September 30, 2004 Form 10-Q - Final


FORM 10-Q
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2004
 
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 the past 90 days.
Yes X No ___
 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes X No ___
 
As of October 22, 2004, 441,975,012 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
         3-38
     
 
-    Condensed Consolidated Statements of Operations
         3
 
-    Condensed Consolidated Balance Sheets
         4
 
-    Condensed Consolidated Statements of Cash Flows
         5
 
-    Notes to Condensed Consolidated Financial Statements
         6-38
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and
 
 
Results of Operations
         39-87
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
         88
     
Item 4.
Controls and Procedures
         88
     
PART II.
OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
         89
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
         89
     
Item 3.
Defaults Upon Senior Securities
         89
     
Item 4.
Submission of Matters to a Vote of Security Holders
         89
     
Item 5.
Other Information
         89
     
Item 6.
Exhibits
         89-90
     
Signatures
           91


 
 
  2  

 

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
HALLIBURTON COMPANY
Condensed Consolidated Statements of Operations
(Unaudited)
(Millions of dollars and shares except per share data)

   
Three Months
 
Nine Months
 
   
Ended September 30
 
Ended September 30
 
   
2004
 
2003
 
2004
 
2003
 
Revenue:
                         
Services
 
$
4,264
 
$
3,661
 
$
13,748
 
$
9,396
 
Product sales
   
531
   
474
   
1,537
   
1,398
 
Equity in earnings (losses) of unconsolidated affiliates
   
(5
)
 
13
   
(20
)
 
13
 
Total revenue
   
4,790
   
4,148
   
15,265
   
10,807
 
Operating costs and expenses:
                         
Cost of services
   
3,926
   
3,436
   
13,163
   
8,940
 
Cost of sales
   
465
   
429
   
1,380
   
1,258
 
General and administrative
   
97
   
80
   
271
   
241
 
Gain on sale of business assets, net
   
(40
)
 
(1
)
 
(40
)
 
(49
)
Total operating costs and expenses
   
4,448
   
3,944
   
14,774
   
10,390
 
Operating income
   
342
   
204
   
491
   
417
 
Interest expense
   
(51
)
 
(33
)
 
(160
)
 
(85
)
Interest income
   
13
   
7
   
30
   
22
 
Foreign currency gains (losses), net
   
1
   
(17
)
 
(9
)
 
(4
)
Other, net
   
(2
)
 
-
   
2
   
2
 
Income from continuing operations before income
                         
taxes, minority interest, and change in accounting
                         
principle
   
303
   
161
   
354
   
352
 
Provision for income taxes
   
(111
)
 
(63
)
 
(131
)
 
(142
)
Minority interest in net income of subsidiaries
   
(6
)
 
(6
)
 
(19
)
 
(17
)
Income from continuing operations before change
                         
in accounting principle
   
186
   
92
   
204
   
193
 
Loss from discontinued operations, net of tax (provision)
                         
benefit of $72, $(3), $218, and $27
   
(230
)
 
(34
)
 
(980
)
 
(58
)
Cumulative effect of change in accounting principle,
                         
net of tax benefit of $5
   
-
   
-
   
-
   
(8
)
Net income (loss)
 
$
(44
)
$
58
 
$
(776
)
$
127
 
Basic income (loss) per share:
                         
Income from continuing operations before change in
                         
accounting principle
 
$
0.43
 
$
0.21
 
$
0.47
 
$
0.44
 
Loss from discontinued operations, net
   
(0.54
)
 
(0.08
)
 
(2.25
)
 
(0.13
)
Cumulative effect of change in accounting principle, net
   
-
   
-
   
-
   
(0.02
)
Net income (loss)
 
$
(0.11
)
$
0.13
 
$
(1.78
)
$
0.29
 
Diluted income (loss) per share:
                         
Income from continuing operations before change in
                         
accounting principle
 
$
0.42
 
$
0.21
 
$
0.46
 
$
0.44
 
Loss from discontinued operations, net
   
(0.51
)
 
(0.08
)
 
(2.22
)
 
(0.13
)
Cumulative effect of change in accounting principle, net
   
-
   
-
   
-
   
(0.02
)
Net income (loss)
 
$
(0.09
)
$
0.13
 
$
(1.76
)
$
0.29
 
                           
Cash dividends per share
 
$
0.125
 
$
0.125
 
$
0.375
 
$
0.375
 
Basic weighted average common shares outstanding
   
438
   
435
   
437
   
434
 
Diluted weighted average common shares outstanding
   
442
   
437
   
441
   
436
 

See notes to condensed consolidated financial statements.

 
 
  3  

 

HALLIBURTON COMPANY
Condensed Consolidated Balance Sheets
(Unaudited)
(Millions of dollars and shares except per share data)
   
September 30
 
December 31
 
   
2004
 
2003
 
Assets
             
Current assets:
             
Cash and equivalents
 
$
2,996
 
$
1,815
 
Receivables:
             
Notes and accounts receivable
   
2,602
   
2,909
 
Unbilled work on uncompleted contracts
   
1,852
   
1,760
 
Insurance for asbestos- and silica-related liabilities
   
965
   
96
 
Total receivables
   
5,419
   
4,765
 
Inventories
   
741
   
695
 
Other current assets
   
667
   
644
 
Total current assets
   
9,823
   
7,919
 
Property, plant, and equipment, net of accumulated depreciation of $3,625 and $3,540
   
2,540
   
2,526
 
Noncurrent deferred income taxes
   
971
   
774
 
Goodwill
   
793
   
670
 
Equity in and advances to related companies
   
527
   
579
 
Insurance for asbestos- and silica-related liabilities
   
488
   
2,038
 
Other assets
   
816
   
993
 
Total assets
 
$
15,958
 
$
15,499
 
Liabilities and Shareholders’ Equity
             
Current liabilities:
             
Asbestos- and silica-related liabilities
 
$
2,415
 
$
2,507
 
Accounts payable
   
2,362
   
1,776
 
Advance billings on uncompleted contracts
   
723
   
741
 
Accrued employee compensation and benefits
   
522
   
400
 
Reserve for estimated loss on uncompleted contracts
   
269
   
225
 
Current maturities of long-term debt
   
50
   
22
 
Other current liabilities
   
714
   
893
 
Total current liabilities
   
7,055
   
6,564
 
Long-term debt
   
3,894
   
3,415
 
Asbestos- and silica-related liabilities
   
2,029
   
1,579
 
Employee compensation and benefits
   
785
   
801
 
Other liabilities
   
403
   
493
 
Total liabilities
   
14,166
   
12,852
 
Minority interest in consolidated subsidiaries
   
113
   
100
 
Shareholders’ equity:
             
Common shares, par value $2.50 per share - authorized 1,000 and 600 shares,
             
issued 458 and 457
   
1,144
   
1,142
 
Paid-in capital in excess of par value
   
259
   
273
 
Deferred compensation
   
(80
)
 
(64
)
Accumulated other comprehensive income
   
(296
)
 
(298
)
Retained earnings
   
1,130
   
2,071
 
     
2,157
   
3,124
 
Less 16 and 18 shares of treasury stock, at cost
   
478
   
577
 
Total shareholders’ equity
   
1,679
   
2,547
 
Total liabilities and shareholders’ equity
 
$
15,958
 
$
15,499
 

See notes to condensed consolidated financial statements.

 
 
  4  

 

HALLIBURTON COMPANY
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Millions of dollars)
   
Nine Months
 
   
Ended September 30
 
   
2004
 
2003
 
Cash flows from operating activities:
             
Net income (loss)
 
$
(776
)
$
127
 
Adjustments to reconcile net income (loss) to net cash from operations:
             
Loss from discontinued operations
   
980
   
58
 
Depreciation, depletion, and amortization
   
374
   
384
 
Provision (benefit) for deferred income taxes, including $(163) and
             
$(8) related to discontinued operations
   
(200
)
 
(73
)
Distributions from (advances to) related companies, net of
             
equity in (earnings) losses
   
(39
)
 
11
 
Change in accounting principle, net
   
-
   
8
 
Gain on sale of assets, net
   
(47
)
 
(53
)
Other non-cash items
   
19
   
(12
)
Other changes:
             
Accounts receivable
   
(252
)
 
(608
)
Accounts receivable facilities transactions
   
458
   
(180
)
Inventories
   
(42
)
 
(28
)
Accounts payable
   
581
   
(101
)
Restricted cash related to Chapter 11 proceedings
   
(107
)
 
-
 
Other working capital, net
   
(30
)
 
(46
)
Other operating activities
   
58
   
(22
)
Total cash flows from operating activities
   
977
   
(535
)
Cash flows from investing activities:
             
Capital expenditures
   
(422
)
 
(371
)
Sales of property, plant, and equipment
   
101
   
82
 
Dispositions (acquisitions) of business assets,
             
net of cash disposed
   
102
   
222
 
Proceeds from sale of securities
   
21
   
57
 
Investments - restricted cash
   
88
   
(23
)
Other investing activities
   
(24
)
 
(32
)
Total cash flows from investing activities
   
(134
)
 
(65
)
Cash flows from financing activities:
             
Proceeds from long-term borrowings, net of offering costs
   
496
   
1,177
 
Proceeds from exercises of stock options
   
48
   
18
 
Payments to reacquire common stock
   
(6
)
 
(6
)
Borrowings (repayments) of short-term debt, net
   
(7
)
 
(27
)
Payments on long-term borrowings
   
(16
)
 
(290
)
Payments of dividends to shareholders
   
(165
)
 
(164
)
Other financing activities
   
(4
)
 
(6
)
Total cash flows from financing activities
   
346
   
702
 
Effect of exchange rate changes on cash
   
(8
)
 
13
 
Increase in cash and equivalents
   
1,181
   
115
 
Cash and equivalents at beginning of period
   
1,815
   
1,107
 
Cash and equivalents at end of period
 
$
2,996
 
$
1,222
 
               
Supplemental disclosure of cash flow information:
             
Cash payments during the period for:
             
Interest
 
$
136
 
$
86
 
Income taxes
 
$
190
 
$
143
 

See notes to condensed consolidated financial statements.

 
 
  5  

 

HALLIBURTON COMPANY
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1. Basis of Presentation
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 2003 Annual Report on Form 10-K, as amended. The condensed consolidated financial statements also include the accounts of all of our subsidiaries currently in Chapter 11 proceedings (see Note 13). 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, 2004, the results of our operations for the three and nine months ended September 30, 2004 and 2003, and our cash flows for the nine months ended September 30, 2004 and 2003. Such adjustments are of a normal recurring nature. The results of operations for the nine months ended September 30, 2004 and 2003 may not be indicative of results for the full year.

