Baker Hughes Incorporated Q3 2009 Earnings Call Transcript

| About: Baker Hughes, (BHGE)

Baker Hughes Incorporated (BHI) Q3 2009 Earnings Call Transcript November 4, 2009 8:30 AM ET

Executives

Gary Flaharty – VP, IR

Chad Deaton – Chairman, President and CEO

Peter Ragauss – SVP and CFO

Martin Craighead – SVP and COO

Analysts

Jim Crandell – Barclays Capital

Bill Herbert – Simmons & Company

Joe Hill – Tudor, Pickering, Holt

Kurt Hallead – RBC Capital Markets

Mike Urban – Deutsche Bank

Brad Handler – Credit Suisse

Dan Boyd – Goldman Sachs

Rob Mackenzie – FBR Capital Markets

Stephen Gengaro – Jefferies & Company

Operator

Good morning. My name is Celeste, and I will be your conference facilitator. At this time, I would like to welcome everyone to the Baker Hughes third quarter 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator instructions)

Thank you. I will now turn the conference over to Mr. Gary Flaharty, Vice President of Investor Relations. Sir, you may please proceed.

Gary Flaharty

All right, thank you Celeste, and good morning everyone. Welcome to the Baker Hughes third quarter 2009 earnings conference call. Here with me this morning are Chad Deaton, Baker Hughes’ President, Chief Executive Officer and Chairman; Peter Ragauss, Baker Hughes’ Senior Vice President and Chief Financial Officer; and Martin Craighead, Senior Vice President and our Chief Operating Officer.

Following management’s comments this morning, we will open the lines for your questions. Reconciliation of operating profits and non-GAAP measures to GAAP results for historic and current periods can be found on our Website at www.bakerhughes.com in the Investor Relations section, under financial information and in this morning’s news release. Finally, I caution you that any company outlooks discussed this morning are subject to various risk factors. We will try to highlight these risk factors as we make these forward-looking statements.

However, the format of the call prevents a more thorough discussion of these risk factors. For a full discussion of these risk factors, please refer to our annual report 10-K, 10-Q, and in particular the forward-looking disclosure in this morning’s news release. With that, I will conclude our discussion of the administrative details. I am turning the call over to Chad Deaton. Chad?

Chad Deaton

All right. Thanks Gary, good morning everyone. To start, I just wanted to make a few brief observations about the quarter. From an earnings standpoint, it was clearly a disappointment, from the standpoint of the ongoing transition initiatives that we have in place, so we are making some progress, good progress.

North America’s performance reflected a solid execution in a difficult market during the quarter. We mentioned on the last call that we felt the bottom was reached in Q2 for North America, and that appears to have held true as Q3 did improve. In North America, we cut costs aggressively on the first half of the year, and that combined with a modest sequential increase in activity resulted in an improvement in our overall profitability. This improvement was in spite of some further pricing deterioration in the quarter and the extremely low levels of drilling activity in the Gulf of Mexico shelf.

On the international performance however, it was a disappointment, as we saw significant deterioration in our bottom line numbers for the quarter. To some degree, this was attributable to the fact that our organizational transformation isn’t complete, requiring us to carry additional cost to ensure a smooth transition without sacrificing, execution or service quality. The need to carry these additional costs will largely be behind us as we enter 2010.

The move to the new geomarket organization has progressed fairly well over these last few months, and we still like the direction we are going, but when you do these type of reorganizations, one of the dangers is that it could become inertly focused, and I think we are guilty of that during the third quarter. This showed up in our revenue trends as we did lose some share in the quarter, but as I said, we very much like the direction this new organization is taking and we feel strongly that this share loss is temporary and we will get it back in the future.

An important fact is that even during this major reorganization, and this is why the concerns I often have when we go into these, our service execution on the well side has remained extremely strong. So, we fully expect the new organization to recapture and grow share beginning in 2010.

Looking forward, we believe that excluding reorganization, severance, and acquisition costs and any additional charges for doubtful accounts, that we are on track to meet current Street expectations for the fourth quarter. And finally, as you know, we announced the transaction of a combined Baker Hughes and BJ Services, and every day we get more excited about BJ joining Baker Hughes, and obviously we look forward to completing the transaction as quickly as possible.

We have established an integration team that is staffed and has been working to assure a smooth transaction once we close. We made our most critical regulatory filings and are working with different agencies to obtain the necessary clearance for the merger, and we did give a second request and so we now expect the transaction to close sometime in the first quarter of 2010.

The strategy that we outlined in Celle, Germany, at our Analyst Day in September, remains very much intact. We are confident in the direction we are going and are focused on building customer intimacy and improving our operational efficiency, and with the brief purchase of BJ, build out our product portfolio. For Baker Hughes, 2010 will be about benefiting from the overhead costs and are executing on our strategy.

I will now turn the call over to Peter to talk some of our financial review of the quarter. Peter?

Peter Ragauss

Thanks Chad. Good morning. This morning, we reported net income on a US GAAP basis of $55 million or $0.18 per share. This compares to $1.39 per share a year ago and $0.28 per share for the second quarter of 2009. Q3 revenue was $2.2 billion, down 26% or $777 million year-over-year, and down 4% or $103 million sequentially.

North America revenue was $817 million in the third quarter, down 38% year-over-year, but up 3% sequentially. Revenue outside of North America was $1.4 billion in the third quarter, down 17% year-over-year and down 8% sequentially. Severance reorganization and acquisition costs in the third quarter were $33 million, and we increased our allowance for doubtful accounts by $5 million in the quarter, for a total of $38 million or $0.08 per share.

You will note in our news release this morning, we provided a new table, which reflects operating profit and operating profit margins on an adjusted basis, excluding these charges. For the balance of our comments this morning, references to operating profit and operating profit margins will be on the adjusted basis. As such, our oilfield operating margin for the third quarter was 10%, down from 22% in the year-ago quarter, and down from 12% in the second quarter.

