奇異 (GE) 2004 Q1 法說會逐字稿

Good day and welcome everyone to this Ionics Inc. first-quarter 2004 earnings results conference call. This call is being recorded. At this time for opening comments and introductions, I would like to turn the call over to the Chief Executive Officer, Mr. Douglas Brown. Please go ahead, sir.

Thank you very much, and welcome everybody to our review of our Q1 results for 2004, the period which ended March 31st. I would like to remind everybody of the Safe Harbor statement and in essence that the listeners are cautioned that forward-looking statements are not promises or guarantees. We would ask you to also look at the risk factors which are disclosed in our 10-Q for the period ending March 31st, 2004 and for the 10-K for December 31st, 2003.

Well, certainly the quarter -- Q1 was an exciting quarter for the Company. It was challenging in that we had to consolidate two new entities, one of which we acquired, Ecolochem, and one of which we were consolidating as a result of FIN 46, which is Desalcott or the Desalination Company in Trinidad which we are a joint venture partner of. It was a rewarding quarter because we are starting to see the first signs that the restructuring effort, which we started at the end of last year, is beginning to bear fruit.

So in the next fifteen minutes, I would like to just go through five points with you. The first is on the revenue side. Excluding Ecolochem and Desalcott, the revenue in Q1 was flat with Q4 but up 7 percent from the comparable quarter last year, and bookings on a same basis, excluding Ecolochem and Desalcott, was relatively level with the last three quarters but up 11 percent from the comparable quarter last year, Q1 of last year.

The third point is that we are seeing significant profit improvements from the reorganization which we started. Excluding Desalcott and one-time charges, we are effectively reporting about a 4.5 percent EBIT margin after intangible asset amortization. And if you look at it before intangible asset amortization, we are reporting about a 5.5 percent EBIT margin.

Item four -- the Ecolochem acquisition was completed in the middle of February, so the results are consolidated only for half of the quarter. But the consolidation process is clearly underway, and we will talk about that.

And then finally, we do see an additional substantial opportunity to reduce our costs on a long-term basis through consolidating our purchasing organization. We will explain what we have been doing on that front. But overall I would say that we are encouraged that the quarter has shown some signs of revenue recovery and has also shown some signs of profit improvements.

On the revenue side, this looks at the revenue in the first quarter of about $88.7 million. It is basically flat with the Q4 of '03 and up to 7 percent from Q1 of 2003. But the other thing that I would point out is that the affiliate revenues declined in the quarter. That is basically revenues related to the Kuwait project. Notably, third-party sales, which do generate better margins for us, have increased, and in fact, third-party revenue in Q1 of '04 is up 15 percent compared to Q1 of '03.

The next slide here looks at bookings by quarter. We booked about 78 million in the quarter. The bookings activity is fairly a bit choppy. There is an upward trend in this graph, if you care to look at it. But we see that Q1 of '04 is up, as I said, 11 percent from Q1 of '03. Bookings at 78 is still less than the essentially 82 million of third-party revenue that we realized in the quarter, so we're looking to increase bookings in the coming quarters.

Now this is a slide that talks about -- that shows our P&L for the quarter from continuing operations. Just to comment about disc-ops, discontinued operations, it is basically our European consumer business. It produced a loss of $2.7 million for us in the quarter, and I am happy to say that as of today this business has been sold. We have realized about $2.1 million in proceeds and have a $900,000 escrow account. So this business has no debt activity. European consumer business is no longer part of Ionics.

This slide then is really talking about the balance of our business. Reporting 107 million in revenue in total. A loss in operations of $1.5 million for a 6 cent (technical difficulty) loss.

In that number is the consolidation of Desalcott. On this slide, I have shown how much -- what Desalcott's contribution is to our P&L. You can see 6.9 million of revenue. So of the 107.4, effectively $100 million is Ionics and Ecolochem and $7 million is Desalcott. Of the 1.8 million of EBIT, that is all basically from Desalcott. Of the interest expense of $3.3 million, 2.7 of it is related to the Desalcott debt financing, which I would remind everyone is nonrecourse to Ionics. It is a project specific financing, but it shows up as a 2.7 million expense item on our books.

So, first of all, with Desalcott, it is reporting a $900,000 loss. Offsetting this is about $500,000 or $600,000 of income that the Company does receive from interest on the loans that we have with Desalcott and the profit on a technical service advisory agreement that we have with Desalcott. So the loss -- but it is still Desalcott on a consolidated basis when you consider all of that is producing a loss.

We have an action plan to look at how we convert that into profitability. One of the big things is that there is a capacity expansion, which is going online in June of this year. It won't necessarily affect Q2 because it will be coming on late in Q2, but it will significantly improve performance in Q3. But we are also looking for ways to reduce expenses. It is a challenging situation because Ionics is not responsible for operating this plant, the Desalcott management team is. So that is a project that we are actively engaged in trying to improve the performance of.

