September 30, 2006 Form 10-Q Final
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q


[X] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2006

OR

[ ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from _____ to _____



Commission File Number 1-3492



HALLIBURTON COMPANY


(a Delaware Corporation)
75-2677995

5 Houston Center
1401 McKinney, Suite 2400
Houston, Texas 77010
(Address of Principal Executive Offices)

Telephone Number - Area Code (713) 759-2600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.
Yes     X        No ______

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer       X            
Accelerated filer                
Non-accelerated filer                  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes               No        X     

As of October 24, 2006, 1,005,509,113 shares of Halliburton Company common stock, $2.50 par value per share, were outstanding.







HALLIBURTON COMPANY

Index

   
Page No.
PART I.
FINANCIAL INFORMATION
 
     
Item 1.
Financial Statements
      3-29
     
 
- Condensed Consolidated Statements of Operations
           3
 
- Condensed Consolidated Balance Sheets
           4
 
- Condensed Consolidated Statements of Cash Flows
           5
 
- Notes to Condensed Consolidated Financial Statements
      6-29
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and
   
 
Results of Operations
           30-69
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
         70
     
Item 4.
Controls and Procedures
         70
     
PART II.
OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
         71
     
Item 1(a).
Risk Factors
         71
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
         71
     
Item 3.
Defaults Upon Senior Securities
         71
     
Item 4.
Submission of Matters to a Vote of Security Holders
         71
     
Item 5.
Other Information
         71
     
Item 6.
Exhibits
         72
     
Signatures
           73

2


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

HALLIBURTON COMPANY
Condensed Consolidated Statements of Operations
(Unaudited)

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
(Millions of dollars and shares except per share data)
 
2006
 
2005
 
2006
 
2005
 
Revenue:
                         
Services
 
$
5,001
 
$
4,317
 
$
14,171
 
$
12,837
 
Product sales
   
826
   
648
   
2,373
   
1,861
 
Equity in earnings (losses) of unconsolidated affiliates, net
   
4
   
(53
)
 
16
   
(30
)
Total revenue
   
5,831
   
4,912
   
16,560
   
14,668
 
Operating costs and expenses:
                         
Cost of services
   
4,081
   
3,684
   
11,887
   
11,170
 
Cost of sales
   
668
   
544
   
1,935
   
1,558
 
General and administrative
   
115
   
89
   
315
   
286
 
Gain on sale of business assets, net
   
(1
)
 
(85
)
 
(18
)
 
(197
)
Total operating costs and expenses
   
4,863
   
4,232
   
14,119
   
12,817
 
Operating income
   
968
   
680
   
2,441
   
1,851
 
Interest expense
   
(42
)
 
(51
)
 
(132
)
 
(154
)
Interest income
   
44
   
17
   
110
   
38
 
Foreign currency losses, net
   
(10
)
 
(2
)
 
(12
)
 
(9
)
Other, net
   
-
   
(2
)
 
(1
)
 
(7
)
Income from continuing operations before income taxes
                         
and minority interest
   
960
   
642
   
2,406
   
1,719
 
Provision for income taxes
   
(320
)
 
(129
)
 
(801
)
 
(445
)
Minority interest in net income of subsidiaries
   
(25
)
 
(21
)
 
-
   
(39
)
Income from continuing operations
   
615
   
492
   
1,605
   
1,235
 
Income (loss) from discontinued operations, net of tax
                         
(provision) benefit of $2, $(3), $(47), and $(10)
   
(4
)
 
7
   
85
   
21
 
Net income
 
$
611
 
$
499
 
$
1,690
 
$
1,256
 
Basic income (loss) per share:
                         
Income from continuing operations
 
$
0.61
 
$
0.49
 
$
1.57
 
$
1.23
 
Income (loss) from discontinued operations, net
   
-
   
0.01
   
0.08
   
0.02
 
Net income per share
 
$
0.61
 
$
0.50
 
$
1.65
 
$
1.25
 
Diluted income (loss) per share:
                         
Income from continuing operations
 
$
0.58
 
$
0.47
 
$
1.51
 
$
1.20
 
Income (loss) from discontinued operations, net
   
-
   
0.01
   
0.08
   
0.02
 
Net income per share
 
$
0.58
 
$
0.48
 
$
1.59
 
$
1.22
 
                           
Cash dividends per share
 
$
0.075
 
$
0.0625
 
$
0.225
 
$
0.1875
 
Basic weighted average common shares outstanding
   
1,011
   
1,012
   
1,021
   
1,006
 
Diluted weighted average common shares outstanding
   
1,048
   
1,050
   
1,062
   
1,032
 
See notes to condensed consolidated financial statements.

3


HALLIBURTON COMPANY
Condensed Consolidated Balance Sheets
(Unaudited)

   
September 30,
 
December 31,
 
(Millions of dollars and shares except per share data)
 
2006
 
2005
 
Assets
Current assets:
             
Cash and equivalents
 
$
3,549
 
$
2,391
 
Receivables:
             
Notes and accounts receivable (less allowance for bad debts of $83 and $90)
   
3,448
   
3,345
 
Unbilled work on uncompleted contracts
   
1,169
   
1,456
 
Total receivables
   
4,617
   
4,801
 
Inventories
   
1,213
   
953
 
Current deferred income taxes
   
346
   
645
 
Other current assets
   
490
   
522
 
Total current assets
   
10,215
   
9,312
 
Property, plant, and equipment, net of accumulated depreciation of $4,070 and $3,838
   
2,884
   
2,648
 
Goodwill
   
775
   
765
 
Noncurrent deferred income taxes
   
538
   
784
 
Equity in and advances to related companies
   
388
   
382
 
Other assets
   
1,184
   
1,119
 
Total assets
 
$
15,984
 
$
15,010
 
Liabilities and Shareholders’ Equity
Current liabilities:
             
Accounts payable
 
$
1,871
 
$
1,967
 
Advanced billings on uncompleted contracts
   
1,059
   
661
 
Accrued employee compensation and benefits
   
738
   
648
 
Current maturities of long-term debt
   
86
   
361
 
Short-term notes payable
   
2
   
22
 
Other current liabilities
   
946
   
768
 
Total current liabilities
   
4,702
   
4,427
 
Long-term debt
   
2,745
   
2,813
 
Employee compensation and benefits
   
723
   
718
 
Other liabilities
   
579
   
535
 
Total liabilities
   
8,749
   
8,493
 
Minority interest in consolidated subsidiaries
   
146
   
145
 
Shareholders’ equity:
             
Common shares, par value $2.50 per share - authorized 2,000 shares, issued 1,059 and 1,054
             
shares
   
2,648
   
2,634
 
Paid-in capital in excess of par value
   
1,500
   
1,501
 
Deferred compensation
   
-
   
(98
)
Accumulated other comprehensive income
   
(219
)
 
(266
)
Retained earnings
   
4,468
   
2,975
 
     
8,397
   
6,746
 
Less 54 and 26 shares of treasury stock, at cost
   
1,308
   
374
 
Total shareholders’ equity
   
7,089
   
6,372
 
Total liabilities and shareholders’ equity
 
$
15,984
 
$
15,010
 
See notes to condensed consolidated financial statements.

4


HALLIBURTON COMPANY
Condensed Consolidated Statements of Cash Flows
(Unaudited)

   
Nine Months Ended
 
   
September 30
 
(Millions of dollars)
 
2006
 
2005
 
Cash flows from operating activities:
             
Net income
 
$
1,690
 
$
1,256
 
Adjustments to reconcile net income to net cash from operations:
             
Depreciation, depletion, and amortization
   
388
   
377
 
Provision for deferred income taxes
   
580
   
209
 
Distribution from (advances to) related companies, net of equity in (earnings) losses
   
(47
)
 
59
 
Gain on sale of assets
   
(77
)
 
(195
)
Asbestos and silica liability payment related to Chapter 11 filing
   
-
   
(2,345
)
Collection of asbestos- and silica-related receivables
   
166
   
1,030
 
Other changes:
             
Receivables and unbilled work on uncompleted contracts
   
68
   
614
 
Accounts receivable facilities transactions
   
-
   
(263
)
Inventories
   
(248
)
 
(172
)
Accounts payable
   
(103
)
 
(570
)
Contributions to pension plans
   
(162
)
 
(55
)
Advanced billings
   
373
   
49
 
Other
   
251
   
(105
)
Total cash flows from operating activities
   
2,879
   
(111
)
Cash flows from investing activities:
             
Capital expenditures
   
(619
)
 
(474
)
Sales of property, plant, and equipment
   
115
   
91
 
Dispositions (acquisitions) of business assets, net of cash disposed
   
284
   
275
 
Proceeds from sales of securities
   
10
   
15
 
Sales of short-term investments in marketable securities, net
   
-
   
891
 
Other investing activities
   
(21
)
 
(26
)
Total cash flows from investing activities
   
(231
)
 
772
 
Cash flows from financing activities:
             
Proceeds from long-term debt, net of offering costs
   
8
   
12
 
Proceeds from exercises of stock options
   
146
   
303
 
Payments to reacquire common stock
   
(1,056
)
 
(10
)
Borrowings (repayments) of short-term debt, net
   
(15
)
 
(9
)
Payments of long-term debt
   
(344
)
 
(546
)
Payments of dividends to shareholders
   
(231
)
 
(190
)
Other financing activities
   
(7
)
 
(5
)
Total cash flows from financing activities
   
(1,499
)
 
(445
)
Effect of exchange rate changes on cash
   
9
   
(9
)
Increase in cash and equivalents
   
1,158
   
207
 
Cash and equivalents at beginning of period
   
2,391
   
1,917
 
Cash and equivalents at end of period
 
$
3,549
 
$
2,124
 
Supplemental disclosure of cash flow information:
             
Cash payments during the period for:
             
Interest
 
$
145
 
$
172
 
Income taxes
 
$
242
 
$
218
 
See notes to condensed consolidated financial statements.

5


HALLIBURTON COMPANY
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1. Basis of Presentation and Description of Company
The accompanying unaudited condensed consolidated financial statements were prepared using generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Regulation S-X. Accordingly, these financial statements do not include all information or footnotes required by generally accepted accounting principles for annual financial statements and should be read together with our 2005 Annual Report on Form 10-K.
Certain prior period amounts have been reclassified to be consistent with the current presentation.
Our accounting policies are in accordance with generally accepted accounting principles in the United States of America. The preparation of financial statements in conformity with these accounting principles requires us to make estimates and assumptions that affect:
 
-
the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements; and
 
-
the reported amounts of revenue and expenses during the reporting period.
Ultimate results could differ from our estimates.
In our opinion, the condensed consolidated financial statements included herein contain all adjustments necessary to present fairly our financial position as of September 30, 2006, the results of our operations for the three and nine months ended September 30, 2006 and 2005, and our cash flows for the nine months ended September 30, 2006 and 2005. Such adjustments are of a normal recurring nature. The results of operations for the three and nine months ended September 30, 2006 may not be indicative of results for the full year.
Common share and earnings per share amounts have been restated for all periods presented to reflect the increased number of common shares outstanding resulting from the two-for-one common stock split, in the form of a stock dividend, paid on July 14, 2006 to stockholders of record as of June 23, 2006.
We intend to completely separate KBR, Inc. from Halliburton as expeditiously as possible through a tax-free dividend distribution of KBR, Inc. stock to Halliburton stockholders. A Form 10 registration statement will be filed with the United States Securities and Exchange Commission (SEC) to register the shares of KBR, Inc. stock under the Securities Exchange Act of 1934. After the distribution, KBR, Inc. will be a separately traded public company. In addition, the separation of KBR, Inc., through the distribution of KBR, Inc. stock to Halliburton shareholders, will substantially reduce Halliburton’s shareholders’ equity.
The distribution of KBR, Inc. stock may be preceded by an initial public offering (IPO) of less than 20% of KBR. In April 2006, KBR, Inc. filed a Registration Statement on Form S-1 with the SEC for an IPO of less than 20% of KBR, Inc. and, in October 2006, filed Amendment No. 3 to that registration statement. We do not intend to delay the complete separation of KBR to wait on favorable conditions for an IPO of KBR, Inc.
We have submitted our request for a ruling from the Internal Revenue Service that, among other things, no gain or loss will be recognized by Halliburton or its stockholders as a result of a distribution of KBR, Inc. stock. We expect to receive the ruling within the timeframe of completing the distribution, which we anticipate being no later than April 2007. Prior to the IPO or separation occurring, we will enter into various agreements to govern the separation of KBR from us, including, among others, a master separation agreement, a tax sharing agreement, transition services agreements, and an employee matters agreement. The master separation agreement will provide for, among other things, KBR’s responsibility for liabilities relating to its business and Halliburton’s responsibility for liabilities unrelated to KBR’s business. Halliburton expects to provide indemnification in favor of KBR under the master separation agreement for certain contingent liabilities, including Halliburton’s indemnification of KBR and any of its greater than 50%-owned subsidiaries for:
 
-
fines or other monetary penalties or direct monetary damages, including disgorgement, as a result of a claim made or assessed by a governmental authority, or a settlement thereof, relating to alleged or actual violations of the United States Foreign Corrupt Practices Act (FCPA) or particular, analogous applicable foreign statutes and regulations; and

6


 
-
all out-of-pocket cash costs and expenses, or cash settlements or cash arbitration awards in lieu thereof, KBR may incur after the effective date of the master separation agreement as a result of the replacement of the subsea flowline bolts installed in connection with the Barracuda-Caratinga project.
The Halliburton performance guarantees and letter of credit guarantees that are currently in place in favor of KBR’s customers or lenders will continue after the separation of KBR until these guarantees expire by their terms. KBR will compensate Halliburton for these guarantees and indemnify Halliburton if Halliburton is required to perform under any of these guarantees. The tax sharing agreement will provide for allocations of United States income tax liabilities and other agreements between us and KBR with respect to tax matters. Under the transition services agreements, we expect to continue providing various interim corporate support services to KBR, and KBR will continue to provide various interim corporate support services to us. The fees will be determined on a basis generally intended to approximate the fully allocated direct and indirect costs of providing the services, without any profit. Under an employee matters agreement, Halliburton and KBR will allocate liabilities and responsibilities relating to current and former employees and their participation in certain benefit plans. KBR’s Registration Statement on Form S-1 contains a more detailed description of these separation agreements.
Any sale of KBR, Inc. stock under a Form S-1 would be registered under the Securities Act of 1933, and such shares of common stock would only be offered and sold by means of a prospectus. This quarterly report does not constitute an offer to sell or the solicitation of any offer to buy any securities of KBR, and there will not be any sale of any such securities in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of such state.