Note 2. Long-Term Construction Contracts
The amounts of unapproved claims included in determining the profit or loss on contracts and the amounts of unapproved claims recorded for the three and nine months ended September 30, 2004 are as follows:

   
Total Probable Unapproved
 
Probable Unapproved Claims
 
   
Claims
 
Accrued Revenue
 
   
(included in determining
 
(unbilled work on
 
   
contract profit or loss)
 
uncompleted contracts)
 
   
Three Months
 
Nine Months
 
Three Months
 
Nine Months
 
   
Ended
 
Ended
 
Ended
 
Ended
 
   
September 30,
 
September 30,
 
September 30,
 
September 30,
 
(Millions of dollars)
 
2004
 
2004
 
2004
 
2004
 
Beginning balance
 
$
262
 
$
233
 
$
261
 
$
225
 
Additions
   
-
   
143
   
-
   
141
 
Claims resolved
   
(57
)
 
(92
)
 
(57
)
 
(86
)
Costs incurred during period
   
-
   
-
   
-
   
3
 
Other
   
(28
)
 
(107
)
 
(28
)
 
(107
)
Ending balance
 
$
177
 
$
177
 
$
176
 
$
176
 


 
 
  6  

 

The probable unapproved claims as of September 30, 2004 relate to six contracts, most of which are complete or substantially complete. Approximately 69% of these claims are with one customer. We are actively engaged in claims negotiations with our customers. The decrease in probable unapproved claims for the three months ended September 30, 2004 is a result of efforts to settle older contract issues that have reduced our exposure on claims, unapproved change orders, and liquidated damages. The change in probable unapproved claims for the nine months ended September 30, 2004 also reflects the terms of an October 2004 agreement in principle with Petroleo Brasilero SA (Petrobras). If implemented, this agreement would resolve outstanding issues regarding the Barracuda-Caratinga project (see Note 3). The December 31, 2 003 probable unapproved claims related to the Barracuda-Caratinga project of $114 million was reduced to $78 million and reclassified as an unapproved change order as a result of the April 2004 agreement in principle, replaced by an October 2004 agreement in principle with Petrobras. The change in probable unapproved claims in the nine months ended September 30, 2004 also included a $76 million reclassification from unapproved change orders for two projects for a single customer that is disputing the pricing of previously agreed-upon scope changes.
We have contracts with probable unapproved claims that will likely not be settled within one year totaling $122 million at September 30, 2004 and $204 million at December 31, 2003 included in the table above, which are reflected as “Other assets” on the condensed consolidated balance sheets. Other probable unapproved claims that we believe will be settled within one year included in the table above have been recorded to “Unbilled work on uncompleted contracts” included in the “Total receivables” amount on the condensed consolidated balance sheets. We have other contracts for which we are negotiating change orders to the contract scope and have agreed upon the scope of work but not the price. Including the $78 million related to the Barracuda-Caratinga project, these change orders amou nt to $102 million at September 30, 2004. Unapproved change orders at December 31, 2003 were $97 million.
Our unconsolidated related companies include probable unapproved claims as revenue to determine 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,” and our share totaled $54 million at September 30, 2004 and $10 million at December 31, 2003. Over 84% of these claims at September 30, 2004 are with one customer. In addition, our unconsolidated related companies are negotiating change orders to the contract scope where we have agreed upon the scope of work but not the price. Our share of these change orders totaled $41 million at September 30, 2004 and $59 million at December 31, 2003.

Note 3. Barracuda-Caratinga Project
In June 2000, Kellogg Brown & Root, Inc. (Kellogg Brown & Root) entered into a contract with Barracuda & Caratinga Leasing Company B.V., the project owner, to develop the Barracuda and Caratinga crude oilfields, which are located off the coast of Brazil. The construction manager and project owner's representative is Petrobras, the Brazilian national oil company. When completed, the project will consist of two converted supertankers, Barracuda and Caratinga, which will be used as floating production, storage, and offloading units, commonly referred to as FPSOs. In addition, there will be 32 hydrocarbon production wells, 22 water injection wells, and all subsea flow lines, umbilicals, and risers necessary to connect the underwater wells to the FPSOs. The original completion date for the Barracuda vessel was December 2003, and the original completion date for the Caratinga vessel was April 2004. The project is significantly behind the original schedule, due in part to change orders from the project owner, and is in a financial loss position.
In October 2004, the Barracuda vessel was moved offshore for sea trials and final inspections. We expect the Caratinga vessel to begin sea trials and final inspections in December 2004. Pursuant to the October 2004 agreement in principle with Petrobras described below, the Barracuda vessel must be completed by March 31, 2006, and the Caratinga vessel must be completed by June 30, 2006. However, there can be no assurance that further delays will not occur.

 
 
  7  

 

Our performance under the contract is secured by:
- performance letters of credit, which together have available credit of approximately $272 million as of September 30, 2004 and represent approximately 10% of the contract amount, as amended to date by change orders;
- retainage letters of credit, which together have available credit of approximately $189 million as of September 30, 2004 and which will increase in order to continue to represent 10% of the cumulative cash amounts paid to us; and
- a guarantee of Kellogg Brown & Root’s performance under the agreement by Halliburton Company in favor of the project owner.
In October 2004, Kellogg Brown & Root and Petrobras, on behalf of the project owner, entered into a nonbinding agreement in principle. The October 2004 agreement in principle replaces an April 2004 agreement in principle, is the basis for settlement of the various claims between the parties, and would amend existing agreements. Implementation of the agreement in principle requires final approval of the board of directors of Petrobras and Halliburton, the project lenders, and possibly the bankruptcy court that confirmed our proposed plan of reorganization. Discussions among all parties, including the project lenders, are underway. The October 2004 agreement in principle provides for:
- the release of all claims of all parties that arise prior to the effective date of a final definitive agreement;
- the payment to us of $78 million as a result of change orders for remaining claims;
- payment by Petrobras of applicable value added taxes on the project, except for $8 million which has been paid by us;
- the performance by Petrobras of certain work under the original contract;
- the repayment on December 7, 2004 by Kellogg Brown & Root of a portion of $300 million of advance payments, without interest; and
- revised milestones and other dates, including settlement of liquidated damages and an extension of time to the FPSO final acceptance dates.
While negotiations are proceeding to reach a final agreement based on the provisions of the October 2004 agreement in principle, there can be no guarantee that an agreement will be achieved.
In the first quarter of 2004, we recorded a charge of $97 million resulting from the April 2004 agreement in principle with Petrobras, as well as adjustments to our estimates of costs expected to be incurred to complete the project. In June 2004, we recorded additional operating losses on our Barracuda-Caratinga project of approximately $310 million. The additional charge resulted from a detailed review of the project indicating higher cost estimates, schedule delays, and increased contingencies for the balance of the project until completion. Specifically, in the second quarter, with the integration phase of the Barracuda vessel we experienced a significant reduction in productivity and rework required from the vessel conversion. We took steps to mobilize more resources including specialized management personnel in both Houston and South America to oversee the final stages of the project. We conducted additional cost and schedule reviews of the remaining project activities, and we initiated several work process changes in an attempt to expedite work on the project.
As of September 30, 2004:
- the project was approximately 90% complete;
- we have recorded an inception-to-date pretax loss of $762 million related to the project, of which $310 million was recorded in the second quarter of 2004; $97 million was recorded in the first quarter of 2004; $238 million was recorded in 2003 ($55 million during the first quarter of 2003, $173 million during the second quarter of 2003 and $10 million in the fourth quarter of 2003); and $117 million was recorded in 2002;
- the losses recorded include an estimated $24 million in liquidated damages based on the October 2004 agreement in principle; and
- the probable unapproved claims were reduced from $114 million at December 31, 2003 to zero based upon the October 2004 agreement in principle.

 
 
  8  

 

Default provisions. In the event that we were determined to be in default under the contract, and if the project was not completed by us as a result of our default, the project owner may seek direct damages. Those damages could include completion costs in excess of the contract price and interest on borrowed funds, but would exclude consequential damages. The total damages could be up to $500 million plus the return of up to $300 million in advance payments previously received by us to the extent they have not been repaid. A termination of the contract by the project owner could have a material adverse effect on our financial condition and results of operations.
Cash flow considerations. The project owner has procured project finance funding obligations from various lenders to finance the payments due to us under the contract. In addition, the project financing includes borrowing capacity in excess of the original contract amount.
Under the loan documents, the availability date for loan draws expired December 1, 2003 and, therefore, the project owner drew down all remaining available funds on that date. As a condition to the draw-down of the remaining funds, the project owner was required to escrow the funds for the exclusive use of paying project costs. The availability of the escrowed funds can be suspended by the lenders if applicable conditions are not met. With limited exceptions, these funds may not be paid to Petrobras or its subsidiary, which is funding the drilling costs of the project, until all amounts due to us, including amounts due for the change orders as agreed in the October 2004 agreement in principle, are liquidated and paid. While this potentially reduces the risk that the funds would not be available for payment to us, we are not party to the arrangement between the lenders and the project owner and can give no assurance that there will be adequate funding to cover current or future claims and change orders.
We have now begun to fund operating cash shortfalls on the project and are obligated to fund total shortages over the remaining project life. That funding level assumes that, pursuant to amended project agreements implementing the October 2004 agreement in principle, neither we nor the project owner recover additional claims against the other. Estimated cash flows relating to the losses are as follows:

(Millions of dollars)
     
Amount funded through September 30, 2004
 
$
330
 
Amount expected to be funded during the remainder
       
of 2004, including repayment of a portion of
       
$300 million advance payments
   
262
 
Amount expected to be funded during 2005
   
170
 
Total cash shortfalls
 
$
762
 

Note 4. Acquisitions and Dispositions
Surface Well Testing. In August 2004, we sold our Surface Well Testing and Subsea Test Tree operations within our Production Optimization segment to Power Well Service Holdings, LLC, an affiliate of First Reserve Corporation, for approximately $129 million, of which we received $126 million in cash. In the third quarter of 2004, we recorded a $40 million gain on the sale. However, for a limited period of time, we continue to have significant involvement with portions of these operations in certain countries and, therefore, have not recognized all the gain from the sale as of September 30, 2004. We expect to recognize substantially all the remaining gain in the fourth quarter of 2004.

 
 
  9  

 

Enventure and WellDynamics. In the first quarter of 2004, Halliburton and Shell Technology Ventures (Shell, an unrelated party) agreed to restructure two joint venture companies, Enventure Global Technologies LLC (Enventure) and WellDynamics B.V. (WellDynamics), in an effort to more closely align the ventures with near-term priorities in the core businesses of the venture owners. Prior to this transaction, Enventure (part of our Fluids segment) and WellDynamics (formerly part of our Landmark and Other Energy Services segment) were owned equally by Shell and us. Shell acquired an additional 33.5% of Enventure, leaving us with 16.5% ownership in return for enhanced and extended agreements and licenses with Shell for its Poroflex™ expandable sand screens and a distribution agreement for its Versaflex™ expandable liner hangers. As a result of this transaction, we changed the way we account for our ownership in Enventure from the equity method to the cost method of accounting for investments. We acquired an additional 1% of WellDynamics from Shell, giving us 51% ownership and control of day-to-day operations. In addition, Shell received an option to obtain our remaining interest in Enventure for an additional 14% interest in WellDynamics. No gain or loss resulted from the transaction. Beginning in the first quarter of 2004, WellDynamics was consolidated and is now included in our Production Optimization segment. The consolidation of WellDynamics resulted in an increase to our goodwill of $109 million, which was previously carried as equity method goodwill in “Equity in and advances to related companies.”
Halliburton Measurement Systems. In May 2003, we sold certain assets of Halliburton Measurement Systems, which provides flow measurement and sampling systems, to NuFlo Technologies, Inc. for approximately $33 million in cash, subject to post-closing adjustments. The gain on the sale of Halliburton Measurement Systems’ assets was $24 million and is included in our Production Optimization segment.
Wellstream. In March 2003, we sold the assets relating to our Wellstream business, a global provider of flexible pipe products, systems, and solutions, to Candover Partners Ltd. for $136 million in cash. The assets sold included manufacturing plants in Newcastle upon Tyne, United Kingdom, and Panama City, Florida, as well as assets and contracts in Brazil. In addition, Wellstream had $34 million in goodwill recorded at the disposition date. The transaction resulted in a loss of $15 million, which is included in our Landmark and Other Energy Services segment. Included in the loss is the write-off of the cumulative translation adjustment related to Wellstream of approximately $9 million.
Mono Pumps. In January 2003, we sold our Mono Pumps business to National Oilwell, Inc. The sale price of approximately $88 million was paid with $23 million in cash and 3.2 million shares of National Oilwell, Inc. common stock, which were valued at $65 million on January 15, 2003. We recorded a gain of $36 million on the sale in the first quarter of 2003, which was included in our Drilling and Formation Evaluation segment. Included in the gain was the write-off of the cumulative translation adjustment related to Mono Pumps of approximately $5 million. In February 2003, we sold 2.5 million of our 3.2 million shares of National Oilwell, Inc. common stock for $52 million, which resulted in a gain of $2 million, and in February 2004, we sold the remaining shares for $20 million, resulting in a gain of $6 million. These gains were recorded in “Other, net.”

Note 5. Business Segment Information
Our five business segments are organized around how we manage the business: Drilling and Formation Evaluation, Fluids, Production Optimization, Landmark and Other Energy Services, and the Engineering and Construction Group or “KBR.” We sometimes refer to the combination of our Drilling and Formation Evaluation, Fluids, Production Optimization, and Landmark and Other Energy Services segments as the Energy Services Group.
During the first quarter of 2004, the results of WellDynamics were moved from the Landmark and Other Energy Services segment to the Production Optimization segment, and prior year segment information has been restated.