We go back then and look at the rest of Ionics, which is Ionics plus Ecolochem. It is showing $100 million of revenue and basically a breakeven EBIT. In those expenses are these items which we consider to be unusual items or non-recurring items. The biggest is related to the project in Israel referred to as CDL, Carmel Desalination Limited. This is a project that we have been notified in the quarter by the Water Desalination Association in Israel that they were terminating the concession, and they were going to be calling a performance bond that CDL had issued to them.

Ionics is a one-third shareholder of this project. There are two other Israeli companies that are the other shareholders, and we have provided CDL with backup guarantees for this performance bond. We made a decision in the quarter to basically expense all assets, write-off all assets and charge any liabilities related to this project in the quarter, and that totals about $3.3 million.

We have made a claim against the government that the reason for our failure to secure financing on this project was related to their failure to deliver on certain aspects of the project that were a part of the contract that we signed. We believe we have a legitimate claim for the recovery of all of our costs, and we are vigorously pursuing that. But given the uncertainty of the recovery, we made the decision to expense the entire amount now.

In addition to the CDL charges of 3.3, there is about 600,000 of restructuring charges. These are primarily related to restructuring leases for rented facilities that we are getting out of, and there is also about $600,000 effectively related to our Oracle implementation. These are third-party costs that we have been expensing as we implement Oracle, and we do not expect them to continue beyond really about the first quarter of next year.

The total affect of these charges is $4.5 million, so if you go back to that previous slide where we had 100 million in revenue and zero EBIT and before these restructuring items or unusual charges, we actually were reporting about 4.5 million of EBIT on 100 million of revenue, which is the 4.5 percent EBIT margin I talked about.

The EPS impact of these charges after tax is about 15 cents a share. So if you were to offset this against the 6 cents a share loss that I showed in the previous slide, we would have been reporting earnings per share of about 9 cents a share for quarter.

Also in the P&L is about $1 million of intangible asset amortization related to the Ecolochem acquisition. This is a non-cash item, and it only results as a result of the acquisition of Ecolochem. That represents about 4 cents a share. So we believe that the true underlying performance of the Company is better reflected by adding this cost back, and that would produce earnings per share in the first quarter of about 12 cents a share and an EBIT of about $5.5 million, and so a 5.5 percent EBIT margin.

Just a couple of quick balance sheet items. The major thing that happened in the quarter was that we used about $55 million related to the acquisition of Ecolochem. Now in our balance sheet with the consolidation of Desalcott, we are reporting Desalcott's $19 million of cash as restricted cash. So on our balance sheet disclosure, restricted cash item is Desalcott's cash. Ionics free cash is about 68 million at the end of the quarter. Current assets picked up about $30 million, 20 of which is related to Ecolochem. The investment and affiliates -- the reason why that declines is because of the Desalcott consolidation, so we have eliminated the investments in Desalcott that showed up there as effectively long-term notes.

The pickup in PP&E -- 100 million of the pickup in PP&E is Ecolochem and 130 million is Desalcott. And then the other is basically about $250 million of goodwill and intangible assets that resulted from the Ecolochem acquisition.

On the liability side of the balance sheet, we picked up some more payables from both Desalcott and Ecolochem. About 7 million Desalcott and 3 million Ecolochem. The big increase in debt is 175 of that debt is the Ionics term loan from the Ecolochem acquisition. 112 million of that debt is from Desalcott, and as I mentioned earlier, that is nonrecourse debt that is specific to that project.

There was somewhat of an increase in other liabilities that effectively the result of Desalcott, the fact that we only owned 40 percent of the equity, 60 percent of the equity is owned by Haves Acarpmap (ph) Construction Company, which is our partner down there, and so we had an increase in that portion of the liabilities. And then the increase in shareholders equity is related to the 4.6 million shares that we issued.

I mentioned that we would talk about the consolidation with Ecolochem. We are fully committed to integrating our two organizations. And, in fact, Skip Dickerson, the previous President of Ecolochem, is now Vice President of our Water Systems Division and is specifically running the sales and plant operation as part of our water systems activity.

During this quarter, since the end of Q1, we have completed the reorganization of our sales group where we have consolidated the sales activities of Ecolochem group and the Ionics group. That reorganization in North America is complete and in Europe is fairly almost complete.

We have also started a number of activities that are either related to expanding our business opportunity, new sales opportunities, or additional cost savings that result from combining the two businesses. Just a couple of examples here. One is that we have started and are now regenerating Ecolochem's Ionics change trailers in our San Jose facility, which allows us to access a new regional market, Northern California, which Ecolochem had not previously been able to access with their trailers, and where Ionics does not have trailers of the size and capacity that Ecolochem did, it represents a new market and a new region for us.

On a cost-saving side, we have an activity, the life sciences activity, that is centered in Montgomeryville, Pennsylvania. It is an Ionics change. It has Ionics change regeneration as part of their activities. We have now been regenerating that resin at Ecolochem's Norfork facility at a substantial cost savings to what they had been doing previously. And the point of consolidating Dallas and Houston -- probably consolidating might be a bit strong word. It is probably better thought of as integrating the two activities. We have two regeneration facilities there -- one in Dallas, which was Ionics previously, and a much larger one in Houston, which was Ecolochem's -- and we actually have a program underway now to regenerate all of the resin in Houston but to continue to have Dallas for filling Ionics change bottles and serving local customers.

