Halliburton Company
Q2 2006 Earnings Call Transcript

Published: 21 Jul 2006

[Operator:]

Good day and welcome to today's Halliburton Company second quarter 2006 earnings results conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to the Vice President of Investor Relations, Ms. Evelyn Angelle. Please go ahead, ma'am.

[Evelyn Angelle:]

Thanks, Allison. Good morning and welcome to Halliburton's second quarter 2006 earnings release conference call. Today's call is being webcast, and a replay will be available on our website for seven days. A podcast download will also be available on our website within 24 hours after the call. Joining me today are Dave Lesar, our CEO; Chris Gaut, our CFO; Andy Lane, our COO; and Bill Utt, the President and CEO of KBR. The press release announcing our second quarter results is available on our website. The financial information in the press release has been restated to reflect our recent two-for-one stock split, as well as the reorganization of our tubing conveyed perforating, slick line, and under-balanced applications operations from Production Optimization into the Drilling and Formation Evaluation division. In today's call Dave will provide opening remarks; Chris will discuss our overall operating performance and financial position; followed by Andy, who will review the ESG regions and our business outlook. Bill will address KBR operations. We will welcome questions after we complete our prepared remarks. Before turning the call over to Dave, I would like to remind our audience that some of today's conference may include forward-looking statements, reflecting the Company's view about future events and their potential impact on our performance. These matters involve risks and uncertainties that could impact the Company's operations and financial results and cause our actual results to differ from our forward-looking statements. These risks are discussed in our Form 10-K for the year ended December 31, 2005, our Form 10-Q for the quarter ended March 31, 2006, and recent current reports on Form 8-K. Now I will turn the call over to Dave Lesar.

[Dave Lesar:]

Thank you, Evelyn and good morning everyone. I would like to begin today by reminding you of the ESG performance objectives that we shared with you at our recent Analyst and Investor Day. We said we believe we can post revenue growth in excess of 20% annually, while at the same time achieving industry-leading operating margins. Already in the first half of 2006 we have increased our revenue over the same period in 2005 by 30%. Our operating margins have increased from 22.2% in the first half of 2005 to 25.1% in the first half of 2006. Our goal is to achieving industry-leading returns on equity. Halliburton's consolidated return on equity in the first half of 2006 on an annualized basis was 27%. If you exclude KBR, this figure increases by approximately 5 percentage points. We also stated that we expect the Energy Services Group operating income to double within three years, and net income and EPS to double as well within that period. The momentum we have seen at ESG is continuing, and our strong second quarter results reflect that. Even with a $100 million decline in Canadian revenue compared to the first quarter, due to the seasonal slowdown from break-up, I'm happy to report that the ESG posted record revenues in the second quarter. It was the first time ever that our Energy Group generated quarterly revenue of over $3 billion, with sequential growth of $178 million in revenues, or 6%, even with the impact of the $100 million Canadian break-up. Production Optimization, Fluid Systems, and Drilling Formation Evaluation all contributed record revenue. Within these three divisions all product service lines had record revenue, with the exception of Security, which was just shy of last quarter's record revenue. Our the ESG also achieved record operating margins of over 25% in the second quarter, with record operating income of $791 million. All of our Production Optimization, Fluid Systems and DFE segments generated record operating income. Sequentially, ESG incremental margins were a strong 36% despite the Canadian impact. Our North American region revenue grew by over 28% from the first quarter. The strength of our U.S. market was shown by double digit sequential increases in revenue from the first and second quarter, with continued increases in operating margins. Now as to the U.S., we see no slowdown in the U.S. market at this time. In fact, we are experiencing increasing demand for all of our services, even with national gas prices at current levels. Therefore, we implemented price book increases over the past few months of up to 12% across our product service lines. We are benefiting from high customer activity, our price increases, and more effective utilization of our equipment. With the Canadian break-up now behind us, the second half of the year should show even stronger results in North America. We also communicated to you our commitment to grow in the Eastern Hemisphere. I would like to share a few highlights from there

[Chris Gaut:]

I will discuss our second quarter results compared sequentially to the first quarter. Halliburton Company revenue in the second quarter was $5.5 billion. That is up 7% from last quarter. Energy Services Group, ESG revenue, was up $178 million or 6% sequentially, led by strong gains in the U.S., the former Soviet Union and the North Sea. Our second quarter Canadian operations were, of course, affected by the significant reduction in rig activity during the spring break-up season, which is now behind us. KBR revenue increased $183 million or 8% sequentially, primarily due to increased activity in Iraq under our LogCAP 3 contract. International revenue was 54% of the total for ESG, and 68% for Halliburton as a whole. Halliburton achieved operating income of $718 million in the second quarter. Overall, ESG's operating income increased to $791 million, reflecting a 25% operating margin. KBR reported an operating loss of $41 million in the second quarter, due to the Nigerian gas-to-liquids project that Dave mentioned. Now let me highlight the ESG segment results