Turning to the performance of our two segments, Drilling and Evaluation revenue was $1 billion in Q3, down 32% year-over-year and down 6% sequentially. The Drilling and Evaluation segment’s operating margin was 5% in Q3, down from 22% in the year-ago quarter and down from 9% in Q2.

Revenue for our Completion and Production segment was $1.2 billion, down 19% from year-ago quarter and down 3% sequentially. C&P’s operating margin in Q3 was 14%, and this compares to 22% in the third quarter of 2008, and 16% in the prior quarter. To help you evaluate our earnings per share in the third quarter, I will review the significant items that bridge the sequential and year-ago quarters to third quarter EPS of $0.18.

In Q2 of 2009, our US GAAP net income per share was $0.28. From this $0.28, subtract $0.02 for the impact of a higher tax rate compared to Q2, add $0.02 as a result of lower corporate expense, add $0.01 for lower net interest expense, add $0.08 for increased profits in North America, and subtract $0.19 for decreased profits outside of North America. This gets us to the $0.18 we are reporting for the third quarter.

Now bridging from the year-ago quarter, from the US GAAP net income per share of $1.39 we reported in the third quarter of 2008, subtract $0.14 for the impact on an unfavorable tax rate this quarter relative to the year-ago quarter, subtract $0.04 for higher interest expense, subtract $0.01 as a result of higher corporate expense, subtract $0.59 for decreased profits in North America, and subtract $0.43 for decreased profits outside of North America. This gets us to the $0.18 we are reporting for the second quarter.

Now that we are three quarters of the way through a very challenging year, I thought it would be a good time to recap all of the cost saving measures we have taken to date and their associated charges we have incurred as well as other costs of a transitory nature. Year-to-date, we have incurred about $75 million in severance charges, representing a net headcount reduction of about 4,800. While we are satisfied with our execution of the transformation so far, we still have duplication of certain costs. We estimate the impact of these duplicate costs was approximately $0.45 per share in the third quarter.

As Chad said, these duplicate costs will be coming out beginning in the fourth quarter. These actions will include a reduction of our headcount by several hundred by year-end, but particular emphasis on our international cost structure. Year-to-date, we have incurred about $28 million in reorganization and acquisition costs. Some reorganization cost will persist into the next few quarters, but we will be ramping down from here.

BJ Services acquisition related costs will be increasing as we get closer to closing that transaction. We have increased our provision for doubtful accounts by $71 million year-to-date, but I am pleased to report that we have made very good progress on our collections in Latin America in the past quarter. Adding all of these up, reorganization, severance and acquisition costs, and allowance for doubtful accounts, totaled $175 million year-to-date of transitory costs, which are behind us. Another area we have made progress on this year is financed outsourcing. We will have invested about $40 million this year, moving several hundred financed subs offshore. Most of these costs will not recur and we will start seeing underlying savings in 2010 coming through the G&A line.

Getting more specific about the corporate cost line, we recorded $76 million in corporate costs in Q3. $9 million of this was related to severance, reorganization and acquisition costs. So, the underlying corporate costs have been running about $67 million per quarter. For Q4, we see a ramp up in BJ Services acquisition related legal fees.

We still have some lingering reorganization costs on systems and alike being incurred. Our estimate is that we will incur an additional $21 million above the underlying $67 million cost for a total of about $88 million in Q4.

Turning to the balance sheet, at quarter end, our total debt was $1.8 billion and our long-term debt to cap ratio was 20%. Our net debt was $319 million. We have no maturities of long-term debt until November 2013. We currently have $1 billion in undrawn committed credit facilities, comprised of $500 million facility, which is accessible through 2012, and a $500 million 364-day facility, which is accessible through March 2010.

At quarter-end, we had cash and short-term investments of $1.5 billion. This totals $2.5 billion in available liquidity. Sequentially, we released another $74 million in working capital, driven by reductions and receivables in inventory. We had generated free cash flow before dividends of about $500 million year-to-date in 2009. Moving on to other guidance, 2009 capital expenditure is still expected to be $1.1 billion. Our tax rate for Q4 is expected to be between 31% and 32%.

I will now turn the call over to Martin, who will highlight our geographic results. Martin?

Martin Craighead

Thanks Peter. As Chad noted earlier, our international margins fell short of our expectations. Latin American revenue was down 7% year-on-year, as growth in the Mexico, Central America, and Brazil geomarkets was offset by declines in Venezuela and the Argentina, Bolivia, Chile geomarkets. Activity in Bolivia decreased and operations in Argentina were impacted by labor strikes.

Revenue declined 4% sequentially as higher revenue in the Brazil, Colombia, Ecuador, Peru geomarkets, was more than offset by lower revenues in Venezuela. Excluding the Venezuela geomarket, Latin America revenue was flat sequentially and up compared to the year-ago quarter. The operating profit margin in Latin America for the third quarter was 5%, down from 18% in the quarter of ’08, and down from 21% in the prior quarter. The sequential decline in operating margins was primarily due to the expected ramp-up costs in Mexico, associated with our expansion of the ATG operation, higher labor costs in Argentina, price erosion and an unfavorable product mix.

We ended the quarter with a record six rigs operating in the Alma marine integrated services project for PEMEX, we TDed two wells in the quarter, one excess of 6,200 meters. In spite of the startup costs with the ATG expansion, I am pleased with our operational execution. We expect to be on three additional rigs by the year-end to further support the indigenous oil companies. Additionally, we have been able to deliver higher technology products and services on the projects to improve reservoir characterization and improved recovery factors. Something PEMEX is going to be increasingly focused on.

Finally, our newly deployed BEACON center for Mexico became fully operational during the third quarter, providing permanent monitoring visibility of ongoing operations allowing Baker Hughes’ experts from around the world to support PEMEX on operational and technical challenges real-time.