There are numerous additional expansion and cost savings activities which we have identified. Each of them has a team working on it, trying to develop and implement a plan to produce additional synergies between the two companies. So I would say that the consolidation activity as a whole is progressing very well, and there is a lot of excitement in the organization for the benefit that we are going to get out of combining the two companies.

Another opportunity that we are putting significant resources into is improving our worldwide purchasing activity. Within our water systems division, previously we had about 15 independent purchasing groups. Purchasing outsourced materials from various vendors, but operating in a not consolidated or not a coordinated way. We have now consolidated these independent purchasing groups into one coordinated activity with one individual responsible for worldwide purchasing activity. We have gone through and categorized the items to be purchased from third parties and outside vendors by volume. We have identified over $200 million worth of purchase materials, which this activity is going to cover, and the group has established a target to save at least 5 percent of purchase materials costs by getting the benefit of a consolidated and coordinated purchasing function where we are able to negotiate better terms and pricing with our vendors because now we are representing a $200 million purchasing activity as opposed to a number of much smaller purchasing groups. This is a significant long-term savings potential for the Company, which could even exceed the cost savings which we have been able to realize through our previous restructuring effort. So we are looking for this in the future to add significantly to our bottom-line.

Finally, there are a couple of events which have occurred so far this year that I would just like to point out. We have continued to expand our build on and operate activity with two new plants in the Caribbean, one in Exima and one in Eleuthra. These plants were built on time and on budget and are now operating and producing water on a reliable basis, and our revenue is being generated by the sale of that water.

We also in the first four months of the year booked four orders in the microelectronics industry for almost $20 million in value. This is a substantial recovery from what we did last year, and we are seeing that the microelectronics sector is showing significant signs of renewed interest in investing in water or wastewater recovery systems.

And then finally, in conjunction with the reorganization of our sales force, we have also implemented a new compensation program that establishes a consistent commission program throughout the U.S. organization. This is not something that Ionics had in place previously, and we found that we had many sales people who were not paid a commission or were paid bonuses that were discretionary and were not consistently applied. We believe all salespeople should have a significant incentive tied to the completion of sales activities. So we have implemented a companywide or U.S. wide commission program that significantly enhances the sales compensation system.

So finally I would say that in summary we are quite encouraged by the first-quarter results. We are seeing signs of improvement in the revenue line. We are seeing signs of improvement in bookings and certainly the quotation activity that is outstanding. The microelectronics industry and the pharmaceutical industry are quite strong. We are experiencing a weakness in the power industry, but overall we are encouraged by the level of quotation activity that is outstanding and signs that our booking rates are improving.

On the profit front, we have achieved a 5 percent EBIT margin in Q1. I remind you that our target is 12 percent, so we have a long way to go. But we are just in the process of realizing some of the cost savings that we have put in place. We are starting to see tangible benefits from the consolidation with Ecolochem, but clearly there is still a lot of opportunity there that needs to be realized.

In purchasing and doing a better job of purchasing worldwide can add considerably to our bottom-line. If we can achieve the bottom of the range of our internal objectives, we can add 50 percent to our EPS and EBIT from what we have produced in the first quarter. So it is a material, an important area for us, and an area we are putting significant resources in.

Overall, an encouraging quarter. Profit margins are improving. Third-party revenues are improving. There is no question, though, that we still have a lot to do, but the signs of progress are starting to show.

At this point, I would like to open the call to questions.

(OPERATOR INSTRUCTIONS). Tracy Marshbanks, First Analysis.

Good morning, everybody. It looks like you’ve once again kept yourself busy during the quarter.

Thank you.

Maybe a first set of questions on Desalcott. Just looking at the revenue numbers and capacity there, it looks like operations went pretty smoothly, but still not turning a profit. So I think you alluded to this that you have to sort of change things. Also, you are in arbitration I guess over some pricing increases. What is the status of that, and what are the possible outcomes of that arbitration process?

Well, it is clear that we have an issue there with the loss of the water and sewage authority on Trinidad. We believe the contract is quite clear. We think that there is actually very little risk that we will not have the contract enforced. The contract is being arbitrated in the UK, and we are in the process now.

We are also, though, trying to seek an understanding from Alasso (ph) why they are taking this position. And, in fact, I am on my way down to Trinidad to meet with the appropriate people this quarter. So we are putting an effort into trying to resolve it.

We think the high likelihood is (technical difficulty)-- contract enforced in the first quarter. It is possible that the contracts could be changed, could be found to be interpreted differently I guess, which would lower the water rate which we are able to collect from Alasso (ph). It is a little bit hard for me to understand on what basis they could conclude that because the contract is quite clear.

But were the contract to be enforced at a lower water rate, it would obviously hurt plant operations. We think the downside is probably that with the increased capacity that we are putting in and a lower water rate that we still can get the plant to basically breaking even, which on a cash-flow basis means that this plant will make money as it pays down its debt. The plant does cash-flow significantly as you can see from the cash balance that it has.