 
 
  10  

 

The table below presents information on our continuing operations business segments.

   
Three Months
 
Nine Months
 
   
Ended September 30
 
Ended September 30
 
(Millions of dollars)
 
2004
 
2003
 
2004
 
2003
 
Revenue:
                         
Drilling and Formation Evaluation
 
$
450
 
$
433
 
$
1,317
 
$
1,226
 
Fluids
   
618
   
510
   
1,707
   
1,508
 
Production Optimization
   
886
   
726
   
2,391
   
2,045
 
Landmark and Other Energy Services
   
154
   
136
   
413
   
417
 
Total Energy Services Group
   
2,108
   
1,805
   
5,828
   
5,196
 
Engineering and Construction Group
   
2,682
   
2,343
   
9,437
   
5,611
 
Total
 
$
4,790
 
$
4,148
 
$
15,265
 
$
10,807
 
                           
Operating income (loss):
                         
Drilling and Formation Evaluation
 
$
62
 
$
45
 
$
164
 
$
160
 
Fluids
   
113
   
55
   
250
   
178
 
Production Optimization
   
222
   
118
   
425
   
298
 
Landmark and Other Energy Services
   
17
   
(48
)
 
60
   
(51
)
Total Energy Services Group
   
414
   
170
   
899
   
585
 
Engineering and Construction Group
   
(50
)
 
49
   
(342
)
 
(118
)
General corporate
   
(22
)
 
(15
)
 
(66
)
 
(50
)
Total
 
$
342
 
$
204
 
$
491
 
$
417
 

Intersegment revenue is immaterial. Our equity in pretax 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, 2004 included $1.6 billion and $6.1 billion, or 34% and 40% of consolidated revenue, from the United States Government, which were derived almost entirely from our Engineering and Construction Group. Revenue from the United States Government during the three and nine months ended September 30, 2003 represented 27% and 16% of consolidated revenue. No other customer represented more than 10% of consolidated revenue in any period presented.

Note 6. Receivables
In April 2004, the expiration date for our Energy Services Group accounts receivable securitization facility was extended to April 2005. We have the ability to sell up to $300 million under this facility. As of September 30, 2004, we had sold $256 million undivided ownership interest to unaffiliated companies.
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 is reflected as a reduction of accounts receivable in our condensed consolidated balance sheets. The amount of receivables which can be sold under the agreement varies based on the amount of eligible receivables at any given time and other factors, and the maximum amount that may be sold and outstanding under this agreement at any given time is $650 million. The total amount of receivables outstanding under this agreement as of September 30, 2004 was approximately $202 million. Subsequent to the third quarter of 2004, these receivables were collected and the balance retired, and we are not currently selling further receivables, although the facility continues to be available.


 
 
  11  

 

Note 7. Inventories
Inventories are stated at the lower of cost or market. We manufacture in the United States finished products and parts inventories for drill bits, completion products, bulk materials, and other tools that are recorded using the last-in, first-out method totaling $40 million at September 30, 2004 and $38 million at December 31, 2003. If the average cost method had been used, total inventories would have been $17 million higher than reported at both September 30, 2004 and at December 31, 2003.
Inventories at September 30, 2004 and December 31, 2003 consisted of the following:

   
September 30
 
December 31
 
(Millions of dollars)
 
2004
 
2003
 
Finished products and parts
 
$
530
 
$
503
 
Raw materials and supplies
   
162
   
159
 
Work in process
   
49
   
33
 
Total
 
$
741
 
$
695
 

Finished products and parts are reported net of obsolescence accruals of $113 million at September 30, 2004 and $117 million at December 31, 2003.

Note 8. Restricted Cash
At September 30, 2004, we had restricted cash of $280 million, which primarily consists of:
- $144 million for the amount of prepetition liabilities that have been paid, as ordered by the bankruptcy court to be set aside subsequent to December 2003, as part of the DII Industries, LLC (DII Industries) and Kellogg Brown & Root reorganization proceedings. At the time the plan of reorganization becomes final and nonappealable, the cash will become unrestricted. This amount is included in “Other current assets”;
- $97 million as collateral for potential future insurance claim reimbursements, included in “Other assets”; and
- $35 million ($23 million in “Other assets” and $12 million in “Other current assets”) primarily related to cash collateral agreements for outstanding letters of credit for various construction projects.
At December 31, 2003, we had restricted cash of $159 million in “Other current assets” and $100 million in “Other assets,” which consisted of similar items as above.

Note 9. Property, Plant, and Equipment
In the second quarter of 2004, we implemented a change in accounting estimate to more accurately reflect the useful life of some of the tools of our Drilling and Formation Evaluation segment. This resulted in a combined $24 million reduction in depreciation expense in the second and third quarters of 2004, thereby reducing our consolidated net loss by $15 million, or $0.03 per share, for the nine months ended September 30, 2004. We extended the useful lives of these tools based on our review of their service lives, technological improvements in the tools, and recent changes to our repair and maintenance practices which helped to extend the lives.


 
 
  12  

 

Note 10. Comprehensive Income
The components of other comprehensive income (loss) adjustments to net income (loss) included the following:

   
Three Months
 
Nine Months
 
   
Ended September 30
 
Ended September 30
 
(Millions of dollars)
 
2004
 
2003
 
2004
 
2003
 
Net income (loss)
 
$
(44
)
$
58
 
$
(776
)
$
127
 
Cumulative translation adjustment, net of tax
   
(6
)
 
1
   
(3
)
 
13
 
Realization of losses included in net income (loss)
   
-
   
-
   
-
   
15
 
Net cumulative translation adjustment, net of tax
   
(6
)
 
1
   
(3
)
 
28
 
Pension liability adjustments
   
-
   
-
   
-
   
(7
)
Unrealized gains (losses) on investments and
                         
derivatives
   
17
   
1
   
5
   
2
 
Total comprehensive income (loss)
 
$
(33
)
$
60
 
$
(774
)
$
150
 

Accumulated other comprehensive income consisted of the following:

   
September 30
 
December 31
 
(Millions of dollars)
 
2004
 
2003
 
Cumulative translation adjustments
 
$
(66
)
$
(63
)
Pension liability adjustments
   
(245
)
 
(245
)
Unrealized gains (losses) on investments and
             
derivatives
   
15
   
10
 
Total accumulated other comprehensive income
 
$
(296
)
$
(298
)

Note 11. Debt
Senior notes due 2007. On January 26, 2004, we issued $500 million aggregate principal amount of senior notes due 2007 bearing interest at a floating rate equal to three-month LIBOR plus 0.75%, payable quarterly. On January 26, 2005, or on any interest payment date thereafter, we have the option to redeem all or a portion of the outstanding notes.
WellDynamics revolving credit line. Upon consolidation of WellDynamics in the first quarter of 2004, our long-term debt included an advance on a revolving credit line with Shell, which is the minority interest holder of WellDynamics, in the amount of $27 million due April 30, 2005 and bearing interest at a floating rate equal to three-month LIBOR plus 3.25%, payable quarterly. As of September 30, 2004, the $27 million balance was classified as current maturities of long-term debt in our condensed consolidated balance sheet. There was no remaining unused commitment under this WellDynamics revolving credit line. This line of credit contains no working capital or dividend restrictions. Under the terms of the agreement, we may, during the period of 30 days immediately preceding the end of the commitment period, request the lenders to extend the availability of the facility for a further period of 364 days from the date of our request.
Chapter 11-related financing activities. The delayed-draw term facility we entered into in the fourth quarter of 2003 expired on June 30, 2004. In the second quarter of 2004, we charged to discontinued operations $11 million in capitalized fees associated with entering into the delayed-draw term facility.
In July 2004, we entered into a $500 million 364-day revolving credit facility for general working capital purposes with terms substantially similar to our $700 million three-year revolving credit facility. The interest rates applicable to these facilities are variable and the borrowings under the revolving credit facilities will be secured by some of our assets until final and nonappealable confirmation of our proposed plan of reorganization is received and our long-term senior unsecured debt is rated BBB or higher (stable outlook) by Standard & Poor’s and Baa2 or higher (stable outlook) by Moody’s Investors Service.

 
 
  13  

 

In September 2004, we issued a letter of credit for approximately $172 million under our $700 million three-year revolver to replace an expiring letter of credit for our Barracuda-Caratinga project, which reduced our availability under the revolver to $528 million. As of September 30, 2004, no cash had been drawn under the $500 million 364-day revolving credit facility or the $700 million three-year revolving credit facility.

Note 12. Asbestos and Silica Obligations and Insurance Recoveries
Summary
Several of our subsidiaries, particularly DII Industries and Kellogg Brown & Root have been named as defendants in a large number of asbestos- and silica-related lawsuits. The plaintiffs allege injury primarily as a result of exposure to:
- asbestos used in products manufactured or sold by former divisions of DII Industries (primarily refractory materials, gaskets, and packing materials used in pumps and other industrial products);
- asbestos in materials used in the construction and maintenance projects of Kellogg Brown & Root or its subsidiaries; and
- silica related to sandblasting and drilling fluids operations.
We have substantial insurance to reimburse us for portions of the costs of judgments, settlements, and defense costs for these asbestos and silica personal injury claims. Since 1976, approximately 702,000 asbestos personal injury claims have been filed against us and approximately 240,000 of these claims have been closed through settlements in court proceedings at a total cost of approximately $232 million. Almost all of these claims have been made in separate lawsuits in which we are named as a defendant along with a number of other defendants, often exceeding 100 unaffiliated defendant companies in total. In 2001, we were subject to several large adverse judgments in trial court proceedings. At September 30, 2004, approximately 462,000 asbestos claims were open, and we anticipate resolving all open and future cl aims in the prepackaged Chapter 11 proceedings of DII Industries, Kellogg Brown & Root, and our other affected subsidiaries, which were filed on December 16, 2003. The first and second tables that follow summarize the various charges we have incurred during the three and nine months ended September 30, 2004 and 2003. The third table presents a rollforward of our asbestos- and silica-related liabilities and insurance receivables.

 
 
  14  

 


   
Three Months Ended September 30
 
   
2004
 
2003
 
   
Continuing
 
Discontinued
 
Continuing
 
Discontinued
 
(Millions of dollars)
 
Operations
 
Operations
 
Operations
 
Operations
 
Asbestos and silica charges:
                         
59.5 million shares revaluation
 
$
-
 
$
245
 
$
-
 
$
-
 
Federal-Mogul partitioning
                         
agreement
   
-
   
43
   
-
   
-
 
Insurance receivable write-down
   
-
   
6
   
-
   
-
 
Revaluation of silica note
   
-
   
3
   
-
   
-
 
Accretion
   
-
   
(11
)
 
-
   
-
 
Subtotal
   
-
   
286
   
-
   
-
 
Asbestos- and silica-related
                         
costs:
                         
Harbison-Walker matters
   
-
   
-
   
-
   
10
 
Professional fees
   
-
   
12
   
-
   
11
 
Cash in lieu of interest
   
-
   
1
   
-
   
10
 
Other costs
   
-
   
1
   
1
   
-
 
Subtotal
   
-
   
14
   
1
   
31
 
Pretax asbestos and silica
                         
charges
   
-
   
300
   
1
   
31
 
Tax (benefit) provision
   
-
   
(71
)
 
-
   
3
 
Total asbestos and silica
                         
charges, net of tax (benefit)
                         
provision
 
$
-
 
$
229
 
$
1
 
$
34
 


   
Nine Months Ended September 30
 
   
2004
 
2003
 
   
Continuing
 
Discontinued
 
Continuing
 
Discontinued
 
(Millions of dollars)
 
Operations
 
Operations
 
Operations
 
Operations
 
Asbestos and silica charges:
                         
59.5 million shares revaluation
 
$
-
 
$
435
 
$
-
 
$
-
 
Federal-Mogul partitioning
                         
agreement
   
-
   
43
   
-
   
-
 
Insurance receivable write-down
   
-
   
686
   
-
   
-
 
Revaluation of the silica note
   
-
   
3
   
-
   
-
 
Accretion
   
-
   
(11
)
 
-
   
-
 
Subtotal
   
-
   
1,156
   
-
   
-
 
Asbestos- and silica-related
                         
costs:
                         
