國民油井華高 (NOV) 2006 Q3 法說會逐字稿

Welcome to the National Oilwell Varco third quarter 2006 earnings conference call.

[OPERATOR INSTRUCTIONS]

With us today is Pete Miller, Chairman, President, and Chief Executive Officer, and Clay Williams, Senior Vice President and Chief Financial Officer. I would now like to turn the call over to Pete Miller, please go ahead, sir.

Thanks, and I'd like to welcome everyone to the National Oilwell Varco third quarter 2006 earnings conference call. I'm Pete Miller, the Chairman and CEO of National Oilwell Varco and with me today is Clay Williams our Chief Financial Officer.

Early today we announced net income of $176.6 million or $1.00 a share on revenues of $1.78 billion. These numbers were all records for National Oilwell Varco. These numbers compare to $147.9 million of net income or $0.84 a share in the second quarter of 2006 and they compare to $88.5 million of net income or $0.50 a share in the third quarter of last year.

We believe both of these are--these numbers clearly show the growth and the profitability that we have been able to achieve since we have accomplished this merger in March of 2005. In addition, this morning we announced a capital backlog of $5.4 billion. This compared to a backlog of $4.1 billion at the end of last quarter.

In this quarter we have received approximately $1.8 billion of new orders, predominantly in the offshore and international arena. We believe this level of new orders shows the confidence of our customers in our employees, products and our ability to execute and deliver these products that they need within the industry.

A little bit later, I'm going to come back and give you more color on the backlog and some of the operational issues and some of the things that we are seeing in markets around the world. But at this point, I would like to turn it over to Clay, so he can expand on both the financials and the operational issues associated with these numbers.

Thanks, Pete and good morning.

Before we begin this discussion, of National Oilwell Varco's financial statements for the third quarter ended September 30, 2006, please note that some of the statements we make during this call may contain, forecasts, projections, and estimates, including but not limited to comments about our outlook for the Company's business. These are forward-looking statements within the meaning of the Federal Securities Laws, based on limited information as of today, which are subject to change. They are subject to risks and uncertainties and actual results may differ materially.

No one should assume that these forward-looking statements remain valid later in the quarter, or later in the year. I refer you to the latest Form 10K National Oilwell Varco has on file with the Securities and Exchange Commission for a more detailed discussion of some of the risk factors affecting our business.

Additionally we may at times refer to results excluding certain merger, integration, stock-based compensation expense and certain estimated proforma result as if National Oilwell and Varco had been during 2004 or during the first 70 days of 2005. Further information regarding these may be found within our press release on our web site at www.nov.com or in our filings with the SEC. Later on in this call, Pete and I will answer your questions. We ask that you limit your questions to two in order to permit more people to participate.

National Oilwell Varco generated earnings of $176.6 million or $1.00 per fully diluted share in the third quarter on revenues of--of about $1.8 billion. Earnings were up 19% sequentially from second quarter 2006 earnings of $0.84 per fully diluted share and double the year ago period when we earned $0.50 per share. Overall NOV's third quarter revenues improved 7% sequentially and 44% year-over-year.

Operating profit was $285.5 million or 16.1% of sales, an increase of 16% sequentially, and an increase of 97% year-over-year. Flow through or operating leverage was 32% sequentially and 26% year-over-year. All three of our business segments posted higher revenue, higher operating profit and higher operating margins compared to both the third quarter of 2005, and the second quarter of 2006.

Our organization is executing very well,thanks to the hard work and dedication of our 25,000 employees. They have embraced the vision of building a world-class organization that the oil and gas industry can rely on to do what it says it will do. Weather and gas storage and oil inventory debates aside, we are here to help the industry modernize and update its rig fleet and to drill and produce more cleanly, effectively, efficiently and safely.

NOV consistently brings the best technologies and ideas to our customers. We are pioneering the application of electronic controls, permanent magnet motor technologies, robotics technologies, information systems, and numerous other promising initiatives to improve drilling and production. Our customers have seen what these new technologies can do for them, and you have seen what these technologies have done for NOV in our strong financial results.

We have more to come. NOV is a lot more than technology, though. We understand well that we are in the service business first and foremost. And our customers are counting on us to execute and so far we have executed very well.

By the time we finish 2006, we will have increased our annual output of Annular BOPs 50% above what we made in 2004. Spherical BOPs will have tripled over 2004 levels. Draw works and iron rough neck production this year will be more than three fold our 2004 production.

Service rigs and tuck drives will have quadrupled and mud pup production in 2006 will be 5.5 times our 2004 production levels. And 2004 was an awfully busy year. For the avoidance of doubt in each instance I'm referring to the 2004 actual production by Varco and National Oilwell combined and comparing it to our actual 2006 output.

These dramatic improvements have come through plain old hard work and innovative engineering. We patiently rearranged much of combined manufacturing footprint in the first 12 months following the merger explaining that we expected margins in our rig technology group to expand once we completed our plan.

The 500 basis point margin increase, since the first of this year, demonstrate that this plan has worked well. Our managers have remained good stewards of capital, accomplishing these production increases without throwing hundreds of millions of dollars in capital at the challenge.