Note 2. Percentage-of-Completion Contracts
Unapproved claims
The amounts of unapproved claims included in determining the profit or loss on contracts and the amounts booked to “Unbilled work on uncompleted contracts” or “Other assets” as of September 30, 2006 and December 31, 2005 are as follows:

   
September 30,
 
December 31,
 
Millions of dollars
 
2006
 
2005
 
Probable unapproved claims
 
$
185
 
$
175
 
Probable unapproved claims accrued revenue
   
182
   
172
 
Probable unapproved claims from unconsolidated
             
related companies
   
93
   
92
 

As of September 30, 2006, the probable unapproved claims, including those from unconsolidated related companies, relate to seven contracts, most of which are complete or substantially complete. See Note 11 for a discussion of United States government contract claims, which are not included in the table above.
A significant portion of the probable unapproved claims as of September 30, 2006 ($148 million related to our consolidated entities and $45 million related to our unconsolidated related companies) arose from three completed projects with Petroleos Mexicanos (PEMEX) that are currently subject to arbitration proceedings. In addition, we have “Other assets” of $64 million for previously approved services that are unpaid by PEMEX and have been included in these arbitration proceedings. Actual amounts we are seeking from PEMEX in the arbitration proceedings are in excess of these amounts. The arbitration proceedings are expected to extend through 2007. PEMEX has asserted unspecified counterclaims in each of the three arbitrations; however, it is premature based upon our current understanding of those counterclaims to make any assessment of their merits. As of September 30, 2006, we had not accrued any amounts related to the counterclaims in the arbitrations.
At September 30, 2006, $173 million of the amount classified as probable unapproved claims accrued revenue included in the table above is reflected as “Other assets” on the condensed consolidated balance sheets since the contracts will likely not be settled within one year. The remaining $9 million is included in “Unbilled work on uncompleted contracts” since the contracts are expected to be settled within one year. Our unconsolidated related companies include probable unapproved claims as revenue in determining the amount of profit or loss for their contracts. Probable unapproved claims from our related companies are included in “Equity in and advances to related companies.”

7


Unapproved change orders
We have contracts for which we are negotiating change orders to the contract scope and have agreed upon the scope of work but not the price. These change orders amount to $308 million at September 30, 2006. Unapproved change orders at December 31, 2005 were $61 million. Our share of change orders from unconsolidated related companies totaled $4 million at September 30, 2006 and $5 million at December 31, 2005.
Included in the $308 million of change orders is $269 million for our consolidated 50%-owned gas-to-liquids project in Escravos, Nigeria. The $69 million increase in change orders from June 30, 2006 is due to additional scope changes to the project. In the second quarter of 2006, we recorded a $148 million charge, before income taxes and minority interest, related to this project. This charge was primarily attributable to increases in the overall estimated cost to complete the project. The project experienced delays relating to civil unrest and security on the Escravos River, near the project site, with additional delays resulting from scope changes and engineering and construction modifications. In October 2006, we reached agreement with our customer to fund $206 million of the $269 million in unapproved change orders. Portions of the remaining work now have a lower risk profile, particularly with respect to security and logistics. The project was approximately 38% complete as of September 30, 2006.
Barracuda-Caratinga project
Following is the status, as of September 30, 2006, of our Barracuda-Caratinga project, a multiyear construction project to develop the Barracuda and Caratinga crude oilfields located off the coast of Brazil:
 
-
the Barracuda and Caratinga vessels are both fully operational. In April 2006, we executed an agreement with Petrobras that enabled us to achieve conclusion of the Lenders’ Reliability Test and final acceptance of the FPSOs. These acceptances eliminate any further risk of liquidated damages being assessed but do not address the bolt arbitration discussed below;
 
-
in the first quarter of 2006, we recorded a loss of $15 million related to additional costs to finalize the project and warranty matters. We have recorded inception-to-date losses on this project of approximately $785 million; and
 
-
our remaining obligation under the April 2006 agreement is primarily for warranty on the two vessels.
In addition, at Petrobras’ direction, we have replaced certain bolts located on the subsea flowlines that failed through mid-November 2005, and we understand that additional bolts have failed thereafter, which were replaced by Petrobras. These failed bolts were identified by Petrobras when it conducted inspections of the bolts. The original design specification for the bolts was issued by Petrobras, and as such, we believe the cost resulting from any replacement is not our responsibility. Petrobras has indicated, however, that they do not agree with our conclusion. We have notified Petrobras that this matter is in dispute. We believe several possible solutions may exist, including replacement of the bolts. Estimates indicate that costs of these various solutions range up to $140 million. Should Petrobras instruct us to replace the subsea bolts, the prime contract terms and conditions regarding change orders require that Petrobras make progress payments for our costs incurred. Petrobras could, however, perform any replacement of the bolts and seek reimbursement from KBR. In March 2006, Petrobras notified KBR that they have submitted this matter to arbitration claiming $220 million plus interest for the cost of monitoring and replacing the defective stud bolts and all related costs and expenses of the arbitration, including the cost of attorneys fees. We disagree with the Petrobras claim because the bolts met Petrobras’ design specification, and we do not believe there is any basis for the amount claimed by Petrobras. We intend to vigorously defend ourselves and pursue recovery of the costs we have incurred to date through the arbitration process. The arbitration hearing is not expected to begin until the first quarter of 2008. As of September 30, 2006, we have not accrued any amounts related to this arbitration.

8


Note 3. Dispositions
Production Services
In the second quarter of 2006, we completed the sale of KBR’s Production Services group, which was part of our Energy and Chemicals segment. In connection with the sale, we received net proceeds of $265 million. The sale of Production Services resulted in an adjusted pretax gain, net of post-closing adjustments, of $120 million, which is reflected in discontinued operations. Production Services operations and assets and liabilities are classified as discontinued operations for all periods presented. At December 31, 2005, Production Services assets were $207 million, of which $140 million were classified as current, and liabilities were $64 million, of which $54 million were classified as current.
Dulles Greenway Toll Road
As part of our infrastructure projects, we occasionally take an ownership interest in the constructed asset, with a view toward monetization of that ownership interest after the asset has been operating for some period and increases in value. In September 2005, we sold our 13% interest in a joint venture that owned the Dulles Greenway Toll Road in Virginia. We received $85 million in cash from the sale. Because of unfavorable early projections of traffic to support the toll road after it had opened, we wrote down our investment in the toll road in 1996. At the time of the sale, our investment had a net book value of zero, and therefore, we recorded the entire $85 million of cash proceeds to operating income in our Government and Infrastructure segment.
Subsea 7, Inc.
In January 2005, we completed the sale of our 50% interest in Subsea 7, Inc. to our joint venture partner, Siem Offshore (formerly DSND Subsea ASA), for approximately $200 million in cash. As a result of the transaction, we recorded a gain of approximately $110 million during the first quarter of 2005. We accounted for our 50% ownership of Subsea 7, Inc. using the equity method in our Production Optimization segment.

Note 4. Business Segment Information
We have six business segments: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Government and Infrastructure, and Energy and Chemicals.
We refer to the combination of the Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as the Energy Services Group and the combination of our Government and Infrastructure and our Energy and Chemicals segments as KBR.
During the second quarter of 2006, we moved slickline services, tubing conveyed perforating, and underbalanced applications from the Production Optimization segment to the Drilling and Formation Evaluation segment, as these services are more closely aligned with the Drilling and Formation Evaluation segment. Prior period balances have been reclassified to reflect this change. Because of this change, what we previously referred to as “logging services” within the Drilling and Formation Evaluation segment we now refer to as “wireline and perforating services.” In addition, for internal management purposes we combined our Drilling and Formation Evaluation and Digital and Consulting Solutions divisions, forming three Energy Services Group internal divisions. However, we continue to disclose four segments for the Energy Services Group.
KBR’s Production Services operations were moved into discontinued operations for reporting purposes in the first quarter of 2006. All prior period amounts have been reclassified to discontinued operations.

9


The table below presents information on our segments.

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars
 
2006
 
2005
 
2006
 
2005
 
Revenue:
                         
Production Optimization
 
$
1,418
 
$
1,032
 
$
3,906
 
$
2,837
 
Fluid Systems
   
928
   
731
   
2,634
   
2,061
 
Drilling and Formation Evaluation
   
845
   
663
   
2,344
   
1,859
 
Digital and Consulting Solutions
   
201
   
171
   
562
   
495
 
Total Energy Services Group
   
3,392
   
2,597
   
9,446
   
7,252
 
Government and Infrastructure
   
1,838
   
1,880
   
5,427
   
6,003
 
Energy and Chemicals
   
601
   
435
   
1,687
   
1,413
 
Total KBR
   
2,439
   
2,315
   
7,114
   
7,416
 
Total revenue
 
$
5,831
 
$
4,912
 
$
16,560
 
$
14,668
 
Operating income (loss):
                         
Production Optimization
 
$
406
 
$
248
 
$
1,087
 
$
759
 
Fluid Systems
   
211
   
139
   
586
   
387
 
Drilling and Formation Evaluation
   
227
   
144
   
588
   
375
 
Digital and Consulting Solutions
   
62
   
35
   
163
   
80
 
Total Energy Services Group
   
906
   
566
   
2,424
   
1,601
 
Government and Infrastructure
   
53
   
150
   
141
   
275
 
Energy and Chemicals
   
45
   
(10
)
 
(22
)
 
70
 
Total KBR
   
98
   
140
   
119
   
345
 
General corporate
   
(36
)
 
(26
)
 
(102
)
 
(95
)
Total operating income
 
$
968
 
$
680
 
$
2,441
 
$
1,851
 

Intersegment revenue was immaterial. Our equity in earnings and losses of unconsolidated affiliates that are accounted for on the equity method is included in revenue and operating income of the applicable segment.
Total revenue for the three and nine months ended September 30, 2006 included $1.5 billion and $4.4 billion or 25% and 26% of consolidated revenue from the United States Government, which was derived primarily from the Government and Infrastructure segment. Revenue from the United States Government during the three and nine months ended September 30, 2005 represented 30% and 33% of consolidated revenue. No other customer represented more than 10% of consolidated revenue in any period presented.

Note 5. Accounts Receivable Facilities
Under our Energy Services Group accounts receivable securitization facility, we had the ability to sell up to $300 million in undivided ownership interest in a pool of receivables. During the fourth quarter of 2005, $256 million in undivided ownership interest that had been sold to unaffiliated companies was collected and the balance retired. No further receivables were sold, and the facility was terminated in the first quarter of 2006.
In May 2004, we entered into an agreement to sell, assign, and transfer the entire title and interest in specified United States government accounts receivable of KBR to a third party. The face value of the receivables sold to the third party was reflected as a reduction of accounts receivable in our condensed consolidated balance sheets. The receivables outstanding under this agreement were collected and the balance retired in the third quarter of 2005. As of December 31, 2005, the facility was terminated.

10


Note 6. Inventories
Inventories are stated at the lower of cost or market. In the United States, we manufacture certain finished products and have parts inventories for drill bits, completion products, bulk materials, and other tools that are recorded using the last-in, first-out method totaling $61 million at September 30, 2006 and $42 million at December 31, 2005. If the average cost method was used, total inventories would have been $26 million higher than reported at September 30, 2006 and $21 million higher than reported at December 31, 2005. Inventories consisted of the following:

   
September 30,
 
December 31,
 
Millions of dollars
 
2006
 
2005
 
Finished products and parts
 
$
844
 
$
715
 
Raw materials and supplies
   
272
   
181
 
Work in process
   
97
   
57
 
Total
 
$
1,213
 
$
953
 

Finished products and parts are reported net of obsolescence accruals of $97 million at September 30, 2006 and $98 million at December 31, 2005.

Note 7. Restricted and Committed Cash
At September 30, 2006, we had restricted cash of $129 million, which primarily consisted of:
 
-
$104 million as collateral for potential future insurance claim reimbursements included in “Other assets”; and
 
-
$23 million related to cash collateral agreements for outstanding letters of credit for various construction projects included in “Other assets.”
At December 31, 2005, we had restricted cash of $123 million in “Other assets,” which primarily consisted of similar items as above.
Cash and equivalents include cash from advanced payments related to contracts in progress held by ourselves or our joint ventures that we consolidate for accounting purposes. The use of these cash balances is limited to the specific projects or joint venture activities and is not available for other projects, general cash needs, or distribution to us without approval of the board of directors of the respective joint venture or subsidiary. At September 30, 2006 and December 31, 2005, cash and equivalents include approximately $562 million and $223 million, respectively, in cash from advanced payments held by ourselves or our joint ventures that we consolidate for accounting purposes.

Note 8. Debt
In August 2006, we repaid, at par plus accrued interest, our $275 million 6.0% medium-term notes that matured.
The stock conversion rate for the $1.2 billion of 3.125% convertible senior notes issued in June 2003 changed as a result of the July 2006 stock split and an increase to our quarterly dividend. As of September 30, 2006, the stock conversion rate is 53.18 shares of common stock per $1,000 principal amount of notes with a conversion price of $18.825. The distribution of KBR, Inc. stock to our shareholders would cause the conversion rate to change.  The amount of such change would be based on the relative valuation of KBR, Inc. at the time of distribution.

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Note 9. Comprehensive Income
The components of other comprehensive income included the following:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars
 
2006
 
2005
 
2006
 
2005
 
Net income
 
$
611
 
$
499
 
$
1,690
 
$
1,256
 
                           
Cumulative translation adjustments
   
14
   
1
   
51
   
(28
)
Realization of (gains) losses included in net income
   
2
   
-
   
(14
)
 
3
 
Net cumulative translation adjustments
   
16
   
1
   
37
   
(25
)
                           
Unrealized net gains (losses) on investments
                         
and derivatives
   
(10
)
 
(8
)
 
11
   
(9
)
Realization of gains on investments and derivatives
                         
included in net income
   
(1
)
 
(1
)
 
(1
)
 
(14
)
Net unrealized gains (losses) on investments
                         
and derivatives
   
(11
)
 
(9
)
 
10
   
(23
)
                           
Total comprehensive income
 
$
616
 
$
491
 
$
1,737
 
$
1,208
 

Accumulated other comprehensive income consisted of the following:

   
September 30,
 
December 31,
 
Millions of dollars
 
2006
 
2005
 
Cumulative translation adjustments
 
$
(35
)
$
(72
)
Pension liability adjustments
   
(184
)
 
(184
)
Unrealized gains (losses) on investments and derivatives
   
-
   
(10
)
Total accumulated other comprehensive income
 
$
(219
)
$
(266
)

Note 10. Asbestos Insurance Recoveries
Several of our subsidiaries, particularly DII Industries and Kellogg Brown & Root, had been named as defendants in a large number of asbestos- and silica-related lawsuits. Effective December 31, 2004, we resolved all open and future claims in the prepackaged Chapter 11 proceedings of DII Industries, Kellogg Brown & Root, and our other affected subsidiaries (which were filed on December 16, 2003) when the plan of reorganization became final and nonappealable.
During 2004, we settled insurance disputes with substantially all the insurance companies for asbestos- and silica-related claims and all other claims under the applicable insurance policies and terminated all the applicable insurance policies. Under the terms of our insurance settlements, we would receive cash proceeds with a nominal amount of approximately $1.5 billion and with a then present value of approximately $1.4 billion for our asbestos- and silica-related insurance receivables. The present value was determined by discounting the expected future cash payments with a discount rate implicit in the settlements, which ranged from 4.0% to 5.5%. This discount is being accreted as interest income (classified as discontinued operations) over the life of the expected future cash payments. Cash payments of approximately $166 million related to these receivables were received in the first nine months of 2006. Under the terms of the settlement agreements, we will receive cash payments of the remaining amounts, totaling $262 million at September 30, 2006, in several installments through 2010.

