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* Results at a Glance McDermott International. Inc. for the Fiscal Years ended March 31, 1986 and 1985 In thousands o1 dollars except per share amounts and number of employees Revenues Operating loss Net income Net earnings per common and common equivalent share Stockholders' equity per common share Cash dividends -- common Cash dividends per common share Working capital Capital expenditures Backlog Number of employees including subcontract labor 1986 S 3,257,095 (88,288) 59,089 1.60 32.57 66,533 1.80 1,258 298,884 4,085,509 35,000 1985 S 3.233,871 (108.779) 30,667 0.83 32.57 66.473 1.80 117.966 172.349 4,003.556 40.000 The operations described in this publication include those of certain subsidiary and affiliated companies. The cover: First of a new generation of ultra-heavy-lift semisubmersible ovue vessels. McDermott's Derrick Barge 102 is seen here in sea trials off Japan. With total lift capacity of 13,000 tons - more than twice the heaviest lift offshore to date DB 102 cent install small jackets and more fully integrated topsides unassisted by other I'essels. The versatile barge can also perform many decommissioning and salvage operations unaided, work deep waters or congested shallow waters using an advanced dynamic positioning system, support subsea completion work, and accommodate up to 1,500 pesonnel. The barge is expected to substantially reduce the cost offabricating, installing, or decommissioning offshore structures. DB 102 at work in the North Sea. To Our Stockholders Intense competition characterized all of our markets during fiscal 1986. This competition was especially evident in our marine construction operations due to the worldwide surplus of oil and natural gas. The market for power generation systems and equipment also remained depressed, and the engineered materials group, as expected, continued to lose money. Trading also incurred a loss, although the loss was less than the one recorded last year. Revenues for fiscal 1986 were $3.3 billion, up slightly from the $3.2 billion reported in fiscal 1985. Net income for the year was $59.1 million, or $1.60 a share, compared with $30.7 million, or $0.83 a share a year ago. Our loss from operations was smaller by $20.5 million this year than in fiscal 1985. However, operating results were enhanced by a significant reduction in pension expense. In addition, net income benefited from higher nonoperating income, primarily realized gains from the sale of government obligations, and a tax benefit for the year. These factors more than offset provisions made for the settlement of certain antitrust civil litigation. Claims settled during fiscal 1986 were the last of the antitrust actions filed against the Company. Our financial position remains strong, which has aided our flexibility. We have consolidated operations, cut general and administrative expenses, and reduced employment more than 10 percent during the fiscal year. As a result of these ongoing efforts, we have strengthened, and we will continue to strengthen, the foundations of our core businesses, a key ingredient in our strategy to be the market leader. Marine Construction Services Marine Construction Services had revenues of $908.2 million in fiscal 1986, compared with $1.0 billion in fiscal 1985. The operating loss in fiscal 1986 was $30.2 million compared with a loss of $8.3 million in fiscal 1985. The lower marine construction results were due to foreign operations and reflect a decrease in utilization of marine construction equipment and a decline in fabrication activity. Domestic operations improved during the year, primarily due to higher margins, better contract performance, and more favorable offshore working conditions. Results also benefited from the settlement of certain claims, the reversal of provisions taken in prior years, and reduced pension expense. In fiscal 1986, we added Derrick Barge 102 to our marine construction fleet. This vessel, which has an unsurpassed lifting capacity of 13,000 tons, is working in the Ekofisk Field in the North Sea. Another major vessel, Derrick Barge 101, is offshore southern California where it will install jackets, decks, and pipelines for Chevron's Gail and Hidalgo platforms. We continued to upgrade and convert the remainder of our fleet from single-purpose barges to combination vessels. These conversions have helped us maintain the highest utilization rate in the marine construction industry. At our Morgan City, Louisiana fabrication yard, we built two deepwater jackets for the Gulf of Mexico during the year. One was installed in June 1986 in 750 feet of water. The other will be installed at a depth of 860 feet this summer. In addition, we received a contract from the U.S. Navy to fabricate and install eight offshore structures that will be used as electronic targets for fighter pilot training. In the Middle East, we relocated our yard to the port of Jebel Ali in Dubai, and we are fabricating 21 replacement decks and helidecks for Aramco. In Indonesia, our Batam Island fabrication yard was awarded a turnkey contract for three platforms for Taiwan's Chinese Petroleum Corporation. We completed our Computer Aided Design, Analysis and Drafting (CADAD) system in fiscal 1986. CADAD allows engineers to work from interactive structural and process databases. This new technology enhances productivity by eliminating problems that develop when structural, electrical, and process engineering are done separately. Despite the projects currently underway, the dramatic decline in oil and gas prices has created many uncertainties that will persist through fiscal 1987 and beyond. As a result, we expect that the marine construction market will continue to shrink, and competitive pressures, which are already quite severe, will intensify even further. We will monitor these conditions on an ongoing basis and take whatever steps are necessary to survive this difficult period. Power Generation Systems and Equipment Revenues from the Power Generation Systems and Equipment segment in fiscal 1986 were $1.4 billion, unchanged from the prior year. However, operating income increased to S37.7 million compared with $15.3 million in fiscal 1985. Operating results benefited from a significant reduction in pension expense. The segment also experienced improved results from power plant service activities and microprocessor-based control systems, as well as from higher shipments of nuclear and other components to the U.S. Government. These positive factors were partially offset by lower volume and reduced profit margins on fossil steam and environmental control systems, and increased development and 1-- marketing expenses. Demand for new equipment by the domestic utility industry remains low and is not expected to increase substantially over the next several years. Accordingly, we have shifted our focus to small power plants and cogeneration facilities. These efforts are beginning to yield results. In fiscal 1986, we assumed an equity position in two wood-fired 25 megawatt power plants in Maine that we will build and operate. Although there is no significant demand for new utility generating capacity, existing facilities all require ongoing maintenance and upgrades. We are aggressively pursuing these markets for replacement parts, field engineering, and construction services. The service business represents an active and expanding market for an entire range of power generation products. In addition to boilers, these markets include Bailey Controls power plant system upgrades, Hudson Products heat transfer devices, and Diamond Power boiler-cleaning equipment. Although more than a half a million tons of refuse is generated each day in the United States, less than 5 percent is burned in refuse facilities. This ratio is expected to increase significantly over the next several years as landfill disposal becomes more difficult. We fully intend to participate in this rapidly expanding market through strategies that utilize our expertise and quality products. In the commercial nuclear business, there has been an absence of new plant orders since 1978. Nonetheless, existing facilities require engineering, computer services, training, maintenance, and fuel replacement. We continue to be very successful in providing these services to utilities with plants designed by Babcock & Wilcox (B&W) as well as by our competitors. A major milestone in fiscal 1986 was a contract to supply Duke Power Company with 21 batches of reload fuel for BaW and Westinghouse designed units. In addition, we are extending our service business into low level radioactive waste management and decontamination, a market of growing significance. We have aiso been awarded contracts as part of a project to convert the William H. Zimmer Generating Station in Ohio from a nuclear-powered to a coal-powered facility. While the U.S. market for power generation equipment has remained at a low level, the international market is showing some strength. During the year we completed construction of our boiler manufacturing facility in Indonesia. In addition, B&W Canada was part of a consortium that contracted with Huaneng International Power Development Corporation to export four 350 megawatt coal-fired units to the People's Republic of China (PRC). We also entered into a joint venture with Beijing Boiler Works in the PRC forming Babcock & Wilcox Beijing Company (China) Ltd. At Bailey Controls, market conditions remain robust, largely due to the ongoing influx of new orders for Network 90s. Since its introduction in 1980, this advanced microprocessor-based control system has been installed at almost 5,000 facilities in the United States and abroad. We are especially pleased by the success of Network 90 in the overseas market. During fiscal 1986, we received significant bookings from the PRC for process control and power applications. In addition, Network 90f will completely automate the Mongstadt refinery for Statoil. the Norwegian national oil company. The market for power generation systems and equipment will remain competitive for the foreseeable future. Orders for new generation equipment should rise slowly as growth in the general economy absorbs the current excess of generating capacity. We fully intend to pursue these new orders as they develop. In the meantime, our strong position in the service market will provide us with a profitable foundation for our near term business. Engineered Materials In fiscal 1986, our Engineered Materials segment had revenues of $310.8 million compared with $385.6 million in fiscal 1985. The operating loss for the year was $3T3 million compared with a loss of $39.8 million the prior year. Shipments of alloy, mechanical, and stainless tubing were lower in fiscal 1986, and shipment's of most other tubular product lines were either down or flat. Tubular results were further depressed by very competitive pricing conditions. Insulating products' sales were somewhat higher during the year, but operating income was lower because of a strike at our Canadian operations, which ended in November 1985. The segment's smaller operating loss in fiscal 1986 was primarily due to a significant reduction in pension expense. Major markets for tubular products remain very depressed. Demand is weak and foreign competition continues to affect all operations adversely. Although pressure and mechanical tubing are severely influenced by these developments, the situation is even more dismal in the case of the oilfield market. The recent decline in the price of oil and natural gas has virtually eliminated the demand for oilfield tubing, and we are not optimistic about the prospects for recovery in this market during the next few years. Trading Revenues for the Trading segment in fiscal 1986 increased to $655.1 million from $435.9 million in fiscal 1985. An operating loss of $0.5 million in fiscal 1986 compared with an operating loss of $4.1 million in fiscal 1985. Results were enhanced in fiscal 1986 by the inclusion of Coutinho, Caro & Co. AG for a full 12 months compared with only nine months in fiscal 1985. Revenues also benefited from the addition of a new petrochemical and plastics trading unit, as well as an increase in steel and metal trading. This increase in revenues was partially offset by reduced volume from Coutinho's construction and engineering business. The smaller operating loss was due to favorable cost adjustments and the settlement of outstanding claims on certain construction contracts, partially offset by lower $ margins in steel and metal trading, and the start-up costs - associated with the new petrochemical trading operations. As Coutinho's trading business is heavily related to steel, this new activity will provide a much broader trading base. Coutinho's construction and engineering unit received a major contract to construct protective shelters for aircraft in Abu Dhabi. In addition, we were awarded contracts for the construction of various facilities in the PRC. In support of these projects, Trading signed its first countertrade contract. Our ability to source steel on a global basis enabled this segment to support other McDermott operating units during the year. We intend to enhance this synergy between operations and further strengthen our competitive position in the international marketplace. Outlook Business conditions within the domestic manufacturing sector are beginning to improve as a result of the continued decline in the value of the U.S. dollar. Compared to the peak level at the end