So this plant will make money as it pays off its debt, but I would say that is probably the downside of an unfavorable (inaudible).

What we saw coming through was pretty clean operations for the first quarter, though?

Pretty clean operations. I would say we have had a little downtime for some maintenance, but nothing unusual, so I would say the plant is running very well, and we are getting very close to starting up what we referred to as phase five, which is another 9 percent increase in minimum purchase requirements, but it is actually about 15 percent increase in production capacity. So there is a possibility that the plant will produce a lot more water. But we need to frankly work on improving the relationship we have with the local water authority there, and that is one of my objectives going down there.

Maybe turning onto Ecolochem now. If I just take the revenue run-rate and annualize it at more like 90, 95 million range versus the 109 in the prior fiscal year, is there a seasonal aspect to that? Is that the weakness that you referred to in power? How should we look at it, and what do the prospects look like?

There are three elements there. Number one is there is a seasonal element. The January to March quarter and the October to December quarters tend to be a bit lower. The warmer summer months tend to be higher because you find that in the U.S. a number of peaking powerplants come online in the summer. So there is some seasonality.

The revenue is down a bit because of softness in the power industry. We expected some of that when we acquired the company, but it is not one -- when that business goes down, it is not a significant decline because they are still making water and selling their service on a per gallon used basis.

The third thing is that in the quarter we also had to make an adjustment in their revenue recognition policy to be consistent with our own. So in the consolidation process there actually was some revenue that was deferred from Q1 into Q2 to make it consistent on a revenue recognition basis with our own policies. That revenue has not gone away. It is just going to show up in Q2.

John Quealy, Adams, Harkness & Hill.

Congratulations on a step forward towards profitability here. A quick question on some of the other revenue items. You mentioned microelectronic strength in terms of orders. You did have a press release out in the quarter about an order to TSMC. Doug, can you give us a little bit more color on other orders there from different players in that marketplace?

Well, we have had a couple of orders now from STMicroelectronics. What is interesting is a lot of the focus is on the microelectronics industry in Asia, and we have had some business with TSMC in Taiwan. But the SP business we are getting is in the U.S. and Europe. And it appears to us that the semiconductor manufacturers are now looking at upgrading their well water supplies for their primary loop, but they are also more importantly looking at wastewater recovery. And, in fact, our internal estimate is that semiconductor fabs will probably spend three or four times as much on wastewater recovery as they will on the primary water loop. And so we are expecting additional opportunities in that area and throughout the world, not just in Asia.

Great. Moving towards Ecolochem, you have it in under the belt now a couple of quarters. Any surprises either way thus far on the integration or the business now that it has wrapped under Ionics?

Under the belt for half of a quarter in Q1 and I guess the month of April you could say. I would say that the integration is going very well. There are certain areas of both companies that, needless to say, when you integrate two companies, there is always concerns on the part of some of the employees about how it's going to affect them personally, and we are trying to be sensitive to that. And we are not taking this on as Ionics has taken over Ecolochem, and we are putting our management team in place.

In fact, when you look at the company today, the top three people in Ecolochem are all playing important roles, extremely important roles in the combined business. So I would say that we are trying to take the best of both companies by putting them together.

I guess from a surprise perspective, I cannot really say that there has been anything material that has been a negative surprise. We had this one adjustment on revenue recognition that we had to deal with as we got into looking at their documentation for the customers. It is a private company. I would say that they probably did things a little bit differently than what we do as a public company, so we have had to make a couple of adjustments there. And so I don't think we were really expecting to shift the revenue from Q1 to Q2 that we did. But I am glad to say that the customers are happy, the revenue is there, the documentation is now in place, and we have a clear understanding of what we need to do on that front going forward. So I don't expect that to be a recurring theme.

With regard to your expectations for further onetime charges as we round out or move through fiscal '04, can you talk a little bit about should we continue to expect some onetime charges here in Q2, Q3 and the potential magnitude if you can offer that?

We still have work to do in facilities. We are also doing some things in benefits that will result in cost savings. I think the magnitude of the charge -- if you look at the magnitude of the charge this quarter, 3.3 out of 4.5 is related to one project that we were dealing with, and the rest is -- so the restructuring charge is really only about 1.2. We are still spending on IT, on Oracle, and that is going to continue through the first quarter next year.

Another item we are spending on is for readiness. That is an item that I did not bring out in this presentation, but we are probably spending 300,000 a quarter with Ernst & Young to help us get 404 (ph) ready, and that is an expense we don't expect to continue. But I think the level of the restructuring charges should be relatively modest going forward. But there will be a tail, and that tail will probably last into the first quarter of next year.

Great. Then the last question I had, with regards to a normalized SG&A run-rate, if you take out some of the charges that you outlined in the press release and in the 10-Q last night, is this percentage of revenue roughly 23, 24 percent, is that a decent run-rate in the near-term that we can expect or any thoughts you can offer there?

