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McDermott International, Inc. (NYSE:MDR)

Q1 FY08 Earnings Call

May 13, 2008, 10:00 AM ET

Executives

John E. Roueche, III - VP, IR and Corporate Communications

Michael S. Taff - Sr. VP and CFO

Bruce W. Wilkinson - Chairman and CEO

Analysts

Martin W. Malloy - Johnson Rice

Jamie Cook - Credit Suisse

Stephen Gengaro - Jefferies & Company

John Rogers - D.A. Davidson & Company

Jeffrey Spittel - Natexis Bleichroeder

Joseph D. Gibney - Capital One Southcoast

W. Richards Kindig - Keeley Asset Management Corp.

Operator

Ladies and gentlemen, thank you for standing by, and welcome to McDermott International's First Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later in the call, we will conduct a question-and-answer session and instructions will be given at that time. I would now like to turn the conference over to our host, Mr. Jay Roueche, McDermott's Vice President of Investor Relations. Please go ahead.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

Thank you, Lisa, and good morning to everyone. We appreciate you joining us today for McDermott's first quarter 2008 conference call to discuss our financial results, which we released yesterday.

With me this morning are Bruce Wilkinson, Chairman and CEO of McDermott, and Mike Taff, Senior Vice President and Chief Financial Officer. Mike will begin this morning with a review of our financial results for the quarter. Bruce will then follow with an overview of our operations. After our prepared remarks, we'll open the lines up for your questions.

Before turning the call over, let me remind everyone that today's event is being recorded and a replay will be available for a limited time on our website. Also some of today's comments will include forward-looking statements and estimates. These comments are subject to various risks and uncertainties. Please refer to our filings with the Securities and Exchange Commission, which are available on our website including our recently filed Form 10-Q as well as our Form 10-K for the year ended December 31, 2007, for a discussion of the factors that may cause actual results to differ from management's projections, forecasts, estimates, and expectations.

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

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

Thanks, Jay, and good morning everyone. For the first quarter of 2008 McDermott's actual results came in at the high end of our pre-announced range with net income of $123.2 million or $0.54 per diluted share. This amount compares to a $158.1 million or $0.69 per share in the 2007 quarter.

McDermott's net income compared to last year declined primarily due to previous announced information. First, the 2008 quarter was adversely affected by harsh weather in a number of our regions and our Offshore Oil & Gas Construction segment, which resulted in a period expense of about $20 million plus the deferral of project revenue and income to future periods. In last year, we benefited from a high level approximately $40 million of project closeouts, change orders and settlements.

Now, looking at the top line, revenues in the quarter were $1.45 billion, approximately 6% above a year ago. This top-line increase was a combination of revenue increases and our Offshore Oil & Gas Construction and Government Operations segments with both growing about 18% which was partially offset by the decline at the Power Generation Systems segments.

McDermott's operating income was $157.1 million in the first quarter of 2008, compared to $192.5 million a year earlier. Strong increases in segment income at Power Generation and Government Operations were more than offset by the decline in Offshore Oil & Gas Construction, due primarily to the external events.

McDermott's other income and expense line item improved by $7.6 million compared to a year ago, generating other income of $6.5 million in 2008 compared to an expense of $1.1 million in the 2007 first quarter. This improvement was due to lower interest expense in the 2008 quarter reflecting our $250 million debt retirement completed last year.

Our income tax line increased $7 million, despite the decline in pre-tax income. As usual, this perceived anomaly is the direct result of where McDermott is making money in the world. Since our U.S. based segment had a strong quarter, this brought our average income tax rate up. I would expect as offshore construction returns to a higher level of income, that our overall tax rate going forward would be in a high teens to the low 20% range.

I will let Bruce go into detail about the business. But let me quickly mention some factors behind the segment financial results. With segment income of about $53 million Offshore Oil & Gas Construction had its lowest quarterly performance since 2006. As Bruce will discuss weather-related delays were the primary detriment to the quarter, offsetting the record backlog and strength of our business and our fabrication facilities in the Middle East and Asia Pacific. Just like we told you year ago... just like a year ago, when we told investors not to annualize the first quarter, we would say that again this year. We believe that this segment will recover substantially during the year.

Our Government Operations had its highest quarter since its inception with $38 million in segment income this quarter, reflecting strong results from our site management activities coming through as equity income, some lower G&A expenses and higher volumes in the manufacture of nuclear components, both for commercial and government use.

Power Generation Systems reported an outstanding quarter at over $76 million, about $10 million of this was due to a gain on the sale of a facility in Scotland. But even without this one-time benefit, margins were over 10% for the second consecutive quarter. Improved profitability on our boiler business and a high level of parts and service work drove the quarter. We are not ready to call this level of margins a trend yet, but Power Generation has clearly started the year off well.

Turning quickly to the balance sheet. We ended the quarter with over $1.4 billion in cash and investments, down modestly from year-end. Changes in working capital were the primary reason cash stayed at a constant level. Another source of liquidity, our bank facilities are committed until about 2011 and had no outstanding borrowings. Additionally, during April we increased the size of our offshore construction segment's revolver by $300 million to support our anticipated backlog growth and the required letters of credit. With this increase and our cash balances, we believe McDermott is well positioned to continue to pursue both organic and acquisitive growth initiatives in our plan.