of fiscal 1985, the value of our currency has fallen 30 percent against the British pound and 35 percent against the Japanese yen and the German mark. As a direct consequence of the weakening dollar, American goods and services have become more competitive in the international marketplace. More importantly, they have become more competitive in our own domestic economy, which accounts for 30 percent of free world GNP. No longer do Japanese steel and automobile producers enjoy a dominant cost advantage over their U.S. counterparts. The 50 percent appreciation of the yen has resulted in a corresponding increase in Japanese production costs when expressed in terms of U.S. dollars. In a similar manner, dollar denominated production costs have also increased for the Germans, the British, the French, and the Italians, to name a few of our major trading partners. As a first reaction to higher dollar denominated costs, foreign manufacturers held prices constant and accepted lower margins, thereby protecting their share of the U.S. market. This marketing ploy is becoming more difficult to achieve. Margins have already been reduced by such an extent that the majority of imported goods are approaching the point of unprofitability. Foreign producers have therefore shifted their focus. They have raised prices and made their products relatively more expensive for the American consumer. As a result of this marketing strategy, we anticipate that American goods and services will gain market share at the expense of the foreign producers during the current fiscal year. The B&W operating unit is expected to benefit from the declining value of the dollar. The Power Generation Group should experience a relative reduction in operating costs compared with their foreign competitors. As a result, we should be more successful in winning additional contracts in the overseas markets. The outlook is not so positive in the case of marine construction. As a result of increased OPEC production, the price of crude oil fell by more than 50 percent during the last four months of fiscal 1986. We now appear to have price stability as the market awaits a new OPEC agreement on future production levels. We expect this agreement to be finalized during the summer months, and the market should come into balance by November or December. Consequently, by the end of the fiscal year, we expect oil prices to rebound to a range of $20 to $22 a barrel. Even with this rebound, the demand for marine construction services will remain weak over the next several quarters. New business will continue to be scarce, and competition for the available market will be fierce. Due to these severe conditions, widespread dislocations are occurring within the marine construction industry on virtually a daily basis. Although this shakeout is progressing rapidly and has already been quite severe, we anticipate that it will continue lor at least another twelve months. We have every intention of surviving this very difficult period. The attention of management and employees is singularly focused on this objective, and we are all committed to further increases in productivity and reductions in costs. Through these ongoing efforts, all our operations -- Marine Construction, Babcock & Wilcox, and Trading -- will remain cost efficient, highly competitve, and in a position to respond to the ultimate rebound in market conditions. By focusing on this long term strategy, we will maintain and improve our position as a premier producer of goods and services in the global marketplace. J.E. Cunningham Chairman of the Board and Chief Executive Officer left: McDermott International's C/1 DAD System employs u -ID plmit misleler that creates tin electronic nuulel irith iln'a from facilities mill structural databases. middle: Coutinho. Cam Ji Co. AG wax responsible far cmiinscOny. project management anti execution, commissioning, alter sales service, personnel training, and marketing counselingfor this Bangkok Glass Industry LTD. facility in Thailand, right'. A! Bni/ey Con!mis' Viilhnmspnrt, Pennsylvania facility, multiple S'etwork 90* circuit boards are drilled using highly automated equipment. below: At McDermott Marine Construction's Mnrgiiii City. Louisiana facility, a newly installed flat pane! fabrication line helps automate fabrication. betuw right: Scheduled for installation in summer ]9n0. Standaid Oil 1`rtxluclion Cam/taiiy's East Breaks jacket lakes shape at McDermott's Morgan City. Louisiana fabrication yard. Marine Construction Services Marine Construction Services designs, builds, and installs facilities for the oil and natural gas Industry. Our engineers, located in Houston, London, and Singapore, specialize in designing offshore drilling, production, and process platforms, underwater pipelines, and onshore processing plants. McDermott's fabrication yard near Morgan City, Louisiana is one of the largest in the world. At this location, as well as at eight other facilities around the world, we fabricate jackets, deck sections, and modules. Supported by the world's largest and most modern fleet of marine construction vessels, we transport, install, hookup, commission, and maintain offshore structures and pipelines. Our operations also include the engineering and construction of oil and natural gas production facilities in marsh and shoreline areas, as well as in remote offshore locations. In addition, we operate a shipyard in Morgan City, Louisiana, which builds and repairs tugboats, . supply boats, packaged drilling rigs, dredges, barges, and various other vessels, including oceanographic research and ocean-going work vessels. All of these activities enhance our international reputation, strengthen our expertise, and allow us to undertake a variety of projects with imagination and efficiency. Power Generation Systems and Equipment Innovative, high-quality products, as well as a fuli line of services, characterize Power Generation Systems and Equipment. The focus of our operations is on the engineering, manufacture, and erection of fossil-fueled and nuclear steam systems. In addition, we are actively involved in the emerging market of providing power through cogeneration, refuse, and other small power units with non-traditional fuel burning capabilities. We are participating in these markets as an equipment supplier, as well as equity participant in build-own-operate projects. We also provide ongoing support to the overall power generation industry. Our services include task and project management, testing and inspection, replacement parts, maintenance, operator training, and engineered modifications to steam systems for electric utility and industrial applications. As a result of these products and services, we continue to improve the productivity of our customers' facilities and equipment, 4 which enhances their ability to operate at peak efficiency. We design and build air heaters, a-'S. precipitators, cleaning equipment, control and perfc-mance computers, and reflective metallic insvation. Our support of the power industry is further strengthened by the Company's construction unit, which undertakes the erection, repair, and alteration of pov.e' generation systems and equipment. We are also actively involved in m tary projects. Ol' defense business is the premier proc-cer of components for nuclear propulsion systems, in acorion, we are pursuing new opportunities in the defense market related to aircraft engine parts, penetrators. nrcket motor casings, and self-contained military rower plants. "" 'V4 ^ : . For The Fiscal,Year Ended March'31.g pv :- *;,&%-- 1986#'%-gl98^p^ .'""iTT ," --- '.'*..'.................. .. . .In thousands^ Engineered Materials Engineered Materials manufactures seamless and welded specialty steel tubing, round steel bars, and insulating products. Tubular products are produced from carbon and alloy steel, designed for severe applications, and extensively utilized in deep oil and natural gas wells that are characterized by high pressure and a corrosive environment. Other markets for tubular products include power generation, automotive, rail transportation, farm equipment, and metal-working industries. In addition, specialty alloy tubing is used in various nuclear applications. Insulating products are used in high temperature furnaces for various heating and heat treating purposes. They are also used in other applications where the temperatures and rates of combustion or chemical reactions are unusually demanding. In these operations, we produce kaolin clay products, engineered and /acuum-formed ceramic fibers, and insulating and specialty firebrick. Other product lines include plastics, mortars, castables, and special oxide refractories. Trading Trading is conducted through a worldwide network of offices managed by McDermott International Trading Co., Inc., as well as Coutinho, Caro & Co. AG, which is Headquartered in Hamburg, West Germany. Our trading ictivities include iron and steel products, non-ferrous naterials, cables and equipment for electric power distribution, and petrochemicals. We also engage in vaterborne commerce through chartered vessels, and ve assist customers in arranging insurance and inancing requirements. This segment enhances the performance of other McDermott operating units in the purchase and shipment cf materials. Trading also provides improved access to 'aw materials, particularly steel, which enables the Company's other operations to compete more effectively n their respective markets. As a result of the Coutinho, Caro acquisition, McDermott has broadened its role in the engineering and construction field. Coutinho designs, constructs, and erects industrial plants, office buildings, business centers, and other large building complexes. above left: The decision by Duke Pinty* fo pome' of its nuclear plants with Babcock tioned ` - 'coding domestic supplier of pressurized u\:te~ -r-v.-v* W/. above rirriC ,-U primary supplierfor Colorado VTE Electric .A.Cruig provided three iTO-megawatt boilers, pulverize-s. :e>.er aitxilio~t middle: At B&Ws Nuclear Equipment -rj-Km iv BarbcTtcr. (n.M. a thermal machining robot is used to fabricate below: .A; czuErr/i Products Corporation's Beasley, Texas plant, fi:* taz-in- art manvfnczvmr.i utilizing mntti-tasking industrial robols. Directors and Management Officer-Directors J.E. Cunningham - Chaimum of the Board and Chief Executin' Officer Robert E. Howson President and Chief Operating Officer, McDermott Marine Construction John A. Lynott Executive Vice President, Chief Financial and Administrative Officer Walter M. Vannoy President and Chief Operating Officer. Babcock Wilcox Directors Staff Organizaton Thomas D. Barrow Retired Vice Chairman of the Board. The Standard Oil Company integrated petroleum company James L. Dutt1 Retired Chairman of the Board and Chief Executive Officer. Beatrice Foods Co. producer offood, chemical, and manufactured products James A. HuntlX3-4 Partner, Kalb. Voorhis < Co. securities brokers J. Howard Macdonald Chairman of the Board and ChiefExecutive Officer, Dome Petroleum Limited oil and gas exploration and production John A. Morgan l--3 Partner, Morgan, Lewis, Githens & Aim investment bankers John D. Ritchie2-3 Consultant and Director of various corporations William T. Seawell ~SA Retired Chairman of the Board and ChiefExecutive Officer, Pan American World Ainvays. Inc. commercial air transportation K.J. Gilly Vice President and General Counsel, and Corporate Secretary C.F. Kraus Vice President, Tax Administration E.A. Robidoux V7 President and Controller R.A. Jolliff Treasurer N.E. Mezey President, McDermott International Investments Co., Inc. J. Tusa Vice President, Information Services G.A. Stoddart Vice President, Financial Relations R.E. Woolbert Vice President, Employee and Public Relations G.F. Ellis Vice President, Government Operations Walter B. Shaw UA Retired Chairman of the Board and Chief Executive Officer, Turner Construction Company general construction contractors Walter O. Spencer3 Former Dean, The Graduate School of Business. Tnlane University of Louisiana John B. Tweedy14 Attorney and Former Executive Vice President and Director. Tosco Corporation oil refining and marketing Russell L. Wagner123 Retired Chairman of the Board and ChiefExecutive Officer, XLT Corporation insurance holding company 'Audit Committee 'Directors .