We are still trying to improve that. And, in fact, there are some changes that we have made in Q1 that don't show up in the Q1 numbers, so that number should come down.

David Monzel (ph), Irvine Capital.

Congratulations. It seems like you are navigating a very full plate fairly well. I had a question on a bid for the Bahamas that I think you guys may have missed on. I guess it is the Blue Hills project down in Nassau. You may have touched on this. I jumped off the call for a second, so I apologize if this is repetitive.

It just seems to me that was kind of right in your sweet spot, and maybe I am wrong on that. Maybe it is too small; maybe it is not. Could you just walk me through what happened there, and was that in any of your plans for the year, and what went on there?

Sure, David. We did quote on the Blue Hills project. There were seven bidders I believe. We did not really hold out a lot of hope. When there are seven bidders on a project, we assume we are not going to win it because the only guy who wins with seven bids is somebody who is willing to take it at a very low price, which is what we think the project was completed at.

It is true that Consolidated had a cost advantage over other participants because they have a significant plant already on the same island. So we're probably guessing that they assumed significant labor savings from the two. Other than that, there is no real basis for assuming that they won other than they took a lower margin.

Now we are the largest player in the Caribbean, and we intend to continue to be. So we are continuing to look for opportunities there. But we are still being pretty selective on projects we go after, and we are focused on projects where we think we can get an attractive order rate.

So that was not in any of your models for the year?

It certainly wasn't in the plan for something that we were expected to win. We bid on it. We actually took an approach to bid for the spec, which everybody had to, but then we put in an alternative bid to see whether they would show an interest in saving. We thought we had some ways they could save considerably by looking at an alternative design approach. They chose not to recognize that bid and stuck with their specs, and that is fine.

Myrna Marsai (ph), ACI Capital.

Thanks for taking my questions. I have a couple of questions. The first one, I think somebody already asked about when you think the charges are going to end, and you said we are looking for first quarter '05. One of the things that -- I know we have a lot of EPS numbers floating out there, and it makes it very hard to predict quarter to quarter not knowing what the charges are going to be, and we have sort of talked about margins and getting to core earnings power. I guess another way to look at it is, when are you guys going to stop earning earning cash and start generating cash again?

Well, in the first quarter, we had an EBITDA. If you look at EBITDA before these extraordinary charges, we had EBITDA of about 14 and we had CapEx of about 8, so we had about 6 million of excess cash flow.

Right. But your free cash flow -- I mean there was 2 million of operating cash flow burned. Could you reconcile the 10 million of free cash flow -- the -10 million of free cash flow in the quarter to what all the charges were?

Yes. Well about 4.5 million was related to the third-party charges, these unusual charges.

That would be Israel and --

Israel and the restructuring charges.

Right. Although I would argue that the systems integration would not be an unusual charge because every company has to do that. But -- (multiple speakers)

We look at it as not the recurring part of our business. In other words, we only bought Ecolochem once. We are going to integrate it. The charge is actually -- the 600,000 of charges are not really related to the acquisition of Ecolochem. They are related to the restructuring program that we undertook at the end of last year where we are getting out of leases in areas where we have consolidated operations, and we have facilities we don't need.

The restructuring I understand. The systems integration where you're putting in the Oracle system, is that related to the Ecolochem acquisition, or is that something separate?

That is separate. That is part of the restructuring program that we started last year.

Okay. So that is 4.5 million. So that gets you -- where is the -6? The other 6 million in the quarter?

Well, there was an increase in working capital during the quarter that consumed about 10 million in cash, most of which is related to the Kuwait project.

I guess my other question -- I am just trying to reconcile the order number. There is definitely progress on the order number. We have talked about up 11 percent year-over-year on the bookings.

But I am looking at the backlog. You were kind enough to give us the numbers that Ecolochem and Desalcott contributed to the backlog. By my calculation, the backlog number is down 9 percent year-over-year. If you did the same-store backlog, it is down 4 percent quarter-over-quarter. I know that the backlog is going to be choppy, but how do you reconcile the bookings with the backlog?

The primary thing that is happening is that we are burning off the backlog from Kuwait. And as you look at the bookings third-party sales, the bookings rate compared to our third-party sales rate, we are still short 4 million for the year -- for the quarter I should say. And so that is -- but the bookings, also if you look at that chart I had from the bookings trend, you see that it tends to be down one quarter and up the next quarter, and it will be 78 million this quarter and hopefully 88 million next quarter. It is choppy in terms of when we get the bookings.

So is it Kuwait coming at the end of it? Is it almost built? Is that basically -- what is the status of Kuwait?

Kuwait is basically continuing in the construction through the balance of this year and will be going into start-up later this year. So there will continue to be revenue on the Kuwait equipment contract through the next several quarters.

It is hitting the backlog, but it is also hitting the working capital. So I am just trying to understand how it is hitting both at the same time.

The equipment contract, the reason the backlog is coming down, is was a large equipment contract approximately $85 million. Of course, that is coming down as we execute on the project. So that is how it is that the backlog would come down.

From a working capital standpoint, it simply just has to do with our spending on the equipment contract and on our receivable balance at the end of the period with the Kuwait project company.

