Halliburton Company (HAL) — Q3 2015 Earnings Call Transcript

Good morning, and welcome to the Halliburton Third Quarter 2015 Conference Call. Today's call is being webcast, and a replay will be available on Halliburton's website for seven days. Joining me today are Dave Lesar, CEO; Christian Garcia, acting CFO; and Jeff Miller, President. Mark McCollum, Chief Integration Officer, will also join us during the question-and-answer portion of the call. During our prepared remarks, Dave will provide an update on the pending Baker Hughes transaction. However, due to the ongoing regulatory review, we will not be taking any questions related to regulatory matters today. Some of our comments today may include forward-looking statements reflecting Halliburton's views about future events. These matters involve risks and uncertainties that could cause our actual results to materially differ from our forward-looking statements. These risks are discussed in Halliburton's Form 10-K for the year ended December 31, 2014, Form 10-Q for the quarter ended June 30, 2015, recent current reports on Form 8-K, and other Securities and Exchange Commission filings. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. Our comments today include non-GAAP financial measures. Unless otherwise noted in our discussion today, we will be excluding the impact of these items. Additional details and reconciliation to the most directly comparable GAAP financial measures are included in our third quarter press release, which can be found on our website. Now, I'll turn the call over to Dave.

Thank you, Kelly, and good morning to everyone. As expected, it was another very challenging quarter for the services industry. Activity levels and pricing took another hit across the globe as our customers respond to the impact of reduced commodity prices, and the pressure that their own shareholders are placing on them. Considering the difficult headwinds we were working against, I am actually very pleased with our overall financial results for the third quarter, especially for our Eastern Hemisphere operations. Now, let me cover some of the key headlines. Total company revenue of $5.6 billion declined 6% sequentially, outperforming our largest peer. I'm very pleased with the resilience of our international business, where we again outperformed our largest peer on both a sequential and year-over-year basis for both revenue and margins. This demonstrates once again that we are not getting distracted as we go through the merger process, and I'm confident that from what we are seeing in the marketplace, this is the same for Baker Hughes. Despite lower revenues as a result of pricing concessions and activity reductions, we were able to maintain operating margins due to a relentless focus on cost management. As expected, North America revenue and operating income declined further as a result of lower activity levels and pricing pressure. However, relative to the overall market, I am pleased with our performance. From the peak that we saw last November, our completions-related activity has declined approximately 18%, relative to a 58% reduction in the U.S. land rig count. This clearly demonstrates the customer flight to quality that has emerged during this downturn and positions us well for when the market recovers. Lastly, we took an additional restructuring charge to reflect current market conditions. Let me remind you, as we approach the finish line on the Baker Hughes acquisition, we continue to maintain North American infrastructure well beyond current market needs, incurring a cost we would have otherwise eliminated. This cost impacted North America margins by approximately 400 basis points in the third quarter. Now, turning to operations, in North America, prices continue to erode during the third quarter, impacting total service industry profitability, obviously including ourselves. We believe these prices are clearly unsustainable, but as we have been saying all along, pricing cannot stabilize until activity stabilizes. Looking ahead to the fourth quarter, visibility is murky at best. Based on current feedback, we believe most operators have exhausted their 2015 budgets and will take extended breaks starting as early as Thanksgiving. Therefore, our activity levels could drop substantially in the last five weeks of the year. In my 22 years in this business, I've never seen a market where we've had less near-term visibility. We are managing this business on a near real-time basis: customer-by-customer, district-by-district, product line-by-product line, and yes, even crew-by-crew. We know the North America land market better than anyone, and we're the execution company. Our view is that the first quarter could end up being a mirror image of the fourth quarter. Just as the fourth quarter is facing a steep drop-off post-Thanksgiving, we expect to see a slow ramp-up beginning in January and improving from there, suggesting that the first quarter could be the bottom of this cycle. If you pull back and look at the full year 2016 and compare it to 2015, you could envision a similar mirror image: directionally a slow start and then perhaps picking up speed in the second half of the year. Many moving parts in North America mean I am not confident enough to call the exact shape of this recovery. But we do expect that the longer it takes, the sharper it will be. Until then, we will continue to execute on our strategy and monitor the same external data points that you do: oil production, rig count, operators' cash flows, and how re-determinations impact our customers' credit lines. Additionally, we have our own proprietary internal metrics to follow. We will continue to adjust our cost structure to market conditions, but it does not make sense to reduce costs or infrastructure to reflect expected fourth quarter's reduced activity levels. Instead, we position our North America land business for future success, outperforming the industry as the market recovers. Internationally, I am very satisfied with our business performance today. International markets have held up better than North America, but they are not immune to the impacts of lower commodity prices. We experienced lower prices during the quarter, but in anticipation of these reductions, we aggressively pursued further cost adjustments. Although we had to concede some on pricing, we have worked with our customers over the past year to improve their project economics through technology and operating efficiency. For 2016, we expect to see trends continue from 2015. Land-based activity, including mature fields, should be the most resilient, while we expect offshore to see additional project delays. Now, let me provide an update on the Baker Hughes acquisition. During the quarter, we announced the second tranche of businesses to be marketed for sale in connection with the Baker Hughes acquisition, and we expect that marketing process to begin shortly. On the first tranche of divestitures, we have now moved into the negotiation process. On the regulatory front, during the quarter, the timing agreement with the DoJ was extended by three weeks. Accordingly, Halliburton and Baker Hughes agreed to extend the closing date to December 16. Outside the U.S., we continue to make progress with completing the required filings and obtaining the necessary approvals. Specifically, we are working cooperatively with the European Commission to respond to their requests and expect to resubmit our filing in the near future, starting the formal review process. Let me be clear: we remain confident this deal will be approved. We continue to target a 2015 close, but the transaction could move into 2016, which is allowed under the merger agreement. We are enthusiastic about closing this compelling transaction and achieving our annual cost synergy target of nearly $2 billion. I want to be clear; this $2 billion will be on top of any cost reductions we've made to date. We are excited about the benefits of this combination for shareholders, customers, and other stakeholders of both companies. This merger with Baker Hughes will create a leading global oil field services company, combining our highly complementary suites of services and products into a comprehensive offering that will deliver unparalleled depth and breadth of cost-effective solutions to our customers. Now, let me turn the call over to Christian to provide more details on our financial results.