[Andy Lane:]

Good morning everyone. This morning I will be discussing ESG operational highlights from a regional perspective. As Dave mentioned, we had a good overall performance led this quarter by the Eastern Hemisphere on a revenue increase of $146 million sequentially, with sequential incremental margins of 42%. Our Europe/Africa CIS region showed a $79 million or 13% increase in revenue from last quarter. The North Sea rebounded well from the seasonal decline we saw in the first quarter, with Cementing and Production Enhancement each contributing to the increase. The strike in Norway had only a minimal impact on our results in the second quarter. The impact on third quarter results will be dependant on the duration of the strike, but will negatively impact revenue by an estimated $7 million in July. After an extremely cold first quarter which impacted our overall Russian operations, we achieved good revenue growth from well stimulations, cementing, and drilling fluids in the second quarter. Second quarter results for Angola were significantly improved, driven by higher utilization of our stimulation vessels and stronger sales of completion products. Our work in Nigeria is being impacted by the unrest in the Niger Delta. We estimate these disruptions to be impacting ESG revenue by approximately $3 million to $4 million per quarter. The bigger impact from the Nigerian unrest is in our Energy and Chemicals division of KBR, and Bill will discuss these issues next. Performance in Egypt was strong, led by improvements in Baroid and cementing. Our operations in Libya are improving as we have been mobilizing equipment into the country. We expect Libya to make a more substantial contribution to earnings later this year. Our Middle East Asian region revenue grew $67 million compared to last quarter. Direct sales in China accounted for approximately $13 million of this increase. We saw increased work in Australia for most of the product lines, most notably for Production Enhancement, Cementing and Sperry as customer demand for these services have increased. We also had good increases in Brunei and Malaysia for sand control, Completion Tools and drilling services. The outlook for the Middle East remains positive with good second quarter performance in Saudi Arabia, Oman, Kuwait and the UAE. We continued to ramp up for the big Al Khurais project in Saudi Arabia, which should provide a meaningful contribution to this region’s results in the fourth quarter. Turning to the western hemisphere, we saw strong revenue in operating income increases and the U.S. market. We are benefiting from continued strength in activity and pricing. Over the past few months, we implemented U.S. price book increases in the range of 5% to 12%, and we continue to deploy additional equipment in the U.S., where our equipment utilization remains extremely high. The current short-term softness in natural gas prices will slow the realization of these price book increases, but we are confident in our ability to get the price increases through later in 2006 and early 2007. Our ability to attract and retain personnel in the U.S. market remains an important factor in meeting the continued high demands for our services in the U.S. In the Gulf Coast, deepwater activity was much higher for us than the first quarter, with additional deepwater rigs. Deepwater activity increased primarily in sand control, Sperry and completions. Our balanced portfolio between the deepwater work and the shelf creates opportunities to maximize the potentials of these two important areas for us. This balance minimizes the impact we see from the jack-up rigs leaving the Gulf, particularly for production optimization and Fluids division. We recently introduced a rig-less solution for the Gulf of Mexico shelf, in which we are offering completions or re-completions as a bundled package of services with both project management and completion engineering. This has proven to be a very effective, efficient alternative for our customers to boost production. In Canada, we were affected by the typical seasonal second quarter spring break-up, with a rig count decrease from an average of 665 rigs in the first quarter to only 282 rigs in the second quarter. Our revenue in Canada decreased by approximately $100 million from the first quarter. The third quarter has returned to normal activity level. Latin America’s results were relatively flat compared to last quarter. Revenue was impacted by the decrease in project management work. This month, we completed our last well on the Pemex Integrated Service project. This 33-well integrated drilling project is now finished. Now I will turn the call to Bill Utt to address KBR.