So you have actually delivered the equipment, and now you are waiting to be paid for it. Is that basically --?

Well remember, any of these projects would be on a percent completion accounting basis. But yes, we have delivered components, and we have been paid for components. But the project is midcycle. It is not complete.

So what happens from quarter to quarter is you will see that if the progress payments don't match the revenue recognition, you will get an increase in receivables that will then get paid when a progress payment is received. Some quarters you will see an increase in receivables, and some quarters you will see a decrease of receivable from affiliate.

The main reason is progress payments don't match precisely the percent completion revenue recognition.

Okay. I noticed that the equipment margins were down again. Is that also related to the completion -- is that related at all to how the completion of accounting -- completion accounting is working?

In equipment sales, you do get the revenue from affiliates, and I think we have said in the past the revenue from affiliates we have to defer the portion of the gross margin that is related to our ownership in the affiliate. And in the case of Trinidad, we have deferred 100 percent of the gross margin because of the structure of that transaction. In the case of Kuwait, we are deferring 25 percent of the gross margin.

So revenue from affiliates and equipment sales is lower than revenue to third-party, which is again why we go back to that revenue trendline and look at the revenue for independent parties as increasing 15 percent as a good sign. (multiple speakers)

Right. So I guess in the future quarters we should see -- with the trend to revenue from third-party, we should see that equipment margin get better?

Absolutely. The equipment margin in the first quarter also includes the $600,000 related to CDL, so that impacted it adversely.

Okay. I guess the last thing, I think it was the first caller was asking about the Ecolochem sales being down year-over-year. When you use the information from the Q to backout, it looked like they were down about 14 percent year-over-year. You gave three reasons. You talked about the softness in the power industry and the adjustment in accounting policy and you talked about seasonality. That all made sense to me except for the seasonality. You talked about seasonality and it being winter in January through March and that affecting demand. But wouldn't that have affected demand in January through March last year?

(multiple speakers) --

Comparing comparable seasonal periods.

Yes, but if you are not comparing -- I think the question was someone asked about the Ecolochem revenues in the quarter for the February 14th to the end of the period, and that we are extrapolating those for the full year.

He was looking at the 109 million full-year number and asking if you just divide that by four, and we are saying no, you just don't divide that by four.

I guess this is a separate question then, though, that if you look in the Q, if you talked about having 11 9 in Ecolochem revenue and if you had had Ecolochem for the whole quarter, there would have been another 12 million in revenue that was in the Q, so the full quarter Ecolochem did 24 million this quarter. It says that last year Ecolochem did 28 million. So it was down this year. And so Ecolochem was down 14 percent year-over-year since you acquired it or since at year-over-year. So would that be basically attributable to the weakness in the power industry? I mean, those are like-for-like revenues aren't they, or is that affected by your accounting policy?

Part of it is affected by the accounting policy. I think it would be more like 25 million because of what was deferred for half the quarter.

You mean your revenues would be the like-for-like revenues. So it would be more like down 11 percent?

Right. And Q1 of 2002 was also (technical difficulty)-- Q1 for Ecolochem. So I would say that it is reasonable to say that the revenue for Ecolochem is probably down in the 8 to 10 percent range based on softness of the power industry.

Now were you surprised by that, or is that something when you were negotiating the deal that you sort of expected Ecolochem to fall off this year?

We expected to see some softness absolutely.

Thanks for answering my questions.

Deborah Coy, Schwab Capital Markets.

I will try to be a little shorter. A couple of things. Just to follow-up on the margin question. Since we have new segment breakouts and difference in margins year-over-year, can you give some idea of how you are looking for margins in the equipment sales and operations segment to trend over the next three quarters?

In terms of gross margins?

Yes. On the gross margin side.

I think what we have said in the past on the equipment side we would think certainly to have margins be in the low to mid-20s, and certainly that is where we would expect those to trend out on the operation side. Those are higher, as you can see in the quarter, at mid-30. I think those are good indicative rates of where that business should be.

So those are the normalized rates, even though equipment is not in the quarter?

Right.

Okay. Then just to clarify on the earlier discussion regarding Desalcott, Doug, in your comments you sounded pretty confident that the phase five is going forward. In fact, I guess it's already under construction. What am I to make of in the Q this comment that Wausau is threatening to seek to reject or terminate phase five? Is this just all part of their negotiation? How much risk do you see there?

I believe it is part of their negotiation. We have taken a really hard look at this contract, and we just don't understand the basis upon which they can make the claim. So it is a little bit disturbing and frankly a bit confusing as to why they are doing this. There is a lot of speculation --

Politics?

There is a lot of speculation in Trinidad about Wausau and how well they are doing. But we are helping them make money because they take our water and they resell it to industrial users at a significant margin, and so it is a little disturbing, which is why I am trying to go down and get a firsthand understanding of what their position is.

I know you are somewhat limited in your potential because of you do not really control the operations. But do you feel relatively comfortable with what you have got down there in terms of management?