Thanks, Dave, and good morning, everyone. Let me begin with a comparison of our third quarter results to the second quarter of 2015. Total company revenue of $5.6 billion represented a 6% decline, while operating income declined 21% to $506 million. North America led the decline as a result of continued activity and pricing headwinds. For our international business, third quarter revenue declined by 5%, while operating income margins remained unchanged from second quarter levels. The impact of price negotiations with our customers in the first half has been offset primarily by a proactive reduction in operational costs. In the Middle East, Asia region, revenue declined by 4% with a similar decline in operating income of 3%. Lower activity levels across the Asia Pacific markets were partially offset by increased activity in the UAE and Iraq. Turning to Europe, Africa, and CIS, we saw our third quarter revenue decline by 7%, with a decrease in operating income of 9%. The decline for the quarter was primarily driven by lower activity in Angola and East Africa. Latin America revenue and operating income both declined 4% during the quarter, driven primarily by reduced activity in Mexico. Partially offsetting this decline was improved unconventional activity levels in Argentina. Moving to North America, revenue declined 7% with operating income at near breakeven levels. Reduced activity levels throughout U.S. land were accompanied by further price reductions across the business, especially in the pumping-related product lines. Globally, the continued activity declines and pricing pressures led us to take additional actions to adjust the cost structure. As a result, we incurred an additional restructuring charge of $257 million after tax in the third quarter, consisting primarily of asset write-offs and severance-related costs. As this market plays out, we will evaluate our operations and make further adjustments as required. Our corporate and other expenses totaled $58 million for the quarter, and we estimate that our corporate expenses for the fourth quarter will be approximately $65 million. Our effective tax rate for the third quarter came in a bit higher at 29% due to the impact of gains from our foreign currency hedging program. We expect our effective tax rate to be approximately 26% to 27% for the fourth quarter. Given the ongoing decline in activity levels, we are reducing our capital expenditure guidance by an additional $200 million to $2.4 billion for the year. This represents a 27% year-over-year decline. However, our Q10 program remains intact as we derive significant cost savings from its deployment, and the Q10 provides us the ability to address the higher completions intensity experienced by the industry. Finally, let me give you some comments on our operations outlook starting with our international business. We believe the typical seasonal uptick in year-end sales will be minimal this year as customer budgets are exhausted, and this may not fully offset continued pricing pressures. Therefore, we expect fourth-quarter revenue and margins to come in flat to modestly lower compared to the third quarter. In North America, the prospects of reduced borrowing capacity for operators and a prolonged holiday season make the fourth quarter challenging and difficult to predict. So far, the average horizontal rig count is down a little less than 10% from the third quarter average. If these headwinds play out, we estimate that the fourth quarter average horizontal rig count could drop about 15% to 20% sequentially. We expect our North America revenues and margins to decline, but we anticipate sequential decrementals to be only in the mid-teens due to our cost reduction efforts. Now, I'll turn the call over to Jeff for the operational update.