I'll now turn the call over to Bruce for his business and operational updates.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Thanks, Mike, and good morning to everyone. Comparing the first quarter 2008 to the first quarter of 2007 is like looking at polar opposites. A year ago everything that could go right seemed to, and at least in the offshore construction segment this year, the apposite was largely true in the first quarter. Despite actual first quarter results this year being at the high end of our preview range, suffice it to say, we were not pleased with our consolidated performance. However, I continue to reiterate the quarter-to-quarter McDermott's results can and will vary, and just the nature of the engineering construction business coupled with the vagaries of the percentage of completion accounting.

Soft results not withstanding, when you look at this quarter, I see much more good news than bad. Overall, the energy markets we serve continue to be robust, which provides a good tailwind to the operational improvements we have made over the last few years. Our Power Generation and Government Operations segments both recorded strong results, and our backlog report grew to an all-time record of $10.2 billion, reflecting... primarily reflecting strong bookings at offshore construction. Since we view recorded offshore construction largely as a period specific issue, we have much higher expectations for the rest of the year.

I will now turn to each segment for greater detail. Offshore Oil & Gas Construction segment revenues were about $646 million over 17% better than a year ago. But about $85 million short of our expected backlog roll-off that we published in the 2007 10-K. While we missed revenues... while the missed revenues were largely just pushed to the right, the impact on operating income that Mike discussed was much more significant. Weather is a regular issue in offshore construction, but what we saw in the first quarter was really beyond anything I've experienced within one fiscal quarter.

Part of it was just bad timing. In other words, being at the wrong field of element at the wrong time. In the Asia-Pacific region, we had to mobilized and demobilize four different times in Australia due to the path of multiple cyclones. In the Middle East, we experienced four times the amount of weather delays in Qatar, for example, as we typically expect based upon long known historical averages.

Qatar was exacerbated by our projects being in the beach bowl in the shallow water near-shore phases, where bad weather makes offshore operations extremely difficult, even the Gulf of Mexico had days lost to weather. All of these was compounded by having the DD-50 and KP1 and drydock for almost the entire period collectively working only about seven days in the quarter.

As we saw in the quarter, the biggest impact in all of these was the inability to make progress on projects, which prevented us from recording revenues and profits on those jobs during the quarter. And in addition, we booked about $20 million period expense which really was a second hit.

So far in April and May, we have been operating on a much more traditional weather pattern. While there have been lost days, it is much more inline with the expectations. Since the summer months are considered the construction season, we hope to make up with some of the loss time in the second and third quarters.

As you look at the 10-Q we just filed, we are expecting revenues to ramp up the rest of the year. Adding our expected backlog roll-off for the rest of 2008 to this quarter's revenue, implies a full year top line exceeding $3.8 billion. We will have to avoid slippage to get it down, but that's our current forecast. If there is any slippage in the next two quarters, we see our fourth quarter having capacity to absorb it.

This higher workload in 2008 has more procured items as the recently won jobs have gotten larger and we have an increased number of cost plus and unit rate jobs in the backlog, which lowers our risk. Despite the changes in backlog mix, we are still targeting operating margins in the 10% to 12% range for this segment on an annual basis. And while a number of items can impact any given quarter, we still believe this is an appropriate range.

The market remains very active for new projects. During the quarter we booked over $1.2 billion in new awards and are off to a good start in the second quarter with an additional $500 million plus that we announced recently. With this high level of bookings our official bids outstanding have declined a bit to the mid- $2 billion level reflecting this recent hit rate. However, we have a sizeable amount of bids coming in the projects that are now on our focus list which we've described before, but increased substantially in the last few months to about $10 billion with most of these not yet in the bid phase.

Despite this ongoing active market, however, we will remain selective on the projects we foresee and avoid work that doesn't fit our criteria for risk and return. To summarize offshore construction, it was a disruptive quarter, but the impact should be viewed as a superior event. The market is as strong as ever and we expect another robust year from this segment.

Moving on to Power Generation Systems; this segment generated over $616 million revenues during the quarter, producing double-digit margins. This level of profitability probably shouldn't be annualized. But this first quarter certainly gets the segment off to a good start in 2008. With bookings of about $500 million in the first quarter, backlog grew about $900 million compared to a year ago and is just short of our record year-end 2007 levels.

Even with another good bookings quarter and our strong backlog, we still have about $2.4 billion in bids outstanding. These bids included a number of scrubbers and SCRs, both new and replacement boiler projects, as well as several biomass and waste-to-energy proposals. We have a high level of bids under the $25 million size. These smaller jobs don't make for big news releases, but they certainly are sizeable when taken as a whole and they tend to be also at high margins.

Going forward we expect strong performance to continue in our parts, service and environmental business, as well as some new boiler opportunities in the US that will move forward. But all three major Presidential candidates supportive of some type portfolio greenhouse gas legislation, it is our hope to the CO2 reduction target gets mandated, so that the industry can start working to solve the related emissions.

Bottom line in a country with increasing electricity demand coupled with a $11 plus per million cubic feet of natural gas cost, and still more talked about nuclear than action, I don't see any way that this country can meet the growing demands without a sizeable new coal-fired capacity coming on line.

In fact an immediate reduction in CO2 emissions could be achieved by utilities simply shutting down over 1950 and 60 vintage plants and replacing that capacity with new efficient super critical version PC boilers. Moving to ultra-supercritical reduces CO2 even further.

Additionally, the CO2 emissions remain the concern. This emission will eventually be stored as scrubbed. But the industry needs a target to be established in Washington before the utility starts spinning in earnest. When this happens, both retrofit opportunities and new build should accelerate. With these opportunities ahead, we are aggressively pursuing our R&D efforts directed at reliable and cost effective solutions.