Turning to the Middle East Asia Pacific region, revenues decreased 10% from year-ago levels, in line with the rig count, as higher activity in Australasia, India and Southwest Asia geomarkets was offset by lower revenue in all other oilfield markets. Revenues declined 7% sequentially, as increased revenues in the India, Southwest Asia, Indonesia and Australasia geomarkets was more than offset by reduced activity in North Asia, Egypt, Gulf, and Southeast Asia geomarkets.

The Middle East and Asia Pacific region’s operating profit margin was 12% in the third quarter, compared to a 19% in the year-ago quarter and 15% in the second quarter. The sequential drop is due primarily to price erosion and activity declines exceeding our cost reduction actions.

During the quarter, we were awarded drilling, evaluation and completion contracts for a 12 well deepwater exploration program for a consortium of six major IOCs in Indonesia. Work on this contract will begin in the second quarter of 2010. And in the Gulf geomarket, we achieved a new milestone in reservoir characterization, performing one of the largest ever onshore 3D VSP jobs for a major NOC. With the introduction of the seismic explorer service, a 100-level bore hole streamer digital [ph] it will become possible to acquire more data in less time. In this particular case, operations were even more efficient as the VSP and surface seismic data were acquired simultaneously, a major breakthrough with Hughes associated cost savings for the operator.

Now, turning to Europe, Africa, Russia and the Caspian, revenue declined 24% year-over-year in the region. With the exception of Angola geomarket, revenues declined year-on-year across all geomarkets, with the largest declines in Russia, UK and Norway geomarkets. Percent of revenue increases in Norway, Sub Sahara Africa, Caspian, And Nigeria geomarkets were offset by declines in the UK, Russia, Continental Europe, Angola and Libya geomarkets.

Our operating profit for the Europe, Africa, Russia and Caspian region was 13% in the third quarter, down from 23% in the year-ago quarter, and down from 19% in the prior quarter. The profit margin change in the third quarter reflected a change in product mix, continuing price pressures, and additional inventory provisions.

In conjunction with Statoil, Baker Hughes successfully tested an exciting new drilling technology in the third quarter, which is designed to improve efficiency and reduce costs, when drilling an unstable formation. The development of this new steerable drilling liner technology is the product of several years of collaboration between Baker Hughes and Statoil, and is designed to answer the challenges of drilling in depleted formation in complex lithology. This world’s first operation was a success and has led to a second pending test in the North Sea.

Baker Hughes’ zone track has seen continued success in North Sea, most recently on an exploration well in Norway’s (inaudible). The zone track system incorporates sensors at the drill bit to identify formation changes as quickly as possible. This technology gives our clients the opportunity to reduce risks, optimize casing-setting depth and enhance boring operations. Based upon this success, we have been awarded another 5 wells in Norway across a consortium of different clients.

Also in the quarter, qualification testing was completed in Norway for our EQUALIZER Select, which is experiencing increasing demand in the North Sea. This technology adds to our portfolio of inflow control device technologies and is specifically designed to allow for greater flexibility and sensitivity to changes in fluid viscosity. This technology is crucial for optimizing production, especially as well paths become more complex due to ever-increasing reservoir complexities and continued advances in directional drilling.

Based on the success of this project, we have been awarded a multimillion dollar contract beginning in early 2010. And in Azerbaijan, we were awarded a $300 million contract by a major oil company for directional drilling services, formation evaluation and completion services. The contract has an initial term of three years, with two 1-year extension option. Work under this contract will begin in January 2010.

To summarize, in Q3, internationally was obviously a very difficult quarter for us. That said, with the progress we are making on our reorganization and the other strategic initiatives, I am confident that international margins bottoms in the third quarter.

Turning to North America, revenue in Q3 was down 38% in comparison to the year-ago quarter, but increased 3% sequentially, principally due to the strength of our completion and production product lines and overall activity recovery in Canada. Our US revenue was down 39% year-on-year compared to a rig count that was down 51% and was flat sequentially compared to a rig count that was up 4%.

The US land rig count rebounded from Q2 lows and was up 6% sequentially. The US offshore rig count continued to decline in the third quarter and averaged 34 rigs in the quarter, down 32% from previous quarter. Offshore activity was impacted by a number of factors, including continued erosion in shelf activity, delays in delivery of new billed rigs for deepwater projects and cash flow challenges for smaller operators. And although we had no hurricanes this year, mooring issues in the deepwater and mid-water market increased air gap requirements in the jack-up market and wind storm insurance premiums had an impact on activity despite the lack of the hurricanes, and we expect to see re-occurring seasonality in the offshore rig count during hurricane season in coming years. The shelf rig count is now at levels not seen since the early 1960s.

We said in last quarter’s conference call that we expect Q2 to mark the low point for North American profitability, this was indeed the case, as the North American operating margin improved from 2% to 7% in the third quarter. We had some notable operational highlights in Q3, which included introduction of additional technologies to support activity in the unconventional reservoirs. In collaboration with a major US independent operator, we successfully installed the first 24-stage FracPoint EX open hole isolation completion system in the Williston Basin.

In addition, we launched IntelliFrac services, an integration of state-of-the-art fracturing and production enhancement services from BJ Services, with advanced micro seismic services from Baker Hughes. This combined offering enables operators to monitor fracture dimensions during stimulation treatments and allows real-time control of fracing operations.

During the quarter, we continued to close or consolidate field locations as part of an ongoing process of aligning our resources with key basins or markets where we see strong demand and growth potential. We believe we have seen the bottom of rig activity in this cycle, oil-directed activity has continued to improve, with the increase in crude prices, and gas-directed drilling in North America is gradually increasing and we believe this trend will likely continue through 2010.

We are confident that actions we have taken will continue to lead to improved profitability in North America. Pricing pressure was significant in the quarter, but we believe it has stabilized. Conversely, a strong recovery in pricing will not occur until we see a substantial rebound in drilling activity for further rationalization of capacity in some of the product lines.

With that, I will turn the call back over to Chad.