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The following table presents a rollforward of our asbestos- and silica-related insurance receivables.

Millions of dollars
     
Insurance for asbestos- and silica-related liabilities:
       
December 31, 2005 balance (of which $193 was current)
 
$
396
 
Payments received
   
(166
)
Accretion
   
8
 
Insurance for asbestos- and silica-related liabilities - September 30,
       
2006 balance (of which $68 is current)
 
$
238
 

A significant portion of the insurance coverage applicable to Worthington Pump, a former division of DII Industries, was alleged by Federal-Mogul (and others who formerly were associated with Worthington Pump prior to its acquisition by DII Industries) to be shared with them. During 2004, we reached an agreement with Federal-Mogul, our insurance companies, and another party sharing in the insurance coverage to obtain their consent and support of a partitioning of the insurance policies. Under the terms of the agreement, DII Industries was allocated 50% of the limits of any applicable insurance policy, and the remaining 50% of limits of the insurance policies were allocated to the remaining policyholders. As part of the settlement, DII Industries agreed to pay $46 million in three installment payments. In 2004, we accrued $44 million, which represents the present value of the $46 million to be paid. The discount is accreted as interest expense (classified as discontinued operations) over the life of the expected future cash payments beginning in the fourth quarter of 2004. The first payment of $16 million was paid in January 2005, and the second payment of $15 million was paid in January 2006. The third and final payment of $15 million will be made in January 2007.
DII Industries and Federal-Mogul agreed to share equally in recoveries from insolvent London-based insurance companies. To the extent that Federal-Mogul’s recoveries from certain insolvent London-based insurance companies received on or before January 1, 2006 did not equal at least $4.5 million, DII Industries agreed to also pay to Federal-Mogul the difference between their recoveries from the insolvent London-based insurance companies and $4.5 million. Accordingly, DII Industries paid Federal-Mogul $1.6 million in January 2006. This amount is expected to be received back from Federal-Mogul following recoveries received by Federal-Mogul from the insolvent London-based insurance companies.
Under the insurance settlements entered into as part of the resolution of our Chapter 11 proceedings, we have agreed to indemnify our insurers under certain historic general liability insurance policies in certain situations. We have concluded that the likelihood of any claims triggering the indemnity obligations is remote, and we believe any potential liability for these indemnifications will be immaterial. At September 30, 2006, we had not recorded any liability associated with these indemnifications.

Note 11. United States Government Contract Work
We provide substantial work under our government contracts to the United States Department of Defense (DoD) and other governmental agencies. These contracts include our worldwide United States Army logistics contracts, known as LogCAP, and contracts to rebuild Iraq’s petroleum industry, such as PCO Oil South. Our government services revenue related to Iraq totaled approximately $1.2 billion and $3.6 billion for the three and nine months ended September 30, 2006 compared to $1.2 billion and $4.1 billion for the three and nine months ended September 30, 2005.
Given the demands of working in Iraq and elsewhere for the United States government, we expect that from time to time we will have disagreements or experience performance issues with the various government customers for which we work. If performance issues arise under any of our government contracts, the government retains the right to pursue remedies which could include threatened termination or termination, under any affected contract. If any contract were so terminated, we may not receive award fees under the affected contract, and our ability to secure future contracts could be adversely affected, although we would receive payment for amounts owed for our allowable costs under cost-reimbursable contracts. Other remedies that could be sought by our government customers for any improper activities or performance issues include sanctions such as forfeiture of profits,

13


suspension of payments, fines, and suspensions or debarment from doing business with the government. Further, the negative publicity that could arise from disagreements with our customers or sanctions as a result thereof could have an adverse effect on our reputation in the industry, reduce our ability to compete for new contracts, and may also have a material adverse effect on our business, financial condition, results of operations, and cash flow.
DCAA audit issues
Our operations under United States government contracts are regularly reviewed and audited by the Defense Contract Audit Agency (DCAA) and other governmental agencies. The DCAA serves in an advisory role to our customer. When issues are found during the governmental agency audit process, these issues are typically discussed and reviewed with us. The DCAA then issues an audit report with its recommendations to our customer’s contracting officer. In the case of management systems and other contract administrative issues, the contracting officer is generally with the Defense Contract Management Agency (DCMA). We then work with our customer to resolve the issues noted in the audit report. If our customer or a government auditor finds that we improperly charged any costs to a contract, these costs are not reimbursable, or, if already reimbursed, the costs must be refunded to the customer. Our revenue recorded for government contract work is reduced for our estimate of costs that may be categorized as disputed or unallowable as a result of cost overruns or the audit process.
Laundry. Prior to the fourth quarter of 2005, we received notice from the DCAA that it recommended withholding $18 million of subcontract costs related to the laundry service for one task order in southern Iraq, for which it believed we and our subcontractors did not provide adequate levels of documentation supporting the quantity of the services provided. In the fourth quarter of 2005, the DCAA issued a notice to disallow costs totaling approximately $12 million, releasing $6 million of amounts previously withheld. In the second quarter of 2006, we successfully resolved this matter with the DCAA and received payment of the remaining $12 million.
Containers. In June 2005, the DCAA recommended withholding certain costs associated with providing containerized housing for soldiers and supporting civilian personnel in Iraq. The DCAA recommended that the costs be withheld pending receipt of additional explanation or documentation to support the subcontract costs.  Approximately $55 million has been withheld as of September 30, 2006, of which $17 million has been withheld from our subcontractors. We will continue working with the government and our subcontractors to resolve this issue.
Dining facilities. In September 2005, Eurest Support Services (Cyprus) International Limited, or ESS, filed suit against us alleging various claims associated with its performance as a subcontractor in conjunction with our LogCAP contract in Iraq. The case was settled during the first quarter of 2006 without material impact to us.
Recently, the DCAA has raised questions regarding $95 million of costs related to dining facilities in Iraq. We have responded to the DCAA that our costs are reasonable.
Other issues. The DCAA is continuously performing audits of costs incurred for the foregoing and other services provided by us under our government contracts. During these audits, there have been questions raised by the DCAA about the reasonableness or allowability of certain costs or the quality or quantity of supporting documentation. The DCAA might recommend withholding some portion of the questioned costs while the issues are being resolved with our customer. Because of the intense scrutiny involving our government contracts operations, issues raised by the DCAA may be more difficult to resolve. We do not believe any potential withholding will have a significant or sustained impact on our liquidity.
Investigations
In the first quarter of 2005, the United States Department of Justice (DOJ) issued two indictments associated with overbilling issues we previously reported to the Department of Defense Inspector General’s office as well as to our customer, the Army Materiel Command, against a former KBR procurement manager and a manager of La Nouvelle Trading & Contracting Company, W.L.L.
In October 2004, we reported to the Department of Defense Inspector General’s office that two former employees in Kuwait may have had inappropriate contacts with individuals employed by or affiliated with two third-party subcontractors prior to the award of the subcontracts. The Inspector General’s office may investigate whether these two employees may have solicited and/or accepted payments from these third-party subcontractors while they were employed by us.
In October 2004, a civilian contracting official in the Army Corps of Engineers (COE) asked for a review of the process used by the COE for awarding some of the contracts to us. We understand that the Department of Defense Inspector General’s office may review the issues involved.

14


We understand that the DOJ, an Assistant United States Attorney based in Illinois, and others are investigating these and other individually immaterial matters we have reported related to our government contract work in Iraq. If criminal wrongdoing were found, criminal penalties could range up to the greater of $500,000 in fines per count for a corporation or twice the gross pecuniary gain or loss. We also understand that current and former employees of KBR have received subpoenas and have given or may give grand jury testimony related to some of these matters.
Claims
We had unapproved claims totaling $45 million at September 30, 2006 and $69 million at December 31, 2005 for the LogCAP and PCO Oil South contracts. Of the $45 million of unapproved claims outstanding at September 30, 2006, $44 million are considered to be probable of collection and have been recognized as revenue. The remaining $1 million of unapproved claims are not considered probable of collection and have not been recognized as revenue. Similarly, of the $69 million of unapproved claims outstanding at December 31, 2005, $57 million were considered to be probable of collection and have been recognized as revenue. The remaining $12 million of unapproved claims were not considered probable of collection and have not been recognized as revenue. These unapproved claims related to contracts where our costs have exceeded the customer’s funded value of the task order.
In addition, as of September 30, 2006, we had incurred approximately $136 million of costs under the LogCAP III contract that could not be billed to the government due to lack of appropriate funding on various task orders. These amounts were associated with task orders that had sufficient funding in total, but the funding was not appropriately allocated within the task order. We are in the process of preparing a request for a reallocation of funding to be submitted to the client for negotiation, and we anticipate the negotiations will result in an appropriate distribution of funding by the client and collection of the full amounts due.
DCMA system reviews
Report on estimating system. In December 2004, the DCMA granted continued approval of our estimating system, stating that our estimating system is “acceptable with corrective action.” We are in the process of completing these corrective actions. Specifically, based on the unprecedented level of support that our employees are providing the military in Iraq, Kuwait, and Afghanistan, we needed to update our estimating policies and procedures to make them better suited to such contingency situations. Additionally, we have completed our development of a detailed training program and have made it available to all estimating personnel to ensure that employees are adequately prepared to deal with the challenges and unique circumstances associated with a contingency operation.
Report on purchasing system. As a result of a Contractor Purchasing System Review by the DCMA during the fourth quarter of 2005, the DCMA granted the continued approval of our government contract purchasing system. The DCMA’s October 2005 approval letter stated that our purchasing system’s policies and practices are “effective and efficient, and provide adequate protection of the Government’s interest.”
Report on accounting system. We received two draft reports on our accounting system, which raised various issues and questions. We have responded to the points raised by the DCAA, but this review remains open. Once the DCAA finalizes the report, it will be submitted to the DCMA, who will make a determination of the adequacy of our accounting systems for government contracting.
The Balkans
                We have had inquiries in the past by the DCAA and the civil fraud division of the DOJ into possible overcharges for work performed during 1996 through 2000 under a contract in the Balkans, for which inquiry has not been completed by the DOJ. Based on an internal investigation, we credited our customer approximately $2 million during 2000 and 2001 related to our work in the Balkans as a result of billings for which support was not readily available. We believe that the preliminary DOJ inquiry relates to potential overcharges in connection with a part of the Balkans contract under which approximately $100 million in work was done. We believe that any allegations of overcharges would be without merit. Amounts accrued related to this matter as of September 30, 2006 are not material.
             
         
15


Note 12. Other Commitments and Contingencies
Foreign Corrupt Practices Act investigations
The SEC is conducting a formal investigation into whether improper payments were made to government officials in Nigeria through the use of agents or subcontractors in connection with the construction and subsequent expansion by TSKJ of a multibillion dollar natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria. The DOJ is also conducting a related criminal investigation. The SEC has also issued subpoenas seeking information, which we are furnishing, regarding current and former agents used in connection with multiple projects, including current and prior projects, over the past 20 years located both in and outside of Nigeria in which The M.W. Kellogg Company, M.W. Kellogg Limited, Kellogg Brown & Root or their or our joint ventures, as well as the Halliburton energy services business, are or were participants. In September 2006, the SEC requested that we enter into a tolling agreement with respect to its investigation. We anticipate that we will enter into an appropriate tolling agreement with the SEC.
TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V. (a subsidiary of Saipem SpA of Italy), JGC Corporation of Japan, and Kellogg Brown & Root (a subsidiary of ours and successor to The M.W. Kellogg Company), each of which had an approximately 25% interest in the venture at September 30, 2006. TSKJ and other similarly owned entities entered into various contracts to build and expand the liquefied natural gas project for Nigeria LNG Limited, which is owned by the Nigerian National Petroleum Corporation, Shell Gas B.V., Cleag Limited (an affiliate of Total), and Agip International B.V. (an affiliate of ENI SpA of Italy). M.W. Kellogg Limited is a joint venture in which we had a 55% interest at September 30, 2006; and M.W. Kellogg Limited and The M.W. Kellogg Company were subsidiaries of Dresser Industries before our 1998 acquisition of Dresser Industries. The M.W. Kellogg Company was later merged with a subsidiary of ours to form Kellogg Brown & Root, one of our subsidiaries.
The SEC and the DOJ have been reviewing these matters in light of the requirements of the FCPA. In addition to performing our own investigation, we have been cooperating with the SEC and the DOJ investigations and with other investigations into the Bonny Island project in France, Nigeria and Switzerland. Our Board of Directors has appointed a committee of independent directors to oversee and direct the FCPA investigations.
The matters under investigation related to the Bonny Island project cover an extended period of time (in some cases significantly before our 1998 acquisition of Dresser Industries and continuing through the current time period). We have produced documents to the SEC and the DOJ both voluntarily and pursuant to company subpoenas from the files of numerous officers of Halliburton and KBR, including current and former executives of Halliburton and KBR, and we are making our employees available to the SEC and the DOJ for interviews. In addition, we understand that the SEC has issued a subpoena to A. Jack Stanley, who formerly served as a consultant and chairman of KBR, and to others, including certain of our current and former KBR employees, former executive officers of KBR, and at least one subcontractor of KBR. We further understand that the DOJ has invoked its authority under a sitting grand jury to issue subpoenas for the purpose of obtaining information abroad, and we understand that other partners in TSKJ have provided information to the DOJ and the SEC with respect to the investigations, either voluntarily or under subpoenas.
The SEC and DOJ investigations include an examination of whether TSKJ’s engagements of Tri-Star Investments as an agent and a Japanese trading company as a subcontractor to provide services to TSKJ were utilized to make improper payments to Nigerian government officials. In connection with the Bonny Island project, TSKJ entered into a series of agency agreements, including with Tri-Star Investments, of which Jeffrey Tesler is a principal, commencing in 1995 and a series of subcontracts with a Japanese trading company commencing in 1996. We understand that a French magistrate has officially placed Mr. Tesler under investigation for corruption of a foreign public official. In Nigeria, a legislative committee of the National Assembly and the Economic and Financial Crimes Commission, which is organized as part of the executive branch of the government, are also investigating these matters. Our representatives have met with the French magistrate and Nigerian officials. In October 2004, representatives of TSKJ voluntarily testified before the Nigerian legislative committee. We are also aware that the Serious Frauds Office in the United Kingdom is conducting an investigation relating to the activities of TSKJ.