In the meantime, coal utilities are running at older plants longer and harder. This is good news for our profitable parts and service offering. Some of the plants that were previously forecasted to be shut down in the near term are likely to stay on line as America needs the power, which means additional retrofit opportunities become a future possibility for us.

I want to congratulate the leadership and employees in our Power Generation segment for delivering these outstanding results. Our conviction in our Power Generation group continues to build.

Wrapping up with our Government Operations segment, our revenues in this segment during the quarter were over $190 million including revenues from a recent acquisition of Marine Mechanical and the contract for the American Centrifuge plant. As we discussed on the last call, with Congress authorizing a second Virginia class submarine, we are expecting an upcoming award from the government probably in the third or fourth quarter, which will be negotiated on a multi-award approach and will be in addition to our traditional year-end award in 2008. Obviously we are pleased with the growing workload and our customers' ongoing confidence.

In addition, there are a number of upcoming opportunities within our site management and operations offering. Some of these sites are large, others are smaller. But our goal is to add our experience to projects where we will make a difference. We don't bid them all, just the sites where we think we add value. We are one of the four teams left in the bidding for the Sellafield project, where we partnering with Bechtel and Serco, which is likely to be awarded sometime in late summer 2008 with an anticipated contract start date in 2009.

There also domestic opportunities including Hanford, Savannah River liquid waste project, and Port Smith [ph] to name a few. Additionally, a number of other M&O sites are coming in 2009 and later. So, the outlook for this surface operating remains strong. This wraps up my prepared remarks for the businesses.

In summary, the first quarter in total was a soft start to the year, but certainly not indicative of what we expect going forward. There are significant opportunities ahead and all of our businesses in the energy E&C markets in which we participate continue to be strong. Our primary focus continues to be on execution.

Finally, a quick message on our CEO search. As most of you know, since announcing my intent to retire by the end of 2008, McDermott has been active in its search for my successor. There are number of good candidates, who have expressed interest in this premier opportunity both from inside and from external executives. There is no rigid timetable. We are seeking the best candidate to continue elevating McDermott during its upcoming growth phase.

Whoever my successor ultimately turns out to be, McDermott is an outstanding enterprise in my view. Our bench strength is good and our 28,000 employees are the best in the industry in my view.

Our strategic plan is directed at continuing to expand our service and product offerings to our measure energy sectors, oil and gas, coal and nuclear. I continue to believe the best legacy of chief executive can leave is the continued success of the company and the lasting performance culture. I am confident that our management... in our management team and fully expect the legacy of performance will continue.

Later this week Mike and Jay will be in New York for the Calyon and Merrill Lynch conferences and they look forward to seeing many of you there. In early June, we will also be representing at Credit Suisse's E&C Conference before the summer months really start. And as always, we invite our shareholders to stop into our offices during their visits to Houston. We pride ourselves in being accessible to you, the owners of our company.

We'll now open the call to your questions.

Question And Answer

Operator

[Operator Instructions]. Your first question comes from the line Martin Malloy with Johnson Rice. Please proceed.

Martin W. Malloy - Johnson Rice

Good morning.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning, Martin.

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

Good morning.

Martin W. Malloy - Johnson Rice

Could you talk a little bit about how the vessel utilization looks for the remainder of the year. And given the push right, in terms of some of the work-off the coast of Australia, how you expect that to shake out?

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

Martin I think if you looked at our vessel utilization during the first quarter, it was certainly well below our standards as a result of the weather-related downtime. Our forecast for the next two quarters shows utilization being well above standards and the fourth quarter probably pretty much right at standards.

Martin W. Malloy - Johnson Rice

Okay. And the Mexico yard, can you talk about how that's ramping up and the outlook for further work there?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, it's continuing. We are fully operational. We are beginning of course to work on the first project we have with PEMEX. We have bid a couple of other projects have not won them. But we don't to buy the market, we just want those that can be the appropriate account to get started on. I am very optimistic we... for any of you who are down here for the OTC meeting, we have a reception for customers and featured, what we are doing down in Altamira, because longer term, it's much more than just Gulf Coast fab yard. It's really where which we expect to be the major player in the big deepwater activities, both U.S. and Mexican sector, with deepwater access hope to have a large craned integrate projects there.

So, we have high expectations for it. But candidly, the Gulf is still a lot of onesies and twosies [ph]. And we continue to say that it's late '09 and 2010 is when we expect the larger activities to begin in the Gulf of Mexico. In fact this year overall, it may be of interest that if you compare '08 with '07, and just take fabrication to fabrication, in spite of our expectations are really good year, at J. Ray this year. The actual fabrication are hours are over 20% lower projected than they were in '07, so this is the year of the water Marty would be the easiest way to describe it.

Martin W. Malloy - Johnson Rice

Thank you.

Operator

Your next question comes from the line of Jamie Cook with Credit Suisse. Please proceed.

Jamie Cook - Credit Suisse

Hi. Good morning.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning, Jamie.

Jamie Cook - Credit Suisse

Bruce, I guess I've two questions, both sort on the margin front. You know within the J. Ray business I think you mentioned when we look at '08 versus '07 there should me more cost plus or unit rate business versus 2007. I guess can you give a little granularity there on what the mix will be in '08 versus '07, and how we should think about on the level that the percentage of projects being completed in '08 versus '07 because that could have impact on closeouts, et cetera. I am just trying to get a feel for the margin sense.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

I can describe it more in backlog. I am not sure I can project it in revenues.