\ominaliug Committee 'Officers Salary and Supplemental Compensation Committees 4Career Executive Stock Plan Commir,ee 7 Management (continued) Operating Organization McDermott Marine Babcock & Wilcox McDermott International Construction D.R. Brown Trading W.L. Higgins Senior Vice President and Group Executive, i'mrrr Generation K.C.M. Thyssen Vice President and Group Executive. Sorih and South America, and UV.s/ Africa Operations J.E. Franklin Vice President and General Manager, Fabrication and Shipyard Operations R.V. Joffrion V^'ce President and General Manager, Xorth and South America, and West Africa Offshore Operations C.J. Baroch Vice President, Advanced Energy Systems R.E. Donovan Vice President and General Manager, Babcock Wilcox International D.H. Roy Vice President. Engineering and Systems Development President and Chiet Operating Olfieer Chairman. Board of Management. Coutiuhii. Own* A- Co. AG K. Hummel Board of Manaiwinent. Coutiuho. Caro A- Co. AG H. Mamsch Board of Management, Coutiuho. Cam A- Co. AG S.P. Victory Vice President, Houston. Lafayette, and .Yea- Orleans Engineering J.J. Stewart Vice President and Group Executiw. Europe Operations R.E, Curtis Vice President. H.K. Smith Vice President. Marketing H.R. Reeves Senior Vice President and Group Executive. Construction and Tubular Products E.O. Hooker Vice President and General Manager, Americon. Inc. J.J. Schutt Board ofManagement. Continha. Caro A- Co. .AG F.C. Seifarth Boaid of Management, Continha. Cam a- Co. .AG London Engineering M.H. Lam Vice President and General Manager, R.C. Angell Vice President and General Sales Manager. Tubular Products Europe Marine Operations B.J. McDonald J.P. Eckert Vice President and Group Executive. Vice President and Genera! Manager, Defense McDermott Scotland R.J. Machen W.F. Heer Vice Presidoit and General Manager, Vice President and Group Executive, Xuciear Equipment Division Middle East and Southeast Asia Operations E.S. Gaffney Vice President and General Manager, Middle East/Southeast Asia Commercial Services and Projects R.E. Tetrault Vice President and General Manager, .Yaw/ Suchar Fuel Division J.H. MacMillan L.E. Walker Vice President and General Manager, Middle East/Southeast Asia Operations Senior Vice President and Group Executive, Xuciear Power and Advanced Technology R.E. Kosiba R.D. Miller Vice President. Marine Construction Services Vice President, Quality and Technology C.W. Pryor Vice President and General Manager, Xuciear Power Division E.A. Womack, Jr. Vice President, Research & Development and Contract Research Divisions M.A. Keyes Vice President and Group Executive, Industrial Products and Services D. Cannon President. Bailey Controls Company J.B. Given Vice President and General Manager, Insulating Products Division J.A. Pittman Vico President and General Manager, Hudson Products Corporation President. TLT-Babcock. Inc. R.C. Scamehorn President. Diamond Power Specialty Company A. Salem Vice President, Marketing SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended March 31,1986 Commission file number 1-8430 McDermott International, inc. (Exact name of Registrant as specified in its Charter) Republic of Panama (State or Other Jurisdiction of Incorporation or Organization) 72-0593134 (I.R.S. Employer Identification No.] 1010 Common Street, New Orleans, Louisiana (Address of Principal Executive Offices) 70112 (Zip Code) Registrant's Telephone Number, including area code (504) 587-5400 Securities Registered Pursuant to Section 12(b) of the Act: Title of Each Class Common Stock $1 Par Value Name of Each Exchange on Which Registered New York Stock Exchange Warrants to Purchase Common Stock Si Par Value New York Stock Exchange Rights to Purchase Common Stock (Currently Traded with Common Stock) New York Stock Exchange Securities Registered Pursuant to Section 12(g) of the Act: None (Title of Class) 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, and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ The aggregate market value of voting stock held by non-affiliates of the Registrant was $602,042,153 as of May 2, 1986. The number of shares outstanding of the Company's common stock at May 2,1986 was 37,073,724. The Proxy Statement for the 1986 Annual Meeting of Shareholders is incorporated by reference into Part III of this report. 1 2 McDermott international, inc. INDEX - FORM 10-K PARTI Items 1. & 2. Business and Properties A. General B. Marine Construction Services General Foreign Operations Raw Materials Customers and Competition Backlog Factors Affecting Demand C. Power Generation Systems and Equipment GeneralRaw Materials Customers and Competition Backlog Factors Affecting Demand D. Engineered Materials General Raw Materials Customers and Competition Backlog Factors Affecting Demand E. Trading General Customers and Competition Backlog Factors Affecting Demand F. Patents and Licenses G. Research and Development Activities H. Insurance I. Employees J. Government Regulations K. Intercompany Agreement Item 3. Legal Proceedings and Proposed Tax Deficiency Item 4. Submission of Matters to a Vote of Security Holders PAGE o 7 8 8 8 9 9 9 10 10 10 11 11 11 12 12 12 12 13 13 13 13 14 14 14 15 15 15 16 PART II Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations Results of Operations 1986 VS 1985 1985 VS 1984 Impact of Changing Prices On Revenues and Net Income Liquidity and Capital Resources Item 8. Consolidated Financial Statements and Supplementary Data Company Report on Consolidated Financial Statements Report of Certified Public Accountants Consolidated Balance Sheet - March 31, 1986 and 1985 Consolidated Statement of Income and Retained Earnings For the Three Fiscal Years ended March 31, 1986 Consolidated Statement of Changes in Financial Position For the Three Fiscal Years ended March 31, 1986 Notes to Consolidated Financial Statements Item 9. Disagreements with Accountants on Accounting and Financial Disclosure PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Exhibit 11 - Statement Re Computation of Per Share Earnings Exhibit 22 - Significant Subsidiaries of the Registrant Consent of Certified Public Accountants Signatures of the Registrant Signatures of Directors 4 16 17 IS IS 19 20 20 22 23 24 26 27 28 45 45 45 45 45 47 49 50 51 PARTI hems 1. and 2. BUSINESS AND PROPERTIES A. GENERAL McDermott International, Inc. ("International") was incorporated under the laws of the Republic of Panama in 1959. Under a reorganization during the fiscal year ended March 31, 1983, International became the parent company of the McDermott group of companies which includes McDermott Incorporated (the "Delaware Com pany") which prior to the reorganization was the parent company. International's common shares and the Delaware Company's Series A $2.20 Cumulative Convertible Preferred Stock and Series B $2.60 Cumulative Preferred Stock are publicly held. Unless the context otherwise requires, hereinafter "International" will be used to mean McDermott Interna tional, Inc., a Panama corporation, the "Delaware Company" will be used to mean McDermott Incorporated, a Delaware corporation, and "McDermott International" will be used to mean the consolidated enterprise. During fiscal year 1985, International acquired the international trading business of Coutinho, Caro & Co. KGaA ("Coutinho"), which is headquartered in Hamburg, West Germany. McDermott International operates in four business segments: Marine Construction Sendees performs activities for the oil and gas industry for offshore development drilling and for the production and transportation of oil and gas on a world-wide basis. Power Generation Systems and Equipment principally serves the electric utility industry and the U.S. Government. Engineered Materials produces metal tubular products for mechanical and pressure applications, and insulating products for a variety of industries. Trading comprises the world-wide trading, engineering and construction operations of Coutinho as well as other trading services of International. The business of the Power Generation Systems and Equipment and Engineered Materials segments are con ducted primarily through a subsidiary of the Delaware Company, The Babcock & Wilcox Company ("B&W"), which was acquired in 1978. McDermott International has a continuing program of reviewing acquisition opportunities. The following tables show revenues, operating income and theft respective percentage contributions for the business segments of McDermott International for the three fiscal years ended March 31,1986. See Note 10 of notes to consolidated financial statements for additional information with respect to McDermott International's business segments and operations in different geographic areas. 5 REVENUES AND PERCENT OF REVENUES (Dollars in Millions) For Fiscal Years Ended March 31, 1986 19S5 1984 Marine Construction Services Power Generation Systems and Equipment Engineered Materials Trading Intersegment Transfer Eliminations Total $ 908.2 1,447.4 310.8 655.1 (64.4) $ 3,257.1 28% 44% 10% 20% (2%) 100% $ 1,045.9 1,413.5 385.6 435.9 (47.0) $ 3,233.9 32% 44% 12% 13% (1%) 100% $ 1,191.3 1,579.3 373.8 -- (55.8) S 3,088.6 39% 51% 12% -- (2%) 100% OPERATING INCOME (LOSS)(1) AND PERCENT OF OPERATING INCOME (Dollars in Millions) For Fiscal Years Ended March 31, 1986 1985 1984 Marine Construction Services Power Generation Systems and Equipment Engineered Materials Trading Total S (30.2) 124% $ (8.3) 22% ;$ 91.1 44% 37.7 (155%) 15-3 (41%) 135.5 65% (31.3) 129% (39.8) 108% (19.2) (9%) (0.5) 2% (4.1) 11% ---- $ (24.3) 100% $ (36.9) 100% :5 207.4 100% (1) Reconciling items between Operating Income (Loss) and Income (Loss) before Provision for Income Taxes. Minority Interest and Extraordinary Items are General Corporate Expenses and Other Income (Expense). 6 B. MARINE CONSTRUCTION SERVICES General The Marine Construction Services segment consists of the design, construction and installation of specialized offshore fixed platforms and marine pipelines used for development drilling, production and transportation of oil and gas. Marine construction services also includes engineering and construction services for oil production in shoreline and marshland areas (principally in Louisiana and Texas); operation of a shipyard for the construction, repair and maintenance of tugboats, barges and other small vessels; and the engineering and construction of processing plants for the oil, gas and petrochemical and mineral industries, primarily for offshore installation. Fixed platforms, which are fastened to the seafloor by pilings driven through their structural legs, have been installed by McDermott International in water depths of more than 1,000 feet. These platforms have been engineered to withstand increasingly greater weights and stresses as the search for oil and gas has expanded into deeper water and into areas subject to severe weather conditions. McDermott International, a world leader (based upon industry standards) in the fabrication of offshore struc tures, has a principal fabrication yard located on approximately 1,300 acres of land, under lease, near Morgan City, Louisiana. This segment also operates fabrication yards on leased property in Indonesia at Batam Island; in the Middle East at Dubai, Abu Dhabi, and Ras A1 Khaimah ofthe United Arab Emirates and Ain Soukhna, Egypt and has fabrication capabilities on leased property in South East Asia at Singapore and in West Africa at Warri, Nigeria. McDermott International also operates a fabrication yard on company owned property in Scotland, near Inverness. The equipment used at these yards, which is capable offabricating a full range of offshore structures, consists principally of cranes, welding equipment, machine tools and other fabrication equipment, most of which is movable. This segment also operates a shipyard on approximately 58 acres of leased land in Morgan City, Louisiana. Expiration dates, including renewal options of leases covering land for the shipyard and fabrication yards are as follows: Morgan City, Louisiana Batam Island, Indonesia Dubai, U. A. E. Abu Dhabi, U. A. E. Ras A1 Khaimah, U. A. E. Ain Soukhna, Egypt Singapore Warri, Nigeria Years 1989-2032 Year 2008 Year 2005 Year 1995 Year 1986 Year 2001 Year 1999 Year 2065 This segment operates one ofthe largest fleets of marine equipment used in offshore construction. The nucleus of a "construction spread" is a large derrick barge, pipelaying barge or combination derrick-pipelaying barge capable of offshore operations for an extended period of time in remote locations. The lifting capacities of McDermott International's derrick and combination derrick-pipelaying barges range from 700 tons to 13,000 tons. These barges, which range in length from 300 feet to 660 feet, are fully equipped with revolving cranes, auxiliary cranes, welding equipment, pile driving hammers, anchor winches and a variety of additional gear. The largest of the existing vessels provides quarters for approximately 750 workers. Included in the above is the DB102, the world's largest semi-submersible derrick barge in both size and lifting capacity, which this segment took delivery of in December 1985. This segment owns and operates 5 derrick barges, 2 pipelaying barges, 11 combination derrick-pipelaying barges and 2 pipeburying barges. These include 4 semi-submersible vessels presently assigned to the North Sea and the Gulf of Mexico, of which 3 are derrick barges capable of lifting 2,000 to 13,000 tons, 2 of which are self-propelled. The other semi-submersible vessel is a lay barge capable of laying 72 inch diameter pipe and is operable in water depths up to 2,000 feet. McDermott International also owns or leases a substantial number of other vessels such as tugs, utility boats and cargo barges to support the major marine vessels. Major spreads of equipment are in the Gulf of Mexico, the Middle East, South East Asia, the North Sea, and West Africa. Underwater pipelaying operations conducted by this segment have required the development of new techniques and equipment as water depths have increased. McDermott International has the capability of installing pipelines with an outside diameter (including concrete coating) of up to 72 inches. This segment has installed several of the world's deepest marine pipelines including one from a platform in the Gulf of Mexico at depths greater than 1.000 feet and two which cross the NonvegiarfTrench in the North Sea at depths approaching 1.000 feet. In connection with its construction and pipelaying activities, this segment conducts diving operations which, because of thg.water depths involved, require sophisticated equipment, including diving bells and an underwater habitat, ^ss- This segment is strengthening its competitive position