16


We notified the other owners of TSKJ of information provided by the investigations and asked each of them to conduct their own investigation. TSKJ has suspended the receipt of services from and payments to Tri-Star Investments and the Japanese trading company and has considered instituting legal proceedings to declare all agency agreements with Tri-Star Investments terminated and to recover all amounts previously paid under those agreements. In February 2005, TSKJ notified the Attorney General of Nigeria that TSKJ would not oppose the Attorney General’s efforts to have sums of money held on deposit in banks in Switzerland transferred to Nigeria and to have the legal ownership of such sums determined in the Nigerian courts.
As a result of these investigations, information has been uncovered suggesting that, commencing at least 10 years ago, members of TSKJ planned payments to Nigerian officials. We have reason to believe that, based on the ongoing investigations, payments may have been made to Nigerian officials. In addition, information recently uncovered suggests that, prior to 1998, plans may have been made by employees of The M.W. Kellogg Company to make payments to government officials in connection with the pursuit of a number of other projects in countries outside of Nigeria. Certain of these employees are current employees or a consultant of ours.  As a result, the consultant may be placed on suspension, and Halliburton's pending investigation will include a review of the actions of these employees.
In June 2004, all relationships with Mr. Stanley and another consultant and former employee of M.W. Kellogg Limited were terminated. The terminations occurred because of violations of our Code of Business Conduct that allegedly involved the receipt of improper personal benefits from Mr. Tesler in connection with TSKJ’s construction of the Bonny Island project.
In 2006, we suspended the services of another agent who, until the suspensions, had worked for KBR outside of Nigeria on several current projects and on numerous older projects going back to the early 1980s. The suspension will continue until such time, if ever, as we can satisfy ourselves regarding the agent’s compliance with applicable law and our Code of Business Conduct. In addition, we are actively reviewing the compliance of an additional agent on a separate current Nigerian project with respect to which we have recently received from a joint venture partner on that project allegations of wrongful payments made by such agent.
If violations of the FCPA were found, a person or entity found in violation could be subject to fines, civil penalties of up to $500,000 per violation, equitable remedies, including disgorgement (if applicable) generally of profit, including prejudgment interest on such profits, causally connected to the violation, and injunctive relief. Criminal penalties could range up to the greater of $2 million per violation or twice the gross pecuniary gain or loss from the violation, which could be substantially greater than $2 million per violation. It is possible that both the SEC and the DOJ could assert that there have been multiple violations, which could lead to multiple fines. The amount of any fines or monetary penalties that could be assessed would depend on, among other factors, the findings regarding the amount, timing, nature, and scope of any improper payments, whether any such payments were authorized by or made with knowledge of us or our affiliates, the amount of gross pecuniary gain or loss involved, and the level of cooperation provided the government authorities during the investigations. Agreed dispositions of these types of violations also frequently result in an acknowledgement of wrongdoing by the entity and the appointment of a monitor on terms negotiated with the SEC and the DOJ to review and monitor current and future business practices, including the retention of agents, with the goal of assuring compliance with the FCPA. Other potential consequences could be significant and include suspension or debarment of our ability to contract with governmental agencies of the United States and of foreign countries. During 2005, KBR and its affiliates had revenue of approximately $6.6 billion from its government contracts work with agencies of the United States or state or local governments. If necessary, we would seek to obtain administrative agreements or waivers from the DoD and other agencies to avoid suspension or debarment. Suspension or debarment from the government contracts business would have a material adverse effect on the business, results of operations, and cash flows of KBR and Halliburton.
These investigations could also result in third-party claims against us, which may include claims for special, indirect, derivative or consequential damages, damage to our business or reputation, loss of, or adverse effect on, cash flow, assets, goodwill, results of operations, business prospects, profits or business value, adverse consequences on our ability to obtain or continue financing for current or future projects or claims by directors, officers, employees, affiliates, advisors, attorneys, agents, debt holders, or other interest holders or constituents of us or our subsidiaries. In this connection, we understand that the government of Nigeria gave notice in 2004 to the French magistrate of a civil claim as an injured party in that proceeding. We are not aware of any further developments with respect to this claim. In addition, we could incur costs and expenses for any monitor required by or agreed to with a governmental authority to review our continued compliance with FCPA law.

17


As of September 30, 2006, we have not accrued any amounts related to these investigations other than our current legal expenses.
Bidding practices investigation
In connection with the investigation into payments related to the Bonny Island project in Nigeria, information has been uncovered suggesting that Mr. Stanley and other former employees may have engaged in coordinated bidding with one or more competitors on certain foreign construction projects, and that such coordination possibly began as early as the mid-1980s.
On the basis of this information, we and the DOJ have broadened our investigations to determine the nature and extent of any improper bidding practices, whether such conduct violated United States antitrust laws, and whether former employees may have received payments in connection with bidding practices on some foreign projects.
If violations of applicable United States antitrust laws occurred, the range of possible penalties includes criminal fines, which could range up to the greater of $10 million in fines per count for a corporation, or twice the gross pecuniary gain or loss, and treble civil damages in favor of any persons financially injured by such violations. Criminal prosecutions under applicable laws of relevant foreign jurisdictions and civil claims by, or relationship issues with customers, are also possible.
As of September 30, 2006, we had not accrued any amounts related to this investigation other than our current legal expenses.
Possible Algerian investigation
We believe that an investigation by a magistrate or a public prosecutor in Algeria may be pending with respect to sole source contracts awarded to Brown & Root Condor Spa, a joint venture with Kellogg Brown & Root Ltd UK, Centre de Recherche Nuclear de Draria, and Holding Services para Petroliers Spa. We had a 49% interest in this joint venture as of September 30, 2006.
Securities and related litigation
In June 2002, a class action lawsuit was filed against us in federal court on behalf of purchasers of our common stock during the approximate period of May 1998 until May 2002 alleging violations of the federal securities laws in connection with the accounting change and disclosures involved in the SEC investigation related to a change in accounting for revenue on long-term construction projects and related disclosures, which we settled with the SEC in the second quarter of 2004. In addition, the plaintiffs allege that we overstated our revenue from unapproved claims by recognizing amounts not reasonably estimable or probable of collection. In the weeks that followed, approximately twenty similar class actions were filed against us. Several of those lawsuits also named as defendants Arthur Andersen LLP, our independent accountants for the period covered by the lawsuits, and several of our present or former officers and directors. The class action cases were later consolidated, and the amended consolidated class action complaint, styled Richard Moore, et al. v. Halliburton Company, et al., was filed and served upon us in April 2003 (the “Moore class action”).
In early May 2003, we announced that we had entered into a written memorandum of understanding setting forth the terms upon which the Moore class action would be settled. In June 2003, the lead plaintiffs in the Moore class action filed a motion for leave to file a second amended consolidated complaint, which was granted by the court. In addition to restating the original accounting and disclosure claims, the second amended consolidated complaint includes claims arising out of the 1998 acquisition of Dresser Industries, Inc. by Halliburton, including that we failed to timely disclose the resulting asbestos liability exposure (the “Dresser claims”). The Dresser claims were included in the settlement discussions leading up to the signing of the memorandum of understanding and were among the claims the parties intended to have resolved by the terms of the proposed settlement of the consolidated Moore class action and the derivative action. The memorandum of understanding called for Halliburton to pay $6 million, which would be funded by insurance proceeds.
In June 2004, the court entered an order preliminarily approving the settlement. Following the transfer of the case to another district judge and a final hearing on the fairness of the settlement the court entered an order in September 2004 holding that evidence of the settlement’s fairness was inadequate, denying the motion for final approval of the settlement in the Moore class action, and ordering the parties, among other things, to mediate. After the court’s denial of the motion to approve the settlement, we withdrew from the settlement as we believe we are entitled to do by its terms. The mediation was held in January 2005, but was declared by the mediator to be at an impasse with no settlement reached.

18


In April 2005, the court appointed new co-lead counsel and a new lead plaintiff, directing that they file a third consolidated amended complaint and that we file our motion to dismiss. The court held oral arguments on that motion in August 2005, at which time the court took the motion under advisement. In March 2006, the court entered an order in which it granted the motion to dismiss with respect to claims arising prior to June 1999 and granted the motion with respect to certain other claims while permitting the plaintiffs to replead those claims to correct deficiencies in their earlier complaint. In April 2006, the plaintiffs filed their fourth amended consolidated complaint. We have filed a motion to dismiss those portions of the complaint that have been replead. A hearing was held on that motion in July 2006, and we await the court’s ruling.
As of September 30, 2006, we had not accrued any amounts related to this matter.
Newmont Gold
In July 1998, Newmont Gold, a gold mining and extraction company, filed a lawsuit over the failure of a blower manufactured and supplied to Newmont by Roots, a former division of Dresser Equipment Group. The plaintiff alleges that during the manufacturing process, Roots had reversed the blades of a component of the blower known as the inlet guide vane assembly, resulting in the blower’s failure and the shutdown of the gold extraction mill for a period of approximately one month during 1996. In January 2002, a Nevada trial court granted summary judgment to Roots on all counts, and Newmont appealed. In February 2004, the Nevada Supreme Court reversed the summary judgment and remanded the case to the trial court, holding that fact issues existed requiring a trial. Based on pretrial reports, the damages claimed by the plaintiff are in the range of $33 million to $39 million. We believe that we have valid defenses to Newmont Gold’s claims and intend to vigorously defend the matter. The case has now been set for trial in February 2007.
As of September 30, 2006, we had not accrued any amounts related to this matter.
Improper payments reported to the SEC
During the second quarter of 2002, we reported to the SEC that one of our foreign subsidiaries operating in Nigeria made improper payments of approximately $2.4 million to entities owned by a Nigerian national who held himself out as a tax consultant, when in fact he was an employee of a local tax authority. The payments were made to obtain favorable tax treatment and clearly violated our Code of Business Conduct and our internal control procedures. The payments were discovered during our audit of the foreign subsidiary. We conducted an investigation assisted by outside legal counsel, and, based on the findings of the investigation, we terminated several employees. None of our senior officers were involved. We are cooperating with the SEC in its review of the matter. We took further action to ensure that our foreign subsidiary paid all taxes owed in Nigeria. A preliminary assessment of approximately $4 million was issued by the Nigerian tax authorities in the second quarter of 2003. We are cooperating with the Nigerian tax authorities to determine the total amount due as quickly as possible.
Operations in Iran
We received and responded to an inquiry in mid-2001 from the Office of Foreign Assets Control (OFAC) of the United States Treasury Department with respect to operations in Iran by a Halliburton subsidiary incorporated in the Cayman Islands. The OFAC inquiry requested information with respect to compliance with the Iranian Transaction Regulations. These regulations prohibit United States citizens, including United States corporations and other United States business organizations, from engaging in commercial, financial, or trade transactions with Iran, unless authorized by OFAC or exempted by statute. Our 2001 written response to OFAC stated that we believed that we were in compliance with applicable sanction regulations. In the first quarter of 2004, we responded to a follow-up letter from OFAC requesting additional information. We understand this matter has now been referred by OFAC to the DOJ. In July 2004, we received a grand jury subpoena from an Assistant United States District Attorney requesting the production of documents. We are cooperating with the government’s investigation and responded to the subpoena by producing documents in September 2004.
As of September 30, 2006, we had not accrued any amounts related to this investigation.
Separate from the OFAC inquiry, we completed a study in 2003 of our activities in Iran during 2002 and 2003 and concluded that these activities were in compliance with applicable sanction regulations. These sanction regulations require isolation of entities that conduct activities in Iran from contact with United States citizens or managers of United States companies. Notwithstanding our conclusions that our activities in Iran were not in violation of United States laws and regulations, we announced that, after fulfilling our current contractual obligations within Iran, we intend to cease operations within that country and withdraw from further activities there.

19


David Hudak and International Hydrocut Technologies Corp.
In October 2004, David Hudak and International Hydrocut Technologies Corp. (collectively, Hudak) filed suit against us in the United States District Court alleging civil Racketeer Influenced and Corporate Organizations Act violations, fraud, breach of contract, unfair trade practices, and other torts. The action, which seeks unspecified damages, arises out of Hudak’s alleged purchase from us in early 1994 of certain explosive charges that were later alleged by the DOJ to be military ordnance, the possession of which by persons not possessing the requisite licenses and registrations is unlawful. As a result of that allegation by the government, Hudak was charged with, but later acquitted of, certain criminal offenses in connection with his possession of the explosive charges. As mentioned above, the alleged transaction(s) took place more than 10 years ago. The fact that most of the individuals that may have been involved, as well as the entities themselves, are no longer affiliated with us will complicate our investigation. For those reasons and because the litigation is in its most preliminary stages, it is premature to assess the likelihood of an adverse result. We filed a motion to dismiss and, alternatively, a motion to transfer venue. Those motions were denied during the first quarter of 2006. It is our intention to vigorously defend this action.
Amounts accrued related to this matter as of September 30, 2006 are not material.
Iraq overtime litigation
During the fourth quarter of 2005, a group of present and former employees working on the LogCAP contract in Iraq and elsewhere filed a class action lawsuit alleging that KBR wrongfully failed to pay time and a half for hours worked in excess of 40 per work week and that “uplift” pay, consisting of a foreign service bonus, an area differential, and danger pay, was only applied to the first 40 hours worked in any work week. The class alleged by plaintiffs consists of all current and former employees on the LogCAP contract from December 2001 to present. The basis of plaintiffs’ claims is their assertion that they are intended third-party beneficiaries of the LogCAP contract, and that the LogCAP contract obligated KBR to pay time and a half for all overtime hours. We moved to dismiss the case on a number of bases. On September 26, 2006, the court granted the motion to dismiss insofar as claims for overtime pay and “uplift” pay are concerned, leaving only a contractual claim for miscalculation of employees’ pay. It is premature to assess the probability of an adverse result on that remaining claim. However, because the LogCAP contract is cost-reimbursable, we believe that we could charge any adverse award to the customer. On October 13, 2006, the plaintiffs filed their notice of appeal. It is our intention to vigorously defend the appeal and the judgment of dismissal.
As of September 30, 2006, we had not accrued any amounts related to this matter.
McBride qui tam suit
In September 2006, we became aware of a qui tam action filed against us by a former employee alleging various wrongdoings in the form of overbillings of our customer on the LogCAP III contract. This case was originally filed pending the government’s decision whether or not to participate in the suit. In June 2006, the government formally declined to participate. The principal allegations are that our compensation for the provision of Morale, Welfare and Recreation (MWR) facilities under LogCAP III is based on the volume of usage of those facilities and that we deliberately overstated that usage.  In accordance with the contract, we charged our customer based on actual cost, not based on the number of users.  It was also alleged that during the period from November 2004 into mid-December 2004, we continued to bill the customer for lunches, although the dining facility was closed and not serving lunches. There are also allegations regarding housing containers and KBR’s provision of services to its own employees and contractors.  Our investigation is in its earliest stages. However, we believe the allegations to be without merit, and we intend to vigorously defend this action.
As of September 30, 2006, we have not accrued any amounts in connection with this matter.
Environmental
We are subject to numerous environmental, legal, and regulatory requirements related to our operations worldwide. In the United States, these laws and regulations include, among others:
 
-
the Comprehensive Environmental Response, Compensation, and Liability Act;
 
-
the Resources Conservation and Recovery Act;
 
-
the Clean Air Act;
 
-
the Federal Water Pollution Control Act; and
 
-
the Toxic Substances Control Act.