Jamie Cook - Credit Suisse

Okay.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

But, yes, we evolve were about 35% of the backlog of J. Ray would be the, what I would call, cost plus rate, something other than EPIC and that is an evolution. Part of it is risk mitigation and part is just kind of the nature of some of the projects that we have been bidding. But, we also... what will happen here in the next couple of quarters, really the rest of this year, is starting to see on the revenue side, a larger percentage of the subcontract and procured items part of projects.

So, whenever you have that, you have that would be the lower end of the margin range. But what I said in my prepared remarks is we... having said that, we really don't expect, we are giving the same, if you will, general guidance in the 10% to 12% range which looking back in the past, we have been beating, and we would hope to bid some in future. So it isn't impacting dramatically, I don't think, the short term. But in the backlog, you will see more of the cost plus. But whether that continues as a trend remains to be seen, I think we are expecting further work in Mid-East, in the not-too-distant future, which should be more of the EPIC, which then might skew that back to where you were down to maybe 20% or so, would be of that nature.

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

Yes. And Jamie, this is Mike. I think historically as you are aware that historically J. Ray's backlog has been 75%, 80%, firm big fixed price, and so that swung a little bit with some of these jobs versus that. Right now, we have looked at in about, 65, 35.

Jamie Cook - Credit Suisse

Okay. And then just my follow-up question on the Power Gen side, you guys have made, great progress over the past few quarters getting margins in the double-digit range. I guess how much of that is the cost initiatives and combining the two segments together versus the actual change in mix of business. I am just trying to see how sustainablethat is going forward?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

I think it's both Jamie. There are two in a quiet and methodical way, if you looked at within Babcocks & Wilcox construction just that one part of the larger segment. There has been a clear move toward away from the lump sum and toward the cost plus, our risk shared target price mode such that now the backlog of the construction company within B&W is probably 85% of that nature and only 15% remaining of the lump sum. We found those markets to be the most difficult with labor shortages and material shortages, and so we have been moving away from that. So we have actually a growing backlog within construction, with a much lower risk. And so a part of it is, I think that clearly will impact the future. I think we are executing better. I think we are basically back on track in construction.

The other thing is we have so called operational excellent plan that when we put the businesses together is essentially taking the Six Sigma approach, the Black Belt analytical approach that had long been in practice within the nuclear business, in the government group, and migrating it to the larger enterprise, and we have multiple specific projects. And over a multiyear period, we have actually set goals of significant reductions in both G&A categories and non-job chargeable direct cost categories, really no one dramatic piece of low hanging fruit, but a lot of small things. So, I believe all of that is really now beginning to show for itself what we have been doing in the past.

So, I have very high expectations for the continued positive performance of our group. We are also blessed unlike maybe some others who are much more OEM dominated. We have... we still have significant amount of proposal activity. In fact, our outlook, things we are bidding on the short term is better than it was quarter ago, six months ago or nine months ago, and so throughout both, the OEM sector including the scrubbers that are included with boilers in our definition. But also in smaller service projects, we have a very active market, we are bidding into. So I am optimistic about that.

Jamie Cook - Credit Suisse

All right. Thanks. I will get back in queue.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Thanks.

Operator:Your next question comes from the line of Andrew Kaplowitz with Lehman Brothers. Please proceed.

Analyst: Hi. This is actually Guo Shou [ph] in place of Andy. Good morning.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning.

C: Michael S. Taff: Good morning.

Analyst:Question on the offshore segment. So, even if we add back the $20 million of period expenses for the quarter to the segment operating income, we're still getting sort of 11.3% in operating margins for the segments versus 16.4% on average last year. My question is, is this something else in particular that's keeping margins down in first quarter?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, I think the period cost is what hit the bottom line essentially for expenses that had no POC or percentage of completion impact, and therefore, were 100% fell through and impacted the quarter. In addition to that, it's really the absence of the percentage of completion that was projected or expected for the quarter, because of these massive delays on the marine side. So in another words, we had some that was period cost hit immediately, and other that simply we were unable to recognize for failure to meet certain milestones, and so it was really a double hit. And so a lot of the latter really just moves to the right. It is we have an opportunity to make it up prospectively.

C: Michael S. Taff: Yes. And the other thing to keep in mind is that since we weren't able to perform as much on some of these projects as normal, and one of things we mentioned was what we did in the first quarter of last year $40 million of closeouts, we just weren't able to kind of harvest as much contingency as we normally would, and get some of these projects completed that were scheduled to be completed. So, a lot of the income we really bring home is in the latter phase of completing these projects which just didn't happen in the first quarter just due to lack of the utilization of our barges.

Unidentified Analyst

Okay. And a question on the utilization rate we should conceivably a rise in margins from the higher utilization for the construction vessels from the deferred revenues in the first quarter. Alright. So for the next two quarters, is it reasonable to separate out those effects, to get a more reasonable sustainable margin level?

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

I think what you should be seeing as by having the vessels being more utilized you should see a higher level of revenues and then the associated project margin associated with that.

Unidentified Analyst

No sort of abnormal higher margin levels within the next two quarters in particular?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

No, it will follow where we are on all of those projects, and at what completion points we are, what revenue and bottom line we can recognize. But essentially, if we are out there fully utilized and working at and beyond our standards then we get the POC accomplished quicker.

Unidentified Analyst

Okay. And we saw pretty good momentum in the Chinese JV that BWBC [ph] equity income last year peaking in the third quarter at about $7 million or so, and then it sort of went down in the last two quarters. Are we seeing the full picture here in terms of the demand and what is your outlook on the boiler business in China?