through an aggressive program for automation and modernization of engineering, welding equipment, pipemii! facilities and pipelaying operations and increased lifting capacity of its derricks. McDermott International owns a 49% interest in a Mexican joint venture that operates 3 self-propelled combina tion barges and one pipelaying barge. Ofpiese, 2 barges are capable of lifting 2,000 tons. This segment's shipyard facility supplies complete maintenance and construction facilities and is a builder of large tugs, packaged rigs, dredges, and oceanographic research and ocean-going work vessels. Foreign Operations ^ The amounts of marine construction's revenues and operating income derived from operations outside of the United States, and approximate percentages of those revenues and operating income to McDermott Interna tional's total revenues and operating income (loss) were as follows: REVENUES OPERATING INCOME Fiscal Year Amount Percent Amount Percent 1986 1985 1984 Raw Materials (In thousands of dollars) $ 603,532 758,169 947,819 19 23 31 $ 18,657 73,029 165,596 _ _ 80 The raw materials used by this segment such as carbon and alloy steel in various forms, welding gases, concrete, fuel oil and gasoline, are available from many sources and this segment is not dependent upon any single supplier or source. Although shortages in certain raw materials and fuels required to be purchased by this segment have existed from time to time, no serious shortage exists at the present time. Customers and Competition This segment's principal customers are the larger oil and gas companies and foreign governments. Customers generally contract with this segment for the design, construction and installation of specific platforms, pumping stations, marine pipelines, and production networks. Contracts are usually awarded on a competitive bid basis. McDermott International's main competitor in offshore construction has operations comparable in size to those of McDermott International but is a subsidiary of a major company that also provides other services to the oil and gas industry. A number of other companies also compete effectively with McDermott International in various parts of the world, but none has the geographical distribution or the extent of capabilities of McDermott International and its main competitor. 8 Backlog As of March 31, 1986 and 1985 the Marine Construction Services' backlog amounted to $735,765,000 and $662,927,000, respectively, an increase of approximately 11%. Of the March 31, 1986 backlog, $722,620,000 is expected to be recognized in fiscal 1987, and $13,145,000 in fiscal years 1988-1991. Work is performed on a fixed price, cost plus or day rate basis or combinations thereof. Almost all contracts call for progress payments and McDermott International attempts to cover increased costs of anticipated changes in general labor rates and material costs on long-term contracts, either through an estimation of such changes, which is reflected in the original fixed price, or through price escalation clauses. This segment's contracts for work in foreign areas generally provide for payment in United States dollars, with exceptions for payments in foreign curreneiesNn amounts approximately equal to expenses to be incurred by this segment in those currencies. Factors Affecting Demand Marine Construction Services activity has traditionally been a cyclical industry depending mainly on the capital expenditure outlay of major oil and gas companies and foreign governments for developmental construction. These expenditures are influenced by the price ofoil, the sale and expiration dates ofoffshore leases in the United States and abroad, the discovery rates of new oil and gas reserves in offshore areas, local and international political and economic conditions, and the ability of the oil and gas industry to generate capital. The price ofoil and its uncertainty in the future has a strong effect on exploration and production which ultimately affects the demand for Marine Construction Services activity. The oil surplus which the world has been experiencing has a depressing impact on oil prices, which will continue until consumption exceeds available production. The current level ofoil prices and their future uncertainty have led the oil industry, including many of this segment's customers, to reduce capital expenditure budgets, resulting in lower levels of demand for marine construction services. Over the long-term, however, McDermott International expects an end to the current oil surplus and an improved level of demand for its Marine Construction Services. C. POWER GENERATION SYSTEMS AND EQUIPMENT General The Power Generation Systems and Equipment segment, which business is primarily performed through B&W, is a supplier of individually engineered complete fossil fuel boilers, nuclear steam systems, nuclear fuel and nuclear fuel assemblies for the electric utility industry, as well as fossil fuel boilers for industrial processes and power generation. Power Generation Systems and Equipment also provides replacement parts, customer services and engineered modifications of existing fossil and nuclear steam systems, and specially engineered accessories and components, such as air heaters and precipitators, cleaning systems for heat transfer surfaces, nuclear reactor components, control and performance computers, automatic controls and instruments and nuclear control rod drives. It also supplies process recovery boilers and pollution control systems for the process and utility industries, heavy pressure vessels and air and water-cooled heat exchangers, fans, hollow forgings for steam piping and other uses and reflective metallic thermal insulation. This segment also provides nuclear reactor and fuel components and other components for the U.S. Department of Energy and the U.S. Department ofDefense. It also is engaged in the erection of utility plants and industrial facilities and the repair and alteration of such existing equipment. In addition. B&W is actively involved in the emerging market for providing power through cogeneration, refuse and other small power units with non-traditional fuel burning capability. It is participating in this market both as an equipment supplier and in build-own-operate projects as an equity participant. Fluid bed combustors are often the preferred boiler design for these projects and B&W offers both circulating and bubbling fluidized bed combustors to service this and the boiler retrofit market. B&W is also developing pressurized fluid bed combus tors for large scale commercial applications. In regard to commercial nuclear power generation, utilities have delayed certain construction programs and in many cases have cancelled orders for nuclear steam generating systems. No contracts for domestic nuclear steam systems have been awarded in several years. As a consequence, engineering, computer and other customer services, and fuel assemblies for refueling existing nuclear reactors have become the major part ofthis segment's commercial nuclear activity. Business with the U.S. Government related to the U.S. Navy's nuclear shipbuilding operations has become an increasingly important part ofthe segment's results. In each ofthe fiscal years 1986,1985 and 1984, revenues from the U.S. Government related to this activity were approximately 12% of McDermott International's total revenues. This activity has contributed significant operating income to McDermott International in all three fiscal years and the Power Generation Systems and Equipment segment would have had an operating loss in the last two fiscal years without the contribution from this program. A decline in this business could have a significant impact on this segment's profitability. In addition, to capitalize on its highly specialized manufacturing and welding capabilities, B&W is actively pursuing new opportunities in the defense market related to such items as aircraft engine parts, penetrators, rocket motor casings and self-contained military power plants. The principal plants of B&W manufacturing power generation systems and equipment are situated at Barberton. Lancaster and Wickliffe, Ohio; Lynchburg, Virginia; Paris and Beasley, Texas; West Point, Mississippi; Wil liamsport, Pennsylvania; and Cambridge, Ontario. These plants and properties are owned by B&W and are well maintained, have suitable equipment, and are of adequate size. In response to the reduction in orders for power stations by electric utilities, B&W closed certain of its manufacturing plants and facilities to balance its capacity with current market expectations. Provisions were made in the accounts in fiscal 1984 to cover the costs of certain of these closings. B&W has an ongoing program for automating and modernizing this segment's engineering and manufacturing facilities. Raw Materials The principal raw materials used by B&W to construct power generation systems and equipment consist of carbon and alloy steels in various forms, such as plate, structural, bars, sheet, strip, heavy wall pipe and tubes. Significant amounts of components are also purchased for assembly into the equipment. These raw materials and components generally are purchased by B&W as needed for individual contracts except that requirements for tubes are supplied mainly from within B&W. The principal raw materials used by B&W in the manufacture of nuclear fuel components and assemblies consist of uranium (customer furnished), zircalloy and specialized stainless steel. Although shortages in certain raw materials and fuels required to be purchased by B&W have existed from time to time, no serious shortage exists at the present time. Customers and Competition The principal customers of this business segment are the electric utility industry (including government-owned utilities), the U-S. Government, and the pulp and paper, and other process industries. The electric utility industry (including government-owned utilities) accounted for 19%, 21% and 29% of McDermott International's total revenues for fiscal years 1986,1985 and 1984, respectively. The U.S. Government accounted for approximately 13% of McDermott International's total revenues for each of the fiscal years 1986,19S5 and 1984. Power Generation Systems and Equipment orders are customarily awarded in response to competitive bids submitted pursuant to proposals based on the estimated cost ofeach job. Domestically, a relatively small number of companies specializing in large steam generating equipment compete with B&W in the utility fossil fuel steam system business. In international markets, these companies plus several foreign based companies compete with B&W. In the sale of nuclear steam systems, B&W competes with a small number of companies. In the sale of nuclear fuel and nuclear fuel assemblies, B&W competes with the other manufacturers of nuclear steam systems, as well as with one petroleum company which is a supplier of nuclear fuel and nuclear fuel assemblies. In the controls and instrumentation market, B&W competes with several broad line suppliers and a great number of specialty suppliers. A number of companies are in competition with B&W in industrial and cogeneration boilers. Other suppliers of fossil and nuclear fuel steam systems, as well as many other businesses in the case of fossil fuel systems, compete in repair and alterations and other services required for backfitting and maintaining existing systems. In the supply of nuclear fuel assemblies and nuclear components to the U.S. Navy, there are a -<gmaB number of suppliers with B&W being the largest based upon revenues. Backlog Backlog as of March 31, 1986 was $3,035,061,000 or approximately 74% of McDermott International's backlog. Backlog at March 31, 1985 was $3,089,000,000. Of the March 31, 1986 backlog, it is expected that approximately $964,967,000 will be recorded in revenues in fiscal 1987, $1,519,362,000 in fiscal years 19SS-1991. and $550,732,000 thereafter. If in management's judgment it becomes doubtful whether contracts will proceed, the backlog is adjusted accordingly. Reduced electric demand growth, excess generating capacity, environmental restraints and financial pressures on the utility industry have resulted in continued delays, suspensions and cancellations of steam systems and environmental control systems. At March 31,1986 delayed and suspended fossil fuel utility boiler and environ mental control system contracts included in the backlog constituted approximately 12% of McDermott Interns^ tional's total backlog. B&W, at the present time, believes that these fossil fuel utility boiler and environmental control system contracts will proceed after the period of delay or suspension. If contracts are delayed, suspended or cancelled, B&W is usually entitled to a financial settlement related to the individual circumstances of the contract. This segment's backlog with the U.S. Government, primarily for the U.S. Navy's nuclear shipbuilding operations, was approximately 25% of McDermott International's total backlog at March 31, 1986. B&W attempts to cover increased costs of anticipated changes in labor, material and service costs of long-term contracts either through an estimation of such changes which is reflected in the original price or through price escalation clauses. Most long-term contracts have provisions for progress payments. Factors Affecting Demand New orders by the U.S. electric utility industry have been at extremely low levels during recent years because of the decline in electrical demand growth and resultant