Thanks, Christian, and good morning, everyone. To begin, I would like to take this opportunity to commend our operational teams for once again executing to our playbook. I want to recognize the performance of our international employees for staying focused on our business in a very difficult market. What's on everyone’s mind is North America, so let me give you more granularity on North America by division. Our drilling-related businesses have been much more resilient than our completions-related businesses. In fact, drilling division margins increased this quarter to 10%, and this includes the 400 basis point impact of the added cost we are carrying in anticipation of the Baker Hughes acquisition. Obviously, the most stressed part of our business is pumping. We know this business best, and it often recovers the fastest. It looks like staying with the fairway players in the basins that we know, not chasing every stake, staying with good customers, and collaborating on our path forward to lower costs per BOE, leading to mutual success. This simple approach requires discipline. If you are looking for a silver lining, the most competitive piece of the business, pumping, is the one that we know the best. It’s the segment that recovers the fastest, and you can be confident that we have the team that gets it done. Last time we reported earnings, oil was in the upper 50s, and the outlook was cautiously optimistic. Since then, we've seen oil drop into the 30s, which elicited an immediate and visceral reaction from our customer base. The rig count followed oil price down soon thereafter. This has caused us to continuously look carefully and strategically at the business and how we're structured to execute. In the short-term, we further adjusted our operations, including partnering with our suppliers for better ways to work together in these tougher times, leveraging our logistics infrastructure, and rightsizing the business to reflect current activity levels. Unfortunately, since the beginning of the year, market conditions have forced us to reduce our global headcount by over 21%. These are tough decisions affecting great people, but they are necessary. Consistent with our service delivery model, we've taken a bottoms-up look at our service processes, examining how we work. In the third quarter, we eliminated an entire level of management in North America. This is ongoing as we clarify and control execution. We are managing through the downturn with two pronged strategy. First, control what we can in the short term; second, prepare for recovery. Our Q10 provides substantial cost savings compared to legacy equipment. We believe Halliburton offers the lowest total cost of service to our customers at any point in the cycle. We are pleased with our customer portfolio, both in North America and internationally, and have aligned with customers who have strong balance sheets. Our emphasis on technology and improving customer's costs per barrel is core to our value proposition. We're focusing on increasing reliability and making better wells with products that have seen increased uptake during this downturn. There is no question that this is a challenging market today. Our playbook remains unchanged; we aim to ensure that we will accelerate our growth when the industry recovers. In the long term, we anticipate that unconventionals, mature fields, and deepwater will offer the most significant growth opportunities. Ultimately, when this market recovers, we believe North America will respond the quickest, and Halliburton will be best positioned to outperform.