20


In addition to the federal laws and regulations, states and other countries where we do business often have numerous environmental, legal, and regulatory requirements by which we must abide. We evaluate and address the environmental impact of our operations by assessing and remediating contaminated properties in order to avoid future liabilities and comply with environmental, legal, and regulatory requirements. On occasion, we are involved in specific environmental litigation and claims, including the remediation of properties we own or have operated, as well as efforts to meet or correct compliance-related matters. Our Health, Safety and Environment group has several programs in place to maintain environmental leadership and to prevent the occurrence of environmental contamination.
We do not expect costs related to these remediation requirements to have a material adverse effect on our consolidated financial position or our results of operations. Our accrued liabilities for environmental matters were $38 million as of September 30, 2006 and $50 million as of December 31, 2005. The liability covers numerous properties, and no individual property accounts for more than $5 million of the liability balance. We have subsidiaries that have been named as potentially responsible parties along with other third parties for 13 federal and state superfund sites for which we have established a liability. As of September 30, 2006, those 13 sites accounted for approximately $10 million of our total $38 million liability. In some instances, we have been named a potentially responsible party by a regulatory agency, but, in each of those cases, we do not believe we have any material liability.
Letters of credit
In the normal course of business, we have agreements with banks under which approximately $1.0 billion of letters of credit or bank guarantees were outstanding as of September 30, 2006, including $551 million that relate to our joint ventures’ operations. Also included in letters of credit outstanding as of September 30, 2006 were $15 million of performance letters of credit related to the Barracuda-Caratinga project. Some of the outstanding letters of credit have triggering events which would entitle a bank to require cash collateralization.
Other commitments
As of September 30, 2006, we had commitments to fund approximately $122 million to related companies. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $4 million of the commitments to be paid during the next twelve months.
Liquidated damages
Many of our engineering and construction contracts have milestone due dates that must be met or we may be subject to penalties for liquidated damages if claims are asserted and we were responsible for the delays. These generally relate to specified activities within a project by a set contractual date or achievement of a specified level of output or throughput of a plant we construct. Each contract defines the conditions under which a customer may make a claim for liquidated damages. However, in most instances, liquidated damages are not asserted by the customer, but the potential to do so is used in negotiating claims and closing out the contract. We had not accrued for liquidated damages of $49 million at September 30, 2006 and $70 million at December 31, 2005 (including amounts related to unconsolidated subsidiaries) that we could incur based upon completing the projects as forecasted.

Note 13. Accounting for Stock-Based Compensation
Our 1993 Stock and Incentive Plan, as amended (1993 Plan), provides for the grant of any or all of the following types of stock-based awards:
 
-
stock options, including incentive stock options and nonqualified stock options;
 
-
restricted stock awards;
 
-
restricted stock unit awards;
 
-
stock appreciation rights; and
 
-
stock value equivalent awards.
There are currently no stock appreciation rights or stock value equivalent awards outstanding.
Under the terms of the 1993 Plan, 98 million shares of common stock have been reserved for issuance to employees and non-employee directors. The plan specifies that no more than 32 million shares can be awarded as restricted stock. At September 30, 2006, approximately 21 million shares were available for future grants under the 1993 Plan, of which approximately 12 million shares remained available for restricted stock awards. The stock to be offered pursuant to the grant of an award under the 1993 Plan may be authorized but unissued common shares or treasury shares.

21


In addition to the provisions of the 1993 Plan, we also have stock-based compensation provisions under our Restricted Stock Plan for Non-Employee Directors and our 2002 Employee Stock Purchase Plan (ESPP).
Effective January 1, 2006, we adopted the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), using the modified prospective application. Accordingly, we are recognizing compensation expense for all newly granted awards and awards modified, repurchased, or cancelled after January 1, 2006. Compensation cost for the unvested portion of awards that are outstanding as of January 1, 2006 is recognized ratably over the remaining vesting period based on the fair value at date of grant. Also, beginning with the January 1, 2006 purchase period, compensation expense for our ESPP is being recognized. The cumulative effect of this change in accounting principle related to stock-based awards was immaterial. Prior to January 1, 2006, we accounted for these plans under the recognition and measurement provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under APB No. 25, no compensation expense was recognized for stock options or the ESPP. Compensation expense was recognized for restricted stock awards. As a result of adopting SFAS No. 123(R), the incremental pretax expense related to employee stock option awards and our ESPP totaled approximately $30 million in the first nine months of 2006, or $0.02 per diluted share after tax.
Total stock-based compensation expense, net of related tax effects, was $14 million in the third quarter of 2006 and $42 million in the first nine months of 2006. Total income tax benefit recognized in net income for stock-based compensation arrangements was $9 million in the third quarter of 2006 and $24 million in the first nine months of 2006, compared to $3 million in the third quarter of 2005 and $13 million in the first nine months of 2005. Total incremental compensation cost resulting from modifications of previously granted stock-based awards was $2 million and $10 million for the three and nine months ended September 30, 2006, compared to $1 million and $14 million for the three and nine months ended September 30, 2005. These modifications allowed certain employees to retain their awards after leaving the company.
The following table summarizes the pro forma effect on net income and income per share for the three and nine months ended September 30, 2005 as if we had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

   
Three Months Ended
 
Nine Months Ended
 
Millions of dollars except per share data
 
September 30, 2005
 
September 30, 2005
 
Net income, as reported
 
$
499
 
$
1,256
 
Add: Total stock-based compensation expense included
             
in net income, net of related tax effects
   
4
   
23
 
Less: Total stock-based compensation expense
             
determined under fair-value-based method for all
   
(11
)
 
(44
)
awards, net of related tax effects
             
Net income, pro forma
 
$
492
 
$
1,235
 
               
Basic income per share:
             
As reported
 
$
0.50
 
$
1.25
 
Pro forma
 
$
0.49
 
$
1.23
 
Diluted income per share:
             
As reported
 
$
0.48
 
$
1.22
 
Pro forma
 
$
0.47
 
$
1.20
 

Each of the active stock-based compensation arrangements is discussed below.
Stock options
All stock options under the 1993 Plan are granted at the fair market value of the common stock at the grant date. Employee stock options vest ratably over a three- or four-year period and generally expire 10 years from the grant date. Stock options granted to non-employee directors vest after six months. No further stock option grants are being made under the stock plans of acquired companies.

22


The fair value of options at the date of grant was estimated using the Black-Scholes option pricing model. The expected volatility of options granted in 2006 is a blended rate based upon implied volatility calculated on actively traded options on our common stock and upon the historical volatility of our common stock. The expected volatility of options granted in 2005 is based upon the historical volatility of our common stock. The expected term of options granted in 2006 and 2005 is based upon historical observation of actual time elapsed between date of grant and exercise of options for all employees. The assumptions and resulting fair values of options granted were as follows:

   
Nine months ended September 30
 
   
2006
 
2005
 
Expected term (in years)
   
5.24
   
5.00
 
Expected volatility
   
42.20
%
 
51.28 - 52.79
%
Expected dividend yield
   
0.76- 1.06
%
 
0.73 - 1.16
%
Risk-free interest rate
   
4.30- 5.03
%
 
3.77 - 4.27
%
Weighted average grant-date fair value per share
 
$
14.42
 
$
10.08
 

The following table represents our stock options activity during the first nine months of 2006, and includes exercised, forfeited, and expired shares from our acquired companies’ stock plans.

       
Weighted
 
Weighted
     
       
Average
 
Average
 
Aggregate
 
   
Number
 
Exercise
 
Remaining
 
Intrinsic
 
   
of Shares
 
Price
 
Contractual
 
Value
 
Stock Options
 
(in millions)
 
per Share
 
Term (years)
 
(in millions)
 
Outstanding at January 1, 2006
   
22.4
 
$
16.81
             
Granted
   
1.5
   
34.72
             
Exercised
   
(5.5
)
 
17.54
             
Forfeited
   
(0.2
)
 
18.75
             
Expired
   
(0.1
)
 
14.82
             
Outstanding at September 30, 2006
   
18.1
 
$
18.03
   
5.81
 
$
200
 
                           
Exercisable at September 30, 2006
   
13.1
 
$
15.43
   
4.75
 
$
170
 

The total intrinsic value of options exercised was $6 million in the third quarter of 2006 and $110 million in the first nine months of 2006, compared to $114 million in the third quarter of 2005 and $164 million in the first nine months of 2005. As of September 30, 2006, there was $37 million of unrecognized compensation cost, net of estimated forfeitures, related to nonvested stock options, which is expected to be recognized over a weighted average period of approximately 1.8 years.
Cash received from option exercises was $29 million and $146 million during the three and nine months ended September 30, 2006, compared to $177 million and $303 million during the three and nine months ended September 30, 2005. As a result of our net operating loss carryforwards at September 30, 2006, our $38 million tax benefit from exercise of stock options will not be realized until such time as the net operating loss carryforwards are fully utilized.
Restricted stock
Restricted shares issued under the 1993 Plan are restricted as to sale or disposition. These restrictions lapse periodically over an extended period of time not exceeding 10 years. Restrictions may also lapse for early retirement and other conditions in accordance with our established policies. Upon termination of employment, shares on which restrictions have not lapsed must be returned to us, resulting in restricted stock forfeitures. The fair market value of the stock on the date of grant is amortized and ratably charged to income over the period during which the restrictions lapse.

23


Our Restricted Stock Plan for Non-Employee Directors (Directors Plan) allows for each non-employee director to receive an annual award of 800 restricted shares of common stock as a part of compensation. These awards have a minimum restriction period of six months and the restrictions lapse upon termination of Board service. The fair market value of the stock on the date of grant is amortized and ratably charged to income over the period during which the restriction lapses. We reserved 200,000 shares of common stock for issuance to non-employee directors, which may be authorized but unissued shares or treasury shares. At September 30, 2006, 106,400 shares had been issued to non-employee directors under this plan. There were 8,000 and 6,400 shares of restricted stock awarded under the Directors Plan in the first nine months of 2006 and the first nine months of 2005.
The following table represents our 1993 Plan and Directors Plan restricted stock awards and restricted stock units granted, vested, and forfeited during the first nine months of 2006.

       
Weighted
 
   
Number of Shares
 
Average
Grant-Date Fair
 
Restricted Stock
 
(in millions)
 
Value per Share
 
Nonvested shares at January 1, 2006
   
7.5
 
$
17.07
 
Granted
   
2.1
   
34.76
 
Vested
   
(1.5
)
 
16.17
 
Forfeited
   
(0.2
)
 
20.28
 
Nonvested shares at September 30, 2006
   
7.9
 
$
21.91
 

The weighted average grant-date fair value of shares granted during the first nine months of 2005 was $22.37. The total fair value of shares vested during the three and nine months ended September 30, 2006 was $5 million and $53 million, compared to $9 million and $39 million during the three and nine months ended September 30, 2005. As of September 30, 2006, there was $141 million of unrecognized compensation cost, net of estimated forfeitures, related to nonvested restricted stock, which is expected to be recognized over a weighted average period of 4.2 years.
2002 Employee Stock Purchase Plan
Under the ESPP, eligible employees may have up to 10% of their earnings withheld, subject to some limitations, to be used to purchase shares of our common stock. Unless the Board of Directors shall determine otherwise, each six-month offering period commences on January 1 and July 1 of each year. The price at which common stock may be purchased under the ESPP is equal to 85% of the lower of the fair market value of the common stock on the commencement date or last trading day of each offering period. Under this plan, 24 million shares of common stock have been reserved for issuance. They may be authorized but unissued shares or treasury shares. As of September 30, 2006, 10.6 million shares have been sold through the ESPP.
The fair value of ESPP shares was estimated using the Black-Scholes option pricing model. The expected volatility is a one-year historical volatility of our common stock. The assumptions and resulting fair values were as follows:

   
Offering period July 1 to December 31
 
   
2006
 
2005
 
Expected term (in years)
   
0.5
   
0.5
 
Expected volatility
   
37.77
%
 
30.46
%
Expected dividend yield
   
0.80
%
 
0.73
%
Risk-free interest rate
   
5.29
%
 
3.89
%
Weighted average grant-date fair value per share
 
$
9.32
 
$
5.50
 

24



   
Offering period January 1 to June 30
 
   
2006
 
2005
 
Expected term (in years)
   
0.5
   
0.5
 
Expected volatility
   
35.65
%
 
26.93
%
Expected dividend yield
   
0.75
%
 
1.16
%
Risk-free interest rate
   
4.38
%
 
3.15
%
Weighted average grant-date fair value per share
 
$
7.91
 
$
4.15
 

Note 14. Income per Share
Basic income per share is based on the weighted average number of common shares outstanding during the period. Diluted income per share includes additional common shares that would have been outstanding if potential common shares with a dilutive effect had been issued. A reconciliation of the number of shares used for the basic and diluted income per share calculations is as follows:

   
Three Months
 
Nine Months
 
   
Ended
 
Ended
 
   
September 30
 
September 30
 
Millions of shares
 
2006
 
2005
 
2006
 
2005
 
Basic weighted average common shares outstanding
   
1,011
   
1,012
   
1,021
   
1,006
 
Dilutive effect of:
                         
Convertible senior notes premium
   
27
   
22
   
30
   
12
 
Stock options
   
8
   
12
   
9
   
10
 
Restricted stock
   
2
   
2
   
2
   
2
 
Other
   
-
   
2
   
-
   
2
 
Diluted weighted average common shares outstanding
   
1,048
   
1,050
   
1,062
   
1,032
 

All the share numbers included in the tables above have been adjusted to reflect the July 2006 two-for-one common stock split. See Note 16 for further information.
Excluded from the computation of diluted income per share are options to purchase two million shares of common stock that were outstanding during the three and nine months ended September 30, 2006 and two million shares during the nine months ended September 30, 2005. These options were outstanding during these quarters but were excluded because they were antidilutive, as the option exercise price was greater than the average market price of the common shares.