Harbison-Walker matters
   
-
   
-
   
-
   
40
 
Professional fees
   
-
   
20
   
-
   
30
 
Cash in lieu of interest
   
-
   
6
   
-
   
25
 
Other costs
   
-
   
14
   
3
   
-
 
Subtotal
   
-
   
40
   
3
   
95
 
Pretax asbestos and silica
                         
charges
   
-
   
1,196
   
3
   
95
 
Tax benefit
   
-
   
(217
)
 
(1
)
 
(28
)
Total asbestos and silica
                         
charges, net of tax benefit
 
$
-
 
$
979
 
$
2
 
$
67
 

 
 
  15  

 


       
(Millions of dollars)
     
Asbestos- and silica-related liabilities:
       
December 31, 2003 balance (of which $2,507 was current)
 
$
4,086
 
59.5 million shares revaluation
   
435
 
Federal-Mogul partitioning agreement
   
43
 
Harbison-Walker payment
   
(119
)
Revaluation of the silica note
   
3
 
Other
   
(4
)
Asbestos- and silica-related liabilities September 30, 2004
       
balance (of which $2,415 was current)
 
$
4,444
 
Insurance for asbestos- and silica-related liabilities:
       
December 31, 2003 balance (of which $96 was current)
 
$
(2,134
)
Insurance settlement write-down
   
686
 
Accretion
   
(11
)
Other
   
6
 
Insurance for asbestos- and silica-related liabilities
       
September 30, 2004 balance (of which $965 was current)
 
$
(1,453
)

Prepackaged Chapter 11 proceedings and recent insurance developments
Prepackaged Chapter 11 proceedings. DII Industries, Kellogg Brown & Root, and six other subsidiaries filed Chapter 11 proceedings on December 16, 2003 in bankruptcy court in Pittsburgh, Pennsylvania. With the filing of the Chapter 11 proceedings and entry of an order of the bankruptcy court, all asbestos and silica personal injury claims and related lawsuits against Halliburton and our affected subsidiaries were stayed. See Note 13 for more information.
Our subsidiaries sought Chapter 11 protection to avail themselves of the provisions of Sections 524(g) and 105 of the Bankruptcy Code which may be used to discharge current and future asbestos and silica personal injury claims against us and our subsidiaries. Upon the entry of a final and nonappealable order confirming the plan of reorganization, current and future asbestos and silica personal injury claims against us and our affiliates will be channeled into trusts established for the benefit of asbestos and silica claimants, thus releasing Halliburton and its affiliates from those claims.
A prepackaged Chapter 11 proceeding is one in which a debtor seeks approval of a plan of reorganization from affected creditors before filing for Chapter 11 protection. Prior to proceeding with the Chapter 11 filing, our affected subsidiaries solicited acceptances to a proposed plan of reorganization from known present asbestos and silica claimants. In the fourth quarter of 2003, valid votes were received from approximately 364,000 asbestos claimants and approximately 21,000 silica claimants, representing substantially all known claimants. Of the votes validly cast, over 98% of voting asbestos claimants and over 99% of voting silica claimants voted to accept the proposed plan of reorganization, meeting the voting requirements of Chapter 11 of the Bankruptcy Code for approval of the proposed plan. The preapproved p roposed plan of reorganization was filed as part of the Chapter 11 proceedings.

 
 
  16  

 

On July 21, 2004, the bankruptcy court entered an order, effective as of July 16, 2004, confirming the plan of reorganization to implement our proposed asbestos and silica settlement. Despite an appeal by certain of our insurance companies, on July 26, 2004, the United States District Court for the Western District of Pennsylvania affirmed the confirmation order. On August 3, 2004, certain insurance companies filed a motion to vacate the District Court’s affirmation order in order to protect their appeal rights. If our previously announced agreements in principle with insurance companies are finalized and approved by the relevant bankruptcy courts, the insurance companies have agreed to dismiss their appeals. Due to efforts being made by our affected subsidiaries to complete these settlements with, among othe rs, the insurance companies that appealed the confirmation order, the parties and the District Court agreed to stay the affirmation order. We have filed motions with the bankruptcy court to request approval of the settlement agreements with substantially all of our insurance companies, and the bankruptcy court has agreed to consider the motions at a hearing scheduled for November 18, 2004. The insurance companies have agreed to join us in support of the motions.  If the settlements with the insurance companies are approved by the relevant bankruptcy courts and the conditions to such settlements are satisfied, then we anticipate all appeals will be withdrawn. The affirmation order (and thus the plan of reorganization) will be final and nonappealable within 30 days after either the District Court favorably adjudicates the appeals or the appeals are withdrawn and the stay of the affirmation order is vacated.
The plan of reorganization, which is consistent with the definitive settlement agreements reached with our asbestos and silica personal injury claimants in early 2003, provides that, if and when an order confirming the proposed plan of reorganization becomes final and nonappealable, the following will be contributed to trusts for the benefit of current and future asbestos and silica personal injury claimants:
- approximately $2.3 billion in cash;
- 59.5 million shares of Halliburton common stock;
- a one-year non-interest-bearing note of $31 million for the benefit of asbestos claimants;
- a silica note with an initial payment into a silica trust of $15 million. Subsequently, the note provides that we will contribute an amount to the silica trust balance at the end of each year for the next 30 years to bring the silica trust balance to $15 million, $10 million, or $5 million based upon a formula which uses average yearly disbursements from the trust to determine that amount. The note also provides for an extension of the note for 20 additional years under certain circumstances. We have estimated the amount of this note to be approximately $24 million. We will periodically reassess our valuation of this note based upon our projections of the amounts we believe we will be required to fund into the silica trust; and
- insurance proceeds, if any, between $2.3 billion and $3.0 billion received by DII Industries and Kellogg Brown & Root. However, if the proposed settlements with our insurance companies are completed on the terms announced or proposed, insurance recoveries will not be contributed to the trusts.
We intend to fund the trusts no later than 30 days after the affirmation order becomes final and nonappealable.
In connection with reaching an agreement with representatives of asbestos and silica claimants to limit the cash required to settle pending claims to $2.775 billion, DII Industries paid $311 million to the claimants in December 2003. We also agreed to guarantee the payment of certain claims, and, in accordance with settlement agreements, we made additional payments of $119 million, plus an additional $4 million in lieu of interest, in June 2004. We may not be entitled to reimbursement for these payments if the proposed plan of reorganization does not become effective. We expect to pay an additional approximately $59 million in pending claims under these settlement agreements within 30 days after the plan of reorganizat ion becomes final and nonappealable.

 
 
  17  

 

Our plan of reorganization calls for a portion of our total asbestos and silica liability to be settled by contributing 59.5 million shares of Halliburton common stock into the trusts. We will adjust our asbestos and silica liability related to the shares if the average value of Halliburton common stock for the five days immediately prior to and including the end of each fiscal quarter has increased by 5% or more from the most recent valuation of the shares. As of September 30, 2004, we revalued our shares to approximately $2.0 billion ($33.48 per share), an increase of $435 million from December 31, 2003, of which $190 million was recorded in the first quarter of 2004 and $245 million was recorded in the third quarter of 2004. The value of the shares to be contributed was classified as a long-term liability on ou r condensed consolidated balance sheets, and the shares were not included in our calculation of basic or diluted earnings per share. If the shares had been included in the calculation as of the beginning of 2004, our diluted earnings per share from continuing operations would have been reduced by $0.05 for both the nine and three months ended September 30, 2004. When and if we receive final and nonappealable confirmation of our proposed plan of reorganization, we will:
- increase or decrease our asbestos and silica liability to value the 59.5 million shares of Halliburton common stock based on the value of Halliburton stock on the date of final and nonappealable confirmation of our proposed plan of reorganization;
- reclassify from a long-term liability to shareholders’ equity the final value of the 59.5 million shares of Halliburton common stock; and
- include the 59.5 million shares in our calculations of earnings per share on a prospective basis.
We understand that the United States Congress may consider adopting legislation that would establish a national trust fund as the exclusive means for recovery for asbestos-related disease. We are uncertain as to what contributions we would be required to make to a national trust, if any, although it is possible that they could be substantial and that they could continue for several years. Our level of participation in and contribution to a national trust could be greater or less than it otherwise would have been as a result of having subsidiaries that have filed Chapter 11 proceedings due to asbestos liability.
Recent insurance developments. In January 2004, we reached a comprehensive agreement with Equitas to settle our insurance claims against certain underwriters at Lloyd’s of London, reinsured by Equitas. The settlement, if all conditions precedent are satisfied, will resolve all asbestos-related claims made against Lloyd’s underwriters by us, including those made by our subsidiaries affected by the Chapter 11 proceedings. Provided that the confirmation order becomes final and nonappealable and the current United States Congress does not pass national asbestos litigation reform legislation before January 5, 2005, Equitas will pay us $575 million, representing approximately 60% of the applicable limits of liab ility that we believe DII Industries had substantial likelihood of recovering from Equitas. The first payment of $500 million, which is classified as a current receivable as of September 30, 2004, will occur within 15 working days of the later of January 5, 2005 or the date on which the confirmation order becomes final and nonappealable. A second payment of $75 million will be made 18 months after the first payment.
In May 2004, we entered into nonbinding agreements in principle with representatives of the London Market insurance companies that, if implemented, would settle insurance disputes with substantially all the solvent London Market insurance companies for asbestos- and silica-related claims and all other claims under the applicable insurance policies and terminate all the applicable insurance policies. The agreements in principle with the London Market insurance companies are subject to board of directors’ approval of all parties, agreement by all remaining London Market insurance companies, and an order by the bankruptcy court confirming the plan of reorganization that has become final and nonappealable. Currently, we expect to receive cash payments during the years of 2005 through 2009.

 
 
  18  

 

We also have entered into agreements in principle with certain of our insolvent London Market insurance companies and with our solvent domestic insurance companies that, if implemented, would settle asbestos- and silica-related claims and all other claims under the applicable insurance policies and terminate all the applicable insurance policies. We are currently drafting the final settlement agreements with our insurers. The final settlement agreements with our remaining insurance companies would be subject to board of directors’ approval of all parties, an order by the bankruptcy court approving the final settlement agreements, approval by the Federal-Mogul bankruptcy court (see “Federal-Mogul” below), approval by certain other parties, and our confirmation order becoming final and nonappealable.< /FONT>
These proposed settlements with our insurance companies are subject to numerous conditions, similar to the conditions of the Equitas settlement, including the condition that the United States Congress does not pass national asbestos litigation reform legislation before January 5, 2005. Although we are working toward implementation of these proposed settlements, there can be no assurance that the transactions contemplated by these agreements in principle can be completed on the terms announced.
Under the terms of our announced insurance settlements and proposed insurance settlements, we expect to receive cash proceeds with a nominal amount of approximately $1.5 billion and with a 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 is approximately 5.5% related to the domestic insurance companies. Beginning in the third quarter of 2004, this discount is accreted as interest income (classified as discontinued operations) over the life of the expected future cash payments.
We have filed motions with the bankruptcy court to request approval of the settlement agreements with substantially all of our insurance companies, and the bankruptcy court has agreed to consider the motions at a hearing scheduled for November 18, 2004. The insurance companies have agreed to join us in support of the motions.
Our December 31, 2003 estimate of our asbestos- and silica-related insurance receivables already included the charge for the settlement amount under the Equitas agreement reached in January 2004, as well as certain other probable settlements with companies for which we could reasonably estimate the amount of the settlement. During 2004, we reduced the amount recorded as insurance receivables for asbestos- and silica-related liabilities insured by domestic companies based upon proposed agreements in principle, resulting in pretax charges to discontinued operations of approximately $686 million.
Other insurance matters
Harbison-Walker Chapter 11 proceedings. A large portion of our asbestos claims relate to alleged injuries from asbestos used in a small number of products manufactured or sold by Harbison-Walker Refractories Company, whose operations DII Industries acquired in 1967 and spun off in 1992. At the time of the spin-off, Harbison-Walker assumed liability for asbestos claims filed after the spin-off, and it agreed to defend and indemnify DII Industries from liability for those claims, although DII Industries continues to have direct liability to tort claimants for all post-spin-off refractory asbestos claims. DII Industries retained responsibility for all asbestos claims pending as of the date of the spin-off. The agreemen t governing the spin-off provided that Harbison-Walker would have the right to access DII Industries’ historic insurance coverage for the asbestos-related liabilities that Harbison-Walker assumed in the spin-off.
In July 2001, DII Industries determined that the demands that Harbison-Walker was making on the shared insurance policies were not acceptable to DII Industries and that Harbison-Walker probably would not be able to fulfill its indemnification obligations to DII Industries. Accordingly, DII Industries took up the defense of unsettled post-spin-off refractory claims that name it as a defendant in order to prevent Harbison-Walker from unnecessarily eroding the insurance coverage both companies access for these claims.