Chad Deaton

Thank you Martin. So before I hand this over for questions, let me just lead you with some final points. As discussed on the last call, and again in Celle, Germany, at the Analyst Conference, this is a company that is undergoing what I believe is a profound transformation. And yes, this quarter results, particularly on the international side were disappointing, but we remain committed to the long-term strategy.

The transformation is taking place on three key fronts. First, we are aggressively moving forward on our supply chain. We are executing plans that will dramatically reduce our costs and improve our ability to service the customers worldwide. We expect the benefits from this strategy to be materially evident by the second half of 2010.

Second, we are focused on improving our operational effect. Key improvement in this area, we are financing outsourcing efforts led by Peter. The first fruits of this effort will be realized in Q1 of 2010 and will grow throughout the year. And third, we are executing on the organizational change that’s part of the customer intimacy strategy in getting closer to the customer. Martin has been driving this change and has made some solid progress. Most people have now moved to their new assignments and response from our clients has been very encouraging. Although, it’s early in the transformation process, we are seeing intangible benefits from our geomarkets, a better and more sophisticated understanding of the market, and a much improved capability to bundle and integrate our products and services.

Last, we are expanding the breadth of products and services we can offer with the pending acquisition of BJ Services. As we said in Celle, we expected to experience a few quarters of disruption. This is a complex transition and we do have a lot on our plate and it is manageable. In the end, I believe we will deliver results from a much stronger company with an improved customer-focused organization and an expanded portfolio of products and services.

So, with that, Gary, let’s open it up for questions.

Gary Flaharty

All right. Thank you Chad. And at this point, I will ask Celeste to open the line for your questions. To give everyone a fair chance to ask their question, we do ask that you limit yourself to a single question and a related follow-up question. Celeste, can we have the first question, please?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line Jim Crandell with Barclays Capital.

Jim Crandell – Barclays Capital

Good morning.

Chad Deaton

Good morning Jim.

Jim Crandell – Barclays Capital

Could you talk a little bit about your statements that, I guess two-part question that you thought that this coming quarter’s earnings would be in line with Street expectations? And can you elaborate a little bit more on your statement that you think that international margins have bottomed, would you say that this would apply to the – is this because that Latin America is coming out with such a depressed number, or would you also say that this enhance your margins to bottom here?

Chad Deaton

Yes, Jim. Tell me again what’s your first question, as I missed that first one.

Jim Crandell – Barclays Capital

I was a little bit surprised that you reiterated your expectation for fourth quarter earnings.

Chad Deaton

Okay. Yes, well again, my statement was if you take a look at where fourth quarter consensus is right now, it’s about $0.37, and granted we are still going to have severance charges in the quarter. We got some reorganization and BJ charges in the quarter, possibly some doubtful accounts, but if you back those out or adjust for them, we feel that the $0.37 – $0.36, $0.37, whatever the consensus is, we feel that that’s still in range for our fourth quarter. And as far as the margins that we are talking about, yes, there’s no doubt that the international margins, as Martin said, has bottomed.

Peter talked about we will be carrying some excess hedge you might say because of the transition over these last couple of quarters to make sure that we can go ahead and close the books and get things done and operate as we move from a product line focus to letting the geomarkets and regions call the shots. Those hedges will be coming out, most of that is on the international side, and as Peter said, that makes a difference of about $0.04 or $0.05 that we have been carrying in third quarter, which will disappear. So, you take that into effect, that we will see an improvement in Q4 international margins, and we expect that we will then see the benefit of these other hedge changes coming out in Q4 and Q1. So, we should be building international margins back up from here.

Jim Crandell – Barclays Capital

I guess my question was, Chad, do you think that eastern hemisphere margins have also bottomed?

Chad Deaton

Yes, definitely. It’s not just Latin America. The eastern hemisphere, same thing. We are carrying a lot of heads in those areas, lot of severance that people are still coming off. As we transition out, they will come out now.

Jim Crandell – Barclays Capital

Okay. Thank you.

Operator

Your next question comes from the line of Bill Herbert with Simmons & Company.

Bill Herbert – Simmons & Company

Thanks, good morning guys.

Chad Deaton

Hi Bill.

Peter Ragauss

Good morning Bill.

Bill Herbert – Simmons & Company

Chad, if we could just stick on the bridge, if you will, to the $0.36 to $0.37 for a little bit longer, and with regard to the international margins, let’s focus on two regions here for a second where I guess relative to my expectations, the margin contraction quarter-on-quarter was the most severe. Latin America and Europe, Africa, CIS, Latin America, I mean, you mentioned Venezuela is being a primary culprit of pricing activity etcetera, 4.9% of margins third quarter. I get the $0.04 to $0.05 in headcount chop in terms of earnings per share benefit quarter-on-quarter, but realistically when you look at Latin America, and then Europe, Africa, CIS are, where can we expect margins to be for those two particular regions in the fourth quarter?

Chad Deaton

Let’s go through – Mexico will improve, we had a lot of startup costs in Mexico on the ATG projects for the three, you know, we are on three different contractors there, quite of a few rigs that we are staffing up.

Bill Herbert – Simmons & Company

Got you.

Chad Deaton

Brazil, activity is still strong in Brazil. We are ramping up on the drilling fluid side, obviously the margins in the drilling fluid aren’t great as they are on the D&E side, the drilling side. So, we have got some startup costs there. We had some switching and some inventory cleanup and some other things that took place in Brazil, that brought us down for the quarter, but we see that and returning back again in the fourth quarter in working these numbers.

Bill Herbert – Simmons & Company

Okay. Good.

Chad Deaton

Argentina is a mess. You don’t see any bright stars there.

Bill Herbert – Simmons & Company

Got it.

Chad Deaton

Venezuela, we have been pulling back there, that as Peter said, we are seeing some nice payments in that area that should encourage us, that will encourage us to get back and take on some more and it appears us that they are continuing to pay. So, that should help offset some of the challenges and problems that was been hit with Venezuela. If you look at the Russia Caspian –

Bill Herbert – Simmons & Company

So, Chad, to linger on Latin America for a brief moment. 21% margins in the second quarter, 4.9% in the third, what do you think is a reasonable expectation in terms of range or margins for the fourth quarter?