Note 15. Retirement Plans
The components of net periodic benefit cost related to pension benefits for the three and nine months ended September 30, 2006 and September 30, 2005 were as follows:

   
Three Months Ended September 30
 
   
2006
 
2005
 
Millions of dollars
 
United States
 
International
 
United States
 
International
 
Components of net periodic
                         
benefit cost:
                         
Service cost
 
$
-
 
$
17
 
$
-
 
$
17
 
Interest cost
   
2
   
43
   
2
   
42
 
Expected return on plan assets
   
(2
)
 
(48
)
 
(3
)
 
(47
)
Amortization of prior service cost (credit)
   
-
   
(1
)
 
-
   
1
 
Recognized actuarial loss
   
2
   
6
   
2
   
4
 
Net periodic benefit cost
 
$
2
 
$
17
 
$
1
 
$
17
 

25



   
Nine Months Ended September 30
 
   
2006
 
2005
 
Millions of dollars
 
United States
 
International
 
United States
 
International
 
Components of net periodic
                         
benefit cost:
                         
Service cost
 
$
-
 
$
52
 
$
-
 
$
56
 
Interest cost
   
7
   
130
   
7
   
128
 
Expected return on plan assets
   
(7
)
 
(145
)
 
(8
)
 
(139
)
Amortization of prior service cost (credit)
   
-
   
(1
)
 
-
   
1
 
Settlements/curtailments
   
-
   
-
   
-
   
5
 
Recognized actuarial loss
   
5
   
19
   
4
   
13
 
Net periodic benefit cost
 
$
5
 
$
55
 
$
3
 
$
64
 

In the first quarter of 2005, we amended the terms and conditions of one of our foreign defined benefit plans and ceased future service and benefit accruals for all plan participants. This action is defined as a curtailment under SFAS No. 88 and, therefore, during the first quarter of 2005, we recognized a curtailment loss of approximately $5 million.
We currently expect to contribute approximately $165 million to our international pension plans in 2006. As of September 30, 2006, we contributed $158 million of the $165 million to our international pension plans. As part of the $158 million, ESG contributed $45 million, and KBR contributed $105 million to the United Kingdom pension plans. We do not have a required minimum contribution for our domestic plans; however, we made an additional discretionary contribution of $4 million in the third quarter of 2006. We do not expect to make additional contributions to our domestic plans in 2006.
The components of net periodic benefit cost related to other postretirement benefits for the three and nine months ended September 30, 2006 and September 30, 2005 were as follows:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars
 
2006
 
2005
 
2006
 
2005
 
Components of net periodic
                         
benefit cost:
                         
Service cost
 
$
-
 
$
1
 
$
1
 
$
1
 
Interest cost
   
3
   
2
   
7
   
7
 
Net periodic benefit cost
 
$
3
 
$
3
 
$
8
 
$
8
 

Note 16. Common Stock
In February 2006, our Board of Directors approved a share repurchase program of up to $1.0 billion. In September 2006, our Board of Directors approved an increase to our existing common share repurchase program of up to an additional $2.0 billion. During the first nine months of 2006, we repurchased approximately 32 million shares of our common stock for approximately $1.0 billion, or an average price per share of $32.99.
In May 2006, the stockholders increased the number of authorized shares of common stock to two billion. Also in May 2006, our Board of Directors finalized the terms of a two-for-one common stock split, effected in the form of a stock dividend. As a result, the split was paid in the form of a stock dividend on July 14, 2006 to stockholders of record on June 23, 2006. The effect on the balance sheet was to reduce “Paid-in capital in excess of par value” by $1.3 billion and to increase “Common shares” by $1.3 billion. All prior period common stock and applicable share and per share amounts were retroactively adjusted to reflect the split.

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Note 17. Related Companies
With respect to the Alice Springs-Darwin railroad project, we own a 36.7% interest in a joint venture that is the holder of a 50-year concession contract with the Australian government to operate and maintain the railway. We account for this investment under the equity method of accounting in our Government and Infrastructure segment. Construction on the railway was completed in late 2003, and operations commenced in early 2004. In the first quarter of 2006, we recorded a $26 million impairment charge. In addition, in the first nine months of 2006, we recorded $11 million in losses related to our investment and made $10 million in advances to the joint venture. This joint venture has sustained losses since the railway commenced operations in early 2004 and at June 30, 2006 was projected to violate the joint venture’s loan covenants. These loans are non-recourse to us. We received revised financial forecasts from the joint venture during the first quarter of 2006, which took into account decreases, as compared to prior forecasts, in anticipated freight volume related to delays in mining of minerals, as well as a slowdown in the planned expansion of the Port of Darwin and ultimately contributed to the impairment charge recorded in the first quarter of 2006. At that time, the joint venture engaged investment bankers in an effort to raise additional capital for the venture. At the end of the second quarter of 2006, our valuation of our investment took into consideration the bids tendered at that time by interested parties to accomplish this recapitalization, and no further impairment was evident. However, the efforts to raise additional capital ceased during the third quarter because all previous bids were subsequently rejected or withdrawn. The board of the joint venture is currently attempting to restructure debt payment terms and raise additional subordinated financing. In October 2006, the joint venture violated its loan covenants by failing to make an interest and principal payment. In light of the loan covenant default and the joint venture’s need for additional equity or subordinated financing, we recorded a $32 million impairment charge in the third quarter of 2006. We will receive no tax benefit as this impairment charge is not deductible for Australian tax purposes.  At September 30, 2006, our investment in this joint venture was $10 million, and we had no additional funding commitments. In addition, the senior lenders have agreed to waive the financial covenant violations through November 15, 2006 to allow the shareholders time to arrange additional subordinated financing estimated at $12 million. KBR has offered to fund approximately $6 million, provided that other shareholders commit to funding $6 million in the aggregate and the senior lenders agree to certain concessions, including a principal payment holiday for 27 months and a reduction in the debt service reserve required by the existing indenture. Even if this additional investment is made and the senior lenders grant the concessions, a further impairment of our investment may be required. We believe that without a restructuring of the joint venture's debt and an additional commitment for financing, we will record an additional impairment charge of $10 million, representing a full impairment of our remaining investment at September 30, 2006, at some point in the future.
We have an investment in a development corporation that has an indirect interest in the new Egypt Basic Industries Corporation (EBIC) ammonia plant project located in Egypt. We are performing the engineering, procurement, and construction (EPC) work for the project and providing operations and maintenance services for the facility. We own 60% of this development company and consolidate it for financial reporting purposes within our Energy and Chemicals segment. The development corporation owns a 25% ownership interest in a company that consolidates the ammonia plant, which is considered a variable interest entity. The development corporation accounts for its investment in the company using the equity method of accounting. The variable interest entity is funded through debt and equity. We are not the primary beneficiary of the variable interest entity. As of September 30, 2006, the variable interest entity had total assets of $297 million and total liabilities of $149 million. Our maximum exposure to loss on our equity investments at September 30, 2006 is limited to our investment of $15 million and our commitment to fund an additional $3 million of stand-by equity. In August 2006, the lenders providing the construction financing notified EBIC that it was in default of the terms of its debt agreement, which effectively prevents the project from making additional borrowings until such time as certain security interests in the ammonia plant assets related to the export facilities can be perfected. Indebtedness under the debt agreement is non-recourse to us. At this time, we are continuing to work on the project, and we understand that discussions with the lenders regarding the security interests are ongoing. No event of default has occurred pursuant to our EPC contract as we have been paid all amounts due from EBIC. We believe EBIC may potentially cure the default by perfecting the lenders’ security interests in the port assets. In addition, EBIC may be required to construct its export facilities at a location farther from the plant than was originally planned. This would require an increase to the overall project cost and a change order, which we estimate at $5 million. In addition, we have been instructed by EBIC to cease

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work on one location of the project on which the ammonia storage tanks were originally planned to be constructed and have been instructed to perform soil testing at an alternative site in the vicinity of the original site. We understand this potential relocation of the ammonia storage site is in connection with the security interest described above. In addition to schedule delays, we estimate that the cost of moving to the alternate ammonia storage site would result in additional EPC costs of up to $6 million, and we would have entitlement to a change order to recover our costs. Any solution resulting in additional costs could require EBIC to raise additional financing, some of which could be from us and the other current stakeholders. If the default under the debt agreement is not cured, the project may not have sufficient financing to continue, which could result in an impairment of our investment and a termination of our EPC contract with EBIC, which could result in a reduction of our profits or a recognition of a loss.
In April 2006, Aspire Defence, a joint venture between us, Mowlem Plc., and a financial investor, was awarded a privately financed project contract, the Allenby and Connaught project, by the Ministry of Defence to upgrade and provide a range of services to the British Army’s garrisons at Aldershot and around Salisbury Plain in the United Kingdom. In addition to a package of ongoing services to be delivered over 35 years, the project includes a nine-year construction program to improve soldiers’ single living, technical, and administrative accommodations, along with leisure and recreational facilities. Aspire Defence will manage the existing properties and will be responsible for design, refurbishment, construction, and integration of new and modernized facilities. We indirectly own a 45% interest in Aspire Defence, the project company that is the holder of the 35-year concession contract. In addition, we own a 50% interest in each of two joint ventures that provides the construction and the related support services to Aspire Defence. Our performance through the construction phase is supported by $159 million in letters of credit and surety bonds totaling approximately $209 million as of September 30, 2006, both of which have been guaranteed by us. Furthermore, our financial and performance guarantees are joint and several, subject to certain limitations, with our joint venture partners. The project is funded through equity and subordinated debt provided by the project sponsors and the issuance of publicly held senior bonds. The entities in which we hold an interest are considered variable interest entities; however, we are not the primary beneficiary of these entities. We account for our interests in each of the entities using the equity method of accounting under our Government and Infrastructure segment. As of September 30, 2006, the aggregate total assets of the variable interest entities were $3.0 billion and the aggregate total liabilities were $3.1 billion. Our maximum exposure to project company losses as of September 30, 2006 was limited to our commitment to fund subordinated debt totaling $102 million. Our maximum exposure to construction and operating joint venture losses is limited to the funding of any future losses incurred by those entities.
In July 2006, we were awarded, through a 50%-owned joint venture, a contract with Qatar Shell GTL Limited to provide project management and cost-reimbursable engineering, procurement, and construction management services for the Pearl gas-to-liquids (GTL) project in Ras Laffan, Qatar. The project, which is expected to be completed by 2011, consists of gas production facilities and a GTL plant. The joint venture is considered a variable interest entity. We consolidate the joint venture for financial reporting purposes within our Energy and Chemicals segment because we are the primary beneficiary.  As of September 30, 2006, the Pearl joint venture had total assets of $69 million and total liabilities of $57 million.

Note 18. New Accounting Standards
In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” The interpretation prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We will not elect early adoption of this interpretation and will adopt the provisions of FIN 48 beginning January 1, 2007. We are currently evaluating what impact, if any, this statement will have on our financial statements.

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In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS. No. 158 requires an employer to:
 
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recognize on its balance sheet the funded status (measured as the difference between the fair value of plan assets and the benefit obligation) of pension and other postretirement benefit plans;
 
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recognize, through comprehensive income, certain changes in the funded status of a defined benefit and postretirement plan in the year in which the changes occur;
 
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measure plan assets and benefit obligations as of the end of the employer’s fiscal year; and
 
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disclose additional information.
The requirement to recognize the funded status of a benefit plan and the additional disclosure requirements are effective for fiscal years ending after December 15, 2006. We will adopt SFAS No. 158 requirements for our fiscal year ending December 31, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end is effective for fiscal years ending after December 15, 2008. We will not elect early adoption of these additional SFAS No. 158 requirements and will adopt these requirements for our fiscal year ending December 31, 2008.
We are currently assessing the quantitative impact to our financial statements, which we believe will be material. For example, using the information disclosed as of December 31, 2005, total assets as of December 31, 2005 would have been approximately $34 million lower, total liabilities would have been approximately $242 million higher, minority interest would have been approximately $74 million lower, and shareholders’ equity would have been $202 million lower. Because our pension and other postretirement benefit plans are dependent on future events and circumstances and current actuarial assumptions, the impact at the time of adoption of SFAS No. 158 will differ from these amounts.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

EXECUTIVE OVERVIEW

During the first nine months of 2006, the Energy Services Group (ESG) produced revenue of $9.4 billion and operating income of $2.4 billion, reflecting an operating margin of 25.7%. Revenue increased $2.2 billion or 30% over the prior year period, primarily driven by higher activity in North America, Asia Pacific, the Middle East, and the North Sea. In the first nine months of 2006, ESG operating income increased $823 million or 51% compared to the first nine months of 2005. Internationally, ESG experienced 24% revenue growth and 47% operating income growth during the first nine months of 2006 as compared to the first nine months of 2005. Increased customer drilling and production activity, increased demand for our unique technologies, higher utilization of assets, and continued price increases have allowed us to consistently produce improved revenue and operating income.
For the first nine months of 2006, KBR revenue was down $302 million to $7.1 billion with operating income decreasing $226 million to $119 million, as compared to the same period in 2005. The revenue decline was primarily due to decreased military support activities in Iraq.
In July 2006, the United States Army announced it would rebid the LogCAP III contract for logistical support that KBR provided in Iraq, transitioning to a new LogCAP IV contract. The Army has determined it wants multiple service providers to perform the work currently provided entirely by us. KBR submitted the final portion of its bid in October 2006, and we understand the work will be awarded during the fourth quarter of 2006. We expect to complete all task orders currently open under the LogCAP III contract during 2007, including a $3.5 billion task order received during the third quarter of 2006. Backlog related to the LogCAP III contract at September 30, 2006 was $4.0 billion. In the first nine months of 2006, Iraq-related work contributed approximately $3.6 billion to consolidated revenue and $120 million to consolidated operating income, resulting in a 3.3% margin before corporate costs and taxes. In the first nine months of 2006, KBR has been awarded $113 million in LogCAP award fees as a result of our performance ratings. During the almost five-year period we have worked under this contract, we have been awarded 58 “excellent” ratings out of 70 total ratings.
In the second quarter of 2006, we recorded a $148 million charge, before income taxes and minority interest, related to our consolidated 50%-owned gas-to-liquids project in Escravos, Nigeria. This charge was primarily attributable to increases in the overall estimated cost to complete the project. The project experienced delays relating to civil unrest and security on the Escravos River, near the project site, with additional delays resulting from scope changes and engineering and construction modifications. In October 2006, we reached agreement with our customer to fund $206 million of the $269 million in unapproved change orders. The $69 million increase in change orders from June 30, 2006 is due to additional scope changes to the project. Portions of the remaining work now have a lower risk profile, particularly with respect to security and logistics. The project was approximately 38% complete as of September 30, 2006.
In May 2006, we completed the sale of KBR’s Production Services group, which was part of our Energy and Chemicals segment. In connection with the sale, we received net proceeds of $265 million. The sale of Production Services resulted in an adjusted pretax gain, net of post-closing adjustments, of $120 million.
In the first nine months of 2006, KBR recorded $58 million of impairment charges related to our investment in a railway joint venture in Australia. This joint venture has sustained losses since the railway commenced operations in early 2004 and violated the joint venture’s loan covenants by failing to make an interest and principal payment in October 2006. The write-down of our investment in this joint venture in the first and third quarters of 2006 resulted from decreases in anticipated freight volume related to delays in mining of minerals, as well as a slowdown in the planned expansion of the Port of Darwin. The board of the joint venture is currently attempting to restructure debt payment terms and raise additional subordinated financing. The senior lenders have agreed to waive the financial covenant violations through December 31, 2006 to allow the shareholders time to arrange the additional financing.

