphasized that it was a shortfall and aftermarket that kind of drove you to the low end of that guidance?

Vincent R. Volpe Jr. - President and Chief Executive Officer

That's right. But it was... but if you look at it in terms of what we were expecting for Q4, we gave you that. We reiterated guidance at the end of Q3. So, whatever we have done in the first three quarters was basically done, and what we were expecting in the fourth quarter was the order of magnitude of what we got in terms of the bookings, we just got them too late in the quarter. We booked as I said booked 40 about 45% or just under 45% is booked in December. And so while that’s helpful for next year, it moved us really down from where we should have been which was around the midpoint of our guidance. Now we did still come inside of the guidance but I am personally disappointed that we weren’t right at the midpoint, and the principal driver that is the aftermarket. Now looking forward in 2008 that is the... still the question mark in the unknown, will this trend continue. We look at the two national oil companies and the good news, which you can kind of glean from our slides is at least in the fourth quarter those two national oil companies were pretty much right on the same run rate they were the previous year for Q4. So I guess our belief and our hope is that problem set is solved going forward, and we sort of climb back up on the trajectory that we're talking about before, and we cautiously guided you to high single digits.

Geoff Kieburtz - Citigroup

My last question is about the working capital. Mark made that comment that expected... I guess you expected why it might move back up into the 5% of sales. You made the same comment last quarter. How should we interpret that? It sounds like you’ve got it down?

Vincent R. Volpe Jr. - President and Chief Executive Officer

I don't think you should believe us.

Geoff Kieburtz - Citigroup

Okay. Just ignore the comment, okay.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes. Kind of Geoff. I mean here is what happens in this business, okay. We function for those that have a question on execution of this company, our average, the 4 point average and probably the 13 point or 12 point average was less than 1% of sales. So, we're running almost at no networking capital right now.

Geoff Kieburtz - Citigroup

Right.

Vincent R. Volpe Jr. - President and Chief Executive Officer

All right. That's because the people that are running this business, the order execution people out there in the operations are doing a good job executing. Now, one of the things that will happen some day is when... they're executing well and we are getting progress payments and so...on new units. As the new unit growth slows down or flattens out someday and I don't know when that's going to be, the progress payments will slow down and so we may backup at sometime in the future but what we are really saying is that, even when that happens it's unlikely that networking capital is going to climb above 5% of sales which is still best in class quartile, it's sort of a top quartile performance. So, ignore the comment for now, it doesn't look to me like it's going to climb back up to 5% or were given ourselves a little bit of breathing room and I think when the bookings slowdown, whenever that happens someday maybe then it will go back to 5%. But I wouldn't read a heck of a lot into it now Jeff, it's like that you said, we said the same thing last year.

Geoff Kieburtz - Citigroup

Okay. Great thank you.

Operator

We will take the next question from Glenn W. Primack with Broadview

Glenn W. Primack - Broadview

Good morning.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Good morning, Glenn.

Glenn W. Primack - Broadview

Congrats on eliminating the material weaknesses, number one. On that note, at a corporate level are there potential savings that you have in the future from maybe some extra cost [inaudible] has booked at... to knock down each one of those issues?

Vincent R. Volpe Jr. - President and Chief Executive Officer

I'm going to let Mark answer the second part of that question. But I'm going to answer the first part because Mark was part of the solution and I want to congratulate him, our Chief Accounting Officer, Lonnie Arnett, our Director of Internal Audit, Tony Ponte [ph] and probably a thousand other people throughout the organization that have really focused on eliminating material weaknesses, this has been a... it's been quite a journey over the last couple of years. We... our first 10-K the '05 filing which was laid, as you may recall, we listed that we had 10 material weaknesses being a newly formed public company. Last year we got that down to three and this year we’ve gotten it down to zero, and I'm going to tell you that those folks have done a terrific job, we're focused on this, it’s just like managing a major project. Our Board was very supportive of this and they are equally delighted I can tell you that we have gotten our material weakness we have obviated them. The trick and the challenge of course going forward is to maintain that level of control over processes and over our financial reporting, we are committed to doing that. So, it's really... this is an opportunity for me to publicly thank all the people in the company that have done a terrific job on eliminating those weaknesses. It is a big deal for us. Now Mark if you would answer the rest of the question on how.... what's going on in the cost structure.

Mark E. Baldwin - Executive Vice President and Chief Financial Officer

Yes. I would also accept your comments about thanking the rest of the organization. They have all done a tremendous job. Glenn as far as savings going forward, one thing we don't want to do is become complacent. We do have more improvements that we can make and so we're going to continue to do that, I think in the near-term we will see some modest cost reduction... it probably won't hit the cost levels that you would see from what I would call our outside suppliers either our accountants or other people that have helped us with the so called implementation of stocks. But in terms of internal cost, that's probably going to be allowed yet. We still got to build some process, if these controls built into the fabric of the organization. So I think any cost reduction, at least in the near-term, will come from outside suppliers and not to a level where they are going to hit your radar screen.