In fact, this year we will only spend about 25% more in CapEx than we will charge in depreciation and amortization, and most of that CapEx will go towards our highly profitable service businesses. This is the plan that we have consistently articulated since the merger closed in early 2005, and our results speak for themselves.

We have benefited from a great market. The world's rig fleet is old. The average floater is 22 years old. The average jackup is 24 years old and the average land rig is pushing 30. These rigs are being run harder than ever, and at pressures and loads that stretch their design limits.

We hear numerous anecdotes about newer rigs we supply, replacing older models that are simply too antiquated to compete any more, or more accurately too antiquated to attract a drilling crew to work on. Interestingly in spite of the roughly 65 new jackups being built today at the current rate of scheduled jackup deliveries, it would take the industry more than 20 years to fully replace the fleet of jackups, let alone grow any new capacity.

In spite of these new additions, the average age of the fleet will continue to increase over the next four years. As a result of our geriatric rig problem, we think the world will be building rigs of all types for sometime to come. Our unprecedented backlog of growth illustrates the pressing needs of this industry, it is up more than six fold since we closed the merger.

While this may seem astonishing to many, in truth, it's not surprising and is, in fact, predictable in an industry that invested virtually no capital and new equipment for more than 20 years. What is most interesting to me and I think most telling about NOV's execution is that our order rate has continually built momentum. Quarterly orders have risen from less of $400 million to over $1.8 billion since we merged in fairly steady progression. This clearly says that our customers' confidence in our ability to execute is rising.

Quarter by quarter our execution commitments have become more challenging. In the past, we have stated that our quoted delivery dates were stretching out a few months but with our order rate running three times our revenue outflow rate quoted delivery slot have moved out dramatically. Many of the components we sell now have deliveries out to 12 months or more.

All this requires our customers and us to both plan better, and for us to work harder than ever to continue to expand our output. We will continue to quote and set realistic delivery dates in view of these challenges. Let me take a moment and explain how we are doing it and why we are confident we will be successful.

Our manufacturing base relies on a combination of internal and external capabilities. Our external demands on our vendors have risen in proportion to our work and to help them manage the load, we are providing them longer range forecasts to assist their planning and placing longer term orders to match our backlog, with backlog deliveries stretching out to 2010, we are able to provide our vendors unprecedented visibility.

We are also working closely with vendors, including sending our experts to their shops to help them debottleneck and qualifying new vendors around the world, working with machine shops, foundries, and assembly operations throughout North America, Europe and Asia to insure that they can meet our stringent quality and production needs.

The downturn in the auto industry has opened up a great source of external capabilities for us, removed from the overheated oil field towns that have traditionally supplied us. We have also been steadily tuning up our internal capability since the merger to achieve the production increases I mentioned earlier and we have more to go. One of the key tools we have employed in this effort has been quick response manufacturing, or QRM, which truly treats time as money.

The focus of QRM is to shorten lead times and processes, sometimes as much as 70% thereby reducing costs and making our business more responsive to the needs of our customers. We've accomplished tremendous results with this technique in places like California where we manufacture [Cothrax].

Our operation there has steadily improved productions to the point where we will be manufacturing nearly a truck drive a day during Q4. This has been done by reorganizing our factories into a series of smaller factories within factories or cells.

Manufacturing cells are staffed with teams that are given high levels of authority and accountability for producing results and we find our employees have really risen to the challenge. All of this has been accomplished with no additional roof line and just a handful of new machine tools.

We've also rolled out or are currently rolling out cellular manufacturing, QRM techniques in Mexico, several plants in Texas, Canada and continental Europe. Additionally we are spending more capital to fuel further increases. We are convinced that the steady adoption of these techniques and this additional capital will insure we meet our growing production commitments and deliver on time for our customers.

Turning back to our financial results for the quarter, revenues for our rig technology segment were $887.3 million, up 5% from the second quarter, and up 55% from the third quarter of '05. Operating profit was $157.2 million, or 17.7% of sales, up 160 basis points from the second quarter.

Sequential flow through or operating leverage from the second quarter to the third was 51%, and third quarter year-over-year flow throughs were 28%, excluding integration charges from prior periods. Backlog for the rig technology group surged again this quarter rising 30% from the second quarter to a record $5.4 billion, up nearly seven fold from the beginning of '05.

The record $1.8 billion in new orders was up about 23% from the second quarter and we expect to see continued growth in the backlog in Q4, as core activity remains brisk. The actual mix within the drilling equipment backlog fell slightly to 69% as the land backlog climbed more than 60%.

Most of the increase in the land backlog and essentially all of the increase in the offshore backlog came from international locations and as a result, $4.1 billion of the backlog or 76% is international. Revenue from backlog increased 12% sequentially in Q3 and non-backlog revenues declined about 8%.

The non-backlog revenue is based on a completed contracts revenue model which can sometimes be lumpy depending on the timing of shipments of goods. We expect revenues out of backlog will climb well above the $600 million mark in the fourth quarter and in total about $2.8 billion in 2007.

2008 shipments out of backlog are expected to be about $1.2 billion, and the balance will flow out in 2009 and 2010. Pricing and terms have continued to improve on new orders. We continue to secure orders with large down payments and aggressive payment terms and as a result deposits from customers and billings in excess of cost, a measure of customer financing rose to $860 million at September 30th.