[Bill Utt:]

Thanks, Andy. Let me begin by saying a little more about the Escravos Project. As Dave said, we have been encountering some significant issues in the Western Niger Delta region, including recent armed attacks on convoys on the Escravos River. We are also experiencing delays and cost increases resulting from site soil conditions, scope changes and necessary engineering and construction modifications. In recent weeks, we have been working closely with our customer, Chevron, regarding a fast-forward. We are approximately 30% complete on the project. The project charge we recorded in the second quarter reflects our best estimate of the cost overruns we have projected to the end of the project, net of probable recoveries from our customer. We will, of course, re-evaluate our estimates on a quarterly basis going forward. I want to reassure everyone that I am very focused on reinforcing and improving our risk-management and contracting practices. I am personally spending a great deal of my time on the details of establishing appropriate risk awareness and pricing guidelines for our company in general, and on a project-by-project basis, as we evaluate which of the many opportunities before us we should pursue. We have in place defined levels of reviews of projects before they are bid. The intensity of the review process increases with the size of the projects and, for our largest projects, includes the review and approval by our Board Of Directors before a bid is ever made. Our pricing of contracts is adjusted for the level of risk we believe we are undertaking. We also have increased the frequency and depth of the review of the projects as it progresses through completion, allowing management to identify issues early and address them with our customers promptly to ensure maximum recoveries of claims and change orders. Outside of Escravos, we are pleased with the level of profitability achieved in the second quarter on the balance of our projects in the Energy and Chemicals segment. These results reflect our continued focus on effective project execution. Let me turn to the Government and Infrastructure division, where we have had another strong quarter. We continue to be highly rated by all of our government customers, and are now receiving the highest award fees for us today on our LogCAP 3 contract. We are also announcing today that we have recently settled the laundry issue related to our services to the U.S. army in Iraq. As you recall, our customer was withholding $12 million of our invoices because the DCAA auditors were questioning the adequacy of our documentation supporting the quantity of laundry services we provided. Having supplied the appropriate documentation, our customer determined that we were entitled to every penny of the $12 million that was withheld, again proving that the negative publicity we received for our work in Iraq to support the U.S. troops is unwarranted and often politically motivated. We have now favorably settled almost all dispute issues, including dining facilities, fuel, and laundry. You probably have heard the news last week that the Department of Defense has planned to issue a request for proposals for the LogCAP 4 contract. This is a standard part of the government contracting process. LogCAP 3 is an annually renewable project. As with previous LogCAP contracts, the government has chosen to re-compete this project at about the five-year mark. We have been preparing for the bid process and are looking forward to the opportunity to continue to provide services to the U.S. and coalition forces on a selective basis. We now anticipate by year-end, we will know the extent of our role in the new LogCap 4 contract. Let me now turn the call back to Dave for some closing comments.

[Dave Lesar:]

Thank you, Bill. Let me close with a quick summary. We posted yet another record quarter at ESG. Our North American work is stronger than it has ever been. Our revenue was up $28 million sequentially, not the 28% I mentioned earlier. Although natural gas prices are still in the $5.00 to $6.00 range, we believe that demand for our North American services will continue strong. Our customers tell us they plan to continue drilling through any near-term weakness in natural gas prices. Our commitment to growing the Eastern Hemisphere has begun to bear fruit with the growth we have seen this quarter plus, the award of some major, multiple-year contracts will increase momentum going forward. At KBR, we will continue to work closely with our customer on the difficult situation with the Escravos project, while focusing on growing our backlog with projects that meet our strict risk and reward requirements. As I said, we are now moving ahead with the KBR separation via a tax-free spin-off, although we will ensure the form of the separation is the most appropriate one given the market conditions. We are very pleased with the results we have had year-to-date. We see continued expansion and great opportunities in the future. The bottom line is that this is a good market, but it will only get better into the foreseeable future. Now, we will take your questions. We will ask you to limit your comments to one question and one follow-up.

[Operator:]

Thank you. (Operator Instructions) Our first question will come from Robin Shoemaker with Bear Stearns.

[Robin Shoemaker:]

Thank you, good morning. In terms of your comments about the North America pricing increases and the length of time that would be required to get those, can you just elaborate on that a little bit more? Normally you would have a full realization of a price book increase in three months, and you are saying that it might be slower this time. Is that correct?

[Andy Lane:]

We have seen good progress, and compared to historical progress on putting price increases through, in the first-half of 2006 with the price increase we had in the fall of 2005. We have seen some slowing of acceptance of price increases here in the last month but we are confident we can get that price increase through. It may be more like six to nine months. We did just increase our pump and services price book 12% July 1st. We are still under tremendous demand for our services. We are still turning away work that we are not able to catch today. We do not see any slowdown in that. So tremendous demand for our services in a market where it is very tight on both people and equipment, so we think it will just take us a little longer to realize the benefit from this price increase.

[Dave Lesar:]

Let me add one thing on North America. We have always been, as our investors know, much more bullish on North America, and the U.S. in general, maybe than some of our competitors have. We recognize there is a lot of equipment potentially being built for the U.S. market but we just do not see that that equipment is going to have major impact in terms of the pricing and the demand structure that is out there, especially from the position that we are playing from in North America, which is basically where we are picking the customers that we are working for. As equipment becomes available, I think it will get soaked up with the demand that we see out there. We continue to be very, very optimistic and very bullish on the North America and the U.S. market in particular.