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

I think unfortunately the way our financial results were portrayed, you're really only seeing part of the picture from the profitability associated with China, because in addition to equity income, we also have some royalty and licensing fees that come through.

Unidentified Analyst

Okay. We are not seeing that.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

Correct, it's part of B&W's income.

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

But overall, I mean the market over there... and maybe Bruce can speak to that, but the market over there within that joint venture continue to be very strong. We are at... from a backlog standpoint that's not included in our numbers, but the backlogs they have within their existing business there within their joint venture is a strong as we have seen it in a number of years.

Unidentified Analyst

Okay. And to that the outlook for new award pipeline is still strong, do you still see significant projects coming up and in what regions do you see particular strength?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, I mean before that joint venture, there has been no slowdown in the Chinese market.

Unidentified Analyst

That's just in particular for that JV, but the overall new awards pipeline?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Overall, we... I think the tenor of my comment to Jamie was bullish. Overall, we have prospects of the six months nature and those that are kind of 12 to 18 month in category, that we track, and it's... if you put those two together, it's a much stronger market that we are looking at as far as short term, high probability projects that we're proposing on than it was quarter ago, six months ago or even a year ago. So, we are blessed. We have a such a broad based array of projects that we pursue within B&W. It's much more than a one-off large boiler projects, somewhere that people may read about or hear about, whether it's advancing or not advancing. So, the scrubber market is active, the SCR market is getting active. We actually have a very strong bidding environment there at B&W.

Unidentified Analyst

Okay. Thank you.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Thank you.

Operator

Your next question comes from the line of Stephen Gengaro with Jefferies. Please proceed.

Stephen Gengaro - Jefferies & Company

Thanks. Good morning, gentlemen.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

Hi Stephen.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning.

Stephen Gengaro - Jefferies & Company

I hate to do this to you, but I'm going to go back to the J. Ray's margin question and when I look at '07 and I sort of adjust for kind of closeouts which are abnormal you looked at, we you end up with a number kind of like in the 13.5% range for margins at J. Ray last year. And I know, I'm trying to get a sense, you sound like you have some drag on the margins which are coming out of maybe a little more procurement numbers in '08. But I would think in the second, third quarters because of backlog work-off you have some better overhead efficiencies. I mean should we think about your margin guidance range kind of like we did last year where if you're continuing to be real busy, you should be able to kind of consistently surpass that going forward still.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Let me tell you, I know those of you on the outside like to talk about margins because it's what we use to model things. It's a way you view it. I think as far as I am concerned, if the quantum of operating income is rises dramatically, then I am more focused on that than exactly what the margin is, because it is true that the mix will change. If you compare us even with the extraordinary results produced here recently and announced by Fluor or Foster Wheeler, this quarter at our low end, we still were the highest margin of the... what we consider the peer group. And so when I look at it, we suddenly were not able to stay up there, I would be more concerned.

So, as a practical matter, I think what I am saying is that I think the abnormality was the first quarter and you should not read anything into that for the rest of year, and there is nothing about our experience last year. It was fundamentally different than what we could experience this year. in other words it is a... projects nearing completion, some just getting started, some in the fabrication phase, some in the marine phase. And yet we still have a year, I mentioned where we have lower fabrication hours projected in '08 than we did in '07 But we have more marine days expected in '07.

So from my view, we have more projects with pass-through procurement subcontract, but, we also have the opportunities. It's not, we don't do that for free, it's less value added than when we are working in the fab yard or on a barge, but we make money there as well. And so I just... I don't think you should conclude anything out in front of us is fundamentally different than looking back at last year. As it's the risk and opportunities. In the words, I would view as not dramatically different one year over the other.

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

With the full understanding that in any given 90 day period the results can be lumpy, and they will be lumpy.

Stephen Gengaro - Jefferies & Company

Yes, I understand that. That makes sense. And then when you look at... is it fair to say that I mean the backlog is obviously enormous, but for the work you as an entity [ph] providing, obviously you are going to have procurement and pass-throughs. But for the non-pass throughs type work, is the pricing in that underlying portion of your business better in the backlog now than it was a year ago. I mean I imagine it is, but

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

I think it's fair to say Stephen that it's certainly just as good. I mean I think the margin

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes,It's not... I mean if you're concerned that that is the problem, I don't believe that it is a problem. I think the margin and the work is still good. We're pricing them the way we did before region by region, customer by customer. We have... we are still putting significant contingencies in. And I think the challenge is the only way, I would differentiate maybe year-over-year is how many... how much of when you put contingency in a job, it really is an indirect way of adding to what you expect to be cost. And when it doesn't go to cost, it becomes profit. That's where your closeouts and all occur, and so that's still the challenge. We just have significant contingency as well as the comparable margins in the jobs we are bidding. The question is how much of that can we bring to the bottom line, which is what the challenge was last year.