To sum up, we continue to make progress with the Baker Hughes acquisition, and we are diligently focused on finalizing all regulatory matters, completing the divestiture process, and preparing for integration activities after closing the deal. We are managing the downturn by executing our two-pronged strategy, getting down to our purest form of cost while retaining the flexibility to grow in our usual disciplined way as activity levels recover. For the fourth quarter, there's a lot of uncertainty as we approach the holiday season. However, we believe that customer budgets will reload in the first quarter and anticipate activity to ramp up in the second half of 2016. Looking ahead, we're not going to try to call the exact shape of recovery, but we do believe that the longer it takes, the sharper it will be. When that recovery comes, we expect North America to offer the greatest upside, and Halliburton will be best positioned to lead the way. There is no doubt that this will be a bumpy road, but history tells us we have outperformed in these markets, turning them into catalysts for growth. We are the execution company, so rest assured, whatever the market gives us, we will take it, and then take some more. Now, let's open it up for questions.

Thank you, good morning. I wanted to start off by asking about your international margins, where you continue to put up good results in spite of the downturn? Could you give us a little more color, first of all, on the resiliency of your margins, and what you are doing there to keep those at relatively flat levels of 2Q, and year-over-year? And also, how should we think about margin progression internationally in 2016 with pricing continuing to come down and offshore activity probably going to be weak again?

Yes, thanks, Jud, this is Jeff. Look, our international teams are absolutely on top of their business. They continue to outperform our competitors in a very tough market due to winning the right contracts and managing costs effectively. I fully expect this team to continue to outperform even when the market starts to recover.

Jud, this is Christian. Let me address your question on 2016. If you look at our margins year-to-date, our international margins have actually improved despite revenues being lower by 11%. We've compressed the margin gap between us and our largest competitor by about 200 basis points in a scenario where our revenues declined less. In 2016, it's unrealistic to think that we can continue to see our margin increase or even remain at these high levels, given that we will continue dealing with a tough environment. Margin progressions will depend on the magnitude of declines between activity and pricing, and it's too early to say right now, but we will continue to aspire to outperform our competition.

Thanks for that. And then I guess my follow-up, maybe for Dave, could you clarify the mirror image you foresee between 1Q relative to 4Q? Do you believe that revenues might rebound modestly in the first quarter? If so, how do you expect margins to adjust in Q1 compared to Q4?

I think it really depends. There must be a budget reload in Q1. The big question mark is how quickly our customers will return to work once they reload. As we anticipate a relatively low rig count volume in December, the speed of the bounce back will largely dictate 1Q outcomes. There’s cash available, and if our customers have it, they will spend it. Slower activity in the first part of Q1 may lead to better margins if there's a sequential improvement later in that quarter.

Thank you, good morning. Dave, could you provide your perspective, perhaps along with Jeff's, on the current state of pumping equipment in the market? How much of what’s on the sidelines do you anticipate will remain there, and how does the downturn impact what that might look like?

Thanks, Sean. Approximately half of the available horsepower is currently sidelined and that equipment is typically not getting any maintenance, thus contributing to its degradation. The service intensity continues to rise on the working equipment. Out of the current stacked equipment, we estimate about half may not be viable for service. Factors show that if we look back to previous downturns, a similar pattern followed where capacity constraints narrowed over time, rather than immediately. That's why we're committed to Frac of the Future—as a means of ensuring our market position.

I think the crucial idea is that given the high decline curves in unconventional plays, our customers are in a 'drill or die' mode. Companies will need to start drilling again to maintain production, or otherwise dismantle their operations. The discussions we have with our customers currently revolve around waiting to see how conditions develop, yet I don't believe we've encountered anyone considering a significant decline in production without drilling next year.

Thanks. Regarding your cost control efforts, could you elaborate on the redundancy that you mentioned being removed in North America, and any additional opportunities to remove fixed costs from your operations?

Certainly. We've identified specific components of our service line in North America where removal of an entire layer of management was possible due to our disciplined execution. This has led to better service quality despite the downturn—a rarity in such times. We're continuously evaluating opportunities for cost reductions across all services globally.

