Oceaneering International - 10-Q quarterly report FY

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In September 2004, we acquired 10 work class ROVs, related equipment and business in North and South America from Fugro N.V. for approximately $17 million.

We are accounting for these business acquisitions using the purchase method of accounting, with the purchase price being allocated to the assets and liabilities acquired based on their fair market values at the respective dates of acquisition. We have made the purchase price allocations based on information currently available to us, and the allocations are subject to change when we obtain final asset and liability valuations. These acquisitions were not material. As a result, we have not included pro forma information in this report. The results of the business acquired are included in our consolidated statement of income from the respective dates of acquisition.

All statements in this quarterly report on Form 10-Q, other than statements of historical facts, including, without limitation, statements regarding our expectations about 2005 net income and segment results, our plans for future operations, our expectations about the profit contribution from our investment in Medusa Spar LLC and industry conditions, are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to various risks, uncertainties and assumptions, including those we have referred to under the headings “Business ¾ Risks and Insurance” and “Cautionary Statement Concerning Forward-Looking Statements” in Part I of our annual report on Form 10-K for the year ended December 31, 2004. Although we believe that the expectations reflected in such forward-looking statements are reasonable, because of the inherent limitations in the forecasting process, as well as the relatively volatile nature of the industries in which we operate, we can give no assurance that those expectations will prove to be correct. Accordingly, evaluation of our future prospects must be made with caution when relying on forward-looking information.

This section should be read in conjunction with the Management’s Discussion and Analysis included in our annual report on Form 10-K for the year ended December 31, 2004.

We generate over 80% of our revenue from our services and products provided to the oil and gas industry. Our second quarter net income was higher than any previous quarter in our history. This was attributable to higher profit contributions from ROV, Subsea Projects and Inspection segments and our equity interest in Medusa Spar LLC.

Compared to the first quarter of 2005, quarterly net income increased primarily due to improved performances from our ROV, Subsea Products and Inspection segments. For the second half of the year, we expect continued improvement led by our ROV and Subsea Products segments.

For information about our Critical Accounting Policies and Estimates, please refer to the discussion in our annual report on Form 10-K for the year ended December 31, 2004 under the heading “Critical Accounting Policies and Estimates” in Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operation.

We consider our liquidity and capital resources adequate to support our operations and capital commitments. At June 30, 2005, we had working capital of $145 million, including $34 million of cash and cash equivalents. Additionally, we had $160 million of borrowing capacity available under our revolving credit facility.

Our capital expenditures were $84 million during the six months ended June 30, 2005, as compared to $85 million during the corresponding period of last year. Capital expenditures in the current year consisted primarily of the acquisition of Grayloc Products, as well as additions and upgrades to our ROV fleet to expand the fleet and replace older units we retired. Prior-year capital expenditures consisted primarily of the acquisition of the drill support ROV business of Stolt Offshore S.A. and expenditures related to our new umbilical facility in Panama City, Florida.

We had no material contractual commitments for capital expenditures at June 30, 2005. We project incurring $4 to $6 million of additional capital expenditures to complete the installation of our Panama City umbilical plant equipment. We will also invest $20 million to build 12 new ROVs by the end of 2005, increasing our fleet size to approximately 180 work class vehicles. Three of these vehicles were in service by the end of June. We are currently implementing a new business management system, which we implemented for our U.S. operations in July 2005 and which we anticipate will be phased into our foreign locations starting in 2006.

At June 30, 2005, we had long-term debt of $191 million and a 28% debt-to-total capitalization ratio. We have $100 million of Senior Notes outstanding, to be repaid from 2006 through 2010, and $90 million outstanding under our $250 million revolving credit facility that expires in January 2008. The revolving credit facility has short-term interest rates that float with market rates, plus applicable spreads. We have not guaranteed any debt not reflected on our consolidated balance sheet and do not have any off balance sheet arrangements as defined by SEC rules.

In the six-month period ended June 30, 2005, our cash and cash equivalents increased $18 million. We generated $44 million in cash from operating activities, used $82 million of cash in investing activities and obtained $56 million of cash from financing activities. The cash used in investing activities was used primarily for the capital expenditures described above and the cash obtained from financing activities was used, along with a substantial portion of the cash provided by operating activities, to pay for those capital expenditures and to finance an increase in working capital of $39 million. The primary increases in working

capital were higher inventories in anticipation of increased Subsea Products sales and spare parts for ROVs necessitated by more units and higher utilization levels.