 
 
  19  

 

On February 14, 2002, Harbison-Walker filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. In its initial Chapter 11 filings, Harbison-Walker stated it would seek to utilize Sections 524(g) and 105 of the Bankruptcy Code to propose and seek confirmation of a plan of reorganization that would provide for distributions for all legitimate pending and future asbestos and silica claims asserted directly against Harbison-Walker or asserted against DII Industries. In order to protect the shared insurance from dissipation, DII Industries began to assist Harbison-Walker in its Chapter 11 proceedings as follows:
- on February 14, 2002, DII Industries paid $40 million to Harbison-Walker’s United States parent holding company, RHI Refractories Holding Company (RHI Refractories);
- DII Industries agreed to provide up to $35 million in debtor-in-possession financing to Harbison-Walker ($5 million was paid in 2002 and the remaining $30 million was paid in 2003); and
- during 2003, DII Industries purchased $50 million of Harbison-Walker’s outstanding insurance receivables, of which $10 million were estimated to be uncollectible.
In 2003, DII Industries entered into a definitive agreement with Harbison-Walker. This agreement was approved by the Harbison-Walker bankruptcy court on December 4, 2003. Under the terms of this agreement, once our plan of reorganization is final, all asbestos and silica personal injury claims against Harbison-Walker and certain of its affiliates will be channeled into trusts created in our bankruptcy proceedings. Our asbestos and silica obligations and related insurance recoveries recorded as of September 30, 2004 and December 31, 2003 reflect the terms of this definitive agreement.
In the first quarter of 2004, we entered into an agreement with RHI Refractories to settle remaining funding issues relating to Harbison-Walker. The agreement calls for a $10 million payment to RHI Refractories and a $1 million payment to our asbestos and silica trusts on behalf of RHI Refractories. These amounts were expensed during 2003. These payments will be made shortly after the effective date of the plan of reorganization of DII Industries, Kellogg Brown & Root and other subsidiaries.
London-based insurance companies. Equitas and other London-based companies have attempted to impose more restrictive documentation requirements on DII Industries and its affiliates than are currently required under existing coverage-in-place agreements related to certain asbestos claims. Coverage-in-place agreements are settlement agreements between policyholders and the insurance companies specifying the terms and conditions under which coverage will be applied as claims are presented for payment. These agreements in an asbestos claims context govern such things as what events will be deemed to trigger coverage, how liability for a claim will be allocated among insurance companies, and what procedures the policyhol der must follow in order to obligate the insurer to pay claims. These insurance companies stated that the new restrictive requirements are part of an effort to limit payment of settlements to claimants who are truly impaired by exposure to asbestos and can identify the product or premises that caused their exposure.
DII Industries is a plaintiff in two lawsuits against a number of London-based insurance companies asserting DII Industries’ rights under an existing coverage-in-place agreement and under insurance policies not yet subject to coverage-in-place agreements. DII Industries believes that the more restrictive documentation requirements are inconsistent with the current coverage-in-place agreements and are unenforceable. The insurance companies that DII Industries has sued continue to pay larger claim settlements where the more restrictive documentation is obtained or where court judgments are entered. Likewise, they continue to pay previously agreed amounts of defense costs that DII Industries incurs defending claims.
In light of the bankruptcy court’s approval of our settlement agreement with Equitas, we have dismissed Equitas from the cases that we filed against them. If, however, the conditions precedent to payment are not satisfied, we have the right to re-file these cases against Equitas. If our agreements in principle with the solvent London Market insurance companies are finalized and become effective, all of our lawsuits with the various London Market insurance companies will be resolved.

 
 
  20  

 

Federal-Mogul. A significant portion of the insurance coverage applicable to Worthington Pump, a former division of DII Industries, is 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. In 2001, Federal-Mogul and a large number of its affiliated companies filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code in the bankruptcy court in Wilmington, Delaware. In response to Federal-Mogul’s allegations of shared insurance coverage, DII Industries filed a lawsuit on December 7, 2001 in Federal-Mogul’s Chapter 11 proceedings asserting DII Industries’ rights to asbestos ins urance coverage under historic general liability policies issued to McGraw-Edison Company, Studebaker-Worthington, Inc. and its predecessor. The parties to this litigation have agreed to mediate this dispute. A number of insurance companies who have agreed to coverage-in-place agreements with DII Industries have suspended payment under the shared Worthington Pump policies until the Federal-Mogul bankruptcy court resolves the insurance issues. Consequently, the effect of the Federal-Mogul Chapter 11 proceedings on DII Industries’ rights to access this shared insurance has been uncertain. During the first quarter of 2004, we reached an agreement with Federal-Mogul which resolved all disputes regarding the insurance coverage provided by Equitas.
During October 2004, we reached an agreement in principle 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 in principle, DII Industries would be allocated 50% of the limits of any applicable insurance policy, and the remaining 50% of limits of the insurance policies would be allocated to the remaining policyholders. As part of the settlement, DII Industries agreed to pay $46 million in three installment payments. The first payment of $16 million will be paid on the same day that DII Industries funds the asbestos and silica trusts. The second and third payments of $15 million each will occur on the first and second anniversaries from the date of the first payment. We are currently attempting to finalize this agreement in principle so that we may also finalize the settlements with the London Market insurance companies and the domestic insurance companies. If we are able to finalize this agreement in principle and the related agreements in principle with our solvent insurers, we will be able to dismiss all of our remaining insurance coverage lawsuits concerning asbestos-related and silica-related matters. In the third quarter of 2004, we accrued $43 million, which represents the present value of the $46 million to be paid. The discount will be accreted as interest expense (classified as discontinued operations) over the life of the expected future cash payments beginning in the fourth quarter of 2004.
Assuming that the agreement in principle with Federal-Mogul is finalized, DII Industries and Federal-Mogul agree 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 do 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. Any recoveries received by Federal-Mogul from the insolvent London-based insurance companies after January 1, 2006 will be reimbursed back to DII Industries until such time as DII Industries is fully reimbursed for the amount of the payment.
Excess insurance on construction claims. Kellogg Brown & Root does not have primary insurance coverage related to construction claims. However, excess insurance coverage policies with other insurance companies are in place. On March 20, 2002, Kellogg Brown & Root filed a lawsuit against the insurance companies that issued these excess insurance policies, seeking to establish the specific terms under which it can obtain reimbursement for costs incurred in settling and defending construction claims. Until this lawsuit is resolved, the scope of the excess insurance coverage will remain uncertain, and as such, we have not recorded any recoveries related to excess insurance coverage. If we are able to finalize ou r agreements in principle with our solvent insurance companies, we will also dismiss this lawsuit.

 
 
  21  

 

Other insurance matters. In the event that we finalize all of the agreements in principle with our insurance companies and the other relevant third parties, we will still continue to pursue our insurance rights against certain insolvent domestic insurance companies, such as Highlands Insurance Company (under insurance policies that were issued to Dresser Industries, Inc. and certain of its predecessors), The Home Insurance Company, and certain insolvent London-based insurance companies.

Note 13. Chapter 11 Reorganization Proceedings
On December 16, 2003, the following wholly owned subsidiaries of Halliburton (collectively, the Debtors or Debtors-in-Possession) filed Chapter 11 proceedings in bankruptcy court in Pittsburgh, Pennsylvania:
- DII Industries, LLC;
- Kellogg Brown & Root, Inc.;
- Mid-Valley, Inc.;
- KBR Technical Services, Inc.;
- Kellogg Brown & Root Engineering Corporation;
- Kellogg Brown & Root International, Inc. (a Delaware corporation);
- Kellogg Brown & Root International, Inc. (a Panamanian corporation); and
- BPM Minerals, LLC.
On July 21, 2004, the bankruptcy court entered an order, effective as of July 16, 2004, confirming the plan of reorganization to implement our proposed asbestos and silica settlement. Despite an appeal by certain of our insurance companies, on July 26, 2004, the United States District Court for the Western District of Pennsylvania affirmed the confirmation order. On August 3, 2004, certain insurance companies filed a motion to vacate the District Court’s affirmation order in order to protect their appeal rights. If our previously announced agreements in principle with our insurance companies are finalized and approved by the relevant bankruptcy courts, the insurance companies have agreed to dismiss their appeals. Due to efforts being made by our affected subsidiaries to complete these settlements with, among others, the insurance companies that appealed the confirmation order, the parties and the District Court agreed to stay the affirmation order. We have filed motions with the bankruptcy court to request approval of the settlement agreements with substantially all of our insurance companies, and the bankruptcy court has agreed to consider the motions at a hearing scheduled for November 18, 2004. The insurance companies have agreed to join us in support of the motions. If the settlements with the insurance companies are approved by the relevant bankruptcy courts and the conditions to such settlements are satisfied, then we anticipate all appeals will be withdrawn. The affirmation order (and thus the plan of reorganization) will be final and nonappealable within 30 days after either the District Court favorably adjudicates the appeals or the appeals are withdrawn and the stay of the affirmation order is vacated.
The affected subsidiaries will continue to be wholly owned by Halliburton Company under the proposed plan. Halliburton Company (the registrant), Halliburton's Energy Services Group, and Kellogg Brown & Root's government services businesses are not included in the Chapter 11 filing. Upon effectiveness of the plan of reorganization, current and future asbestos and silica personal injury claims filed against us and our subsidiaries will be channeled into trusts established under Sections 524(g) and 105 of the Bankruptcy Code for the benefit of claimants, thus releasing Halliburton and its affiliates from those claims.

 
 
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Debtors-in-Possession financial statements. Under the Bankruptcy Code, we are required to periodically file with the bankruptcy court various documents, including financial statements of the Debtors-in-Possession. These financial statements are prepared according to requirements of the Bankruptcy Code. While these financial statements accurately provide information required by the Bankruptcy Code, they are unconsolidated, unaudited, and prepared in a format different from that used in our condensed consolidated financial statements filed under the securities laws and from that used in the condensed combined financial statements that follow. For example, the “Right to Halliburton shares” ar e currently adjusted to fair value periodically in the financial statements prepared for the bankruptcy court, but not in the condensed combined financial statements. Accordingly, we believe the substance and format of the financial statements prepared for the bankruptcy court do not allow meaningful comparison with the following condensed combined financial statements.
Basis of presentation. We continue to consolidate the Debtors in our condensed consolidated financial statements. While generally it is appropriate to deconsolidate a subsidiary during its Chapter 11 proceedings on the basis that control no longer rests with the parent, the facts and circumstances particular to our situation support the continued consolidation of these subsidiaries. Specifically:
- substantially all affected creditors have approved the terms of the plan of reorganization and related transactions;
- the entire duration of the Chapter 11 proceedings is likely to be short, excluding any potential appeals;
- the Debtors were solvent and filed Chapter 11 proceedings to resolve asbestos and silica claims rather than as a result of insolvency; and
- the plan of reorganization provides that we will continue to own 100% of the equity of the Debtors upon completion of the plan of reorganization. The plan of reorganization will not impact our equity ownership of the Debtors.
All reorganization items, including but not limited to all professional fees and provisions for losses, are included as discontinued operations in both our condensed consolidated financial statements and the condensed combined financial statements of the Debtors-in-Possession. During the first nine months of 2004, we recorded a total of $20 million as reorganization items, which consisted primarily of professional fees and $11 million of bridge loan fees, and disbursed $26 million in cash for reorganization items.
Furthermore, certain claims against the Debtors existing before the Chapter 11 filing are considered liabilities subject to compromise. The principal categories of claims subject to compromise included the following:
- $2.4 billion at September 30, 2004 and $2.5 billion at December 31, 2003 of current asbestos- and silica-related liabilities; and
- $2.0 billion at September 30, 2004 and $1.6 billion at December 31, 2003 of noncurrent asbestos- and silica-related liabilities.
Prior to the filing of the Chapter 11 proceedings, DII Industries was the parent for all Energy Services Group and KBR operations. As part of a prefiling corporate restructuring, immediately prior to the Chapter 11 filing, DII Industries distributed the Energy Services Group operations to Halliburton Company, while the operations of KBR continued to be conducted through subsidiaries of DII Industries. The condensed combined balance sheet as of December 31, 2003 of the Debtors-in-Possession was prepared as if this distribution had taken place as of January 1, 2003.