We believe that such heavy investment by our customers in their orders demonstrates their commitment to complete these projects. Looking forward, we expect to see overall rig technology revenues rise again in the fourth quarter, in the mid-single digit range and margins continuing to increase modestly above the 18% mark.

Our petroleum services and supply segment continued to post higher revenues and margins, owing to excellent execution, better pricing and rising demand. Revenues were $624.1 million, and operating profit was $142.4 million. Margins rose to 22.8% of sales. Revenues grew 6% from the second quarter and 32% from the third quarter of 2005.

Over the past several quarters, the--the past 10 quarters the world wide rig count has risen 29%. During the same period on a pro forma basis for the Varco merger, our petroleum services and supplies group has grown sales 95%, expanded operating margins--or operating profit more than three fold and added 840 basis points to its margins. All due to the many great people that we have at work in this group.

The group benefited from the seasonal turn around in Canada, following Q2 breakup, but at a lower level than expected due to softening in the shallow gas drilling up there. A combination of lower gas prices and rain have dampened the enthusiasm of many Canadian operators. Elsewhere, component sales into rig building and reactivation projects, things like multiplex pumps, drilling motors, solace control equipment, these all increased and demand for coil tubing outside of Canada continued to surge.

Services for domestic drilling operations generally increased with rising rig counts and international activity remains brisk. Like others, we have seen domestic pipe distributors reduce their OCTG inventory going into the fourth quarter but demand for our drill pipe services like coding and hard banding continue to build.

We are actively increasing our coating capabilities around the world, in addition to our new coating joint venture in China that we discussed earlier this year. Business remains good but we are finding pricing improvements more difficult to come by in this market. Nevertheless, several product lines continue to raise prices, in part to cover rising costs, particularly premium alloys and labor.

Overall for the fourth quarter we are forecasting petroleum services and supplies revenues to be roughly flat with very modest margin expansion as new pricing takes hold. Earlier this week we announced that we entered in a preacquisition agreement within NQL Energy Services wherein we would make an offer to buy all of the outstanding shares of NQL for C$7.60 per share or approximately $300 million.

We expect to close the transaction by year end, and are excited about what NQL will bring to our own downhole tools business within petroleum services and supplies. NQL conducts business in seven countries through 23 locations and brings us some very interesting products for use in performance drilling and a mud lubricated bearing pact for use in high temperature drillings.

We expect that the C$10 million--that we expect in synergies will be obtained quickly but that this will be largely offset by additional amortization and depreciation from the purchase accounting step-up. The acquisition is expected to be accretive to 2007 earnings.

Turing to our distribution services segment, we are pleased to once again announce record margins the third time in three quarters. Margins improved to 7.2%, up basis points on record revenues of $353.5 million. Profits have more than tripled since the first quarter of 2005, rising to $25.5 million in the third quarter of 2006. Revenues rose 11% from the second quarter, with all three major areas, Canada, the U.S. and international operations posting strong gains.

Strategic alliance agreements with new customers in several areas ramped up faster than we expected, fueling the growth. And margin improvements were driven by smart bulk buying and close attention to costs. Purchases of large containers of consumables from Asia and cultivation of strategic vendors have reduced costs on many items and our unique, IT infrastructure permits customers to more closely manage their spending.

The group is also selling more MRO supplies to legacy Varco organizations which increases our leverage through greater volumes. We believe further margin expansion from here will prove challenging for distribution, given the competitive nature of this business. Therefore for the fourth quarter, we are forecasting the distribution services group to post roughly flat results.

Turning back to National Oilwell Varco's consolidated third quarter income statement, SG&A increased slightly from Q2, but declined as a percentage of sales from 9.3% in the second quarter to 8.8% in the third. Interest expense declined $3 million from the second quarter, due mostly to favorable interest rate movements on some swaps we have on some of our debt.

Other expenses improved $1.9 million sequentially due to FX improvements in the third quarter and our minority interest line increased $2 million due to higher levels of profitability in our China joint rig venture. The tax rate was roughly flat at 33.5%, about the same rate we expect for the fourth quarter.

Unallocated expenses and eliminations on our supplemental schedule were $31.7 million, flat with the second quarter. Options expense which is not included in the supplemental schedule was $7.9 million, down modestly from the second quarter. Turning to the balance sheet, working capital excluding cash and debt was $1.5521 billion at the end of the quarter down $81 million from the second quarter and down $141 million from our high in Q1, despite substantially higher revenues.

Working capital on this basis as a percentage of annualized revenue fell to 21.8% in the third quarter, a solid 10 percentage points below our long term historical average. Higher inventory balances and receivables associates with the rising backlog and revenue were more than offset by customer deposits on new orders and more favorable billing terms on projects which favorably impacted accrued liabilities.

Capital expenditures in the quarter totaled $55.9 million, up $3.4 million from the second quarter. All of the increase came in rig technology. For the year, we expect to spend about $200 million total. Depreciation and amortization was $41.6 million, up $2.9 million from the second quarter. Cash totaled $786.7 million at September 30, 2006, up $271 million sequentially.

At this point, let me turn it back to Pete for his comments. Pete?

Thanks, Clay.