increased reserve margins, primarily due to cost induced conservation, and a decreased dependence on energy by U.S. industry. Fiscal 1984 saw the start of a moderate resumption in electrical demand growth due primarily to the economic recovery, although existing capacity continues to be adequate to meet current demand. Two domestic orders for new electric utility power plants were placed in fiscal 1986, one of which (involving the conversion of a partially constructed nuclear power plant to a fossil power plant) was placed with B&W. Accordingly, B&W has continued its efforts to obtain orders outside the United States and expand its business in backfitting of existing power plants requiring replacement parts, repair and alteration, and other services. In fiscal 1986 B&W received an order for four utility boilers in the People's Republic of China. D.ENGINEERED MATERIALS General Engineered Materials consists of tubular and insulating products designed and manufactured by B&W. Tubular products include stainless, alloy and carbon steel, seamless and welded tubes, tubular and solid shapes, extrusions, special metal tubes and seamless rolled rings. These are principally "specialty" products of high quality and engineered for special mechanical and pressure tubing applications, including high quality tubing for petroleum production operations. Insulating products include specially engineered and vacuum formed ceramic fibers, insulating and specialty firebrick, fire protection insulation, plastics, mortars, castables and special oxide refractories. These insulating products are used in high temperature furnaces for various heating and heat treating purposes and in other applications where the temperatures and rates of combustion or chemical reactions are unusually demanding. B&W's principal plants manufacturing tubular products are located at Beaver Falls and Ambridge, Pennsylvania; Alliance, Ohio; and Bryan, Texas. B&W manufactures insulating products principally at Augusta, Georgia; Emporia, Kansas; and Burlington, Ontario. All of these plants and properties are owned by B&W, are well maintained, have suitable equipment, and are ofadequate size. In response to reduced demand for mechanical and pressure tubing, B&W permanently closed its Milwaukee, Wisconsin plant in fiscal 1984. Provisions were made in the accounts in fiscal 1986, 1985 and 1984 to cover the costs associated with this closing. B&W has an ongoing program to automate and modernize this segment's facilities. In fiscal 1984, B&W commissioned a new steel making facility, which includes a continuous caster, at its Beaver Falls location and, in fiscal 1985, began an extensive two-year modernization of its welded tube facility in Alliance, Ohio. Raw Materials The principal raw materials used by B&W in the manufacture of tubular products consist of steel, steel scrap, special metals and alloying materials. Most ofthe steel and special metals used for seamless tubemaking purposes are produced by B&W's own electric furnace facilities, except that B&W purchases its requirements for strip steel in the open market. Most ofthe steel scrap and all alloying materials utilized in the manufacturing process are also purchased in the open market. The principal raw material used to produce this segment's insulating products is kaolin clay which it obtains under a long-term supply contract. Also used are bauxite, alumina, silicon carbide, gypsum, plaster and wood chips, all of which are purchased on the open market. Significant amounts of natural gas and oil are used in the manufacture of tubular and insulating products. Although shortages in certain raw materials and fuels required to be purchased by this B&W segment have existed from time to time, no serious shortage exists at the present time. 11 Customers and Competition The principal users of the tubular products portion of this business segment are the bearing, automotive, agricultural and construction machinery, petroleum and petrochemical, primary metal, fabricated metal, proc ess, and power generation industries. This segment services these users through both direct sales and sales to distributors. In addition, material quantities of tubes are manufactured by this segment for B&W's own require ments for power generation systems and equipment. The principal customers of the insulating products portion of this business segment are the iron and steel, chemical process, ceramic and foundry and furnace builders industries. Many companies, both domestic and foreign, are in competition with B&W with respect to tubular and insulating products. Backlog As of March 31,1986 the Engineered Materials' backlog was $37,898,000 compared with $58,000,000 as of March 31,19S5, reflecting the reduced demand by user industries for this segment's products. Substantially all of this segment's backlog is expected to be recorded in revenues in fiscal 1987. Factors Affecting Demand Purchases of tubular products by industries served by this segment were at severely depressed levels throughout fiscal years 1986,1985 and 1984, in nearly all user industries. This segment supplies pressure tubing to makers of steam generating equipment for use in power plants, refineries, chemical and petrochemical plants and pulp and paper and other process industries. Demand for such tubing is closely tied to capital spending of these industries or their ultimate customers, and such spending levels are depressed. In addition to the reduced demand for tubular products in general, this segment has experienced significant foreign competition in many of its tubular product lines. Demand for insulating products is dependent upon capital spending for modernization and expansion, production levels and energy conservation in user industries and such demand continued the moderate upturn that began in fiscal 1984. E. TRADING General This segment conducts its operations through a network of offices located in the United States, Continental Europe, the United Kingdom, West Africa, South America and South East Asia. The business is provided through Coutinho, Caro & Co., headquartered in Hamburg, West Germany and through McDermott Interna tional Trading. This segment buys and sells primarily iron and steel products, wire and wire products, non-ferrous materials, chemical products, cables and equipment for electric power distribution, tools, machinery and utility vehicles, aromatics, olefins, plastics, and fine chemicals. The operations of this segment also include inland and ocean transport as well as assisting customers in arranging insurance and financing. While this segment ordinarily functions as a principal in its trading activities, it also acts as agent under certain circumstances. In addition, this segment regularly enters into substantial forward purchases and sales of all materials handled. These are not normally maintained over periods longer than three months. This segment also provides certain engineering and construction services consisting of the design, construction and erection of industrial plants, primarily for the cement, glass, pulp and paper, and food industries as well as hotels, hospitals, office buildings, business centers and other large building complexes. This segment does not produce any ofthe materials in which it trades, but purchases them from others in the open market. No long-term contractual supply arrangements are in place. This segment has access to and purchases these materials on a worldwide basis. 12 Customers and Competition The principal customers of this segment are warehousing and stockholding companies, steel producers and end-users of steel products such as construction companies, large chemical companies, and a number of other industrial consumers. These customers are mainly commercial organizations although some are partially or wholly government owned or controlled. This segment's competitors in international trade include many large trading organizations and producers or end-users of the products in which the segment trades. No one competitor is dominant, although many have greater financial and other resources than McDermott International. Of the factors affecting competition in this business, the most significant are expertise, service and reliability. Management believes that it possesses adequate resources in these areas to enable it to compete effectively in this marketplace. This segment's customers for engineering and construction services include various process industries and development companies, some of which are owned or partly controlled by governments of the countries in which contracts are performed. Customers generally contract with this segment for the design and construction of specific industrial plants or high-rise buildings. Contracts are normally awarded on a competitive bid basis and, particularly at the present time, are heavily dependent upon the conclusion of related project financing arrange ments. Competition in the engineering and construction business is present on a worldwide basis, from companies based in all major developed countries, none of which are dominant. Backlog As of March 31,1986, Trading segment backlog was $276,785,000 compared with $192,950,000 as of March 31,1985. The increase in backlog is due primarily to a construction contract being performed in the Middle East. Of the March 31,19S6 backlog, $197,764,000 is expected to be recognized in fiscal 1987, and $79,021,000 in fiscal years 1988 and 1989. The majority oftrades are completed within three months. Payment is usually based on normal commercial terms and is normally settled using letters of credit arranged through various banks. Payment terms may be extended under certain circumstances. Credit insurance is purchased for the majority of trade accounts receivable. Engineering and construction work is principally performed on a fixed price or cost plus basis or a combination thereof. Almost all contracts call for progress payments and the segment attempts to cover increased costs on long-term contracts either through an estimation of such charges which is reflected in the agreed fixed price or through price escalation clauses. Trades are primarily settled and major contracts normally call for payment in U.S. Dollars or Deutschmarks. The segment enters into substantial forward currency exchange contracts as a means of hedging its commitments in various currencies. Factors Affecting Demand Demand for this segment's services is influenced by a variety of constantly changing market factors which affect supply and demand for the materials in which the segment trades. In addition, local and international political and economic conditions influence the capital and industrial development budgets of developing nations and their ability to obtain financing for projects or trading. Due to the present uncertainty in the funding ofindustrial expansion programs ofdeveloping nations and delays in completing project financing arrangements, few contracts are being awarded at the present time. These factors are considered likely to affect the segment's engineering and construction activities until world demand and credit conditions become more favorable. F. PATENTS AND LICENSES Many U. S. and foreign patents have been issued to McDermott International and it has many pending patent applications. Patents and licenses have been acquired and licenses have been granted to others when advanta geous to McDermott International. While McDermott International regards its patents and licenses to be of value, no single patent or license or group ofrelated patents or licenses is believed to be material in relation to its business as a whole. G. RESEARCH AND DEVELOPMENT ACTIVITIES McDermott International maintains research ami development activities in Alliance, Ohio; Lynchburg, Virginia; and Houston, Texas; and also conducts development activities at its various manufacturing plants and engineer ing and design offices. During the fiscal years ended March 31,1986,1985 and 1984, approximately $88,000,000. $82,700,000 and $61,600,000, respectively, was spent by McDermott International on research and development activities, of which approximately $53,400,000, $41,600,000 and $27,000,000, respectively, was paid for by customers of McDermott International. Research and development activities were related to development and improvement of new and existing products and equipment and conceptual and engineering evaluation for translation into practical applications. Approximately 408 employees were engaged full time in this activity. H. INSURANCE McDermott International maintains liability and property insurance that it considers norma! in the industry. It does not maintain insurance covering certain risks for which insurance is not available or is only available at rates which McDermott International considers uneconomical. Among such risks are war and confiscation in certain areas of the world at certain times, and pollution liability. Depending on competitive conditions and other factors. McDermott International endeavors to obtain contractual protection against uninsured risks from its customers. McDermott International has coverage under commercially available nuclear liability and property insurance for its five nuclear facilities. Two of these facilities are also subject to the indemnity and limitations of liability provisions of the Price-Anderson Act. This Act limits the public liability of manufacturers and operators of licensed nuclear facilities and other parties who may be liable, in respect of, and