In September 2002, our Board of Directors authorized us to repurchase up to 3,000,000 shares of our common stock, subject to a $75 million aggregate purchase price limitation. Under this plan, we have repurchased an aggregate of 897,800 shares of common stock to date, at a total cost of $20 million. We have reissued all of those shares as contributions to our 401(k) plan or in connection with exercises of stock options. Although we have not made any such repurchases since April 2003, we may from time to time effect additional repurchases in accordance with the terms of the Board authorization, which remains in effect.

We operate in six business segments. The segments are contained within two businesses ¯ services and products provided to the oil and gas industry (“Oil and Gas”) and all other services and products (“Advanced Technologies”). Our unallocated expenses are those not associated with a specific business segment.

Consolidated revenue and margin information is as follows:

We generate a material amount of our consolidated revenue from contracts for marine services and inspection services in the Gulf of Mexico and North Sea, which are usually more active from April through November compared to the rest of the year. In the first six months of 2005, Subsea Projects had higher-than-normal revenues due to inspection and repair work made necessary in the Gulf of Mexico by Hurricane Ivan. Revenues in our Mobile Offshore Production Systems, Subsea Products and Advanced Technologies segments are generally not seasonal.

The table that follows sets forth our revenues and gross margins for our Oil and Gas business for the periods indicated.

Our ROV segment revenues reflect the utilization percentages of the respective periods and increased capacity from the acquisition of 34 ROVs from Stolt Offshore S.A. in February 2004 and 10 ROVs from Fugro N.V. in September 2004. Gross

margins improved over the previous quarter and the corresponding quarter of the prior year due to an increase in days on hire with an 81% fleet utilization and higher average revenue per day of ROV utilization. The improvement over the first quarter of 2005 was also partially attributable to the high repair and maintenance expense and mobilization costs incurred in putting several systems to work in the first quarter of 2005. As compared to 2004, for 2005 we expect a higher profit contribution from our ROV business segment due to increases of our fleet size and pricing.

During the quarter ended June 30, 2005, our Subsea Products gross margin decreased from the corresponding quarter of the prior year. The profit decline was attributable to the start-up difficulties incurred at the new Panama City umbilical plant. We determined the Panama City planetary cabling machine underrollers were inadequately designed. Consequently, we now anticipate we will not be able to manufacture steel tube umbilicals at this plant until sometime around the end of 2005. As compared to the first quarter, Subsea Products gross margin and operating income improved due to our Oceaneering Intervention Engineering operations, particularly on sales of subsea valves and ROV tooling. Mainly as a result of the difficulties experienced in beginning manufacturing operations at our Panama City plant, we expect our Subsea Products profit contribution for 2005 to be comparable to that achieved in 2004.

For our Subsea Projects segment, we experienced a significant revenue and gross margin increase compared to the corresponding quarter of the prior year due to a continuation of the Hurricane Ivan repair work in the Gulf of Mexico. Revenues and gross margin were comparable to the preceding quarter, which also benefited from the Hurricane Ivan work. We believe our Subsea Projects segment results in 2005 will be higher than those achieved in 2004.

Our Mobile Offshore Production Systems gross margins were flat for all periods presented, as our three main assets were working under the same contracts as in 2004. We expect margins to continue at about the same levels through the remainder of 2005. We expect the dayrate we receive on theOcean Legend will decline starting mid-May 2006, assuming that our customer exercises its fixed-price renewal option to continue to lease the unit beyond the initial five-year term.

Compared to the corresponding period of 2004 and the immediately preceding quarter, our Inspection revenues and gross margins increased as a result of our efforts to provide more value-added services and to reduce our operating expenses. Although we expect lower quarterly results in the remainder of the year than those we achieved in the second quarter of 2005, we expect higher revenue and an improvement in margins for the full-year 2005 as compared to 2004, as a result of the same efforts.

Revenue and gross margin information is as follows:

Advanced Technologies revenues and gross margins were relatively flat in the periods presented, reflecting normal fluctuations in business activity and changes in job mix. We anticipate 2005 results to be comparable to those achieved in 2004.

Our unallocated expenses, i.e., those not associated with a specific business segment, within gross margin consist of expenses related to our incentive and deferred compensation plans, including restricted stock and bonuses, as well as other general expenses. Our restricted stock expense varies with the market price of our common stock. Our unallocated expenses within operating income consist of those within gross margin plus general and administrative expenses related to corporate functions. The table that follows sets out our unallocated expenses for the periods indicated.

Unallocated operating expenses in the six months ended June 30, 2004 included $1.8 million of accumulated transaction costs related to a terminated acquisition effort in the first quarter of 2004.

The table that follows sets forth our significant financial statement items below the income from operations line.