Yes. From our side, we do. But the challenge is that the management of Desalcott is not within our control. Now I would say we have a good open and working relationship with our partner there, and we have been working cooporatively and trying to deal with Wausau, the dispute with Wausau and improving the plant operations. But it does impose certain limitations on what we can do.

I would say on the phase five it would be surprising that they would challenge that because, number one, they need the water. Number two, part of the phase five agreement gives them the ability to purchase additional water beyond the contractual amount at a very favorable water rate. So I would be honestly quite surprised why they would not want to take advantage of that.

All right. So we will wait and see. On Algeria, according to what you have written here, you have not gotten your final financing yet. Can you give us an update of where you stand on that? And then that being the case, what would be your timing of making additional equity investments?

Well, we have -- Citigroup is acting as our financial advisor to help us raise the capital. We're talking to a number of institutions who are interested in potentially investing in the project, which includes by the way a number of local Algerian financial institutions and banks. There is actually quite a lot of currency in Algeria, and they are very interested in investing in these kind of projects. So we are currently thinking that we could raise a significant portion of the capital for this project from Algerian sources.

And the fact that the AEC is our customer -- is our partner in this project is a real positive. We knew that the June 30 timeframe to raise the financing was very tight, and I think our customer was well aware of that. But we agreed to go forward in any case on that basis. We expect to get an extension to September 30th to complete that, and we think that that -- we are very confident we are going to get that extension, and so we are proceeding forward to try to complete that financing.

I would also point out that we have not taken anything related to the Algerian job into backlog because until we get financing, we do not recognize that project.

No, I understand that. And you have these pending promised equity investments. None of that would come until after financing as well?

Absolutely.

Okay. Then just finally, I will come back off-line with some smaller questions, but you obviously did not give us any guidance again in the quarter. You had said before that you were thinking that once you got Ecolochem under your belt that you thought you might be able to have a little more earnings visibility. You have given some idea of where you think margins might be trending. Are you willing to hazard anything on earnings guidance?

I did say that, and I will do that. But I would like one more quarter before we give you some guidance. We are still -- there is still a lot we are trying to do here. And we are pleased that the results are starting to show, but we also recognize as you noted in your write-up, that we have not come close to realizing earnings potential that we can realize. And so we have got an awful lot going on and an awful lot to do, so it is a little bit awkward and a little difficult for us to feel good about giving a forecast at this time.

Richard Eastman, Robert W. Baird.

Doug, could you just talk to the revenue from affiliates? The Kuwait revenue recognition looked a bit low to us. Anything there? Plus how much is left on Kuwait? Is it 18 million-ish, or where are we on that (inaudible)?

Rick, maybe I can take that question. The affiliate revenue on the quarter is essentially due to just a delta on the Kuwait contract, and it is timing-related more than anything else. There is still some substantial work to go on that project, and I would say that for the balance of the year I think off the top of my head the revenue remaining on that contract is probably in the $20, $25 million range.

Okay. And you have not recognized any revenue on Algeria. But are there some costs involved there that you are deferring?

There is a nominal amount of costs on the balance sheet, and in fact, no, we have not recognized any revenue. Bear in mind in the case of Algeria, since that is a majority-owned sub, there won't be revenue during the construction phase. But the revenue will start when the plant starts up again.

Also then the bookings number, using the 78 million number for the quarter, typically your shipping cycle is maybe six months out. And given where the bookings came in in the base business and maybe a slightly below trend on Ecolochem, are you comfortable that there is enough revenue coming in the front door to deliver on second half expectations?

Well, we have to book it. There is no question that we've got to increase our bookings rate. We feel pretty good about the projects that we booked in the quarter and when we can get the revenue from those. But we are now looking at -- part of this reorganization of the sales group and the commission schedule is really oriented toward doing everything we can to get bookings up. So we are clearly working on that.

We cannot keep booking at 78 million and expect to be able to hit our targets. That is true in the long-term.

Okay. Also in terms of -- I think in the Q there was some comment on some equipment overruns that impacted the margin. I think we are talking less than $500,000. Is that hopefully still Legacy issues, or where is that coming from?

Yes. I don't think there were any significant items in there. It was several smaller projects, and I think they are not indicative of any problems.

All right. Thank you.

(OPERATOR INSTRUCTIONS). David Kurzman, Needham & Co..

Good morning. You seem to have a lot of confidence on the Desalcott arbitration. Do you have a similarly level of confidence, and perhaps you can talk us through if you do, on the Kalden (ph) lawsuit and the CDL inability to obtain financing?

CDL's inability to obtain financing, I don't want to get too specific because this is something that is in arbitration at the moment. But effectively when we were awarded that contract, our plan called for part of the return to be generated by a power generating station that would be built in conjunction with the water treatment facility. As you know, these water treatment facilities consume a lot of electricity, and in some cases colocating a power plant and a water treatment plant adds to the economics of the overall project. So that was the approach we took on this project. And it turned out that when the award was issued on CDL, putting in a power plant was an integral part of the total project, and WDA, which is the Water Desalination Association, which awarded the contract, agreed to that plant.