indemnifies them against all claims in excess ofan amount which is determined by the sum ofcommercially available nuclear liability insurance plus certain retrospective premium assessments payable by operators of commercial nuclear reactors. One additional facility is covered by a contractual indemnity from the U.S. Government whereby the Government has assumed the risks of public liability claims. McDermott International's insurance policies do not cover liability and property damage losses resulting from nuclear incidents at facilities of its utility customers. To protect against such losses McDermott International has obtained contractual indemnification from such customers and waivers oftheir insurers' rights of subrogation and generally has been named as an additional insured under its customers' nuclear property insurance policies. In addition, McDermott International's third-party nuclear liability is an insured risk under such customers' nuclear liability policies and the Price-Anderson Act indemnity discussed above. McDermott International's offshore construction business is subject to the usual risks of operations at sea, with additional exposure due to the utilization of expensive construction equipment, sometimes under extreme weather conditions and often in remote areas of the world. In addition, McDermott International operates in many cases on or in proximity to existing offshore facilities which are subject to damage by McDermott International and such damage could result in the escape of oil and gas into the sea. McDermott International has two wholly-owned insurance subsidiaries. To date, these subsidiaries have written policies concerning general liability, builders' risk within certain limits, marine hull, and workmen's compensation for McDermott International. No significant amounts of insurance have been written for unrelated parries. I. EMPLOYEES At March 31, 1986, McDermott International employed, under its direct supervision, approximately 35.000 persons compared with 40,000 at March 31,1985. Approximately 8,000 employees were members of labor unions at March 31, 1986 compared with 9,000 employees at March 31, 1985. Approximately 1,300 tmion employees engaged in the tubular products operations are represented by United Steelworkers of America and have a labor contract expiring in August 1986. McDermott International considers its relations with its employees to be satisfactory. 14 J. GOVERNMENT REGULATIONS McDermott International's compliance with U.S. federal, state and local environmental protection regulations necessitated capital expenditures of $474,000 in fiscal 1986, and it expects to spend another $5,487,000 over the next five years. However, McDermott International cannot predict all the environmental requirements or circumstances which will exist in the future. The recurring costs of complying with environmental regulations was a charge against income before taxes of approximately $1,580,000 in fiscal 19S6. In addition, McDermott International incurred a charge against income in fiscal 1986 of approximately $4,500,000 in connection with a plant shutdown. McDermott International performs significant amounts of work for the U.S. Government under both prime contracts and subcontracts and operates certain nuclear facilities and thus is subject to continuing reviews by governmental agencies including the Environmental Protection Agency and the Nuclear Regulatory Commis sion. Compliance with government regulations controlling the discharge of materials into the environment, or other wise relating to the protection of the environment, does not have, nor is it expected to have a material effect upon the competitive position of McDermott International. K. INTERCOMPANY AGREEMENT In November 1982, International and the Delaware Company entered into a Stock Purchase and Sale Agreement (the "Intercompany Agreement"), pursuant to which the Delaware Company has the right to sell to International and International has the right to buy from the Delaware Company units ofstock, each unit consisting ofone share of International Common Stock and one share of International Series A Preferred Stock. If a unit is purchased by International upon the Delaware Company's exercise of its right to sell under the Intercompany Agreement, the purchase price ofsuch unit will be 90% ofthe then current value of the unit, as defined in the agreement (the "unit value"). If a unit is purchased by International pursuant to an exercise of its right to purchase under the Intercompany Agreement, the purchase price of such unit will be 110% of the unit value. As of March 31,1986 the unit value was $7,031 and the aggregate unit value of the Delaware Company's 100,000 units was $703,149,000. Item 3. LEGAL PROCEEDINGS AND PROPOSED TAX DEFICIENCY The Internal Revenue Service (the "IRS") has examined the U.S. federal income tax returns of the Delaware Company for its fiscal years ended March 31,1976 through March 31,1982, and those of International for its fiscal years ended November 30,1976 through November 30,1982; and those of B&W for its fiscal years ended December 31, 1977 and March 31, 1978, the latter being the year ended on the day B&W was acquired by the Delaware Company. The IRS has issued notices which propose additions to the U.S. federal income tax liability of the Delaware Company and International in respect of each of these years. Such notices assert among other things that the Delaware Company is subject to U.S. federal income tax on unremitted earnings of International on the ground that the portion thereof which constituted "Subpart F" income under Sections 951 through 964 of the Internal Revenue Code substantially exceeded the portion so classified by the Delaware Company in its U.S. federal income tax returns. Additional U.S. federal income taxes asserted by the notices in question which are allocable to Subpart F income items from International are approximately $210,000,000. In the notices issued by it, the IRS does not state specifically the grounds upon which additional taxes under Subpart F are asserted. Revenue Agents' reports delivered in connection with such notices assert that the income of International constituted Subpart F income because it was realized from the performance of services on behalf of the Delaware Company. These reports assert, in the alternative, that International was engaged in the business of manufacturing rather than in the construction business, with consequential effects on the calculation of Subpart F income. The Delaware Company is contesting the additional U.S. federal income taxes with respect to Subpart F income items proposed in the notices and believes it will succeed with respect thereto. The notices to International essentially represent alternative grounds for asserting a deficiency with respect to a portion of the aforesaid Subpart F income. International believes it will succeed in contesting these deficiencies. The notices also propose additional U.S. federal income taxes for the years in question on grounds other than the Subpart F rules, including additional taxes arising out of transactions done and contracts entered into by B&W before its acquisition by the Delaware Company and the consequential effects thereof on the Delaware Company for its fiscal years ended March 31,1979,1980 and 1981. The additional U.S. federal income taxes which the IRS has asserted on these grounds are substantial. The Delaware Company, however, believes that any U.S. federal income taxes ultimately assessed on the basis of such notices will not exceed reserves established with respect thereto. 15 For the fiscal year ended March 31,1983 the IRS has issued a draft report of income tax examination changes. The draft report indicates, among other things, that the IRS will propose to treat the reorganization in that fiscal year in which International became the parent of the McDermott group of companies as a taxable event on which the Delaware Company owes approximately $300,000,000 in U.S. federal income taxes. This amount is duplicative to the extent of income taxes asserted under Subpart F for prior years through March 31, 1982. If a notice of deficiency is issued on this basis, the Delaware Company will contest any amounts asserted therein and it believes it will succeed with respect thereto. In March 1986, the legal action involving claims by Exxon Corporation and affiliated companies against Brown & Root, Inc. and the Delaware Company (Case No. 80-1402, E.D. La.) under Sections 1 and 2 of the Sherman Act was settled. This was the last of 79 actions which were filed in or (unless earlier terminated) transferred to the United States District Court for the Eastern District of Louisiana, instituted by or on behalf of purchasers and alleged purchasers of marine construction services in the United States and abroad, alleging a combination and conspiracy to restrain or eliminate competition in marine construction in violation of Sections 1 and 2 of the Sherman Act and various state laws through a conspiracy to allocate contracts, fix prices and contract terms and other means. The Delaware Company and International have paid a total of approximately $52,000,000 and $42,000,000, respectively, in settlement of purchasers' claims. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. PART II Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS International's Common Stock is traded on the New York Stock Exchange. High and low stock prices and dividends declared for the years ended March 31, 1986 and 1985 were as follows: QUARTER ENDED June 30, 1985 September 30, 1985 December 31, 1985 March 31, 1986 QUARTER ENDED June 30, 1984 September 30, 1984 December 31, 1984 March 31, 1985 FISCAL 1986 SALES PRICE CASH DIVIDENDS HIGH LOW DECLARED 28% 23% 26 16% 2014 16% 19% 13% $0.45 $0.45 $0.45 $0.45 FISCAL 1985 SALES PRICE CASH DIVIDENDS HIGH LOW DECLARED 31% 25 31 23% 30% 23% 3oye 23% $0.45 $0.45 $0.45 $0.45 As of March 31, 1986, the approximate number of record holders of common stock was 9.46*). Item 6. SELECTED FINANCIAL DATA 1986 For The Fiscal Years Ended March 31, 1985 1984 1983 (In thousands except for per share amounts) 1982 Revenues Income Before Extraordinary Items Net Income $ 3,257,095 S 3,233,871 $ 3,088,583 S 3,707,767 $ 4,843,186 $ 56,300 $ 18,980 $ 120,856 s 50,522 S 183,589 $ 59,089 $ 30,667 $ 120,856 $ 55,664 3 183,589 Earnings Per Share: Primary Before Extra ordinary Items Net Earnings $ 1.52 $ 0.51 $ 3.06 $ 1.37 $ 4.98 $ 1.60 $ 0.83 $ 3.06 $ 1.51 $ 4.98 Fully Diluted Before Extra ordinary Items Net Earnings $ 1.52 $ 0.51 $ 2.95 $ 1.37 $ 4.56 $ 1.60 $ 0.83 $ 2.95 $ 1.51 $ 4.56 Total Assets Long-Term Obligations $ 4,350,942 $ 4,180,684 $ 3,981,114 $ 3,820,689 $ 4,063,484 $ 913,260 $ 732,248 $ 621,045 $ 525,086 $ 419,259 Subsidiary's Redeemable Preferred Stocks 204,693 204,693 204,709 204,783 393,763 Total $ 1,117,953 $ 936,941 $ 825,754 $ 729,869 $ 813,022 Cash Dividends per common share $ 1.80 $ 1.80 $ 1.80 $ 1.80 $ 1.65 See Note 2 of notes to consolidated financial statements regarding the acquisition of Coutinho during fiscal year 1985, which was accounted for as a purchase and Note 4 regarding changes in actuarial assumptions for domestic pension plans during fiscal year 1986. 17 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS Results of Operations 1986 VS 19S5 Marine Construction Services' revenues decreased by $137,752,000 to $908,186,000 and operating loss increased by $21,903,000 to $30,196,000. The decreased revenues resulted from lower utilization of marine construction equipment worldwide and fabrication facilities in the foreign operations offset to a significant extent by favorable settlements of outstanding claims in foreign operations and increased fabrication revenues from domestic operations. The increase in operating loss resulted from foreign operations and was primarily due to the decreased revenues and lower profit margins, offset primarily by approximately $29,000,000 relating to the settlement of an outstanding claim and the reversal of certain provisions no longer required. This decline was further offset by an increase in domestic operating income due primarily to improved profit margins, improved contract performance and favorable offshore working conditions. Marine Construction Services benefited from reduced operating costs due to implementation of a cost reduction program and reduced pension expense of approximately $12,200,000, resulting from a change in actuarial assumptions for domestic pension plans. A surplus of oil and natural gas and uncertainty regarding the future prices of these resources resulted in continued reduced demand for Marine Construction Services. Consequently, overcapacity continued in all major activities and asset utilization remained at low levels. Power Generation Systems and Equipment revenues of $1,447,394,000 were $33,913,000 higher than last year. This was principally due to higher revenues from fossil plant enhancement and replacement parts, repair and alterations as well as higher revenues from microprocessor-based control systems and nuclear and other components for the U.S. Government. These higher revenues were partially offset by reduced activity on fossil steam and environmental control system fabrication and erection for electric utilities, lower revenues from nuclear fuel and services, heat exchangers and boiler-cleaning equipment. This segment reported operating income of $37,747,000 which was $22,402,000 higher than last year. The higher operating