What I want to do at this point is just make a few brief comments on some operations backlog, and then something I'm sure everyone is interested in, which is the--the gas market right now. And I think the gas market is the--is the one wild card that currently throughout the industry we are all very concerned with.

And there's--I don't know that I have ever seen a bigger divergence in opinions from analysts and theorists and historians and everything on what exactly is going on with the gas market. In our mind today, it clearly looks like it's somewhat of a weather bet. If the winter is a colder winter than we have had in the last few years, clearly, there's going to be some issues with natural gas and you'll probably continue to drill.

If it's not then you could see a reduction in the rig count. However, I think the one thing that clearly we are very confident in is that the natural gas story long term is in tact.

There could be a little bit of a slowdown. I'm not sure. I think, again, the next few weeks the weather will predict that, however, I would suggest you read Chesapeake's statement from Aubrey McClendon that basically, I think was very bullish on where gas was going over the--the near term.

For us, though, I think the thing that's really critical is our backlog does not matter on that gas number. It really doesn't. Everything that's in that backlog is going to blow through whatever type of lull we might have in the gas market. It's a backlog that goes well into '08, and '09.

And it's a backlog that really is associated with international, Deepwater, and a retooling of the business that Clay was talking about earlier, and when you think of those issues, you look at all of our services. I will go into operations just a little bit.

Distribution and our petroleum services and supplies business performed extremely well. These are all leading businesses. Distribution can switch very easily from the drilling rigs to production.

When you look at things like our Tube-O-Scope operations, our MBCO operations, these things all go on--they look at new drill type and they go on new rigs and the new rigs will continue to come into this industry, even, in fact, if you see a decline in the rig count. Almost every rig that we have in our backlog that's U.S. based is protected by a contract, and those rigs are going to go in and they are going to replace older rigs that are in the market.

We are still going to inspect the new drill pipe. We are still going to put the MBCO equipment on there, we're still going to have brand equipment on those rigs. And so when you look at our petroleum services supplies, while they will be impacted somewhat if there's a rig downturn, they're not going to impacted the way they would be, I think by some of the other industry participants that are out there.

We feel like we are in very good position with that natural gas price, regardless of which way it goes. I could almost make the argument that if you lost a few rigs out there, it would give the industry a little bit more time to catch their breath, and be able to position themselves more for expanding out of it in '07, latter half of '07 into '08.

I'm not sure that's going to happen. We are prepared to respond to it either way. I think that the effect on this company is going to be fairly minimal. Again it's very nice to have a $5.4 billion backlog, when you are looking at any softening and we don't see anything in that backlog that really is going to have any-- is going to be affected at all by any of these near term natural gas prices.

I would like to talk just a little bit about operations, I mentioned distribution. Clay mentioned it earlier about we had some record margins in the business. When you look at the margin expansion that we have had and the revenue expansion, I think it really shows the type of businesses that we have out there, and the demand for those businesses in the--in the marketplace.

Again, very much a leading name whether it's Star Fiberglass, whether it's our quality tube flow tubing, whether it's Brant, whether it's MBCO, these are names that continue to be in demand worldwide. Clay mentioned the NQL acquisition. I think it shows the confidence that we have in this particular end of the business.

I think you will see more acquisitions as we go forward that are going to be pushing more into that petroleum services and supplies because we have such great management teams. We're also then able to take a lot of those products and put them into the our international platform, which, in fact, then enhances a lot of the things that we can do with it.

I think NQL again will be a prime example. We'll be able to take many of the products that Clay mentioned earlier, put those into our international matrix and away we go. It really provides with us some tremendous leverage and able to expand. So really one-on-one becomes a four or five, as opposed to a two. So, again, those operations performing very, very well. We think while they could be impacted somewhat by a turndown in the North American rig count we think it will be mitigated because of the market position that we have and because of the demand of the new rigs coming into the marketplace.

Now, let me talk a little bit about geographics. I'm going to first talk about Russia and I could probably spend an entire conference call on Russia. Very exciting place for us today.

Interesting dynamics in Russia. I think most of us are reading things, like well, the U.S.-based companies are not going to be helping out in the Stockman Deal. That really is the E&P companies.

What the Russians are protecting today, they want to have their oil and gas in the ground. Quite frankly, they need western equipment and services to get it out of the ground. And so we continue to have very brisk business in Russia. And we continue to have what we think are very interesting and exciting opportunities in the future.

The Stockman Deal is going to go on. That deal is going to need some very sophisticated semi-submersible rigs we believe we are in a very good position to work with gas prime and gas blocks to be able to produce those rigs.

You have more and more things going on in places like Siberia, with (inaudible) gas. This past quarter we delivered five new rigs to [Sergud]. The Amal Peninsula is going to be I think a very exciting area. The Russians have tog to have natural gas to be able to deliver it to Western Europe. That's their primary customer.

We view them as needing ourselves and many of the other western-based service companies to be able to help them extract that gas and oil in a very efficient fashion. That will continue to be a very, very exciting marketplace. I think over the next few years, you're going to see a lot of western rigs go in there to really retool that business in the same fashion that we are retooling the business, both offshore and in North America.

I think many of the other areas within Russia, whether you are talking Ukraine, Belarus, many Stan, they are searching for more and more energy independence if you will and the opportunity to provide drilling equipment, services into those areas will expand appropriately over the next few years. Another area that's very, very exciting for us is Middle East and North Africa. The Middle East continues to be a hot spot for us. If you look at last year we talked an awful lot about Saudi Arabia.