Chad Deaton

Well, I don’t think we would be out of the woods in the fourth quarter, and Latin America necessarily getting back up to 20%, that’s going to happen, Bill, but I think in the fourth quarter, we can come close to doubling where we ended up in the third quarter.

Bill Herbert – Simmons & Company

Okay, got it.

Chad Deaton

And I think as we get some of the other things out, first quarter, need to see a little more improvement from that.

Bill Herbert – Simmons & Company

Okay, and with regard to Europe, Africa, CIS, if you could sort of provide us with a little bit more color in terms of the third quarter and bridging the fourth?

Chad Deaton

Okay. Well, Europe, the place that has been hit hard there is the UK. Revenue is down significantly there. We have not gotten our costs out of there as fast as what we did in North America, and again part of it is, Aberdeen is one of those areas where we had a lot of outsourcing as a finance sector as well as some transition to let Africa handle. So, we have got – those costs are coming out in Q4. So, we will see some improvement in the UK sector. Russia Caspian, and especially Russia, we didn’t have a good quarter in Russia.

We believe that some of our – a couple of our competitors had a very strong quarter in Russia, because we are watching the frac market a little closer for obvious reasons now. It was very strong. And Russia started back up and a lot of fracing going on in Russia during third quarter and probably gone and also in the North Sea, there was a lot of frac activity in West Africa for vessel stimulation. Basically, we didn’t participate in. So, I think Russia was an area that is slowly coming back for us. But again, I think in both Middle East and Europe Africa, we will see some improvement in margins in Q4, and should see some additional as those other costs come out for Q1.

Bill Herbert – Simmons & Company

Okay, that’s very helpful. Thank you Chad.

Chad Deaton

You bet.

Operator

Your next question comes from the line of Joe Hill with Tudor, Pickering, Holt.

Joe Hill – Tudor, Pickering, Holt

Good morning.

Chad Deaton

Good morning.

Joe Hill – Tudor, Pickering, Holt

I noticed, Martin mentioned a negative mix shift a couple of times in his commentary regarding the various regions, and I am just kind of wondering if there’s any broad observations you can make with regards to what’s going on with your mix and the potential for that to improve.

Martin Craighead

Yes, Joe. Let me take it two ways. When I say mix, it’s not only product by mix, it’s geographic mix as well. Back to some of the comments that Chad made in Latin America, obviously the most attractive country in Latin America is Brazil, we have a very strong presence, but if you go back five years ago, there was another one there in Northern Latin America, Venezuela, which was also very, very strong. But it has been become increasingly obvious that we had to branch out into some other places.

Now, parallel to all that, with Venezuela coming down in the southern cone, particularly the labor issues in Argentina, that’s compressed our margins, but we had to stay the course in Mexico. We have a very nice contract offshore, but it’s small relative to the market, and to get the size that we need in Mexico, we are moving into the ATG field. So, there’s a mix issue geographically as well.

If you want to stay on the topic of Latin America, we were pretty much biased for just a couple of key product lines, and while the drilling fluids business doesn’t have the margin contribution of, let’s say directional drilling, wireline or completions, it is by far the largest spend by any of our competitors outside of probably pressured pumping. So, again from an economy of scale and scope perspective, we need to be in that business and lot of costs associated with getting that off the ground in Brazil.

And one other one I will pick on I guess from a mix standpoint is back to again following up on some of Chad’s comments, in the UK, we had a very strong quarter on the completions side in the second quarter. Sequentially, we knew it was going to be painful as that came off and we moved a little bit more towards production chemicals and couple of others which didn’t contribute the same as the drilling activity. So, now, going forward, we got to get some of these startup costs behind us. We got to get the benefits of the additional revenue without the additional cost that would come from getting the fluids off the ground, and we fully expect it in the first half of 2010, back to the UK sector that a lot of the rigs that were shutting down and we took a hit on the drilling side, we will be back and again, that will drive product mix for the more attractive levels.

Joe Hill – Tudor, Pickering, Holt

Okay. Would you characterize the level of startup costs in Latin America surprising? I was certainly surprised how much they may have impacted the quarter?

Martin Craighead

The startup costs in Mexico, no, were not a surprise. In Brazil, a bit on the fluids contract, but I think that did catch us by a surprise was the ongoing strife in the southern cone and the compression of our business in Venezuela which is a pretty big Baker Hughes territory.

Joe Hill – Tudor, Pickering, Holt

Okay. And how is your operational performance been on the Alma marine project so far?

Martin Craighead

It’s been relatively good. We started with maybe a couple of bumps. We certainly had a different cold well, but we have TDed it, that’s the one we got to 6,200 meters, we are in the completion process now. And in the second TD, we came in at 24 days ahead of our plan, which is very impressive for us and obviously delighted our customers there. I am quite happy with the operational performance. I am disappointed, Joe, with how long it takes to get all of these rigs up and running and in getting the work in a very compacted fashion so we can just keep running. There’s still some logistical humps down there as we work through issues with our customers, but in terms of actually turning to the right and getting the wells down, I am happy with the job that the folks are doing.

Joe Hill – Tudor, Pickering, Holt

Okay. That’s good color. Thanks Martin.

Operator

Your next question comes from the line of Kurt Hallead with RBC Capital Markets.

Kurt Hallead – RBC Capital Markets

Hi. Good morning.

Martin Craighead

Good morning Kurt.

Chad Deaton

Good morning Kurt.

Kurt Hallead – RBC Capital Markets

All right. So, just kind of put the – your reference that if you exclude Venezuela, Latin American revenue would have been flat sequentially. So, if you take a look at the margin front, if you include Venezuela, what impact was that on margins, and if you give us some color around the impact that startup costs, and the Brazil startup costs had on the quarter?