 
 
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Debtors-in-Possession
Condensed Combined Statements of Operations
(Unaudited)
(Millions of dollars)

   
Three Months Ended
 
Nine Months Ended
 
   
September 30, 2004
 
September 30, 2004
 
Revenue
 
$
384
 
$
1,314
 
Equity in losses of majority-owned
             
subsidiaries
   
(199
)
 
(224
)
Total revenue
   
185
   
1,090
 
Operating costs and expenses
   
289
   
1,467
 
Operating loss
   
(104
)
 
(377
)
Nonoperating income
   
17
   
43
 
Loss from continuing operations before income
             
taxes
   
(87
)
 
(334
)
Income tax (provision) benefit
   
(39
)
 
43
 
Loss from continuing operations
   
(126
)
 
(291
)
Loss from discontinued operations, net of tax
             
benefit of $73 and $219
   
(229
)
 
(979
)
Net loss
 
$
(355
)
$
(1,270
)

The subsidiaries of DII Industries that are not included in the Chapter 11 filing are presented in the condensed combined financial statements using the equity method of accounting. These subsidiaries had revenue of $2.5 billion and operating income of $49 million for the three months ended September 30, 2004 and revenue of $8.3 billion and operating income of $5 million for the nine months ended September 30, 2004. These subsidiaries had assets of $2.6 billion and liabilities of $2.6 billion as of September 30, 2004, and assets of $2.3 billion and liabilities of $2.3 billion as of December 31, 2003.

 
 
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Debtors-in-Possession
Condensed Combined Balance Sheets
(Unaudited)
(Millions of dollars)

   
September 30
 
December 31
 
   
2004
 
2003
 
Assets
             
Current assets:
             
Cash and equivalents
 
$
67
 
$
108
 
Receivables:
             
Trade, net
   
142
   
191
 
Unbilled insurance for asbestos- and silica-related liabilities
   
873
   
-
 
Intercompany, net
   
52
   
50
 
Unbilled work on uncompleted contracts
   
151
   
60
 
Other, net
   
56
   
75
 
Total receivables, net
   
1,274
   
376
 
Inventories
   
20
   
23
 
Right to Halliburton shares (1)
   
1,547
   
1,547
 
Restricted cash - prepetition liability payments
   
144
   
37
 
Other current assets
   
54
   
43
 
Total current assets
   
3,106
   
2,134
 
Property, plant, and equipment, net
   
94
   
91
 
Goodwill, net
   
188
   
188
 
Investments in majority-owned subsidiaries
   
1,223
   
1,567
 
Insurance for asbestos- and silica-related liabilities
   
488
   
2,038
 
Noncurrent deferred income taxes
   
600
   
436
 
Other assets
   
326
   
257
 
Total assets
 
$
6,025
 
$
6,711
 
Liabilities and Shareholders’ Equity
             
Current liabilities:
             
Accounts payable
 
$
270
 
$
13
 
Accrued employee compensation and benefits
   
6
   
30
 
Advance billings on uncompleted contracts
   
67
   
23
 
Prepetition liabilities not subject to compromise
   
375
   
834
 
Current prepetition asbestos- and silica-related liabilities
             
subject to compromise
   
2,415
   
2,507
 
Other current liabilities
   
-
   
14
 
Total current liabilities
   
3,133
   
3,421
 
Prepetition liabilities not subject to compromise
   
128
   
137
 
Noncurrent prepetition asbestos- and silica-related liabilities
             
subject to compromise
   
2,029
   
1,579
 
Other liabilities
   
26
   
2
 
Total liabilities
   
5,316
   
5,139
 
Shareholders’ equity
   
709
   
1,572
 
Total liabilities and shareholders’ equity
 
$
6,025
 
$
6,711
 

(1)     Represents an option for DII Industries to acquire 59.5 million shares of Halliburton stock at no cost and was valued at $26.00 per share.

 
 
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Debtors-in-Possession
Condensed Combined Statement of Cash Flows
(Unaudited)
(Millions of dollars)

   
Nine Months Ended
 
   
September 30, 2004
 
Total cash flows from operating activities
 
$
(495
)
Total cash flows from investing activities
   
(10
)
Total cash flows from activities with Halliburton
   
457
 
Effect of exchange rate changes on cash
   
7
 
Decrease in cash and equivalents
   
(41
)
Cash and equivalents at beginning of period
   
108
 
Cash and equivalents at end of period
 
$
67
 

There can be no assurance that we will obtain all of the required judicial approval of the proposed plan of reorganization or any revised plan of reorganization acceptable to us. A prolonged Chapter 11 proceeding could adversely affect the Debtors’ relationships with customers, suppliers, and employees, which in turn could adversely affect the Debtors’ competitive position, financial condition, and results of operations. In addition, if the Debtors are unsuccessful in obtaining final and nonappealable confirmation of a plan of reorganization, the assets of the Debtors could be liquidated in the Chapter 11 proceedings, which could have a material adverse effect on Halliburton.

Note 14. United States Government Contract Work
We provide substantial work under our government contracts business to the United States Department of Defense and other governmental agencies, including worldwide United States Army logistics contracts, known as LogCAP, and contracts to rebuild Iraq’s petroleum industry, known as RIO and PCO Oil South. Our government services revenue related to Iraq totaled approximately $1.4 billion and $5.4 billion for the three and nine months ended September 30, 2004. Our units operating in Iraq and elsewhere under government contracts such as LogCAP, RIO, and PCO Oil South consistently review the amounts charged and the services performed under these contracts. Our operations under these contracts are also regularly reviewed and audited by the Defense Contract Audit Agency (DCAA) and other governmental agencies. The DCA A 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 will then issue an audit report with their recommendations to our customer’s contracting officer. We then will work with our customer to reach a resolution.
Fuel. In December 2003, the DCAA issued a preliminary audit report which alleged that we may have overcharged the Department of Defense by $61 million in importing fuel into Iraq. To the best of our knowledge and belief, the DCAA report was never finalized. The DCAA questioned costs associated with fuel purchases made in Kuwait that were more expensive than buying and transporting fuel from Turkey. We responded that we had maintained close coordination of the fuel mission with the Army Corps of Engineers (COE), which is our customer and oversees the project, throughout the life of the task order and that the COE had directed us to use the Kuwait sources. After a review, the COE concluded that we obt ained a fair price for the fuel. However, Department of Defense officials thereafter referred the matter to the agency’s inspector general, which we understand has commenced an investigation.

 
 
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The DCAA has issued various audit reports related to task orders under the RIO contract which reported $296 million in questioned and unsupported costs The majority of these costs are associated with the humanitarian fuel mission. In these reports, the DCAA has compared fuel costs we incurred during the duration of the RIO contract in 2003 and early 2004 to fuel prices obtained by the Defense Energy Supply Center (DESC) in April 2004, when the fuel mission was transferred to that agency. We believe the conditions specified by the customer for fuel purchases are materially different under the DESC and RIO contracts, and therefore a direct comparison of costs is not valid. We are currently preparing responses to the COE contracting officer, which we believe will substantiate that the costs questioned by the DCAA are allowable and reimbursable.
Dining Facility and Administration Centers (DFACs). During 2003, the DCAA raised issues relating to our invoicing to the Army Materiel Command (AMC) for food services for soldiers and supporting civilian personnel in Iraq and Kuwait. We believe the issues raised by the DCAA relate to the difference between the number of troops the AMC directed us to support and the number of soldiers actually served at dining facilities for United States troops and supporting civilian personnel in Iraq and Kuwait. In the first quarter of 2004, we reviewed our DFAC subcontracts in our Iraq and Kuwait areas of operation and have billed and continue to bill for all current DFAC costs. During 2004, we received notice fr om the DCAA that it was recommending withholding a portion of our DFAC billings. For DFAC billings relating to subcontracts entered into prior to February 2004, the DCAA has recommended withholding 19.35% of the billings until it completes its audits. Subsequent to February 2004, we have renegotiated our DFAC subcontracts to address the specific issues raised by the DCAA and have advised the AMC and the DCAA of the new terms of the arrangements. To date, we have had no objection by the government to these new DFAC subcontract agreements. During the third quarter of 2004, we received notification that, for three Kuwait DFACs, the DCAA is recommending to our customer that costs be disallowed because the DCAA is not satisfied with the level of documentation provided by us. The amount withheld related to suspended and recommended disallowed DFAC costs for work performed under the pre February 2004 subcontracts and totaled approximately $216 million as of September 30, 2004. The amount currently wi thheld could change as the DCAA continues their audits of the remaining DFAC facilities. We are negotiating with our customer, the AMC, to resolve this issue. We can withhold a proportionate amount of these billings from our subcontractors and are currently doing so. See “Investigations” section below for further discussion.
Laundry. During the third quarter of 2004, we received notice from the DCAA that it is recommending withholding $16 million of subcontract costs related to the laundry service for one task order in southern Iraq for which it believes we and our subcontractors have not provided adequate levels of documentation supporting the quantity of the services provided. The DCAA has recommended that the cost be withheld pending receipt of additional explanation or documentation to support subcontract cost. We are working with the AMC to resolve this issue.
Investigations. On January 22, 2004, we announced the identification by our internal audit function of a potential overbilling of approximately $6 million by La Nouvelle Trading & Contracting Company, W.L.L. (La Nouvelle), one of our subcontractors, under the LogCAP contract in Iraq, for services performed during 2003. In accordance with our policy and government regulation, the potential overcharge was reported to the Department of Defense Inspector General’s office as well as to our customer, the AMC. On January 23, 2004, we issued a check in the amount of $6 million to the AMC to cover that potential overbilling while we conducted our own investigation into the matter. Later in the first quarter of 2004, we determined that the amount of overbilling was $4 million and the subcontractor billing should have been $2 million for the services provided. As a result, we paid La Nouvelle $2 million and have billed our customer that amount. We are continuing to investigate whether La Nouvelle paid, or attempted to pay, one or two of our former employees in connection with the billing. See Note 15 “Litigation brought by La Nouvelle” for further discussion.