Today, you see a lot more interest in places like Kuwait, the Kuwaitis are really adding some rigs. You are seeing a lot--a migration of many United States, Gulf of Mexico-based rigs into the Persian Gulf displaced us because we follow a lot of those rigs with our services.

We are opening up a downhole tool manufacturing facility in the Middle East this--I think the first quarter of next year. So we--we see the expansion going on there that's very positive.

Most recently, we sold a six rig drilling package into North Africa. This has been a traditional customer. These rigs are probably in the area of about $150 million, but it also shows that our traditional customers come back to us. They want the rigs that we provided, and we have been able to give them these rigs, many, many times over, and that will continue to be a very great market.

They need the same sort of technology that we have talked about being needed in the North American market. China, we are seeing a migration of many of the shipyards into the Chinese arena.

I think it will continue again to be an area where we are going to see jackups and semi-submersibles built, plus the South China Sea, I think is going to be a very exciting arena, you're going to see many platform rigs and jackups going into that area to develop it.

I think many of those will be Chinese owned. You see such Chinese operators as China Offshore Services Limited that really push for western equipment. That will continue well into the future.

And the last two places I will really talk about internationally are basically Southeast Asia, and Korea. Singapore continues to be the locust of all jackup activity. If you really want to get a good jackup, you go down there to the shipyards. We are a major player with those shipyards.

The sinbest rigs, many of the early rigs coming out are going out at very high day rates, very good equipment and getting tremendous reports as to the way they are running. These rigs are coming out on time, on budget.

In Korea recently with companies like Samsung and Daewoo, we are in the process of completing contracts with them. That's where many of the floaters and drill ships that we are talking about are being built. So you are seeing throughout of the Asian continent, there are going to be many opportunities that are going to continue to rise for us as time goes on.

Finally, I want to talk just a second about the backlog. Right now, it's $5.4 billion, 76% of that is international, 24% of that is domestic, 69% of that is offshore with 31% being land. That's actually a bump up in land and one of the reasons for that is my forementioned North African rig package plus.

Some rig packages that we've been done and announced here in the United States with Patterson Drilling and some others. So we are seeing a little bit of a move upward in that land business which is pretty exciting for us.

The backlog will grow as Clay mentioned. One thing I will say today, I always like to throw a nice little tidbit in, earlier this week, we signed another drill ship contract with Stenna in London, it's for approximately $150 million, and I want to emphasize this because the neat thing about this is this is going to be the third one that's exactly the same.

And what we are doing in the backlog today is not so much seeing rigs of--that we're seeing for the first time but we are reloading the backlog, I kind of liken it to a good college football team, we are not losing seniors, we are reloading with some great freshman, and we don't have to retrain them and we don't have to reengineer this, so I think as we push forward into this backlog, you will see some really interesting numbers coming out of it because of our ability to become much more efficient as Clay pointed out and our ability to reduce the amount of engineering we need and to be able to make the same thing over and over and over again. So, it's exciting as we see that in the backlog.

Finally, just a couple of quick issues. We are building a new facility here in town. Actually, we are going to lease the facility but it's going to be a 400,000 square foot facility that is going to be state-of-the-art for spare parts and being able to repair and overhaul our customers equipment.

It's really exciting, when we came together as National Oilwell and Varco we committed to our customers that we were going to provide the best possible service. This is an example of what we are going to do with that and that should be online, I think the first quarter of next year. Very excited about the opportunities to really help our customers enhance their operations, reduce their costs. That's kind of a quick overview.

At this point, what I would like to do is open it up for any questions that our listeners might have.

Thank you, sir.

[OPERATOR INSTRUCTIONS]

And our first question is from Jim Crandell, please state your company name, followed by your question.

Good morning, guys.

Hi, Jim. How are you doing?

I'm doing well, thank you. Congratulations on your--on the good quarter.

Thanks, Jim.

Could you give us, going forward, your expectations for margins in the rig equipment area? I know you have had--it seemed to me, anyway, to be fairly modest expectations for incremental margins, which you have surpassed and now that you are maybe into a different phase of the cycle, can you give us maybe an update on your expectations for incremental margins there?

You bet. And you are referring to the 22%--

Right.

Incremental margins that we've talked about in the past and we have tried--I think there are some misperceptions about that. That's based upon just kind of looking across the broad range of products we have in rig technology, a wide range of contribution margins. And we sell things in that--in that group that range from pass throughs, like diesel engines and compressors, on which we get almost no markup.

So it ranges from effectively zero percent contribution margin, up through structural steel, like substructures and [dericks] where we get margins there that are a little dilutive, on up to a very high margin high technology high intellectual property components like top drives and the like, which are way above the 22% type guidance. And so that's what that is based on.

As you have noticed and as others have noticed, the past several quarters we have been exceeding that level. And I will tell you, up through the second quarter, most of that was efficiency driven. We have been doing a lot of things there to improve the manufacturing efficiency and so that's fueled our incrementals up into the high 20%, maybe low 30% range.