Martin Craighead

I don’t have that. Kurt, I don’t think I can answer that. I haven’t excluded the margins of Venezuela to see how the rest would have performed. I don’t know.

Chad Deaton

Yes, Kurt, I think to go back to that, you know, I think it was Bill or Jim who asked the question, we saw a big swing in Brazil from Q2 to Q3 and we see it coming back in Q4. And again, there was cleanup things down there, some inventory cleanup and we see Brazil coming back. We are on 13 out of 25 better than our 50% market share or so. Brazil will bounce back. Venezuela was quiet [ph] revenue was down – revenue was down quite a bit purposely of 26%, and when that hits in your fixed costs and everything else, you are down inch in the quarter. Now, as Venezuela comes back, and we get some additional revenues, and that will help offset through the next quarter. We also have, which contributed in the third quarter. Martin talked about the Alma project. We did have one well where we did have trouble on a well and had to make a concession on that. It’s wasn’t huge but it did also contribute to the poor results in Latin America.

Kurt Hallead – RBC Capital Markets

Okay. And then my follow-up question relate to your reference to meeting capacity rationalization, I think the specific reference was in North America, but I would have to imagine that it will play well, and I was wondering if you can give us some specific color around product line in Q3, you need to capacity rationalization and how likely it is if that occur, say within a six or nine-month time frame?

Martin Craighead

Kurt, this is Martin. I don’t know how practical this is going to happen. I can tell you that probably the product lines that need to, let’s say consolidate or have some more capacity taken out particularly on the directional drilling side, there’s a lot of capacity that’s been added to the market over the last several years. That all said, I think there is going to be some natural selection going on, and obviously not all the players can participate in the difficult environment of the resource plays, but nevertheless, the whole lot of hit, if you will, that’s moved into these four or five key basins, I think on the wireline side, there may be a bit more on the case full side. I think that’s probably pretty much it. That’s really the directional drilling side where we still see some excess capacity.

Kurt Hallead – RBC Capital Markets

And just a last follow-up along those lines was, so pricing across – now, when you say pricing across all product lines in all regions, North America, globally pricing pressures have elevated sector?

Martin Craighead

In North America, it’s hard to say across all the product lines, but I think, like I said, in US land, it’s pretty much, we think the worst is over, it’s pretty stable. Canada of course coming into the season, it’s not going down, it will probably come up. I think the thing that no one really understands, I think it came out on some previous calls in the last couple of weeks is that internationally, modeling the effect of these contracts that we recently have been awarded and bidding on, there were certainly a flurry of intensity on pricing in the last six months in the eastern hemisphere particularly. You know, how do those actually work their way through, so I think the realization of those is something we still don’t completely understand, but certainly no one is getting contracts at higher prices over the last six months. Now, in terms of the bidding that’s going on right now, again, that’s very product line oriented and by region. But I think I will just leave it with the point that we got to just see how these contracts work through our backlog.

Kurt Hallead – RBC Capital Markets

Okay, great. Thanks.

Operator

Your next question comes from the line of Mike Urban with Deutsche Bank.

Mike Urban – Deutsche Bank

So, you guys have obviously highlighted some of the challenges and the cost associated with moving to the geomarket organization, and Chad, you spoke to some of the, I think general success there. Are there any early successes specifically you can reference or some clearer sign what this is, you know, the right way to go and you are having some success and moving to structure.

Chad Deaton

It’s Chad, Mike. I think we need to look at North America and look at what’s taken place there over the last few months. Now granted their reorganization and the upheaval for North America obviously isn’t anywhere as near as that was it is internationally. But we were able to react quickly in North America, get the cost out of the system in a very bad market, and if you look at our North American results, they are very strong. Margins are as high as anybody, if not higher. I think that’s encouraging when we can see what we need to now do is, as we go into the next phase, you know, finishing this transition internationally.

And the international transition for the last few months has been major, and we would move some 350 people, mostly senior management and their staff around the world, passed off the product line managing of the business to the geomarket managing of the business, make sure that we had duplication in terms of the areas of finance etcetera, got to really focus. I don’t think there’s any doubt about that, as people went out and look to getting their organizations in placed, established and looking at the people and that’s a change in how we call the shots out there. So, we are seeing some encouraging signs, as I said.

We had a lot of conversation with our clients around the world, from MLCs, the IOCs, I think very much like having a one Baker Hughes base. They feel that we are much more responsive in getting things done. We recently won a nice contract in Azerbaijan, which we really didn’t have much of a presence there, but we ended up winning a bundled package type thing, a $300 million package and we are able to get the things submitted in place quickly. So, I think over this next quarter or two, as we fine-tune the international side, I expect that we start seeing things humming a little bit better along the lines of the way North America got through some of its last couple of quarter issues and earned in a fairly decent quarter considering how bad the market is.

So, yes, we are encouraged by what we are seeing in the geomarket structure. The product line themselves are being refocused to develop technology and answer products and the geomarkets are focusing now on making sure we execute on the clients as well. We like the way the direction has gone, but we are not happy with the results, but we like the direction and we believe that it’s going to pay off for us.

Mike Urban – Deutsche Bank

And as you look around the world outside of North America, are there parts of the world regions businesses where you would expect to see this traction sooner and places where it might take a little longer because of customer mix or contracts or whatever. How should we expect to see this fairly randomly over the next several quarters?

Chad Deaton

It all depends on what activity it does, Mike. I mean, if activity stays flat internationally or domestically, there’s a lot of excess capacity in both places and especially North America. So, it will stay within a bidding world and you have to sharpen your pencil. That’s one reason why we are making the moves on the supply chain, the financed outsourcing, the new market structures all of those things, we can get our overall support costs now. I think where you are going to see some success of this would be in the places like the Caspian where in areas where the national oil companies are looking for more bundled type services, one answer type product. I think West Africa is an area that we could see some success in that area.