Stephen Gengaro - Jefferies & Company

Okay. And then... that's fine. No, I was actually not hinting. I thought prices were going down. I was hinting that I thought prices maybe going up, but

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Well, I think project, we are... every customer and every part of the world we operate in has its unique biorhythms. And so we have some customers that are always at the lower end of the range as well as price. But we operate well with them, we work hand in glove, execute well, and typically improve the margin by project. And we have others that are more challenging, and we have larger contingency going in. And sometimes use quite a bit of it and may be end up at the same place as the others. So

Stephen Gengaro - Jefferies & Company

I understand you are not selling widgets, and I understand that. That's fine. And a just one final question and I will turn it over. You still have, and this is a good problem, you saved a lot of cash, I know you need a strong balance sheet to bid on the lot of these large jobs. Do you have any commentary on use of the cash, same as kind of acquisitions when they come? Is that how we should think about it still?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes. But I would say you shouldn't think of it as just kind of when they come up. We have some pretty clear plans we have laid out with the Board looking five years out, segment by segment. And we believe that we don't have to go for the long ball or hit things out of the park or look for show stopper numbers, but to be very methodical and thoughtful, going at acquisition opportunities.

So, there are some of those. We are pushing forward. We continue to invest in our marine and our fabrication assets. We are looking for additional selective marine assets that would fill some voids, where we have been chattering vessels that we think would be better to own. We have continued Board support. We're going to push forward with our investments up in Kazakhstan, anticipating a major market coming in a couple of years, two to three years up there.

In other words, doing what we are doing in Mexico, but doing at there. And so we are also seriously in the throes [ph] of looking at investment opportunity for J. Ray in the China market, and in fact participating in the integration of FPSOs through that market. So, we have a lot of projects of investing ourselves, and a number of, what I would call, niche acquisitions throughout the company, and we are working at that we hope to execute on.

Stephen Gengaro - Jefferies & Company

That's very helpful. Thank you.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

Thanks Stephen.

Operator

Your next question comes from the line John Rogers with D.A. Davidson Please proceed.

John Rogers - D.A. Davidson & Company

Hi. Good morning.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning, John.

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

Good morning, John.

John Rogers - D.A. Davidson & Company

Just a little more clarification on J. Ray. You substantially increased sort of your backlog burn rate, especially into the... I guess the third quarter. And I am curious what... if you could give us a little more color on what incrementally is driving that. And are we getting to a point, are you getting to a point were your capacity, I mean that's maxing out capacity there, if you could talk about that a little bit.

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

Yes.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, that's really not the issue. I think part of it is at certain percentage completion on a number of projects that we are working on. You will begin to see this impact of the large amount of procured and subcontract items. So in other words, it's some think that it is going to happen at a point certain in completion of the contract, and one can in effect say, the work has already been done. In another words, it is work accomplish, but not yet recognized. When you go beyond that and you go back into our traditional fabrication yard byyard, vessel by vessel, I would say that the great irony is we expect a very strong year from J. Ray with effectively over 20% fewer fabrication man hours in it than last year.

So, what you have is not only the access capacity that we have talked about in Mexico, Morgan City, and Baku, but you even have in effect baked into this year in our projections, particularly at Batam, a slice of time it's half of what it was last year. Now, '09 is already dramatically stronger and we will see it be at on all-time high again there. So in other works, even in the fourth quarter of this year, we have the capacity, if we sold selective work to add a little bit in Jebel Ali in Dubai, but quite a bit also in Batam.

So, I think what you are going to see is the ramp-up in revenues is going to be a factor more of where we are on this procurement and subcontract issues, which is just another way that we really leverage the capacity of J. Ray.

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

Yes. And the other thing John is just the accounting method we're on is not an inconsistent with what some of the other people in the industry do. But we use partial calls, so we may... if we go out and buy a $100 million worth of procured items, we don't really start recognize that cost until we start burning fabrication and barge days.

John Rogers - D.A. Davidson & Company

Okay. So that would explain some of then at least on a reported basis by margins. I mean you don't get the margins on that type of work that you do.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, and you will have... but it also addresses the large quantum of backlog rollout that you're addressing, because I mean if one is sitting there and saying, is it conceivable that you go from, let's just say, $800 million to a $1.5 billion, $1.6 billion, just in man hours and barge days, no it's not. That's probably not doable. But it is, when you take in the mix of the procured and subcontracted management [ph].

John Rogers - D.A. Davidson & Company

Okay. And if you look out into 2009 in terms of the opportunities that are out there, I mean do you expect to have higher utilization rates, especially in the fab yards?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, we actually are '09 the fab looks stronger than '08, and we would hope toward the end of '09 is where we have been setting the prophecy that we would like to expect that the Gulf of Mexico will start returning. And then even beyond that, if you look at the Caspian, we're really building this whole thing in Kazakhstan that we are going to proceed with is geared toward 2010 through 2012 looking at the Kazakhstan sector. But by then, there aggressive plans by BP and the whole AIOC group with whom we worked in Azerbaijan that you could actually have a return of as robust to market in the southern Caspian by than as well.

So, when you go back my $10 billion of so called focused projects, they are a whole array of things, but there is still a very robust market for what's near term including '09 and '010, as well as a huge array of things that we look at that are beyond that timeline.

John Rogers - D.A. Davidson & Company

Okay. And sorry just one more follow-up on that, powers side of business, when you talked about more bidding activity out there and you are saying across your markets, but specifically on the boiler side of it. Are you seeing project deferrals?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Some of the big high visibility ones have certainly been deferred. We have talked about that over the last, I think, three quarters at least. But by the same token, there are number of smaller ones, and those in certain areas that continue to go forward, and so it's mixed. I think those that are such an order of magnitude that the concern over what sort of carbon tax legislation could be impacted on them. Those are the ones that you read about are being deferred and slowed. But we have of the number the others that we are pursuing that have continued to go forward. So

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

I think a fair statement John is that, some of the utilities have become somewhat media shy on their projects that are going forward. And there is probably not a whole lot of advantage to them for massive press releases being put out on the projects.