[Operator:]

Our next question will come from Brad Handler with Wachovia Securities.

[Brad Handler:]

Thanks very much, just a couple quick ones, please. Can you share with us the decremental margins in Canada in the quarter?

[Andy Lane:]

With that $100 million reduction in revenue that was mentioned earlier, it was a very significant change there and, given the fixed costs, was under a real challenge with that kind of decrement to show profitability. We would expect, Brad, a pretty dramatic recovery as we usually do in the third quarter and the fourth quarter. The second quarter is really, you are kind of just trying to break even there in Canada in that period.

[Brad Handler:]

Fair enough. If I could, an unrelated follow-up -- you have recorded a number of new contract wins and a lot of impressive stuff in the Eastern Hemisphere; is it possible to calibrate how much on an annual revenue basis that translates to? You gave us some sense of Al Khurais as it relates to Saudi, and that is helpful, but could you do it more broadly for all of the contracts, the big contracts awards you posted?

[Dave Lesar:]

Let me address that one. We did say in the Al Khurais that, when it is up to full activity, that will increase our Saudi-based business by 30%, but there is a slow ramp-up in that project and we see very minimal impact in the third quarter in Saudi, a good increase in the fourth quarter and then a strong increase next year. That is still a very good project for us. The large Statoil win, the big win in cementing in Baroid and production enhancement fluid, that will really start to impact us in the fourth quarter slightly and will impact next year, primarily in 2007 with that win. Then, the integrated bundled services package for drilling production technology will really impact us most in 2007, too.

[Operator:]

Our next question will come from Kurt Hallead with RBC Capital Markets.

[Kurt Hallead:]

Thank you, good morning. I just want to get some clarity on the KBR spend one more time, just to make sure I understood correctly. On the timeframe, did you reference that the spend could be completed within six to nine months? Or were you referring more toward an IPO, along those lines?

[Dave Lesar:]

What we are saying, Kurt, is we are now giving further detail on what the final separation is going to be, and the final separation we expect to occur within nine months in a six- to nine-month window of achieving the tax-free spin-off. We still view an IPO as attractive. If the market is attractive, we would have an IPO before the ultimate spin-off.

[Operator:]

Pierre Conner with Capital One.

[Pierre Conner:]

Good morning, everybody. Dave, first question, on the Eastern Hemisphere results -- impressive in the quarter. I wanted to know, it seems early to have gotten results from some of the reorganizations you discussed with us at the analyst meeting, so do you see further improvement as a focus because of some of things you have done, or did you get some of that it this last quarter?

[Dave Lesar:]

I think that it was too early to have any impact from some of the reorganizational things we talked about back when we had our analyst day. I think the focus of the management team that Andy discussed and the focus on business acquisition and the positive impacts that we will get from that really are in front of us and really are not reflected in the results, nor are they really reflected in the contract wins that we have announced. Those were really things that we have been working on for the past year or so. I think we do have some potential upside as we get the new team even more tightly focused on the Eastern Hemisphere.

[Operator:]

We will go next to Robert MacKenzie with Friedman Billings Ramsey.

[Robert MacKenzie:]

Good morning. I guess my question is directed towards Andy. Within your more-bullish-than-average outlook for the U.S. market, are there any geographies and-or play types that you are less bullish on right now?

[Andy Lane:]

No, Robert. I mean, we are very bullish on pump and services, of course, with our position there. We are very bullish on the completion market, the sand control market offshore, deepwater activity picking up -- we do very well there. We are very bullish on cementing and Baroid and completions and PE offshore. In the land market, the land marketing completion remains very competitive. From a geographic standpoint, the Rockies are extremely strong and we see the Rockies staying very strong. The Gulf will be solid for us, and we see very good activity in the southern areas, South Texas, primarily.

[Operator:]

Our next question will come from Dan Pickering with Pickering Energy Partners.

[Dan Pickering:]

Good morning. I wanted to come back to the Escravos project. I thought that project had been bid at a time period after we had already seen some changes to the bidding process, and I am trying to understand -- it sounds like most of the cost is in the engineering and construction changes. What has happened in the last year that changes what needs to be done there? Is it the customer driving it or you guys driving it?