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In April 2006, KBR, Petrobras, and the project lenders agreed to technical and operational acceptance of the completed Barracuda and Caratinga production vessels. This agreement will not affect the bolt arbitration. In March 2006, Petrobras submitted to arbitration a $220 million claim related to the Barracuda-Caratinga project. The submission claimed that certain subsea flowline bolts failed and that the replacement of these bolts was our responsibility. We disagree with the Petrobras claim since the bolts met Petrobras’ design specification, and we do not believe there is any basis for the amount claimed by Petrobras. We have examined possible solutions to the problem and determined the cost would not exceed $140 million. We are defending ourselves in the arbitration process and will pursue recovery of our costs associated with this defense.
Separation of KBR
We intend to completely separate KBR, Inc. from Halliburton as expeditiously as possible through a tax-free dividend distribution of KBR, Inc. stock to Halliburton stockholders. A Form 10 registration statement will be filed with the United States Securities and Exchange Commission (SEC) to register the shares of KBR, Inc. stock under the Securities Exchange Act of 1934. After the distribution, KBR, Inc. will be a separately traded public company. In addition, the separation of KBR, Inc., through the distribution of KBR, Inc. stock to Halliburton shareholders, will substantially reduce Halliburton’s shareholders’ equity.
The distribution of KBR, Inc. stock may be preceded by an initial public offering (IPO) of less than 20% of KBR. In April 2006, KBR, Inc. filed a Registration Statement on Form S-1 with the SEC for an IPO of less than 20% of KBR, Inc. and, in October 2006, filed Amendment No. 3 to that registration statement. We do not intend to delay the complete separation of KBR to wait on favorable conditions for an IPO of KBR, Inc.
We have submitted our request for a ruling from the Internal Revenue Service that, among other things, no gain or loss will be recognized by Halliburton or its stockholders as a result of a distribution of KBR, Inc. stock. We expect to receive the ruling within the timeframe of completing the distribution, which we anticipate being no later than April 2007. Prior to the IPO or separation occurring, we will enter into various agreements to govern the separation of KBR from us, including, among others, a master separation agreement, a tax sharing agreement, transition services agreements and an employee matters agreement. The master separation agreement will provide for, among other things, KBR’s responsibility for liabilities relating to its business and Halliburton’s responsibility for liabilities unrelated to KBR’s business. Halliburton expects to provide indemnification in favor of KBR under the master separation agreement for certain contingent liabilities, including Halliburton’s indemnification of KBR and any of its greater than 50%-owned subsidiaries for:
 
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fines or other monetary penalties or direct monetary damages, including disgorgement, as a result of a claim made or assessed by a governmental authority, or a settlement thereof, relating to alleged or actual violations of the United States Foreign Corrupt Practices Act (FCPA) or particular, analogous applicable foreign statutes and regulations; and
 
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all out-of-pocket cash costs and expenses, or cash settlements or cash arbitration awards in lieu thereof, KBR may incur after the effective date of the master separation agreement as a result of the replacement of the subsea flowline bolts installed in connection with the Barracuda-Caratinga project.
The Halliburton performance guarantees and letter of credit guarantees that are currently in place in favor of KBR’s customers or lenders will continue after the separation of KBR until these guarantees expire by their terms. KBR will compensate Halliburton for these guarantees and indemnify Halliburton if Halliburton is required to perform under any of these guarantees. The tax sharing agreement will provide for allocations of United States income tax liabilities and other agreements between us and KBR with respect to tax matters. Under the transition services agreements, we expect to continue providing various interim corporate support services to KBR, and KBR will continue to provide various interim corporate support services to us. The fees will be determined on a basis generally intended to approximate the fully allocated direct and indirect costs of providing the services, without any profit. Under an employee matters agreement, Halliburton and KBR will allocate liabilities and responsibilities relating to current and former employees and their participation in certain benefit plans. KBR’s Registration Statement on Form S-1 contains a more detailed description of these separation agreements.
Any sale of KBR, Inc. stock under a Form S-1 would be registered under the Securities Act of 1933, and such shares of common stock would only be offered and sold by means of a prospectus. This quarterly report does not constitute an offer to sell or the solicitation of any offer to buy any securities of KBR, and there will not be any sale of any such securities in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of such state.

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Other corporate matters
In May 2006, our Board of Directors approved a dividend for the second quarter of 2006 of $0.075 per share, representing a 20% increase over previous quarterly dividends. The Board of Directors also finalized the terms of a two-for-one common stock split, following the shareholder approval at the 2006 annual shareholders meeting of a proposal to increase the number of authorized shares of common stock from one billion shares to two billion shares. On July 14, 2006, each shareholder of record as of June 23, 2006, received one additional share for each outstanding share held. All periods presented have been adjusted to reflect the common stock split.
In February 2006, our Board of Directors approved a share repurchase program of up to $1.0 billion. In September 2006, our Board of Directors authorized an increase to our existing common share repurchase program of up to an additional $2.0 billion. For the three and nine months ended September 30, 2006, we repurchased approximately 27 million and 32 million shares of our common stock at an average price of $32.51 and $32.99, respectively. The total cost of repurchasing the 32 million shares was approximately $1.0 billion.
In January 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)) and began expensing the cost of our employee stock option awards and our employee stock purchase plan. On a pretax basis, these costs totaled approximately $30 million in the first nine months of 2006 and are in addition to $26 million in costs we have historically expensed related to other equity based compensation and $10 million of incremental compensation cost related to modifications of previously granted stock-based awards retained when certain employees left the company. All expense related to stock compensation awards were charged to the segments to which each affected employee is assigned.
Business outlook
The outlook for our business remains favorable. Despite declining oil prices and softening natural gas prices in the third quarter of 2006, stronger than historical commodity prices, a lack of oil in storage compared to other periods when prices have been historically high, and continuing strong cash flow continue to drive increased spending plans for our exploration and production customers. Worldwide demand for hydrocarbons continues to grow, and the reservoirs are becoming more and more complex. Demand for our services in North America continues to be strong. We currently do not have enough capacity to serve all the customers seeking our pressure pumping services in North America. If some of our current customers were to decrease their activity levels, it would allow us to go to work for others, thus keeping our people and equipment highly utilized. Also, if natural gas drilling were to decrease, we expect to see our customers shift their focus to drilling oil wells in the near term, rather than letting the rigs go unutilized. However, we do believe that the softness in natural gas prices could, in the next three to six months, impact our ability to push through price increases as aggressively as we have in the past. Finally, we expect the energy services sector in regions outside North America to grow. Therefore, we have been and will continue investing resources predominantly in the Eastern Hemisphere, consistent with our initiative to grow our operations in that part of the world.
For the remainder of 2006, we will continue to focus on:
 
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improving the utilization of our equipment and deploying additional resources to address the growing demand for our services and products, in particular, our pressure pumping services and directional drilling and formation evaluation tools in North America and the Eastern Hemisphere;
 
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increasing pricing and reducing discounts, as the market allows, for ESG’s services and products, due to expected labor and material cost increases and high demand from customers;
 
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leveraging our technologies to provide our customers with the ability to more efficiently drill and complete their wells and to increase their productivity;
 
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capitalizing on the liquefied natural gas (LNG) and gas-to-liquids (GTL) markets. Forecasted LNG market growth remains strong and is expected to grow further. Significant numbers of new LNG liquefaction plant and LNG receiving terminal projects are proposed worldwide and are in various stages of development. We are currently in the bidding process for several LNG and GTL projects, and expect to receive decisions on those in the next few quarters;
 
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diversifying the services of our Government and Infrastructure segment. With the rebid of the LogCAP contract, we are focused on diversifying the Government and Infrastructure project portfolio. We continue to serve the United States Navy under the CONCAP construction contingency contract and are positioned for future contingency work for the United States Air Force under the AFCAP contract. In addition, we have strengthened our position with the United Kingdom Ministry of Defence; and

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maintaining our ESG growth initiative both domestically and internationally through capital expenditures of approximately $875 million during 2006 and $1.2 billion in 2007.
Detailed discussions of the Foreign Corrupt Practices Act investigations and our liquidity and capital resources follow. Our operating performance is described in “Business Environment and Results of Operations” below.

Foreign Corrupt Practices Act investigations
The United States Securities and Exchange Commission (SEC) is conducting a formal investigation into whether improper payments were made to government officials in Nigeria through the use of agents or subcontractors in connection with the construction and subsequent expansion by TSKJ of a multibillion dollar natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria. The DOJ is also conducting a related criminal investigation. The SEC has also issued subpoenas seeking information, which we are furnishing, regarding current and former agents used in connection with multiple projects, including current and prior projects, over the past 20 years located both in and outside of Nigeria in which The M.W. Kellogg Company, M.W. Kellogg Limited, Kellogg Brown & Root or their or our joint ventures, as well as the Halliburton energy services business, are or were participants. In September 2006, the SEC requested that we enter into a tolling agreement with respect to its investigation. We anticipate that we will enter into an appropriate tolling agreement with the SEC.
TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V. (a subsidiary of Saipem SpA of Italy), JGC Corporation of Japan, and Kellogg Brown & Root (a subsidiary of ours and successor to The M.W. Kellogg Company), each of which had an approximately 25% interest in the venture at September 30, 2006. TSKJ and other similarly owned entities entered into various contracts to build and expand the liquefied natural gas project for Nigeria LNG Limited, which is owned by the Nigerian National Petroleum Corporation, Shell Gas B.V., Cleag Limited (an affiliate of Total), and Agip International B.V. (an affiliate of ENI SpA of Italy). M.W. Kellogg Limited is a joint venture in which we had a 55% interest at September 30, 2006; and M.W. Kellogg Limited and The M.W. Kellogg Company were subsidiaries of Dresser Industries before our 1998 acquisition of Dresser Industries. The M.W. Kellogg Company was later merged with a subsidiary of ours to form Kellogg Brown & Root, one of our subsidiaries.
The SEC and the DOJ have been reviewing these matters in light of the requirements of the FCPA. In addition to performing our own investigation, we have been cooperating with the SEC and the DOJ investigations and with other investigations into the Bonny Island project in France, Nigeria and Switzerland. Our Board of Directors has appointed a committee of independent directors to oversee and direct the FCPA investigations.
The matters under investigation related to the Bonny Island project cover an extended period of time (in some cases significantly before our 1998 acquisition of Dresser Industries and continuing through the current time period). We have produced documents to the SEC and the DOJ both voluntarily and pursuant to company subpoenas from the files of numerous officers of Halliburton and KBR, including current and former executives of Halliburton and KBR, and we are making our employees available to the SEC and the DOJ for interviews. In addition, we understand that the SEC has issued a subpoena to A. Jack Stanley, who formerly served as a consultant and chairman of KBR, and to others, including certain of our current and former KBR employees, former executive officers of KBR, and at least one subcontractor of KBR. We further understand that the DOJ has invoked its authority under a sitting grand jury to issue subpoenas for the purpose of obtaining information abroad, and we understand that other partners in TSKJ have provided information to the DOJ and the SEC with respect to the investigations, either voluntarily or under subpoenas.