Well, subsequently it turned out that the local municipal authority where the site had been identified and located refused to issue an operating permit for a power plant because of concerns about emissions. As a result, we were unable -- the power plant had to be eliminated from the project scope. Well, when you eliminate the power plant from the project scope, the economics become substantially less favorable to the point that we were unable to raise financing for it.

And there were some other issues regarding the site that on the one hand the authority that awarded the contract had approved the site without letting us know that we had to go through an approval process and an environmental review process, which considerably delayed the project.

The net of all of it is that our position is that they awarded us a contract that was flawed. Then they failed to deliver on certain aspects of the permits for the site and for the power plant, and as a result, the project collapsed. So we believe we have a very strong claim to recover not only the bid bond or the performance bond but also the costs that we have incurred on the project up to this point.

Now in likely case on arbitration, you end up probably somewhere in the middle. We will have to see. But we think we've got a very good position to get a full recovery. So that is what we are aggressively pursuing.

I think in this case we also have to remember that we are a one-third partner in the project. We have two other drilling companies that are also our partners, and so I think we all have exactly the same incentive and that is to recover as much of these parts as we can.

In terms of the 3.3 million charge that you took, how much of that is reserved, and how much of that reserve do you think -- I guess my question is, is there a chance that you might need to take additional reserve against CDL, or is that all-encompassing?

As far as I can tell, that is the maximum expense possible because we have written off costs that we had capitalized on the project, and then we wrote off the investment that we made in the equity investment that we made in the company, and we reserved the full amount -- our pro rata share of the performance bond, which is $2.5 million. So we have written off everything that we can write-off. I cannot see how we would have additional charges in the future.

Sure. I was just going to very quickly -- it is a much smaller number -- but the Kalden (ph) lawsuit. This is all hinging on a failed weld, is that right, which I don't think would have anything to do with your product?

Yes. David, we tried to write it up in the Q there that is basically a product that we just fabricate, and we are not responsible for the design for the product. We believe we have very strong defenses and do not foresee a liability here, but nonetheless it is a compliant. It is a lawsuit, so we disclosed it, and again we are just the fabricator of the product.

Interesting. In terms of going forward in the water equipment, do you have any visibility in terms of quotes that you can talk about for water equipment sales for the next couple of quarters?

In terms of the level of quotation activity?

Well, you have said that you have done a lot to incent your salesforce. I want to take a look from the other side and look at it from quoting, can you put sort of a rough quality on the level of quoting?

Well, there is a lot of quotation activity outstanding, and there is an increase in the quotation activity. We don't really like to get into talking about our sales pipeline too much because it's quite a proprietary part of what we do. But the general quotation activity is up, and I would say we have been organized, a newly organized (inaudible) and incentive sales group.

And I would also like point out that we brought in a new head of sales and marketing for the Americas who joined us just a couple of months ago who is really making quite an impact. We feel pretty good that we have got it right in terms of organization, structure and management and compensation, and it does seem like if you are looking out at the market and you are saying, is there enough market interest out there to support this level of activity? It would certainly seem to be the case because the level of quotations seems to be up.

But we have -- that is one of the keys. We have to deliver on that. Bookings and sales is going to be one of the things that we are paying very close attention to.

A very quick final question perhaps for Dan. In terms of as the free cash flow ramps up, I want to get a sense as to your list of priorities. Is paying down the debt your first priority? More build on operates? How do you think about it?

Well, of course, those are all the interests that we will manage with our cash flow, and I think what we have said is, it is our intent to manage our leverage ratios, and we would probably pay that down to some extent over the near-term. But we also have good opportunities as we have talked about. We build on operates, and we don't want to throttle that business either. So it is a balancing act, but clearly I think you can see that we would intend to pay the debt levels down somewhat and bring the leverage ratios down maybe by over a period of time by a turn.

Okay. And so do you have a target level of debt that is optimal?

Yes, I think beyond what I have told you, that gives you clearly the direction we are headed in.

We do have a plan, and we do have a target, but at this point, we would like to --

Lorraine Maikis, Merrill Lynch.

This is Gina Gordon calling in for Lorraine, but all of my questions have been answered. Thank you.

Nathaniel Pulsenberg (ph), Pulsenburg & Associates (ph).

Good morning. Could you please clarify for me the $15 million increase in cost of sales to the operations?

That is primarily related to introducing the Ecolochem and Desalcott businesses into the equation. In other words, (multiple speakers)

The bulk of that is non-recurring then.

Let me make sure I am answering the right question. You have asked why the cost of sales, why the cogs number in operations is higher than it was a year ago?

And the bulk of that is bringing in the Ecolochem?

And Desalcott. It is both new businesses that we are consolidating this quarter.

All right. Thank you very much.

There appears to be no further questions at this time. I would like to turn the call back over to you, Mr. Brown.

Well, I appreciate the interest everyone has shown. Thank you for attending, and we are certainly willing to and interested to hear from you if you have any further questions. If not, we will look forward to talking with you again next quarter. Thank you very much.

This does conclude today's conference call. At this time, you may disconnect.