You will see it a little bit less in places like the UK and Norway where business is established and the client in some cases will altogether unbundle it, and we want to pick and choose individual service client. So, it’s more from the national oil companies is I think where we will start seeing something. Iraq once it does, finally return. I think there we can walk in with a whole group of services, and a single managed area going to be able to move faster and be able to pick up a project. We need to throw in one more point on this, and this is this acquisition of BJ and why we get this done and take on the BJ side, why it’s important. If you look at our TAM, our total available market that we operate in around the world with Baker Hughes type services is about, in 2009, it’s about $43 billion.

If you look at what our three major competitors, Schlumberger, Halliburton, and Weatherford play in, that TAM or that market is about give or take $65 billion. So, with the BJ acquisition, the things that they are in on pumping and on some of the (inaudible) that puts us at about $63 billion or $64 billion total TAM. And that’s needed on these international markets, especially with this bundling and the integrated approach. You need to play in that bigger market, so you can get better pull-through for the different service lines you are offering.

Mike Urban – Deutsche Bank

That’s very helpful. Great, thank you.

Operator

Your next question comes from the line of Brad Handler with Credit Suisse.

Brad Handler – Credit Suisse

Hi. Good morning.

Martin Craighead

Hi Brad.

Chad Deaton

Hi.

Brad Handler – Credit Suisse

Could you just come back to couple of your comments, you, Chad, acknowledged the market share losses in the quarter, and I guess was trying to reconcile kind of, is that with loss awards versus kind of loss revenue realization? In another words, is this something you experienced already, where is the market share pressure something that comes in few quarters then?

Chad Deaton

You know, I think we are still trying to get our handle on this delta that we had in international, because a lot of our contracts are long term, a significant size of that. So, in a period of a quarter, just doing the rework, we didn’t lose any of that business. We were removed from rate or anything else. Where we must have lost some business is just short call out, being in the clients’ office, which is typically North American, UK type phenomenon. It’s not what you find internationally. Most of our contracts are long term. I think what we say is we just think that we got this thing organization in place, get it done, this transmission on the finance, factors all of these things out of the way and get our guys focused on the customer and in that customer’s office pick up these one-off caller type businesses. I think that’s what we are looking at.

Brad Handler – Credit Suisse

Okay. Very interesting. And an unrelated follow-up, please, you made a couple of comments related to inventory I guess in Europe, somewhere in the Europe, Africa region as well as in Brazil. I guess I am not quite sure I understand that, so maybe a little bit more color, please on it? And then secondly, kind of what gives you the confidence if that doesn’t recur next quarter or this quarter or something?

Chad Deaton

I think we have to be realistic is think back in the days when we were District Managers or Division Managers or whatever and got assigned to a new operation somewhere, and knowing that come January 2010, January of next year, you have got full responsibility, accountability etcetera, and that’s a lot of what we have done. We have moved from the product lines mostly based in Houston to 23 geomarkets sitting around the world in charge. Obviously, they are probably going through and looking at things and saying, okay, we need to clean this up and get it ready and everything else. So, we did have some additional obsolescence inventory in various product lines and everything else that we felt like need to get cleaned up, they felt like getting cleaned up. And I think that’s one reason why we saw a little extra in Q3, as people were getting their house in order. I don’t know, Peter, do you want to comment on?

Peter Ragauss

As Martin mentioned in Europe, we did have probably a couple of pennies of inventory obsolescence because our turn rates are down obviously compared to where they were given you know our year-over-year revenues declined across the board and some of that’s particularly in Europe. And in the case of Brazil, we had a – I think we had an order reversed by a client down there on inventory, that was reverted by the penny in Brazil. So, that was specific to the client. One was more general to our overall inventory levels, but the one in Brazil was specific to our client.

Brad Handler – Credit Suisse

Guess I will follow-on to this, you are not doing this, and maybe that’s a good thing that you are not trying to do this, but through the course of the call, I knew you started $0.26 clean, you have added as much as $0.05 for stuff that is going the way relative to the reorganization and severance and redundancy, you have just added $0.03 based on inventory. So, if you felt like it, would you say that a clean quarter is more or like $0.34? I know you are not trying to do that, but –?

Chad Deaton

We are not – we don’t want to sit there and try to add everything back in. You know, it’s not a good quarter, there was a lot of moving parts, probably would be some in Q4, but like I said, we like the direction we are going on this thing to stand with it.

Brad Handler – Credit Suisse

Fair enough. So, they are probably right. I understand there is some ongoing into Q4 including maybe some of this inventory, maybe some more sort of inventory adjustment if you will just based on this new charges responsibilities?

Chad Deaton

Yes.

Brad Handler – Credit Suisse

Okay, that’s helpful. Thank you.

Chad Deaton

Thank you.

Operator

Your next question comes from the line of Dan Boyd with Goldman Sachs.

Dan Boyd – Goldman Sachs

Hi, thanks. I just wanted to follow up on the Russian market. It sounds like your peers grew faster, but I think you attributed most of that to the product mix or frac picking up in the quarter. Would you say that your market share helped steady in other product lines or is that not the case and what is your outlook over the next 12 months for Baker Hughes in Russia?

Chad Deaton

I would say we held steady in the other product lines. We did see a drop-off in ESPs because we had a very good Q2 on ESP sales in Russia, that did not repeat again, these are sale products, didn’t repeat in Q3. So, that was a little bit of a swing there. Other product lines are okay, moving up fine. We are actually fairly bullish about Russia for 2010. Eastern Siberia with the tax changes tend to be picking up. We have done quite well there in several different product lines as we move forward. So, we think Russia will be a much better story in 2010 and it has been for us in the last second half of 2009. And the reward in Azerbaijan is a big one for us, because that’s a key area of us and we have won a couple of other smaller one, $50 million or $60 million projects in Kazakhstan, which will be kicked off in 2010 as well.

Dan Boyd – Goldman Sachs

Okay. And then just following up on one of your initial comments in your prepared remarks that you expect to see the benefits of the reorganization internationally in the second half of next year. So, as you progress through the transition, you are not learning anything that would delay your expectation. I am assuming that means you will be capturing market share in the back half of 2010 and you continue to expect that?