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The SEC and DOJ investigations include an examination of whether TSKJ’s engagements of Tri-Star Investments as an agent and a Japanese trading company as a subcontractor to provide services to TSKJ were utilized to make improper payments to Nigerian government officials. In connection with the Bonny Island project, TSKJ entered into a series of agency agreements, including with Tri-Star Investments, of which Jeffrey Tesler is a principal, commencing in 1995 and a series of subcontracts with a Japanese trading company commencing in 1996. We understand that a French magistrate has officially placed Mr. Tesler under investigation for corruption of a foreign public official. In Nigeria, a legislative committee of the National Assembly and the Economic and Financial Crimes Commission, which is organized as part of the executive branch of the government, are also investigating these matters. Our representatives have met with the French magistrate and Nigerian officials. In October 2004, representatives of TSKJ voluntarily testified before the Nigerian legislative committee. We are also aware that the Serious Frauds Office in the United Kingdom is conducting an investigation relating to the activities of TSKJ.
We notified the other owners of TSKJ of information provided by the investigations and asked each of them to conduct their own investigation. TSKJ has suspended the receipt of services from and payments to Tri-Star Investments and the Japanese trading company and has considered instituting legal proceedings to declare all agency agreements with Tri-Star Investments terminated and to recover all amounts previously paid under those agreements. In February 2005, TSKJ notified the Attorney General of Nigeria that TSKJ would not oppose the Attorney General’s efforts to have sums of money held on deposit in banks in Switzerland transferred to Nigeria and to have the legal ownership of such sums determined in the Nigerian courts.
As a result of these investigations, information has been uncovered suggesting that, commencing at least 10 years ago, members of TSKJ planned payments to Nigerian officials. We have reason to believe that, based on the ongoing investigations, payments may have been made to Nigerian officials. In addition, information recently uncovered suggests that, prior to 1998, plans may have been made by employees of The M.W. Kellogg Company to make payments to government officials in connection with the pursuit of a number of other projects in countries outside of Nigeria. Certain of these employees are current employees or a consultant of ours.  As a result, the consultant may be placed on suspension, and Halliburton's pending investigation will include a review of the actions of these employees.
In June 2004, all relationships with Mr. Stanley and another consultant and former employee of M.W. Kellogg Limited were terminated. The terminations occurred because of violations of our Code of Business Conduct that allegedly involved the receipt of improper personal benefits from Mr. Tesler in connection with TSKJ’s construction of the Bonny Island project.
In 2006, we suspended the services of another agent who, until the suspensions, had worked for KBR outside of Nigeria on several current projects and on numerous older projects going back to the early 1980s. The suspension will continue until such time, if ever, as we can satisfy ourselves regarding the agent’s compliance with applicable law and our Code of Business Conduct. In addition, we are actively reviewing the compliance of an additional agent on a separate current Nigerian project with respect to which we have recently received from a joint venture partner on that project allegations of wrongful payments made by such agent.
If violations of the FCPA were found, a person or entity found in violation could be subject to fines, civil penalties of up to $500,000 per violation, equitable remedies, including disgorgement (if applicable) generally of profit, including prejudgment interest on such profits, causally connected to the violation, and injunctive relief. Criminal penalties could range up to the greater of $2 million per violation or twice the gross pecuniary gain or loss from the violation, which could be substantially greater than $2 million per violation. It is possible that both the SEC and the DOJ could assert that there have been multiple violations, which could lead to multiple fines. The amount of any fines or monetary penalties that could be assessed would depend on, among other factors, the findings regarding the amount, timing, nature, and scope of any improper payments, whether any such payments were authorized by or made with knowledge of us or our affiliates, the amount of gross pecuniary gain or loss involved, and the level of cooperation provided the government authorities during the investigations. Agreed dispositions of these types of violations also frequently result in an acknowledgement of wrongdoing by the entity and the appointment of a monitor on terms negotiated with the SEC and the DOJ to review and monitor current and future business practices, including the retention of agents, with the goal of assuring compliance with the FCPA. Other potential consequences could be significant and include suspension or debarment of our ability to contract with governmental agencies of the United

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States and of foreign countries. During 2005, KBR and its affiliates had revenue of approximately $6.6 billion from its government contracts work with agencies of the United States or state or local governments. If necessary, we would seek to obtain administrative agreements or waivers from the United States Department of Defense (DoD) and other agencies to avoid suspension or debarment. Suspension or debarment from the government contracts business would have a material adverse effect on the business, results of operations, and cash flows of KBR and Halliburton.
These investigations could also result in third-party claims against us, which may include claims for special, indirect, derivative or consequential damages, damage to our business or reputation, loss of, or adverse effect on, cash flow, assets, goodwill, results of operations, business prospects, profits or business value, adverse consequences on our ability to obtain or continue financing for current or future projects or claims by directors, officers, employees, affiliates, advisors, attorneys, agents, debt holders, or other interest holders or constituents of us or our subsidiaries. In this connection, we understand that the government of Nigeria gave notice in 2004 to the French magistrate of a civil claim as an injured party in that proceeding. We are not aware of any further developments with respect to this claim. In addition, we could incur costs and expenses for any monitor required by or agreed to with a governmental authority to review our continued compliance with FCPA law.
As of September 30, 2006, we have not accrued any amounts related to these investigations other than our current legal expenses.

Bidding practices investigation
In connection with the investigation into payments related to the Bonny Island project in Nigeria, information has been uncovered suggesting that Mr. Stanley and other former employees may have engaged in coordinated bidding with one or more competitors on certain foreign construction projects, and that such coordination possibly began as early as the mid-1980s.
On the basis of this information, we and the DOJ have broadened our investigations to determine the nature and extent of any improper bidding practices, whether such conduct violated United States antitrust laws, and whether former employees may have received payments in connection with bidding practices on some foreign projects.
If violations of applicable United States antitrust laws occurred, the range of possible penalties includes criminal fines, which could range up to the greater of $10 million in fines per count for a corporation, or twice the gross pecuniary gain or loss, and treble civil damages in favor of any persons financially injured by such violations. Criminal prosecutions under applicable laws of relevant foreign jurisdictions and civil claims by, or relationship issues with customers, are also possible.
As of September 30, 2006, we had not accrued any amounts related to this investigation other than our current legal expenses.

Possible Algerian investigation
We believe that an investigation by a magistrate or a public prosecutor in Algeria may be pending with respect to sole source contracts awarded to Brown & Root Condor Spa, a joint venture with Kellogg Brown & Root Ltd UK, Centre de Recherche Nuclear de Draria, and Holding Services para Petroliers Spa. We had a 49% interest in this joint venture as of September 30, 2006.

LIQUIDITY AND CAPITAL RESOURCES

We ended the third quarter of 2006 with cash and equivalents of $3.5 billion compared to $2.4 billion at December 31, 2005.
Significant sources of cash
Cash flows from operations contributed $2.9 billion to cash in the first nine months of 2006. In the second quarter of 2006, we completed the sale of KBR’s Production Services group, which was part of our Energy and Chemicals segment. In connection with the sale, we received net proceeds of $265 million. Our working capital requirements for our Iraq-related work, excluding cash and equivalents, decreased from $495 million at December 31, 2005 to $332 million at September 30, 2006.

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We received approximately $166 million in asbestos- and silica-related insurance proceeds in the first nine months of 2006 and expect to receive additional amounts as follows:

Millions of dollars
     
October 1 through December 31, 2006
 
$
1
 
2007
   
68
 
2008
   
46
 
2009
   
131
 
2010
   
16
 
Total
 
$
262
 

During the first quarter of 2005, we sold $891 million in investments in marketable securities and received approximately $200 million from the sale of our 50% interest in Subsea 7, Inc. In the third quarter of 2005, we received $85 million from the sale of an investment in a United States toll road.
Further available sources of cash. We have available an unsecured $1.2 billion five-year revolving credit facility for general working capital purposes. There were no cash drawings under the unsecured $1.2 billion revolving credit facility as of September 30, 2006.
KBR has available an unsecured $850 million five-year revolving credit facility. Letters of credit that totaled $54 million were issued under the KBR revolving credit facility, thus reducing the availability under the credit facility to approximately $796 million at September 30, 2006. There were no cash drawings under the unsecured $850 million revolving credit facility as of September 30, 2006.
Any proceeds KBR receives from an initial public offering of KBR, Inc. common stock would be used to pay intercompany notes due to us.
Significant uses of cash
Capital expenditures of $619 million in the first nine months of 2006 were 31% higher than in the first nine months of 2005. Capital spending in the first nine months of 2006 was primarily directed to the Energy Services Group for the Production Optimization, Drilling and Formation Evaluation, and Fluid Systems segments.
In February 2006, our Board of Directors approved a share repurchase program of up to $1.0 billion. In September 2006, our Board of Directors approved an increase to our existing common share repurchase program of up to an additional $2.0 billion. During the first nine months of 2006, we repurchased approximately 32 million shares of our common stock at a cost of approximately $1.0 billion, or an average price per share of $32.99. The Board of Directors also approved a dividend for the third quarter of 2006 to shareholders of record at the close of business on September 1, 2006 of $0.075 per share, payable on September 22, 2006. We paid $231 million in dividends to our shareholders in the first nine months of 2006. We repurchased $41 million of debt at a total cost of $49 million in the first nine months of 2006. In the third quarter of 2006, we repaid, at par plus accrued interest, our $275 million 6.0% medium-term notes that matured.
In the first nine months of 2006, we contributed a total of $4 million to our domestic pension plans and $158 million to our international pension plans, which included ESG contributing $45 million, and KBR contributing $105 million to the United Kingdom pension plans. We expect the total amount contributed in 2006 for all pension plans to be approximately $169 million.
We also continued to fund operating cash shortfalls on the Barracuda-Caratinga project, a multiyear construction project to develop the Barracuda and Caratinga crude oilfields off the coast of Brazil. During the first nine months of 2006, we funded approximately $34 million, net of revenue received.
Future uses of cash. Capital spending for 2006 is expected to be approximately $875 million and approximately $1.2 billion for 2007. The capital expenditures budget for 2006 includes a steady level of activities related to our DML shipyard and increased spending in the Energy Services Group to accommodate higher activity levels.
In future periods, we expect to make $1.0 billion to $2.0 billion annually in discretionary acquisitions in order to add to our oilfield products and technologies.

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We will also continue with our discretionary share repurchase program, which has $2.0 billion remaining under it.
As of September 30, 2006, we had commitments to fund approximately $122 million to related companies. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $4 million of the commitments to be paid during the next twelve months.
In October 2006, the Board of Directors declared a dividend of $0.075 per share for the fourth quarter of 2006, payable Decmber 22, 2006 to shareholders of record at the close of business on December 1, 2006.
Other factors affecting liquidity
Accounts receivable securitization facilities. In April 2002, we entered into an agreement to sell eligible United States Energy Services Group accounts receivable to a bankruptcy-remote limited-purpose funding subsidiary. As of December 31, 2004, we had sold $256 million of undivided ownership interest to unaffiliated companies. During the fourth quarter of 2005, these receivables were collected and the balance retired. No further receivables were sold, and the facility was terminated in the first quarter of 2006.
In May 2004, we entered into an agreement to sell, assign, and transfer the entire title and interest in specified United States government accounts receivable of KBR to a third party. The face value of the receivables sold to the third party was reflected as a reduction of accounts receivable in our condensed consolidated balance sheets. The receivables outstanding under this agreement were collected and the balance retired in the third quarter of 2005. As of December 31, 2005, the facility was terminated.
Letters of credit. In the normal course of business, we have agreements with banks under which approximately $1.0 billion of letters of credit or bank guarantees were outstanding as of September 30, 2006, including $551 million that relate to our joint ventures’ operations. Also included in the letters of credit outstanding as of September 30, 2006 were $15 million of performance letters of credit related to the Barracuda-Caratinga project. Some of the outstanding letters of credit have triggering events that would entitle a bank to require cash collateralization.
Credit ratings. Our current ratings are BBB+ on Standard & Poor’s and Baa1 on Moody’s Investors Service. In the second quarter of 2006, Standard & Poor’s revised its long-term senior unsecured debt rating from BBB to BBB+ with a “stable” outlook due to the significant improvement in ESG operating performance and the considerable reduction in debt over the past year. In the fourth quarter of 2005, Moody’s revised its long-term senior unsecured debt rating from Baa2 to Baa1 with a “stable” outlook. In the first quarter of 2005, Standard & Poor’s revised its credit watch listing for us from “developing” to “stable” and its short-term credit and commercial paper rating from A-3 to A-2. Our Moody’s Investors Service short-term credit and commercial paper rating is P-2.
Debt covenants. Letters of credit related to our Barracuda-Caratinga project and our $1.2 billion revolving credit facility contain restrictive covenants, including covenants that require us to maintain financial ratios as defined by the agreements. For the letters of credit related to our Barracuda-Caratinga project, we are required to maintain interest coverage and leverage ratios. We are also required to maintain a maximum debt-to-capitalization ratio under our $1.2 billion revolving credit facility. At September 30, 2006, we were in compliance with these requirements.
In addition, the unsecured $850 million five-year revolving credit facility entered into by KBR contains covenants including a limitation on the amount KBR can invest in unconsolidated subsidiaries. KBR must also maintain financial ratios including a debt-to-capitalization ratio, a leverage ratio, and a fixed charge coverage ratio. At September 30, 2006, KBR was in compliance with these requirements.

BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS

We currently operate in about 100 countries throughout the world. We provide a comprehensive range of discrete and integrated services and products to the energy industry and to other industrial and governmental customers. The majority of our consolidated revenue is derived from the sale of services and products to major, national, and independent oil and gas companies and governments around the world. The services and products provided to major, national, and independent oil and gas companies are used throughout the energy industry from the earliest phases of exploration, development, and production of oil and gas through refining, processing, and marketing. We have six business segments: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Government and Infrastructure, and Energy and Chemicals. We refer to the combination of Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as ESG, and the combination of Government and Infrastructure and Energy and Chemicals as KBR.

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The industries we serve are highly competitive with many substantial competitors for each segment. In the first nine months of 2006, based upon the location of the services provided and products sold, 33% of our consolidated revenue was from the United States, and 19% of our consolidated revenue was from Iraq, primarily related to work for the United States Government. In the first nine months of 2005, 27% of our consolidated revenue was from Iraq, and 27% of our consolidated revenue was from the United States. No other country accounted for more than 10% of our revenue during these periods.
Operations in some countries may be adversely affected by unsettled political conditions, acts of terrorism, civil unrest, force majeure, war or other armed conflict, expropriation or other governmental actions, inflation, exchange controls, or currency devaluation. Except for our government services work in Iraq discussed above, we believe the geographic diversification of our business activities reduces the risk that loss of operations in any one country would be material to our consolidated results of operations.
Halliburton Company
Activity levels within our business segments are significantly impacted by the following:
 
-
spending on upstream exploration, development, and production programs by major, national, and independent oil and gas companies;
 
-
capital expenditures for downstream refining, processing, petrochemical, gas monetization, and marketing facilities by major, national, and independent oil and gas companies; and
 
-
government spending levels.
Also impacting our activity is the status of the global economy, which impacts oil and gas consumption, demand for petrochemical products, and investment in infrastructure projects.
Energy Services Group
Some of the more significant indicators of current and future spending levels of oil and gas companies are oil and gas prices, exploration and production spending by international and national oil companies, the world economy, and global stability, which together drive worldwide drilling activity. Our ESG financial performance is significantly affected by oil and gas prices and worldwide rig activity, which are summarized in the following tables.
This table shows the average oil and gas prices for West Texas Intermediate (WTI) crude oil, United Kingdom Brent, and Henry Hub natural gas:

   
Three Months Ended
 
Year Ended
 
   
September 30
 
December 31
 
Average Oil Prices (dollars per barrel)
 
2006
 
2005
 
2005
 
West Texas Intermediate
 
$
70.80
 
$
62.70
 
$
56.30
 
United Kingdom Brent
   
70.03
   
61.57
   
54.45
 
                     
Average United States Gas Prices (dollars per million British
                   
thermal units, or mmBtu)
                   
Henry Hub
 
$<