John Rogers - D.A. Davidson & Company

Okay. Fair enough. Thank you very much.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Thank you.

Operator

Your next question comes from the line Jeff Spittel with Natexis. Please proceed.

Jeffrey Spittel - Natexis Bleichroeder

Good morning, gentlemen.

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

Hi, Jeff.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning.

Jeffrey Spittel - Natexis Bleichroeder

I just wanted to get some clarification. You talked about the $85 million short of the expected backlog roll-off in J. Ray for Q1, is it safe to assume that's fairly evenly distributed in Q2 and Q3 in terms of recapturing that?

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

Jeff I think that's a fair statement. I think as we have indicated in the Q we filed last night, those... the roll-offs schedules are in there. But that's an unfair statement.

Jeffrey Spittel - Natexis Bleichroeder

Okay. And that would be independent of potential contingencies as well, right?

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

Absolutely. I mean as we have always stated, as we complete the jobs, our ultimate goal is to harvest as much of those contingencies as possible in the closeout period.

Jeffrey Spittel - Natexis Bleichroeder

And then switching over to the Power Generation segment, I know you just touched on it a little bit, or as you look at the election overhang here and gas prices where they are and LNG not really showing up in the US right now. Have you noticed the discernible change in customer behavior in terms of enquiries about new builds, I know you said you might have a few in the pipeline. But are they really standing pad at this time or at least they are starting to engage in discussions about new builds.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Well it's interesting, that the... I think the B&W at any point over the last several years back when gas was kind of getting beyond the $5 level and holding, we had had periods where you go, would have 20,000, 30,000... 30,000 plus megawatts of things, if you will, out there under study. And then it crept way down, when I looked at, I have some numbers here that if you take within the 18 months horizon. And I can't break it out between boiler and scrubbers because they both... the way we account for things internally, they are both OEM. But that grand total is well beyond the 20,000 megawatt range out there that we are looking at with may be a considerable amount of it in what we would call the high probability prospects meaning within a year. So, it's still quite active.

I think at the end of the day, if you look longer term, there was a Wall Street Journal article couple of days ago, I think that up until recently, the average person thought the reason we weren't advancing the ball on nuclear new build was a repeat of the old, a fear of the environmental issues, fear of litigation, fear of this, fear of that. That article basically articulated what we have been saying is that I think it's more a fear of what the cost will be, and because the construction community, the supply chain, everybody around that were part of the last build-out are either gone or much older or are configured in a different way. And so, you are seeing these numbers now going $5 billion to $8 billion, $9 billion, $10 billion estimates.

And so as long as that's out there and gas is $11 and rising, I mean I just don't see how we can get there without the coal. And so, what I would hope is that we with any kind of a carbon legislation, we come to that reality that if you just go, if you replace old plants with supercritical, and within a couple of years or so, we really get to the ultra-supercritical as well, where you are then taking emissions, our CO2 down 12%, 15% simply with existing and known technology that they will come back into a realistic mix, because again, the alternative is going to still be either extraordinary priced gas or LNG or a hope that the cost of the nuclear plants suddenly shrinks to something more affordable.

So, I just don't see it changing or breaking away from the need for every day that we can generate existing coal plants, and as soon as possible get some new capacity.

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

And Jeff, I think the other thing that we are seeing more and more of is probably kind of what we would describe as the older, kind of marginal plants that I think everyone was predicting that we're going to be shut down at one time with this news... with; one, not building the new coal plants; two, the increased demand for electricity; and three, the high price of natural gas. We are getting lot of enquires from those existing utilities about different projects and things of that nature that we probably didn't been anticipate getting at one time.

So we are doing more and more kind of what we had determined [ph] as kind of higher end type service and replacement parts and things of that nature, and what we've had done historically.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

And probably one final topic on the subject is that while investors seem very keen into the new build activity and what's happening with new plants and new boilers, it's important to reiterate that probably only about 20% of the current power backlog relates to new OEM projects.

Jeffrey Spittel - Natexis Bleichroeder

Okay guys. Thanks. It's very helpful. I'll turn to back.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Thanks.

Operator

Your next question comes from the line of Joe Gibney with Capital One Southcoast. Please proceed.

Joseph D. Gibney - Capital One Southcoast

Good morning everybody.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Hi, Jeff.

Joseph D. Gibney - Capital One Southcoast

Most of my questions have been answered. I appreciate all the color. I just wanted to get a sense here on the government upside. Could you walk us through little bit of the order of magnitude here on the work potential for the new Virginia class sub, and how that's going to work out. I know you indicated multiyear kind of a shake out here on the award size, but little color there, I appreciate it.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Yes, for the year you mean.

Joseph D. Gibney - Capital One Southcoast

Yes.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

The order of magnitude that we would expect additional bookings.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

The total bookings probably will be in the $1 billion dollar range.

Joseph D. Gibney - Capital One Southcoast

That's helpful. And Bruce just following up on the nuclear side, I know you mentioned the more talks than action. Certainly this is going to be rather convoluted and drawn out process here on the new generation side. But certainly, it is meaningfully moving forward in one way, shape, or form here, just wanted to get your sense, are you gravitating towards any particular design concept, are you still kind of approaching this from of the free agent standpoint right now to see how its shakes out. And obviously, it's going to be some delays here in COLs [ph] moving forward. But just wanted to get your sense on where you stand relative to the design concepts out there, and how you are approaching it and how much McDermott explain that?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

I would say we are more of the free agent, if you will, and we also back to my comment about acquisitive activities, we definitely have also decided that we have long enjoyed a very strong nuclear service business in Canada. We are free to compete in the lower 48, and we are actively doing it as to the existing 104 reactors in place in this country. And so, we are actively interested in acquiring both service businesses and hardware businesses that in fact reestablishes working at the existing sides long before the new build get started.