 
 
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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 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.
We understand that the United States Department of Justice, an Assistant United States Attorney based in Illinois, and others are investigating some matters relating to our government contract work. We also understand that former employees of KBR have received subpoenas and have given or may give grand jury testimony relating to some of these matters. 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.
Withholding of payments. During 2004, the AMC issued a determination that a particular contract clause would cause it to withhold 15% from our invoices until our task orders under the LogCAP contract are definitized. We have advised the AMC that we disagree with this interpretation. The AMC has not implemented this withholding; however, it has requested additional information regarding the impact of the potential withholding on us and our subcontractors’ ability to provide troop support under the LogCAP contract. We have provided information in response to this request, but do not know whether or how this information will impact the AMC’s decision to implement the 15% withholding in the fu ture. We do not believe the potential 15% withholding will have a significant or sustained impact on our liquidity because the withholding is temporary and ends once the definitization process is complete. During the third quarter of 2004, we and the AMC identified three senior management teams to facilitate negotiation under the LogCAP task orders, and these teams are working to negotiate outstanding issues and definitize task orders as quickly possible. We are continuing to work with our customer to resolve outstanding issues. To date, definitization proposals for 30 task orders totaling over $500 million have been agreed in principle.
As of September 30, 2004, the COE had withheld $76 million of our invoices related to a portion of our RIO contract pending completion of the definitization process. All ten definitization proposals required under this contract have been submitted by us and three have been agreed in principle. The remaining seven have been reviewed by the DCAA, and we are in the process of responding to our customer on the auditor’s questions. These withholdings represent the amount invoiced in excess of 85% of the amounts we have currently estimated to the COE to complete the tasks ordered. The COE also could withhold similar amounts from future invoices under our RIO contract until our task orders under the RIO contract are definitized. Approximately $4 million was withheld from our PCO Oil South project as of September 30, 2004. We do not believe the withholding will have a significant or sustained impact on our liquidity because the withholding is temporary and ends once the definitization process is complete.
We are working diligently with our customers to proceed with significant work when we have a fully definitized task order, which should limit withholdings on future task orders.
Report on estimating system. The DCAA issued an audit report to our corporate administrative contracting officer (CACO) dated August 4, 2004 stating that, in the DCAA’s opinion, our estimating system is not adequate to produce proposals for our customer to negotiate final pricing on government contracts. The report states that the DCAA has identified approximately $1.8 billion in unsupported costs relating to proposals under our LogCAP contracts. An unsupported cost in an estimate is one in which the DCAA requires additional documentation before expressing an opinion on the acceptability of the estimate. While the alleged $1.8 billion in unsupported costs referenced in the DCAA report represent s estimated costs rather than incurred and/or billed costs and the DCAA is not recommending that such amounts be withheld, the untimely resolution of unsupported cost issues could affect the definitization process. In October 2004, we developed a corrective action plan with the CACO and DCAA and believe we will be able to demonstrate that our estimating system is adequate for negotiating with our customer and that we have appropriate support for our proposals. Should the estimating system ultimately be judged inadequate, all proposals over $100,000 would be required to be reviewed by the DCAA. Currently, all of our proposals over $500,000 must be reviewed.

 
 
  28  

 

Report on purchasing system. As a result of a Contractor Purchasing System Review by the Defense Contract Management Agency (DCMA) during the second quarter of 2004, the DCMA granted the continued approval of our government contract purchasing system. The review was conducted due to the unprecedented level of support we currently provide the military in Iraq and Kuwait. The DCMA’s approval letter, dated September 7, 2004, stated that our purchasing system’s policies and practices are “effective and efficient, and provide adequate protection of the Government’s interest.”
The Balkans. We have had inquiries in the past by the DCAA and the civil fraud division of the United States Department of Justice into possible overcharges for work performed during 1996 through 2000 under a contract in the Balkans, which inquiry has not yet been completed by the Department of Justice. 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 Department of Justice 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.
 
Note 15. Other Commitments and Contingencies
Securities and Exchange Commission (SEC) investigation of change in accounting for revenue on long-term construction projects and related disclosures. In August 2004, we reached a settlement in the investigation by the SEC involving our 1998 and 1999 disclosure of and accounting for the recognition of revenue from unapproved claims on long-term construction projects. Our settlement with the SEC covers a failure to disclose a 1998 change in accounting practice. We disclosed the change in accounting practice in our 1999 Form 10-K and continued to do so in subsequent periods. The SEC did not determine that we departed from generally accepted accounting principles, nor did it find errors in accounting o r fraud. We neither admitted nor denied the SEC’s findings, but paid a $7.5 million civil penalty, and recorded a charge of that amount in the second quarter of 2004. As part of the settlement, the company agreed to cease and desist from committing or causing future securities law violations.
Securities and related litigation. On June 3, 2002, a class action lawsuit was filed against us in federal court on behalf of purchasers of our common stock during the period of approximately May 1998 until approximately May 2002 alleging violations of the federal securities laws in connection with the accounting change and disclosures involved in the SEC investigation discussed above. In addition, the plaintiffs allege that we overstated our revenue from unapproved claims by recognizing amounts not reasonably estimable or probable of collection. After that date, 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 on or about April 11, 2003 (the “Moore class action”). Subsequently, in October 2002 and March 2003, two derivative actions arising out of essentially the same facts and circumstances were filed, one of which was subsequently dismissed, while the other was transferred to the same judge before whom the Moore class action was pending.

 
 
  29  

 

In early May 2003, we announced that we had entered into a written memorandum of understanding setting forth the terms upon which both the Moore class action and the remaining derivative 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 c laims, 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 are among the claims the parties intended to be 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. After the May 2003 announcement regarding the memorandum of understanding, one of the lead plaintiffs in the consolidated class action announced that it was dissatisfied with the lead plaintiffs’ counsel’s handling of settlement negotiations and what the dissident plaintiff regarded as inadequate communications by the lead plaintiffs’ counsel. The dissident lead plaintiff further asserted that it believes that, for various reasons, the $6 million settlement amount is inadequate.
The attorneys representing the dissident plaintiff filed another class action complaint in August 2003, raising allegations similar to those raised in the second amended consolidated complaint regarding the accounting/disclosure claims and the Dresser claims. In addition, the complaint enhances the Dresser claims to include allegations related to our accounting with respect to the acquisition, integration and reserves of Dresser. We moved to dismiss that complaint, styled Kimble v. Halliburton Company, et al.; however, the court never ruled on our motion and ordered the case consolidated with the Moore class action. On August 3, 2004 the attorneys representing the dissident plaintiff filed a motion for leave to file yet another class action complaint styled Murphey v. Halliburton Company, et al. The court has not ruled on that motion. The proposed complaint raises and augments allegations similar to those in the Moore class action and the Kimble action, including additional allegations regarding disclosure of asbestos liability exposure.
On June 7, 2004, the court entered an order preliminarily approving the settlement. Following the transfer of the case(s) to another district judge and a final hearing on the fairness of the settlement, on September 9, 2004, the court entered an order denying the motion for final approval of the settlement in the Moore class action and ordering the parties, among other things, to mediate. The mediation is expected to take place in the first quarter of 2005. 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 (although the settli ng plaintiffs assert otherwise).
On September 9, 2004, the court ordered that if no objections to the settlement of the derivative action described above were made by October 20, 2004, the court would finally approve the derivative action settlement. No timely objections were made to the settlement of the derivative action.
BJ Services Company patent litigation. On April 12, 2002, a federal court jury in Houston, Texas, returned a verdict against Halliburton Energy Services, Inc., a wholly owned subsidiary, in a patent infringement lawsuit brought by BJ Services Company. In January 2004, we filed a petition requesting that the United States Supreme Court review and reverse the judgment, which was denied in April 2004. In April 2004, we paid the $107 million judgment amount, including pre- and post-judgment interest.

 
 
  30  

 

Anglo-Dutch (Tenge). On October 24, 2003, a Texas district court jury returned a verdict finding a subsidiary of Halliburton liable to Anglo-Dutch (Tenge) L.L.C. and Anglo-Dutch Petroleum International, Inc. for breaching a confidentiality agreement related to an investment opportunity we considered in the late 1990s in an oilfield in the former Soviet Republic of Kazakhstan. On January 20, 2004, the judge in that case entered judgment against us and our codefendants, Ramco Oil & Gas, Ltd. and Ramco Energy, PLC (collectively, Ramco), jointly and severally, for the total sum of $106 million. A charge in the amount of $77 million was recorded in the third quarter of 2003 related to this matter. In April 2004, we reached a settlement with the plaintiffs and made all payments to the plaintiffs pursuant to the settlement agreement. As a result of the settlement, the judgment entered against us has been vacated and the litigation dismissed. The settlement also provided Halliburton total indemnity for contribution claims, if any, of Ramco against Halliburton. After consideration of the settlement and legal costs, we reversed approximately $13 million of our remaining accrual in the first quarter of 2004. In the second quarter of 2004, we recovered the $25 million cash that we posted in lieu of a bond related to this matter, which was included in restricted cash as of December 31, 2003.
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 on 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 which would require trial. We believe our exposure is no more than $40 million. We believe that we have valid defenses to Newmont’s claims and intend to vigorously defend the matter. As of September 30, 2004, we had not accrued any amounts related to this matter.
Smith International award. In June 2004, a Texas district court jury returned a verdict in our favor in connection with a patent infringement lawsuit we filed against Smith International (Smith). We were awarded $24 million in damages by the jury. We filed the lawsuit in September 2002 seeking damages for Smith’s infringement of our patented Energy Balanced ™ roller cone drill bit technology. The jury found that Smith’s competing bits willfully infringed three of our patents. Under applicable law the judge has the discretion to enhance the damages to a total amount of up to three times the amount awarded by the jury and to award attorney’s fees and costs. Subsequent to the verdic t, upon our motion, the court enhanced the jury verdict by $12 million and added another $5 million in attorneys’ fees and costs for a total judgment of $41 million. Unless pending motions for judgment as a matter of law are granted, Smith is expected to appeal.
Related litigation dealing with claims of infringement of the same technology is pending in courts in Italy and England and expected to go to trial during 2005.
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 employe es. 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.

 
 
  31  

 

Investigation into Nigerian joint venture and related matters. The SEC is conducting a formal investigation into payments made 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 United States Department of Justice is also conducting an investigation. TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V., which is an affiliate of ENI SpA of Italy, JGC Corporation of Japan, and Kellogg Brown & Root, each of which owns 25% of the venture.
The SEC and the Department of Justice have been reviewing these matters in light of the requirements of the United States Foreign Corrupt Practices Act. We have produced documents to the SEC both voluntarily and pursuant to a subpoena, and intend to make our employees available to the SEC for testimony. In addition, we understand that the SEC has issued a subpoena to A. Jack Stanley, who most recently served as a consultant and chairman of Kellogg Brown & Root, and to other current and former Kellogg Brown & Root employees. We further understand that the Department of Justice has invoked its authority under a sitting grand jury to obtain letters rogatory for the purpose of obtaining information abroad.
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. Commencing in 1995, TSKJ entered into a series of agency agreements in connection with the Nigerian project. We understand that a French magistrate has officially placed Jeffrey Tesler, an agent of TSKJ, 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 Fre nch magistrate and Nigerian officials and expressed our willingness to cooperate with those investigations. In October 2004, representatives of TSKJ voluntarily testified before the Nigerian legislative committee.
As a result of our continuing investigation into these matters, information has been uncovered suggesting that, commencing at least 10 years ago, the members of TSKJ considered payments to Nigerian officials. We provided this information to the United States Department of Justice, the SEC, the French magistrate, and the Nigerian Economics and Financial Crimes Commission. We also notified the other owners of TSKJ of the recently uncovered information and asked each of them to conduct their own investigation.
We understand from the ongoing governmental and other investigations that payments may have been made to Nigerian officials. In addition, we understand that, at our request, TSKJ has suspended the receipt of services from and payments to TSKJ’s agent, Tri-Star Investments, of which Jeffrey Tesler is a principal, and is considering instituting legal proceedings to declare all agency agreements with Tri-Star terminated and to recover all amounts previously paid under those agreements.
We understand that the Department of Justice has expanded its investigation to include whether Mr. Stanley may have received payments in connection with bidding practices on certain foreign projects. We also understand that the matters under investigation by the Department of Justice involve parties other than Kellogg Brown & Root and M.W. Kellogg, a joint venture in which Kellogg Brown & Root has a 55% interest, cover an extended period of time, in some cases significantly before our acquisition of Dresser Industries, including M. W. Kellogg in 1998, and possibly include the construction of a fertilizer plant in Nigeria in the early 1990’s and the activities of agents and service providers.
In June 2004, we terminated all relationships with Mr. Stanley and another consultant and former employee of M.W. Kellogg. The terminations occurred because of violations of our Code of Business Conduct that allegedly involve the receipt of improper personal benefits in connection with TSKJ’s construction of the natural gas liquefaction facility in Nigeria.
There can be no assurance that any governmental investigation or our investigation of these matters will not conclude that violations of applicable laws have occurred.
As of September 30, 2004, we had not accrued any amounts related to these investigations.