[Dave Lesar:]

The project, the original intention to tender was issued by Chevron back I believe in the 2003 timeframe. During that period, we did a lot of work on that under some of the old regime of looking at projects. We encountered some issues there related to the quality of the feed that we were provided on that project, and some changes that we had within the execution team outside of KBR. Where the changes we have identified, you know, have affected us, is more downstream towards the on-site work in Nigeria for construction. We examined the present situation, and what we have seen with respect to the site development issues and the preparation of the site, some of the community issues arising, some of the aspects we have seen on the Niger River, as well as some global escalation in some bulk commodities, they have really -- our projected estimates in completing the project have resulted in a market change in price. We have been working with Chevron to address these issues, particularly the issues regarding the site and the local community issues in the Escravos area to find the best way to execute the project going forward. Unfortunately, it was different than what we had envisioned. Some of the risks that manifested themselves at this stage were ones we should have picked up in 2003, that we clearly would have picked up today.

[Operator:]

We will now take a question from James Wicklund with Banc of America.

[James Wicklund:]

Good morning. I hate to beat this too much, but when you guys plan for capital spending, and supply chain management is real critical, in terms of adding capacity or managing capacity for the North American market, are you assuming natural gas prices or rig activity -- what drives it? I have no doubt, Dave, that business will stay strong and stay good, but the big question is

[Andy Lane:]

We believe it will continue to increase in '07. We are planning for a robust rig count still and we are appropriately sizing. Chris mentioned we are going to ramp up our capital spending to $1.1 billion to $1.2 billion in 2007. We are still both very excited about the U.S. market but also our Eastern Hemisphere growth.

[Dave Lesar:]

Let me just add, to specifically answer your question, we are planning for growth -- volume growth in North America and especially the U.S. market. I would really refer you back to some of the comments that Jim Brown made on Analyst Day, some of the things that are driving that -- new fields, the expansion of the Barnett shale, shale developments going on in West Texas, the down-spacing that we are seeing in the Rocky Mountains, the expansion of the Bakken play in Montana, and now moving into Canada. We continue to see customers expanding not only their existing plays but new plays being developed. When I say good, I mean good from a continued pricing standpoint and certainly growth opportunities as market expansion continues, new rigs come on -- we are building our capital accordingly.

[Operator:]

We will take our next question from Daniel Henriques with Goldman Sachs.

[Daniel Henriques:]

Good morning. Just so I understand a little bit more about your timing for KBR, let's assume the scenario that, let's say five months from now, you still do not have the IRS approval but the IPO market is better. Would you still decide to go with the IPO or, given that the full separation will be so close with the spin-off, you would just wait for the spin-off?

[Dave Lesar:]

If the IPO market is attractive, we feel there are benefits to doing an IPO first but what we are signaling here is that we do want to achieve the ultimate separation in the near term. Although they cannot be right on top of each other, there is no minimum waiting period, for tax reasons or anything else. There have been a number of examples where there has been an IPO followed by a spin shortly thereafter. They are not mutually exclusive. We are going to achieve the ultimate separation and, if the market is attractive, that will be preceded by an IPO.

[Evelyn Angelle:]

I think we have time for just one more question, please.

[Operator:]

Our final question will come from Scott Gill with Simmons and Company.

[Scott Gill:]

Good morning. Bill, I guess this is directed towards you. When you look at the E&C part of KBR, we have not seen a lot of change in the backlog over the past couple of quarters. I was just wondering if you could give some commentary on order flow, projects that you are looking at today and -- do you think we have kind of reached a steady state in terms of order flow for this part of your business?

[Bill Utt:]

Scott, one of the interesting things we have seen in the last 12 months, certainly with the price of oil, has resulted in a very strong increase in commodities and also the ability of our supply chain to deliver at historical prices and delivery times. We see a lot of projects out there that I wish I was in a position to say we have in the backlog today, but because of the significant ramp-up in the cost to build these plants, the customers are digesting this new cost environment for capital projects. As a result, the projects are getting a little more scrutiny. They are getting pushed off to the right -- as we are prone to say back at KBR, they are sliding in time. The programs are going to get executed. It is just getting them through the appropriations process when the initial budgets were a lot less than what we are looking at now, but they will ultimately get completed. I am hopeful that by the end of the year, a lot of what we thought would happened during the 2006 period would actually come to fruition, but it really has been just the customer community really digesting the appreciation of capital projects from a cost standpoint.

[Operator:]

That would conclude our question-and-answer session today. I would like to turn the conference back to our speakers for any additional or closing comments.

[Evelyn Angelle:]

Thank you, Millicent, and thank you to our audience. That concludes our 2006 second quarter conference call.

[Operator:]

Thank you everyone for your participation in today's conference. You may disconnect at this time.