As it relates to the nearly $2 billion in cost synergies expected after closing Baker Hughes, how do any of the actions you've taken impact that figure? With the market conditions having deteriorated, has your outlook changed regarding these opportunities?

We are very confident in our anticipated $2 billion synergies. These savings are not simply related to market conditions, but rather involve fundamental operational changes that lead to sustainable cost reductions across our organization. The integration of supply chains, streamlining processes, and enhancing technological capabilities will contribute significantly to achieving these synergies.

Thanks. Good morning, everyone, and great job on international performance. If we return to North America and think back to 2012, during significant overcapacity in pressure pumping. You saw steady increases in margin with no pricing movement as activity improved. Have you considered how the cycle might play out in 2016 and 2017? What rig count would yield high single-digit margins—could we see that at 1,100 to 1,200?

Yes, our strategy remains the same. By staying focused on customers who operate efficiently and are positioned advantageously in lucrative basins, we can capitalize on volume leverage and low delivery costs, which drive profitability. Historical metrics indicate that with the right activity levels, it’s entirely possible to achieve high single-digit margins, and potentially even double-digit margins under a muted recovery.

Dave or Jeff, what changes are you observing in customer conversations, especially since many are facing production declines next year? Is it reasonable to expect some companies might be inclined to accept production declines rather than mobilize for drilling?

Conversations vary; some customers may adopt a wait-and-see approach. However, it’s rare for customers to accept significant production declines before taking action to drill again. The strong performers will survive this phase; they have the capital to drill next year.

Could you comment on performance in D&E for North America in Q4? Are similar resiliencies expected compared to Q3, or do you foresee adjustments?

Q4 remains unpredictable, particularly as customers may slow work around the holidays. While D&E performance was strong in Q3, it’s unlikely they will be immune to the general activity slowdown expected in Q4.

In a typical year, we generate most of our cash in Q4 and expect this trend to hold. Year-to-date cash flows have been impacted by Macondo legacy payments and acquisition-related costs. While we are lowering the capital expenditure guidance to $2.4 billion for the year, we remain committed to our Q10 program, which continues to yield significant savings.

Can you provide an update on your agreement with BlackRock to execute refracs in the U.S.? What has been the reception from the E&P community and any capital utilization thus far?

The refrac market is small but growing. We are finalizing terms under our agreement and focusing on the technology and diversion capabilities that enhance production. Refracs serve as an asset management tool for our clients.

Christian, could you clarify how you’re managing costs to achieve shallow decrementals in Q4?

Most cost reductions occurred towards the end of the quarter, which will manifest as savings in Q4, leading to expected decrementals being in the mid-teens.

On international margin outlook, can you provide a ballpark of the pricing reductions agreed to and their realization in Q3 results?

Negotiations on pricing have been ongoing, with previous cuts absorbed during the current quarter. As long as pricing remains depressed, I expect additional reductions to continue, focusing on efficiency improvements.

In analyzing customer leverage in negotiations, a significant portion of costs in unconventional plays relate to completions. We’ve seen pricing pressure mainly directed at our lower costs; however, our competitive pricing strategy remains focused around customer retention for the long term.

What do you think is the timing for international activity recovery relative to rising oil prices?

The recovery will be slower for international markets. NOCs have shown resilience, while IOCs will need assurance in sustained higher oil prices before resuming activity and contracting. We may see preliminary engagements but a full recovery will take longer.

If we look specifically at West Africa, we could see quicker responses given existing infrastructure. However, the overall pattern remains consistent with a delay in higher international activity.

Are you experiencing challenges with payments from Saudi or other regions given the economic landscape?

We have observed a lengthening of payment patterns from most customers, including those in the Middle East, but we maintain a competitive edge in day sales outstanding compared to peers.

Could you comment on the outlook for D&E performance in Q4 versus Q3, especially considering the broader market conditions?

Currently, Q4 is uncertain for all segments, including D&E. While earlier performance was strong, the general market slowdown is likely to affect D&E as well.