In the third quarter that we just reported, we reported 51% kind of sequential incremental margins and I think what you are seeing much of more of in the third quarter is pricing which is just starting to creep in, and our expectation is that the pricing impact will continue to be strong. As we've said, we've continued to price higher and that is a little bit of a lagging indicator in our financial statements.

So you are seeing things flow out in this period's income statement that were priced middle of 2005, maybe late 2005, and so we know we have rising margins in our backlog. All that points to the fact that we will likely probably exceed our 22% incrementals going forward a little bit.

I will caution, you though, that given the broad range of contribution margins across the different categories of things that we sell, mix is going to have a lot to do with measuring the flow through between any two periods. So there may be quarters where we don't do better than that, and maybe the quarters where we do a little bit better.

But 51% is just a terrific performance. I don't--we would be delighted to repeat that I don't know that we will. I think something maybe in the high 20s or low 30s is probably more realistic.

And my second question is about the U.S. land business. Can you comment on the--on new U.S. rig orders, sort of post Patterson and how many you are building at the current time, and what are you quoting people in terms of a time frame who want to build new rigs?

Jim, right now, it's kind of a combination of methods with which we build rigs for the U.S. based fleet. As an example on Patterson, they made an announcement and that was really a grouping of components.

Mud pumps, draw works, mass substructures and things like that, that will go to Patterson and Patterson, will, in fact, put them together. We're going to be delivering those on a weekly basis, as we go into '07, and probably deliver that through about the second or third quarter. Today, if you came to me and said, hey, I want to have a complete land rig for the U.S.-based market, it would be--it would probably be the fourth quarter, of next year.

That would be, for instance, one of our ideal rigs. If you said just give me the complete ideal rig, I want to have that thing just like a car, I can turn the key, run it, we'll give it--we'll give it to you about a year from now. And that's--we are pretty well filled from there.

My expectation is with some of the things that we are doing on throughput, I'm libel to next quarter tell, you hey, I could probably cut a quarter off of that, because we are getting better at doing that sort of thing. Right now, that's about where you would be, Jim.

That surprises me, it's that far out which indicates that the tenor of orders for new rig construction, the land has continued to be strong?

Absolutely. It--as we mentioned earlier--and I think this is one that we have talked about a lot, we are retooling the industry right now.

If you take a look, most of the major contractors will tell you that they are good rigs are maintaining very good contracts and the rigs that are going to fall off a little bit are going to be the ones that are older and don't have the technological capability. The crews don't want to work on them. And they are going to be rigs that have to be replaced or completely refurbished.

Okay. Thank you very much.

Thank you, Jim.

Thank you. Our next question is from Marshal Adkins. Please state your company name, followed by your question.

Raymond James.

Clay, you started out the call talking about how you'v ramped up significantly since '04, but it clearly appears given your comments just then, Pete, that you are starting to hit the wall in a few areas, you're starting to see some bottlenecks. Help us understand going forward how you debottleneck it in the magnitude to which you can continue to ramp up your throughput.

I mean should we be thinking about a 5% a quarter sequential increase in throughput, both on rig technology and petroleum services or can you ramp it up faster or is it going to be slower.

I think that's kind of in the ballpark, Marshall. To be clear, manufacturing operations always have bottlenecks. By definition we have a critical path, there's something kind of in the way.

What we are fortunate to have are great manufacturing people who every day get up and think, how can I build things better--better, faster, cheaper. And what you've seen are the results so far of what they have done.

We are pretty excited because a lot of the techniques that I described, we have a--we have many more locations and many more parts of our manufacturing infrastructure that we can apply these to. And gain--gain there. We also do a great deal outside, and have cultivated a really good supply chain over the years. And so a lot of efforts are going in to expanding that supply chain.

So, again, just to make sure I heard the right--roughly 5% a quarter, plus or minus is the run rate you think you can continue to ramp up the throughput?

Well, yes, I'm going to stop short of quantifying it further for you. We are in a business that's inherently lumpy, because whether we book revenue in a particular quarter depends on whether we ship that particular unit in the 90 day time frame or not.

We have a lot of things that sometimes slide out of a quarter. So individual quarters period to period, you're going to see some lumpiness, but I think that's the right order of magnitude.

Okay, follow up. You mentioned pricing is really starting to kick in as one of the margin drivers. Can you give us some sense of the backlog that you are booking today? How much higher is pricing a year out, for example, than--or really for the backlog you're booking today, than the stuff that we just saw in the actual numbers?

The--the pricing is substantially better, but, again, I'm not going to--I really don't want to quantify it for competitive reasons. We--we have said, I think, pretty clearly that the pricing has got better. We expect that margins will improve as a result of better margins of things that we have been adding to the backlog lately as compared to what we were adding a year or two ago. And so the trend is definitely up.

Well, okay. Well, it's--I was trying to pin you down on something. Thanks, guys.

Thanks, Marshall.

You bet.

Thank you. Our next question is from Ken Sill. Please state your company name followed by your question.

Yes, it's Credit Suisse. Again, congratulations, guys. Surprising with that backlog build and it's interesting to hear that there is more to come. We'll see about that. I love it when you guys do that!

A couple of questions on Clay's guidance for Q4. Kind of guiding flattish for petroleum services supplies and distribution, yet if I go back and kind of look historically, you almost always see a little bit of a bump in revenue for both of those segments. Is there anything unusual in Q3 or in Q4, other than just kind of caution given the rebounding Canada being a little bit soft?