The amounts of equity earnings (losses) of unconsolidated affiliates are as follows:

We own a 50% equity interest in Medusa Spar LLC, which owns a 75% interest in the Medusa Spar production platform in the Gulf of Mexico. Medusa Spar LLC earns revenue on a tariff basis on oil and gas production throughput processed by the spar from the Medusa field and surrounding dedicated blocks. The increases in earnings of Medusa Spar LLC from each of the corresponding periods of the prior year were due to a full quarter of production from the initial six Medusa wells. The decrease in earnings from the immediately preceding quarter was attributable to the natural decline in production from the initial six Medusa wells. This decrease was, however, partially offset by the tieback of Medusa North completed in April. We expect that the quarterly profit contribution from this operation will continue to decline as increases in production throughput of Medusa North and Ulysses, which was tied back in June 2005, are expected to only partially offset the natural production decline from the initial six Medusa field wells.

We own 50% of Smit-Oceaneering Cable Systems, L.L.C., a telecommunications cable laying and maintenance venture. Due to the current condition of the telecommunications market, the single vessel owned by the venture has been marketed for oilfield and other uses since 2004. In the fourth quarter of 2004, we recognized $1.9 million of pre-tax impairments related to the

venture. In March 2005, we purchased the cable laying and maintenance equipment from the venture at a price equal to its adjusted book value.

In February 2005, we purchased 51% of Pro-Dive Oceaneering Co., a venture that operated our ROVs in Canada, from our partner in that venture. We now own 100% of this company, so the results of its operations from the acquisition date are included in our consolidated financial statements.

Interest expense for the three-month period ended June 30, 2005 increased compared to the corresponding period in the prior year due to higher average debt levels. We have borrowed funds under our credit facility to fund business acquisitions, including Grayloc Products in 2005, the ROV drill support business of Stolt Offshore S.A. and Fugro N.V. in 2004 and OIS International Inspection plc in 2003. Prior to that time, we have also incurred debt to fund equipment purchases, including the Ocean Legend and equipment in connection with the expansion of Subsea Products production capacity.

The provisions for income taxes were related to U.S. income taxes that we provided at estimated annual effective rates using assumptions as to earnings and other factors that would affect the tax calculation for the remainder of the year and to the operations of foreign branches and subsidiaries that were subject to local income and withholding taxes. We anticipate our effective tax rate for 2005 to be 35.5%.

We are currently exposed to certain market risks arising from transactions we have entered into in the normal course of business. These risks relate to interest rate changes and fluctuations in foreign exchange rates. We do not believe these risks are material. We have not entered into any market risk-sensitive instruments for trading purposes. We manage our exposure to interest rate changes through the use of a combination of fixed and floating rate debt. See note 4 of notes to the consolidated financial statements contained in this report and note 4 of notes to consolidated financial statements contained in our annual report on Form 10-K for the year ended December 31, 2004 for a description of our long-term debt agreements, interest rates and maturities. We believe that significant interest rate changes will not have a material near-term impact on our future earnings or cash flows. Because we operate in various oil and gas exploration and production regions in the world, we conduct a portion of our business in currencies other than the U.S. dollar. The functional currency for many of our international operations is the applicable local currency. We manage our exposure to changes in foreign exchange rates primarily through arranging compensation in U.S. dollars or freely convertible currency and, to the extent possible, by limiting compensation received in other currencies to amounts necessary to meet obligations denominated in those currencies. We use the exchange rates in effect as of the balance sheet date to translate assets and liabilities as to which the functional currency is the local currency, resulting in translation adjustments that we reflect as accumulated other comprehensive income or loss in the shareholders’ equity section of our consolidated balance sheets. We recorded a $9.3 million adjustment to our equity accounts for the six-month period ended June 30, 2005 to reflect the net impact of the strengthening of the U.S. dollar against various foreign currencies for locations where the functional currency is not the U.S. dollar.

Our Subsea Products business in Brazil conducts much of its operations in U.S. dollars, which is its functional currency. Our foreign currency gains (losses) related to Brazil were $546,000 and $(413,000) for the three-month periods ended June 30, 2005 and 2004, respectively, and $502,000 and $(499,000) for the six-month periods ended June 30, 2005 and 2004, respectively.

In accordance with Exchange Act Rules 13a-15 and 15d-15, we carried out an evaluation, under the supervision and with the participation of management, including our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of June 30, 2005 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There has been no change in our internal control over financial reporting that occurred during the three months ended June 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We are currently implementing a new business management system, which we started using for our U.S. operations in July 2005 and which will be phased into our foreign locations starting in 2006. We are taking the necessary steps to monitor and maintain appropriate internal controls during the implementations.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.