 
 
  32  

 

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 that is 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 i n full compliance with applicable sanction regulations. In January 2004, we received a follow-up letter from OFAC requesting additional information. We responded fully to this request on March 19, 2004. We understand this matter has now been referred by OFAC to the Department of Justice. 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 have responded to the subpoena by producing documents on September 16, 2004. As of September 30, 2004, 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 full 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.
Litigation brought by La Nouvelle. In October 2004, La Nouvelle, a subcontractor to us in connection with our government services work in Kuwait and Iraq, filed suit alleging breach of contract and interference with contractual and business relations. The relief sought includes $224 million in damages for breach of contract, which includes $34 million for tortious interference, and an unspecified sum for consequential and punitive damages. The dispute arises from our termination of a master agreement pursuant to which La Nouvelle operated a number of DFACs in Kuwait and Iraq and the replacement of La Nouvelle with ESS which, prior to La Nouvelle’s termination, had served as La Nouvelle’s s ubcontractor. In addition, La Nouvelle alleges that we wrongfully withheld from La Nouvelle certain sums due La Nouvelle under its various subcontracts.
While we admit that we have withheld certain sums from La Nouvelle, we believe that we were contractually entitled to do so and that we had the right to terminate the master agreement with La Nouvelle for cause. The case has only recently been filed and our investigation is in its preliminary stages. Accordingly, it is premature to assess the likelihood of an unfavorable result. It is, however, our intention to vigorously defend the action.
David Hudak and International Hydrocut Technologies Corp. On October 12, 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 Corrupt 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 in early 1994 of certain explosive charges which were later alleged by the United States Department of Justice to be military ordnance, the possession of which by persons not possessing the requisite licenses and registrations is unlawful. As a result of th at 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 ten 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. It is, however, our intention to vigorously defend this action. As of September 30, 2004, we had not accrued any amounts related to 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;

 
 
  33  

 

- the Clean Air Act;
- the Federal Water Pollution Control Act; and
- the Toxic Substances Control Act.
In addition to the federal laws and regulations, states and other countries where we do business may 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, 2004 and $31 million as of December 31, 2003. The liability covers numerous properties and no individual property accounts for more than $5 million of the liability balance. 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. We have subsidiaries that have been named as potentially responsible parties along with other third parties for 14 federal and state superfund sites for which we have established a liability. As of September 30, 2004, those 14 sites accounted for approximately $10 million of our total $38 million liability.
Letters of credit. In the normal course of business, we have agreements with banks under which approximately $1.1 billion of letters of credit or bank guarantees were outstanding as of September 30, 2004, including $191 million which relate to our joint ventures’ operations.
In the fourth quarter of 2003, we entered into a senior secured master letter of credit facility (Master LC Facility) with a syndicate of banks which covered at least 90% of the face amount of our then existing letters of credit. The Master LC Facility became effective in December 2003. Each bank has permanently waived any right that it had to demand cash collateral as a result of the filing of Chapter 11 proceedings by certain of our subsidiaries. In addition, at the discretion of the banks involved, the Master LC Facility provides for the issuance of new letters of credit, so long as the total facility does not exceed an amount equal to the amount of outstanding letters of credit at closing plus $250 million, or approximately $1.5 billion.
The purpose of the Master LC Facility is to provide an advance for letter of credit draws, if any, and to satisfy any cash collateralization rights of issuers of substantially all our then existing letters of credit during the pendency of the Chapter 11 proceedings of eight of our subsidiaries. In May 2004, we extended the Master LC Facility, and advances under the Master LC Facility will now remain available until the earlier of December 31, 2004 or when an order confirming the proposed plan of reorganization becomes final and nonappealable. At that time, all advances outstanding under the Master LC Facility, if any, will become term loans payable in full on June 30, 2005 and all other letters of credit shall cease to be subject to the terms of the Master LC Facility. If our subsidiaries do not exit Chapter 11 pr oceedings until after December 31, 2004, we would expect to be able to extend the availability of the Master LC Facility. As of September 30, 2004 and December 31, 2003, there were no outstanding advances under the Master LC Facility.
We currently have commitments to fund approximately $55 million to certain of our related companies. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $46 million of the commitments to be paid during the next year.

 
 
  34  

 

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. 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 liabilities for $46 mi llion at September 30, 2004 and $243 million at December 31, 2003 of liquidated damages we could incur based upon completing the projects as forecasted. If the October 2004 agreement in principle between Kellogg Brown & Root and Barracuda and Caratinga Leasing Company B.V. were not finalized, based on September 2004 project forecasts, Kellogg Brown & Root could be subject to an additional approximately $141 million in liquidated damages beyond the estimated $24 million of liquidated damages recorded as of September 30, 2004 in the event that the delay in the project is determined to be attributable to us. There can be no assurance that further project delays will not occur.
Other. We are a party to various other legal proceedings. We expense the cost of legal fees as incurred related to these proceedings. We believe any liabilities we may have arising from these proceedings will not be material to our consolidated financial position or results of operations.
 
Note 16. Accounting for Stock-Based Compensation
We have six stock-based employee compensation plans. We account for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. No cost for stock options granted is reflected in net income, as all options granted under our plans have an exercise price equal to the market value of the underlying common stock on the date of grant. In addition, no cost for the Employee Stock Purchase Plan is reflected in net income because it is not considered a compensatory plan.
The fair value of options at the date of grant and the employee stock purchase plan shares were estimated using the Black-Scholes option pricing model. The following table illustrates the effect on net income (loss) and income (loss) per share if we had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

   
Three Months
 
Nine Months
 
   
Ended September 30
 
Ended September 30
 
(Millions of dollars except per share data)
 
2004
 
2003
 
2004
 
2003
 
Net income (loss), as reported
 
$
(44
)
$
58
 
$
(776
)
$
127
 
Total stock-based employee compensation
                         
expense determined under fair value
                         
based method for stock options and
                         
employee stock purchase plan awards,
                         
net of related tax effects
   
(8
)
 
(8
)
 
(21
)
 
(21
)
Net income (loss), pro forma
 
$
(52
)
$
50
 
$
(797
)
$
106
 
                           
Basic income (loss) per share:
                         
As reported
 
$
(0.11
)
$
0.13
 
$
(1.78
)
$
0.29
 
Pro forma
 
$
(0.13
)
$
0.11
 
$
(1.83
)
$
0.24
 
                           
Diluted income (loss) per share:
                         
As reported
 
$
(0.09
)
$
0.13
 
$
(1.76
)
$
0.29
 
Pro forma
 
$
(0.11
)
$
0.11
 
$
(1.81
)
$
0.23
 


 
 
  35  

 

We also maintain a restricted stock program wherein the fair market value of the stock on the date of issuance is being amortized and ratably charged to income over the average period during which the restrictions lapse. The related expense, net of tax, reflected in net income as reported for the three- and nine-month periods ended September 30, 2004 is $4 million and $9 million, and for the three- and nine-month periods ended September 30, 2003 is $3 million and $8 million.

Note 17. Income (Loss) Per Share
Basic income (loss) per share is based on the weighted average number of common shares outstanding during the period. Diluted income (loss) per share includes additional common shares that would have been outstanding if potential common shares, consisting primarily of stock options, with a dilutive effect had been issued. The effect of common stock equivalents on basic weighted average shares outstanding was an additional four million shares in the three and nine months ended September 30, 2004 and an additional two million shares in the three and nine months ended September 30, 2003. Excluded from the computation of diluted income (loss) per share are options to purchase nine million shares of common stock which were outstanding during the three and nine months ended September 30, 2004, 16 million shares which we re outstanding during the three months ended September 30, 2003, and 15 million shares during the nine months ended September 30, 2003. These options were outstanding during these quarters but were excluded because the option exercise price was greater than the average market price of the common shares. The shares issuable upon conversion of the 3.125% convertible senior notes due 2023 were not included in the computation of diluted income (loss) per share since the conditions for conversion had not been met as of September 30, 2004. Loss per share for discontinued operations and net loss for the three and nine months ended September 30, 2004 were antidilutive, as the control number used to determine whether to include any common stock equivalents in the weighted shares outstanding for the period is income from continuing operations.
On September 30, 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” which changes the treatment of contingently convertible debt instruments in the calculation of diluted earnings per share. Contingently convertible debt instruments are financial instruments that include a contingent feature, such as a feature by which the debt becomes convertible into common shares of the issuer if the issuer's common stock price has exceeded a predetermined threshold for a specified time period. Our 3.125% convertible senior notes due 2023 are an example of these types of instruments. Prior to the effective date of the new consensus, we excluded the potential dilutive effect of the conversion feature from dilut ed earnings per share until the contingency threshold is met. EITF Issue No. 04-08 provides that these debt instruments should be included in the earnings per share computation (if dilutive) regardless of whether the contingent feature has been met. This change does not have any effect on net income (loss), but it will affect the related per share amounts. The new rules are currently expected to be effective for the fourth quarter of 2004.
We plan to adopt EITF Issue No. 04-08 as of December 31, 2004 and will restate the computations of earnings (loss) per share for prior periods. We will include, if dilutive, the assumed conversion of our $1.2 billion 3.125% convertible senior notes due July 2023 in our diluted earnings per share calculations. This will increase the denominator in our diluted earnings per share calculations by approximately 32 million shares, resulting in lower diluted earnings per share in periods in which we report net income. We expect this change to have an immaterial impact on our diluted earnings (loss) per share calculations.

Note 18. Income Taxes
Provision for income taxes of $111 million resulted in an effective rate of 37% in the third quarter of 2004, compared to an effective tax rate of 39% in the third quarter of 2003. The tax rate for the third quarter of 2004 was primarily due to a reduction of current taxes in foreign jurisdictions.

 
 
  36  

 

Provision for income taxes of $131 million resulted in an effective tax rate of 37% in the first nine months of 2004, compared to an effective tax rate of 40% in the first nine months of 2003. The tax rate for the first nine months of 2004 was attributable to lower tax benefits on Barracuda-Caratinga charges, offset by a reduction of current taxes in foreign jurisdictions. The tax rate for the first nine months of 2003 was partially the result of the tax effect on the gain from the sale of our Mono Pumps business and loss from the sale of Wellstream. These transactions included $14 million of realized cumulative translation loss, which is not deductible for tax purposes.

Note 19. Retirement Plans
The components of net periodic benefit cost for the three and nine months ended September 30, 2004 and September 30, 2003 are as follows:

   
Pension Benefits
     
   
Three Months Ended
 
Other Postretirement
 
   
September 30
 
Benefits
 
   
2004
 
2003
 
Three Months Ended
 
   
United
     
United
     
September 30
 
(Millions of dollars)
 
States
 
International
 
States
 
International
 
2004
 
2003
 
Components of net periodic
                                     
benefit cost:
                                     
Service cost
 
$
1
 
$
21
 
$
-
 
$
18
 
$
1
 
$
-
 
Interest cost
   
2
   
37
   
3
   
30
   
1
   
3
 
Expected return on plan assets
   
(2
)
 
(41
)
 
(3
)
 
(34
)
 
-
   
-
 
Transition amount
   
-
   
-
   
-
   
(1
)
 
-
   
-
 
Amortization of prior
                                     
service cost
   
-
   
-
   
-
   
-
   
(2
)
 
-
 
Settlements/curtailments
   
-
   
-
   
2
   
-
   
-
   
-
 
Recognized actuarial loss
   
1
   
3
   
-
   
5
   
-
   
1
 
Net periodic benefit cost
 
$
2
 
$
20
 
$
2
 
$
18
 
$
-
 
$
4
 


   
Pension Benefits
     
   
Nine Months Ended
 
Other Postretirement
 
   
September 30
 
Benefits
 
   
2004
 
2003
 
Nine Months Ended
 
   
United
     
United
     
September 30
 
(Millions of dollars)
 
States
 
International
 
States
 
International
 
2004
 
2003
 
Components of net periodic
                                     
benefit cost:
                                     
Service cost
 
$
1
 
$
64
 
$
1
 
$
54
 
$
1
 
$
1
 
Interest cost
   
7
   
109
   
8
   
90
   
4
   
9
 
Expected return on plan assets
   
(8
)
 
(122
)
 
(9
)
 
(102
)
 
-
   
-
 
Transition amount
   
-
   
-
   
-
   
(1
)
 
-
   
-
 
Amortization of prior
                                     
service cost
   
-
   
-
   
-
   
-
   
(7
)
 
-
 
Settlements/curtailments
   
1
   
-
   
2
   
-
   
-
   
-
 
Recognized actuarial loss
   
3
   
11
   
1
   
14
   
1
   
1
 
Net periodic benefit
                                     
(income) cost
 
$
4
 
$
62
 
$
3
 
$