results were primarily due to a change in actuarial assumptions for domestic pension plans which reduced pension expense by approxi mately $27,500,000 (net of cost sharing formulas on certain contracts with the U.S. Government). In addition, operating income in fiscal 1986 improved from the contribution to profits as a result ofthe increased revenues from the utility parts and plant enhancement business and from microprocessor-based controls. Also, there was lower spending on coal-water fuel development and improved operating results on heat exchangers despite their lower volume. These positive factors were partially offset by the lower volume with reduced operating margins on fossil steam and environmental control systems and erection, significant costs associated with prototype small power plants, and the lower revenues from boiler-cleaning equipment. Also, there were increased expenditures related to development and marketing of cogeneration and refuse boilers, microprocessor-based control systems and construction services and an increase in insurance costs. In addition, in fiscal 1985 there were favorable contract adjustments to remaining nuclear steam systems as well as a favorable nuclear termination settlement. Engineered Materials' revenues of $310,814,000 decreased $74,778,000 compared to last year primarily due to lower shipments of alloy, mechanical and stainless tubing. Shipments were lower or flat in most other tubular product lines and revenues were depressed by pricing pressures in many of these product lines. Revenues from insulating products were higher due to increased ceramic fiber sales. An operating loss of $31,289,000 was incurred in fiscal year 1986 compared to a loss of $39,843,000 last year. Pension expense in fiscal 19S6 was reduced approximately $11,400.,000 due to a change in actuarial assumptions for domestic pension plans. In addition, in fiscal 1986 there were reductions in steel production, tube finishing and certain raw material costs and lower claims expense on welded tubing. These were more than offset by the lower volume and continuing pricing pressure for tubular products. Insulating products' profit was lower due to a strike in its Canadian operations which ended late in November and higher selling and administrative expenses. A cost-price squeeze induced by competitive pricing policies in the tubular markets that this segment serves and the lack of demand for pressure, mechanical, stainless and heat resistant tubing continues to be responsible for loss operations in tubular products. The Trading segment had revenues of $655,145,000 and operating losses of $536,000 compared to revenues of $435,924,000 and losses of$4,137,000 for last year. The revenue and operating results of Coutinho for the current year are included for a full twelve months as opposed to only a nine month period in the previous year as Coutinho was not consolidated until the quarter ended September 30,1984. After allowing for the above. Trading segment revenues increased over last year clue primarily to the addition of the new petrochemical business in the current fiscal year as well as an increase in steel and metal trading. These increased revenues were partially offset by reduced volume in the construction/engineering business. The decrease in operating loss was due primarily to favorable cost adjustments and the settlement of outstanding claims on certain construction contracts, partially offset by lower margins in steel and metal trading and start-up costs associated with the new petrochemical trading operations. Interest income as reported for fiscal year 1986 decreased $18,964,000 from fiscal year 1985 and interest expense increased $20,602,000 over the same period. The primary reason for the decline in interest income was $10,160,000 of interest income that was received from a joint-venture company in fiscal 1985. The remainder of the decrease was consistent with changes in McDermott International's investment portfolio during fiscal 1986 and changes in the interest rates that prevailed during the two year period. The increase in interest expense in fiscal 1986 over fiscal 1985 was consistent with McDermott International's debt and the interest rates prevailing thereon in the respective periods, as well as being affected by an increase of $6,173,000 during fiscal 1986 in the provision for interest on estimated income taxes. Other-net income for fiscal 1986 increased $76,546,000 over fiscal 1985. The primary reason for the increase was a $94,695,000 increase in the gain recognized from the sale ofgovernment obligations. In addition, the increase was affected by the payment in fiscal 1985 of$5,450,000 for fees relating to the termination ofan agency agreement and a decrease in bad debt expense from fiscal 1985 to fiscal 1986 of $4,510,000. The increase was partially offset by a $21,078,000 decline in gains from the disposal of assets, a $8,715,000 decrease from fiscal 1985 to fiscal 1986 in the amount realized from receivables previously deemed restricted because of foreign exchange controls. Expense for the settlement of certain antitrust civil litigation was $29,510,000 in fiscal 1986 compared with $31,299,000 in fiscal 1985. In fiscal 1986, benefit from income taxes decreased by $18,379,000 to $71,234,000. The decreased tax benefit arose primarily because International experienced lower pre-tax losses in jurisdictions where tax benefits exist. Extraordinary items net of tax were $2,789,000 in fiscal 1986 and $11,687,000 in fiscal 1985, due primarily to differences in utilization of certain operating loss carryforwards and a gain on extinguishment of certain debt. 1985 VS 1984 Marine Construction Services' revenues declined by $145,411,000 to $1,045,938,000 and operating income declined $99,414,000 to a loss of $8,293,000. These declines, were principally in the foreign operations and resulted from lower utilization of marine construction equipment. In addition, domestic operating income for fiscal 1985 was affected by significantly lower depreciation expenses due to the accelerated depreciation ofcertain construction equipment in the prior period due to its technical obsolescence and diminished cost effectiveness. This was offset by unfavorable offshore working conditions and terms of certain contracts, lower profit margins on certain other contracts, and high mobilization costs. Operating income was also adversely affected by unfavorable cost performance on certain fabrication contracts in both domestic and foreign operations. Power Generation Systems and Equipment revenues of$1,413,481,000 were $165,846,000 lower than in fiscal 1984. This was principally due to reduced activity on fossil systems fabrication and erection, and lower service activity related to nuclear systems partially offset by higher revenues from nuclear fuel assemblies and fossil service and replacement parts business. Operating income of $15,345,000 was $120,132,000 lower than the same period in fiscal 1984. The lower operating results were primarily due to the lower volume with reduced operating margins particularly on fossil system fabrication and erection contracts, lower nuclear services volume, increased expenditures related to development and marketing of coal-water fuel and microprocessor-based control sys tems, higher expenses related to automation projects, and increased provisions required for worker's compensa tion benefits. These were partially offset by the higher utility and industrial parts business and improved margins from nuclear and other components for the U.S. Government. Engineered Materials' revenues of $385,592,000 increased $11,814,000 compared to fiscal 1984, due primarily to higher revenues for seamless oil country tubular products and mechanical tubing partially offset by a decrease in pressure tubing. Revenues from insulating products were modestly higher primarily due to increased ceramic fiber sales. An operating loss of $39,843,000 was incurred in fiscal year 1985 compared to a loss of $19,222,000 in fiscal 1984. A cost-price squeeze induced by competitive pricing policies in the steel markets that this segment serves and the lack of demand for pressure, stainless and heat resistant tubing were responsible for the continuation of loss operations in tubular products. In addition, in fiscal 1985 tubular products experienced higher claims expense and additional provisions for worker's compensation benefits. These unfavorable factors were partially offset by a reduction in steel production costs and an improvement in insulating products margins. In addition, in fiscal 1984 certain expenses were incurred related to streamlining and modernization of certain tube making facilities and McDermott International obtained a favorable settlement of $5,750,000 for a business interruption insurance claim. 19 Trading revenues were $435,924,000, primarily attributable to Coutinho whose results of operations for the period April 1,1984 through December 31,1984 have been included in the results of McDermott International for fiscal 1985. Revenues from trading activities reflected a strong demand for commercial steel, non-precious metals, paper, and chemical products. However, competition in the market for construction and engineering projects and difficulties in arranging financing for available projects in certain developing countries, have resulted in a low volume of orders booked. The operating loss of $4,137,000 was primarily attributable to losses on certain turnkey engineering contracts partially offset by positive operating income from trading activities primarily in steel products. Interest income for fiscal year 1985 increased by $31,315,000 over fiscal year 1984 and interest expense for the fiscal year 1985 increased by $15,028,000 during the same period. The increase in interest income was consistent with changes in McDermott International's investment portfolio and the interest rates prevailing thereon as well as recognition of $10,160,000 for interest income on a note from a joint-venture company and $6,198,000 interest income on investments acquired in the Coutinho acquisition during fiscal 1985. The increase in interest expense was consistent with McDermott International's debt and the interest rates prevailing thereon in the respective periods. In addition there was $8,990,000 interest expense on debt incurred due to the acquisition of Coutinho. Other-net expense decreased by $16,156,000 in fiscal year 1985 over fiscal year 1984. This was primarily due to a decrease between periods of$37,591,000 in provisions for facility closings and disposition of product lines, most of which related to facilities in power generation systems and equipment and engineered materials. In addition, in fiscal 19S5 there was income of $25,570,000 related to the net gain on disposal of assets, the realization of $9,825,000 from receivables previously deemed restricted because cfforeign exchange controls, and a decrease in expense related to foreign exchange transactions of $9,688,000. These increases were partly offset by a net decrease between the periods of $40,198,000 in net gain on the sale of securities, a net increase in expense in fiscal year 1985 of $14,710,000 for the settlement of certain antitrust civil litigation and a decrease between the two periods of $9,813,000 due to income which was recorded in fiscal year 1984 for the settlement of pending litigation and claims involving a certain nuclear fuel contract. In addition there was a decrease of $4,724,000 in royalty income in fiscal year 1985 and other-net expense for fiscal year 1985 included $5,450,000 for fees relating to the termination of an agency agreement. In fiscal 1985, benefit from income taxes was $89,613,000 compared with aprovision for income taxes of$4,542,000 in the previous year. The increased tax benefit arose because International experienced tax benefits in jurisdic tions where pre-tax losses occurred, and decreased profits which were dispersed among jurisdictions with varying rates of taxation. Net income from extraordinary items increased by $11,687,000 in fiscal 1985 as compared to fiscal 1984 due primarily to a gain on extinguishment of certain debt and utilization of certain operating loss carryforwards. Impact of Changing Prices on Revenues and Net Income As a result of inflation, historical dollar accounting (as reflected in the financial statements) does not reflect the cumulative effect of increasing costs and changes in the purchasing power of the dollar. The effects of changing prices and their impact upon McDermott International and its reported results are shown pursuant to FASB Statement No. 33 (as amended by FASB Statement No. 82) in Note 12 of notes to the consolidated financial statements. Liquidity and Capital Resources At March 31, 1986, McDermott International's working capital was $1,258,000, a decrease of $116,708,000 from March 31, 1985. Principal movements in working capital were an increase of $117,728,000 in notes payable and current maturities of long-term debt due primarily to conversion of the Delaware Company's revolving credit agreement to term debt and $61,434,000 of short-term reverse repurchase agreements which were entered into during the fiscal year. In addition, there was a decrease of$35,308,000 in accounts and notes receivable reflecting reduced activity in marine construction services and a decrease of $16,611,000 in inventories due primarily to completion of a planned inventory reduction program in tubular products. These negative movements in working capital were partially offset by a decrease of $43,305,000 in accrued liabilities-other due primarily to payment of certain antitrust civil litigation expense which was accrued at March 31,1985 and a net increase of $41,428.000m contracts in progress and advance billings on contracts. International has available to it a short-term line of credit with various banks which was reduced from $90,090,000 to $85,000,000 during fiscal 1986. As of March 31, 1986 there were no borrowings against this line of credit. 