Chad Deaton

Yes. I still – we talked about in Celle, and we all believe that still is very likely to happen, especially when we get the BJ acquisition done and settled, we got to roll that in, but we think by the second half of the year, we should have a bigger, stronger geographical footprint and a much broader product line portfolio, and we will have an organization that connect as one in each of these geomarkets. So, yes, we are still on plan for that.

Dan Boyd – Goldman Sachs

Great. And just bridging the gap between now and then over the next couple of quarters, I assume we will fully progress towards that where maybe by the first or second quarter of next year, you will be growing in line with the market, is that how we should think about it?

Chad Deaton

Yes.

Dan Boyd – Goldman Sachs

Okay, thank you.

Operator

Your next question comes from the line of Rob Mackenzie with FBR Capital Markets.

Rob Mackenzie – FBR Capital Markets

Hi guys. Just one quick further question here, Chad, can you give us a feel for where your technical sales effort stand in terms of integrating with the geomarket structure, in terms of being at the product line and/or reporting to the geomarket managers versus their former product line supervisors?

Chad Deaton

The geomarkets are structured so that down at the execution phase of the geomarket, not much changes for the individual that’s in place, similar to Angola, where achievers are Intec or whatever. Now, in that Angola geomarket, there will be technical links representatives back to the product line, Vice Presidents for any type technical issues, problems, new technology coming out, introduction of new technology, standardization of equipment, reliability etcetera. So, with Intec product line in Houston or Celle, comes out with a new TecTrac [ph] tool, that will be broadcast out through the product lines, down through these technical representatives and you feature these rigs in the geomarkets, we will then make sure that that’s implemented in Angola on a standard global format basis. I don’t know if that answers your question.

Rob Mackenzie – FBR Capital Markets

Let me rephrase a bit. If you look at the field level of sales folks, are they in sense selling one product or multiple product lines?

Chad Deaton

Okay. You would have both. You are going to have sales people there that are broad, account managers that are across the client in particular areas, Angola or Senegal, there will be people there that can get in, and again it depends on the level of who you are calling in the client. The higher the level of the client, the more they just want to know what Baker Hughes can do for them in a total package in Angola, and as you go down through the clients, just like anybody else they have their specialists, and we will have sales specialists or technical specialists in Hughes Christensen, or Intec or fluids or whatever it may be in Angola that can correspond and correlate with that particular client.

Rob Mackenzie – FBR Capital Markets

Okay. That’s helpful, because I remember one of the things that seem to have happened early on in some companies transition to geomarkets was losing some touch when they do all the product line in trying to sell things that you didn’t necessarily know how to sell. So, it sounds like kind of at the field level sales, Intec selling Intec and so on and so forth?

Chad Deaton

Yes, we are not trying to make generals out of everybody. You are going to some generals and you are going to have specialists that can answer the questions and follow-up and make sure that each product line executes on what it needs to do.

Rob Mackenzie – FBR Capital Markets

Great. That’s all I had. Thank you.

Chad Deaton

You bet.

Martin Craighead

Great. Thanks Rob. Celeste, at this point, could we take one final question, please?

Operator

Okay. Your final question comes from the line of Stephen Gengaro with Jefferies & Company.

Stephen Gengaro – Jefferies & Company

Thanks. Good morning gentlemen.

Martin Craighead

Good morning Stephen.

Stephen Gengaro – Jefferies & Company

As we look out to next year and maybe even beyond, once you have this reorganization complete, and I know BJ has an impact, but if you were to take that out of your thought process, do you think incremental margins look healthier than you have seen in prior upturns or do you think it’s more of a revenue issue?

Chad Deaton

I don’t know if – I can’t go back and say healthier than prior upturns, I can say that we will see obviously incremental margin improvement and if you look at North America, the incremental was out of sight from Q2 to Q3. It’s not going to happen yet internationally, but we will see them come on. It just comes down to activity and how fast it goes up, what happens to capacity during that time frame.

Stephen Gengaro – Jefferies & Company

Okay. But you are not – you don’t think that the geographic structure helps the margin per se, it’s more of the revenue popular?

Chad Deaton

I think it will help both. I think it’s going to help the revenue, but I also think when we get this all done, it should help the bottom line just through lower overall costs, you know, support costs and things like that. I think that will help the margin side as well. And I think the big one with all of this in the transition it’s going to help is the supply chain. We are doing on the international supply chain front, and that one takes some time and that’s why we are saying we are not going to see the first improvement, the first benefits of that till the second half of 2010. For those of people in Celle, they saw us give a very good presentation on some of the long-term strategy on supply chain and we will see that benefit second half and then in 2011.

Stephen Gengaro – Jefferies & Company

And just following up on that, and your presentation in Celle, I know I heard you talk about the details. Do you think there is more to it than sort of that initial thought process, has that dollar amount changed at all as you have moved forward?

Chad Deaton

Well, let’s see the word is right now until we get it in place and (inaudible).

Stephen Gengaro – Jefferies & Company

Great. Thank you.

Chad Deaton

All right.

Gary Flaharty

All right. Thanks Stephen. I want to thank Chad, Martin, and Peter, I thank everyone as well as all of our participants this morning for your time and for your very thoughtful questions. Following the conclusion of today’s call, both Jean and I will be available to answer any additional questions you may have. So, once again, thank you for your participation. Celeste?

Operator

Thank you ladies and gentlemen for participating in today’s Baker Hughes Incorporated conference call. This call will be available for replay beginning at 10:30 AM Eastern, 9:30 AM Central and will be available through 10 o'clock PM Eastern Time on Wednesday, November 18th, 2009. The conference ID number for the replay is 33298674. Again the conference ID number for the replay is 33298674. The number to dial for the replay is 800-642-1687 in the US or 706-645-9291 international. That’s 800-642-1687 in the US or 706-645-9291 international. You may now disconnect.

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