Glenn W. Primack - Broadview

Okay. Well, congrats on taking care of that past issue. Second question just... our university is going through some upgrade package of their generation because it seems between Notre Dame and Iowa state that I don't know if this is the trend but you seem to be getting some little wins here and there in the market, that I never really thought you would play that?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, everybody gets so enamoured with these mega projects, Glenn that... I'm kind of laughing because, it’s a lot of these little parts which should make the company grow also. We have a very strong steam turbine product offering... sort of below the 100 megawatt range and what you're seeing is these industrial applications are the need for energy infrastructure build-out continues, okay? That's... now what people think of is, we talk about this being an oil and gas, and petrochemicals play and so forth and we talk about upstream, midstream and downstream, but the reality is that that same product line, that steam turbine that drives the compressor or a pump or a fan or a mill in a refining or a some sort of a petrochemical application is exactly the same product, but is being used to drive the entire fleet of the aircraft carriers. Do you know that the Nimitz-class of aircraft carriers is being driven by Dresser-Rand, steam turbines. We are building the next one right now for the CVN-78 in our facility in Wellsville... it’s just not – it’s something we don't talk a lot about but we have a very strong steam offering. We added the Tuthill energy services steam business a couple of years ago, which is done than nothing but enhanced particularly that mid and small-size offering. And so, I think you're going to continue to see both on the new units side and in some applied technology applications, continued growth and expansion in that independent power generation field.

Glenn W. Primack - Broadview

Okay. And do you think Applied Technology can crack a $100 million going into this year.

Vincent R. Volpe Jr. - President and Chief Executive Officer

I hope so. We got to $80 million this past year and so I think the people that are in that organization will be disappointed if they don't pick up at least another $20 million this year, I'm counting on at least that. Therefore, I hope they're listening to the call by the way, Glenn.

Glenn W. Primack - Broadview

Okay. And then the ICS package being able to utilize that on the surface, that seems to be... somewhat a new revenue stream as well versus... I just kind of counted that as 2012 or whatever being able to do something subsea?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Right.

Glenn W. Primack - Broadview

Is that?

Vincent R. Volpe Jr. - President and Chief Executive Officer

I think it will ramp up as I said on the previous… on previous comments I made. It is actually not new in terms of... the people inside the company understanding what we had here but, again we sort of... we don't want to get out too far in front of the headlights in terms of talking about some of these things before their time, but I think Glenn what we will do is... we're going to work on this... this summer doing a better job in sort of explaining the value proposition and the market size and some of the opportunities to the investment community. I think this summer would be about the right time to do that. So, sort of stay tuned for that.

Glenn W. Primack - Broadview

Okay. But is it safe to assume it has a higher margin profile than there is some different standard package for your platform?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes. It will, going forward.

Glenn W. Primack - Broadview

Okay. And then, finally, I don't know who is going to win the election this year, but it seems like there is going to be some sort of carbon credit tax structure system finalized at some point in time, maybe in '09 or 2010 and you've been working on the... your CO2 system was I think correct?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Correct.

Glenn W. Primack - Broadview

Is there anything new to report there, is it just still on the kind of R&D stages on that?

Vincent R. Volpe Jr. - President and Chief Executive Officer

Well, from our standpoint we actually don't have any R&D to do with what we're working on in that specific application. It's a well developed, middle of the fairway machine for us. Depending on the size of the plants, they may be turbo compressors, they may be reciprocating compressors, but that is technology that we have for that size application. Now we need to understand a little bit better, how big some of these things are and what the different flow requirements are and so we may want to augment the existing technology platform and we're looking at that. But, we're in good shape. I think it's the issue here really is getting some government funding on the specific project that you're referring to and I'm hopeful that both the Governor of New York and the Department of Energy continue to feel along with our legislatures that this is important and this is important legislation for us and that it’s a priority. And so, there is nothing new to report other than what's out in the public domain.

Glenn W. Primack - Broadview

Okay. And so, you are thinking it’s more like a super size piece of equipment that you'd use for a then varied type application.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Yes. Right now, might be in the same order of magnitude size.

Glenn W. Primack - Broadview

Okay. Great, that's it.

Vincent R. Volpe Jr. - President and Chief Executive Officer

Thank you, Glenn.

Operator: And that does conclude today's question-and-answer session. At this time, I'd like to turn the call back over to our speakers for any additional or closing remarks.

Stephen A. Riordan - Vice President of Finance

Thank you, Melissa. And thank you folks for participating today. If there are any further questions, please contact Blaise Derrico our Director of Investor Relations. His contact information can be found on the earnings press release from last evening. Thank you.

Operator

And once again that does conclude today's call. We do appreciate your participation, you may disconnect at this time.

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Source: Dresser-Rand Group, Inc. Q4 2007 Earnings Call Transcript
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