It's mostly Canada. And, we're definitely hearing about softness up north, and, down here in the U.S., I think the galloping increases in recounts that we have had over the past couple of years, kind of quarter to quarter to quarter are going to flatten out just because now we are just talking about incrementally new rigs coming online. By the way, we still contend that a lot of those new rigs are going to replace old rigs and so there may not be necessarily a net addition to the rig count. Things feel like they are flattening, and that guidance reflects that.

Okay, but you're not seeing that the Canadian rebound that normally happens in the Rockies and Northwest territories is mostly shallow gas containment. Are you seeing a difference in what you'd expect for Q1 in Canada, versus last year?

Well, we are hearing anecdotally some of the operators were saying they want to wait until the ground to freezes up which is happening in this quarter and that there may be some things that go back to work then. But just generally, an awful lot, of an abundance of caution in Canada about the outlook for Q4.

Okay. And then as a follow-up, I want to get your backup, and get you going, but, some of the drilling contractors are citing issues with equipment reliability and down time. Nobody is naming names, but I know you guys have a pretty good system for tracking it.

Are you guys seeing any issues with for instance, one contractor is saying that they've got some problems with some top drives on some big north sea rigs. Is that related to you guys getting out and repairing them, or are they just working them harder or is there anything showing up in your data on equipment reliability right now?

Ken, not really. Not anything that I would put into a material aspect of things. Clearly we are staying very, very, busy. Top drives are moving pieces of equipment. There's problems all over the world almost every day some place where you have to pair one or send a send a maintenance person out.

We've got a very professional, qualified maintenance group and those guys are on and off rigs every day. I will say this we continue to have a very robust top drive business. Clearly, it's the leader in the industry. I think our support mechanisms are out there. We try to stay very much on top of it with our customers. Our customers aren't shy.

If they have an issue, they are bringing it to our attention and we address it as rapidly as we can. And we say--you take a look at the orders, and we think that reflects the confidence that our customers have in us.

But I think whenever you are ramping up a little bit, you're going to have some problems, a customer might call and say I want this particular guy, and three years ago, he could always get that guy because he was only working about a third of the time out there. Today that guy is liable to be spread out all over the world and he gets a different person. So we deal with issues like that every day but I think for the most part, they are contained very well.

All right. Thanks, guys.

Thanks, Ken.

Thank you. Our next question is from James Wicklund. Please state your company followed by your question.

Banc of America Securities.

Good quarter, guys. Thanks.

Thanks.

Clay, if I missed this I apologize, but with the margins in rig technology where they are and the backlog price where they are, are you willing to--to take a stab at where margins can go, kind of like distribution. You talk about if margins get much higher, you will start to see increased competition. Is there a threshold like that for rig technology?

I'm not--well, as I said, they can go higher.

I understand. All the caveats. I understand. They can. But--but distribution--distribution margins are not going to 10%?

No. I think--

And so where can rig technology margins? Do they get capped the same way?

No, I don't think there's necessarily a cap on it, I think looking out at our plans through next year, for instance, wouldn't be surprised to see them get up over the 20% mark, kind of late '07.

Okay.

And Jim, a lot of times when you are talking about those margins, we have two things we have to be concerned with. Number one, our competition, but secondly, it's also the decisions that our customer makes, whether or not to go ahead and buy something or build something, because at some point, those margins are going to impact their ability to get an internal rate of return as an example on a rig. They have to look at what the day rate is they can get, what our pricing is. So I think it's kind of a --

A whole value chain approach.

A continuous process, but I will guarantee you the one thing is we're searching to find out what that number is.

And I hope you push hard to get there. The second question, the follow-up question, Pete, you and I were talking the other night about Russia and Stockman.

It wasn't a very long conversation and there was drinking involved. Can you talk to us about what the opportunities are in places like Russia, with gas prom being as nationalistic as they are being?

I think they are great when it comes to the equipment, and you have to understand because again, as I pointed out earlier when I was talking, you really have a lot of issues associated with E&P companies going in there and taking what someone considers our natural resources, but when you talk about services and equipment going in there, it really is a situation where they want to have the start of the art equipment.

The Stockman Deal, as an example is probably going to be one of the most difficult deals in the history of this business to develop. And it's going to need the absolute best equipment that it can get.

And while I think there's a nationalism involved that we want to maintain our gas and oil in the ground, they also know that they have to have the help to be able to get that out in an appropriate fashion. And I think that's where ourselves, other international service companies, whether it's the (inaudible), Halliburton, Baker Hughes, I think that's where we come in to show them what we can do to help support that.

I think they're going to have to build state-of-the-art semi-submersibles. I think they will have to build state-of-the-art platform and development production, development platforms, and I think we're going to be positioned to be able to take advantage of that.

Okay. Thanks, guys. A appreciate it. Good quarter.

Thanks, Jim.

Thank you. Our next question come is from Scott Gill. Please state your company name, followed by your question.

Yes, Scott Gill with Simmons & Company. Good morning.

Hi, Scott.

Good morning, Scott.