So, I still not believe any of us think there is a clear and compelling winner. I mean if you... if any of the big guys certainly have the magic bullet that was going to make their number $3 billion and instead of $5 billion, we would all have been reading about it, and you would say there is a likely winner in this race. But I think it's really how to get them built, that's confounding everybody and what the cost would be in, and can they ever get... the other thing I think that we have to see where it plays itself out. But for better or worse even with the overruns of the last build-out, virtually all those units were built in a rate-based environment, where the rate payer had to pick up some of it, maybe not of it, but certainly some of it.

What you are really talking about now is primarily guys building merchant plants. And so to be the first want to do merchant, a merchant plant nuclear in this environment is a pretty tall orders. So, that's where I think you've seen it move to the right. But, I think all the major reactor vendors are still actively in the hunt, and we will all participate in this market.

Joseph D. Gibney - Capital One Southcoast

Okay, understood. I appreciate it. And Mike just one follow up, if you can refresh us on CapEx expectations for this year. We still are in the $240 million, 250 million kind of bandwidth.

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

Yes, I think that's fair. I think we will be probably, I would say $240 million to $260 million range or so, give or take a few million. And as well as continue the investments in the pension aspects as well and any other acquisitions. And Bruce mentioned some other initiatives that have recently been approved by the Board. So, we are using some of cash for those as well as there is Kazakhstan or potential joint venture for J. Ray in China as well.

Joseph D. Gibney - Capital One Southcoast

Alright, I appreciate it. Thanks guys. I'll turn it back.

Operator

The final question comes from the line of Dick Kindig with Keeley Asset Management. Please proceed.

W. Richards Kindig - Keeley Asset Management Corp.

Good morning gentlemen.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Good morning.

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

Good morning, Dick.

W. Richards Kindig - Keeley Asset Management Corp.

Could you tell us a little bit about what you are doing to educate our legislators and political candidate?

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Well, we have a very active Washington office hub, and the first caveat is our primary mission at our Washington office really is getting work for the company, where we, in other words, actively proselytizing what we can do to the Department of Energy, Naval Reactors program and like agencies. Having said that though we also are very active in... I think what we try to do is after three years of my involvement and this company's massive involvement in attempting to influence as best as legislation, I became realistic about how little maybe on a positive level you can get done. I think our specific activity is more going after trying to make sure nothing negative happens.

We continue... I mean, if it's an unrealistic mandate that simply can't be met then the whole society is going to suffer. What we want to make sure up is that we have a technology neutral and a market based type legislation when it occurs, because we think the answer to the CO2 thing is simply not converting all coal to nuclear or stopping this or stopping that. It's every increment works and so in other words, you don't have to... if you have to get rid of all the CO2 from the coal plants, that's probably a tall order. If we're just reducing it by 20%, because that's good enough in a cap [ph] and trade event and that's much more do doable.

So, we are actively... with as each of the builds tries to advance a little bit here, there, we track every one of them, and aggressively try to make sure that they stay on course. And because many of these guys get their ear turned by everybody out there has a magic time that can romance a non-technically inclined congressman and to believing that certain things don't [ph] work, and most of them are really experimental at best.

W. Richards Kindig - Keeley Asset Management Corp.

I only asked the question because I happen to be watching C-Span the other day. They were talking about energy about energy, and I was appalled at the ignorance of our representative. It was actually scary. And I just think people like you should be educating them.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Well, I tell you we are... and I tell you the other thing we have done, we and many of the energy companies and others have worked with them, have joined and there is a section of the US Chamber of Commerce that is a under this general Jim Jones that used to be Supreme Commander over NATO. It's a very aggressive active group, and I believe in the upcoming campaign, you will see them really working on Main Street throughout to communicate to business owners, large and small that we are perilously playing with our ability, I mean there is no such thing as energy independence in this country is a really piped dream for 100 years. That's not all. And what we can have though is energy stability and what we are very concerned about is this group that really actually believe that you can solve it all with wind and biomass and other things. They simply... there is a niche to be filled and we need it all. We don't bad mouth anything.

But there is no question that a lot of us have got to get our voice in the game because that what you saw is probably a small thing yet. I don't think many of them have a clue what's the real issues are.

W. Richards Kindig - Keeley Asset Management Corp.

Well Bruce there is some for you to do in retirement.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Man that would really make me a younger man quickly, wouldn't it?

W. Richards Kindig - Keeley Asset Management Corp.

Thanks.

Bruce W. Wilkinson - Chairman and Chief Executive Officer

Thank you.

Operator

There are no additional questions at this time. This concludes the question-and-answer session of today's conference. I would now like to turn the presentation back over to Mr. Jay Roueche.

John E. Roueche, III - Vice President, Investor Relations and Corporate Communications

Thanks, Lisa, and thank you all again for joining us today. A quick reminder that today's call included some forward-looking statements. For more information on these, I encourage you to see our SEC filings. Please call Robby or me if you have any follow-up questions or need any clarifications. And Mike and I look forward to seeing many of you later this week and in the coming months. Operator, this concludes our call.

Operator

Thank you, and thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: McDermott International, Inc. Q1 2008 Earnings Call Transcript
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