Pete, I want to talk a little bit about inbound orders if we can. You mentioned reloading the backlog, $150 million order for Stenna, completing contracts in some of these Asia markets, with shipyards and also, I think answering Jim Crandell's question, no slowing in interest for U.S. land rigs. What does that portend for Q4 order levels?

Well, I think, Scott, it's difficult to kind of give you an absolute number. As you kind of know from the last two or three conference calls I always say it's going to be tough to equal that last number and we beat it.

This number is a pretty big number. My--I will tell you this, backlog will increase this quarter. Now, what the order intake is, there's some issue around that, in my mind, simply because you are coming up to Thanksgiving. You've got Christmas.

We are not dealing with a 90 day quarter, if you will. We are dealing with more like a 70 day quarter. And I have think some of this stuff can get pushed out. The one job that I just talked about, the offshore floater that we signed this week, that's been ongoing for a couple of months.

And so whether or not we're going to sign that now, which is fortunate, and that will go into the backlog in the fourth quarter. Some of the things that we're talking about today may extend out to January and February. That's why I'm always a little reluctant to say this is what's going to happen in this quarter.

Over a six month or a nine month period we have a little bit better visibility, but it just really depends on when somebody wants to pull the trigger. What I will say is this, interest is still there on almost every type of rig that's out there, whether it's a jackup, whether it's a semi-submersible, a drill ship, or various types of land rigs.

There's still a tremendous amount of interest. The backlog will grow this quarter, but I'm not sure--I doubt that it will equal the level with which the order intake will hit the 1.8. It will still be a very good order intake and backlog will grow.

Well, if I could, Pete, push you a little bit further on this do you see a steady state level of order flow as we get into 2007 and what that number might like?

Scott, I've said all along that we are in the process of retooling the industry. I think I said this at your conference a couple of years ago. I think 10 to 15 jackups will be ordered every year for the foreseeable future.

I think as rigs move out of place just like (inaudible) and PPL, rigs will come back in because the industry needs those rigs. I think you will continue to see semi-submersible and drill ships move in and out of these yards.

I think when you ask about a steady state, I think you're going to continue to see a steady state of orders coming in for the foreseeable future. What that ultimate level is, I wouldn't want to say right now, but you will continue to see this industry retool over the--certainly through the remainder of this decade.

If I could just squeeze one more question in, you talked a little bit about kind of product quality, and maintenance on the equipment out there. We've also heard on the conference call using some delays in rig deliveries, can you just as a reminder review for us what your contract obligations are for delivery times and for product warranties and what kind of risk that may portend for rig technology?

The product warranty is pretty simple, we warrant most of our equipment for a year. We don't have any real big issues that we think--we think that we have our warranty reserves well in place. We haven't had many issues when it comes to the new equipment going out.

Maybe back in the early to mid-90s there might have been issues but most of the equipment that people are talking about today, for instance if you talk about a top drive that needs some maintenance, that's probably been out five or six years. That's not a warranty issue, that's a repair and maintenance issue that gets paid for.

As far as deliveries go, for the most part, we are about where we need to be. If--generally speaking if a delivery is delayed, in many cases, it's delayed because the customer wanted to change something. Maybe the shipyard wanted to do something different.

Very few of our contracts have anything that's significant in the way of liquidated damages because of late deliveries. When we talk about late deliveries, and especially coming out of our system, Scott, we are talking about days not months.

We might instead of delivering a rig on the 31st of October, maybe it doesn't go until the 7th of November. Those are not material delays that affecting these people.

Right, sometimes the customer will want to leave a land rig in our Buena Park yard for instance for a few weeks while they train their crew on it. A lot of times we are accommodating the wishes of our customers.

Thank you. And Our Final Question Is From Roger Read. Please state your company name followed by your question.

Natexis Bleichroeder.

Quick question for you, I guess. On the rig attrition side, can you--you've talked about that numerous times. I just wonder, have you seen anything at this point on either the on or offshore side of legitimate attrition, stepping away from equipment or is it more of a, we expect to see that as you progress forward here through '07?

Roger, I think it happens almost on a stealth basis. Really, I mean, nobody--nobody really makes any big announcements about moving something in and out.

And when you see it, all of a sudden you will see three or four new rigs come in and the rig cap doesn't go up three or four rigs it only goes up one or two rigs. It's because they've moved another rig around, taken some parts off of it, decided not to work the rig anymore.

I think as it goes on, you aren't going to see any huge announcements. It's almost going to be just an evolution and you will wake up one day and say, oh look at what the rig fleet looks like today versus what it looked like five years ago.

Hello?

Mr. Read disconnected.

Okay. I hope he liked my answer.

I would now like to turn the call back over to you, Mr. Miller for any closing comments.

Thank you. I appreciate the interest that everyone has. I thank all the employees of National Oilwell Varco who might be listening for the efforts that they've made for the success of this quarter and I look forward to talking to everyone when we have our end of the year conference call. Thank you very much.

Thank you, sir. Ladies and gentlemen this concludes the National Oilwell Varco third quarter 2006 earnings conference call.

If you would like to listen to a replay of today's conference call, please dial 800-405-2236 with access code 11071200 followed by the pound sign, once again that number is 800-405-2236 with access code 11071200 followed by the pound sign. You may now disconnect and thank you for your participation.