20 During fiscal 1986, International entered into a $51,422,000 short-term reverse repurchase borrowing agreement whereby $44,150,000 par value of its portfolio of government obligations was committed, and the Delaware Company entered into a similar agreement for $10,012,000 whereby $8,600,000 par value of its portfolio of government obligations was committed.. Proceeds from these agreements were used to pay down existing balances on short-term lines of credit and for general corporate purposes. In fiscal 1985, McDermott International arranged a short-term line of credit facility totalling $100,539,000 with a foreign bank in connection with the acquisition of Coutinho. Borrowings against this line of credit at March 31, 1986 were $93,531,000. In addition, Coutinho has available to it various short-term lines of credit from various banks which increased from approximately $121,000,000 to $136,000,000 during fiscal 1986. At March 31,1986, the amounts outstanding on these facilities totalled $19,957,000, a decrease of $11,537,000 from March 31, 1985. The Delaware Company has available to it from various banks ashort-term line of credit which was reduced from $93,000,000 to $60,000,000 during fiscal 1986. As of March 31,1986, borrowings against this line of credit totalled $6,700,000 a decrease of $15,900,000 from March 31,1985. During fiscal 1986, the Delaware Company's revolving credit agreement with various banks converted to a $200,000,000 term loan. The term loan is repayable in sixteen equal quarterly installments on March 31, June 30, September 30, and December 31. The first such installment was paid on December 31,1985 and the final installment is due September 30,1989. The term loan bears interest at the applicable rate of A of 1% plus the prime rate, % of 1% plus LIBOR or % of 1% plus the certificate of deposit rate, as elected by the Delaware Company. As of March 31,1986, $175,000,000 was outstanding under the facility at an interest rate of-8.31%. The Delaware Company and its subsidiaries are limited, principally as a result of credit agreement covenants, in their ability to transfer funds to International in intercompany loans, advances or cash dividends. At March 31,1986 approximately $811,995,000 of the net assets of the Delaware Company and its subsidiaries were subject to such restrictions. It is not expected that these restrictions will have any significant effect on International's liquidity. During the fiscal year ended March 31, 1986, McDermott International's outstanding borrowings under its short-term lines of credit averaged $198,476,000. During fiscal 1985, McDermott International arranged a$157,000,000 fourteen and one half-year term loan facility at an interest rate of 10.375% which has been used to finance certain capital expenditures. The loan is secured by a portion of McDermott International's portfolio of government obligations which must amount to a fair market value of at least $108,645,000. At March 31,1986, this facility was fully drawn down, an increase of $139,005,000 during the fiscal year. During fiscal 1986, International entered into two separate long-term debt arrangements with two banks totalling $26,500,000 and $25,250,000 at interest rates of % of 1% plus LIBOR, and % of 1% plus LIBOR respectively. During fiscal 1986, these facilities were fully drawn down and proceeds were used to finance certain foreign operations. Also, during fiscal 1986, the Delaware Company entered into a $50,000,000 long-term floating rate debt agreement with a U.S. bank at an interest rate equal to the daily Federal Funds Rate plus 0.75%. Proceeds from this loan were applied against exisiting debt. During fiscal 1986, the Delaware Company obtained the approval ofthe holders ofover 66%% principal amount of its 9%% Debentures Due March 15, 2004 to amend the Indenture under which such Debentures were issued. In conjunction therewith, approximately $46,697,000 principal amount of Debentures were tendered at a price of $980 net per $1,000 principal amount, plus accrued interest in cash. The amendment to the Indenture altered the restrictions on payment by the Delaware Company of dividends and other payments with respect to its capital stock. McDermott International has committed to make capital expenditures of $80,236,000 during fiscal 1987. These proposed expenditures are principally to increase capacity and upgrade and modernize McDermott Interna tional's marine fleet and its fabrication facilities. McDermott International expects to obtain funds for these expenditures from its operations and through borrowings. For the fiscal year ended March 31,1986, working capital provided from operations was $109,318,000. During this same period, McDermott International expended $298,884,000 for additions to property, plant and equipment and S66,533,000 for cash dividends on common stock. McDermott International maintains an investment portfolio ofprimarily government obligations which is held for long-term investment purposes. During the year, McDermott International increased this portfolio (net) by $121,586,000 to an amortized cost at March 31, 1986 of $1,098,792,000 with a market value of $1,334,343,000. At March 31, 1986 the ratio of long-term debt to total common stock and other stockholders' equity was .76 as compared with .61 at March 31, 1985 and .50 at March 31, 1984. Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Company Report on Consolidated Financial Statements McDermott International has prepared the consolidated financial statements and related financial information included in this report. McDermott International has the primary responsibility for the financial statements and other financial information and for ascertaining that the data fairly reflect the financial position and results of operations of McDermott International. The financial statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily reflect estimates and judgments by appropriate officers of McDermott International with appropriate consideration given to materiality. McDermott International believes that it maintains a system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded against loss or unauthorized use and that the financial records are adequate and can be relied upon to produce financial statements in accordance with generally accepted accounting principles. The concept of reasonable assurance is based on the recognition that the cost ofa system of internal control must not exceed the related benefits. Although accounting control procedures are designed to achieve these objectives, it must be recognized that errors or irregularities may nevertheless occur. McDermott International seeks to assure the objectivity and integrity ofits accounts by its selection ofqualified personnel, by organizational arrangements that provide an appropriate division of responsibility and by the establishment and communication of sound business policies and procedures throughout the organization. McDermott International believes that its accounting controls provide reasonable assurance that errors or irregularities that could be material to the financial statements are prevented or would be detected. McDermott International's accompanying consolidated financial statements have been examined by its certified public accountants, who provide McDermott International with expert advice on the application of U.S. generally accepted accounting principles to McDermott International's business and also provide an objective assessment of the degree to which McDermott International meets its responsibility for the fairness of financial reporting. They regularly evaluate the system of internal accounting controls and perform such tests and other procedures as they deem necessary to reach and express an opinion on the fairness ofthe financial statements. The report of the certified public accountants appears elsewhere herein. The Board of Directors pursues its responsibility for McDermott International's consolidated financial state ments through its Audit Committee which is composed solely of directors who are not officers or employees of McDermott International. The Audit Committee meets periodically with the certified public accountants, management and the internal auditors to review matters relating to the quality of financial reporting and internal accounting control and the nature, extent and results of the audit effort. In addition, the Audit Committee is responsible for recommending to the Board of Directors the engagement of certified public accountants for McDermott International, who in turn submit the engagement to the stockholders for their approval. The certified public accountants, as well as the internal auditors, have free access to the Audit Committee. May 23, 1986 22 Report of Certified Public Accountants The Board of Directors and Stockholders McDermott International, Inc. We have examined the accompanying consolidated balance sheet of McDermott International, Inc. at March 31, 19SG and 1985. and the related consolidated statements of income and retained earnings and changes in financial position for each ofthe three years in the period ended March 31,1986. Our examinations were made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. In our report dated May 28,1985, our opinion on the 1985 consolidated balance sheet was qualified as being subject to the effects of such adjustments, if any, as might have been required had the outcome of certain litigation been known. As explained in Note 7 to the financial statements, the litigation was settled during 1986. Accordingly, our present opinion on the 1985 consolidated balance sheet, as presented herein, does not include the qualification. In our opinion, the financial statements mentioned above present fairly the consolidated financial position of McDermott International, Inc. at March 31,1986 and 1985, and the consolidated results of operations and changes in financial position for each of the three years in the period ended March 31,1986, in conformity with generally accepted accounting principles applied on a consistent basis during the period. ARTHUR YOUNG & COMPANY New Orleans. Louisiana May 23, 19S6 23 mcdermott international, inc. CONSOLIDATED BALANCE SHEET MARCH 31, 1986 and 1985 ASSETS Current Assets: Cash Short-term investments, principally time deposits at cost which approximates market Account0 and notes receivable Income taxes refundable Contracts in progress Inventories Prepaid expenses Total Current Assets Property, Plant and Equipment, at Cost: Land Buildings Machinery and equipment Property under construction Less accumulated depreciation and amortization Net Property, Plant and Equipment Investments in Government Obligations, at Amortized Cost Excess of Cost Over Fair Value of Net Assets of Purchased Businesses Less Accumulated Amortization of $80,604,000 at March 31, 1986 and $69,315,000 at March 31,1985 Other Assets TOTAL See accompanying notes to consolidated financial statements. 1986 ___ 19S5 (In thousands) $ 21,272 $ 20,341 85,127 817,064 8,753 296,811 236,692 33,883 1,499,602 91,752 852,372 94,644 268.692 258.303 22,034 1,603.138 30,101 258,933 2,036,901 90,358 2,416,293 1,110,361 1,305,932 30.037 247.545 1,771.250 91.451 2,140.283 986.625 1,153.658 1,098,792 977.206 345,257 101,359 $ 4,350,942 345.590 101.092 S 4,180.684 24 LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Notes payable and current maturities of long-term debt Accounts payable Accrued employee benefits Accrued interest payable Accrued liabilities - other Advance billings on contracts Provision for warranty expense U. S. and foreign income taxes Dividends payable Total Current Liabilities Deferred and Non-Current Income Thxes Long-Term Debt Other Liabilities Contingencies Minority Interest: Subsidiary's Redeemable Preferred Stocks: Series A $2.20 cumulative convertible, $1.00 par value; at redemption value Series B $2.60 cumulative, $1.00 par value; at redemption value Other minority interest Total Minority Interest Pieferred Stock Common Stock and Other Stockholders' Equity: Common stock, par value $1.00 per share, authorized 150,000,000 shares; outstanding 36,973,724 at March 31, 1986 and 36,936,524 at March 31,1985 Capital in excess of par value Retained earnings Cumulative foreign exchange translation adjustments Total Common Stock and Other Stockholders' Equity TOTAL 1986 (in thousands) 1985 $ 263,549 282,806 118,266 123,204 307,554 176,305 69,513 140,509 16,638 1,498,344 391,916 913,260 133,949 $ 145,821 286,967 127,840 98,395 350,859 189,614 78,027 191,027 16,622 1,485,172 414,252 732,248 135,970 88,300 116,393 4,407 209,100 _ 88,300 116,393 5,440 210,133 _ 36,974 313,990 885,436 (32,027) 1,204,373 $ 4,350,942 36,936 313,223 892,880 (40,130) 1,202,909 $ 4,180,684 25 McDermott international, inc. CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE THREE FISCAL YEARS ENDED MARCH 31. 1986 1986 _ _L9S2 On thmisan(i>`i 1984 Revenues Costs and Expenses: Cost of operations Depreciation and amortization Selling, general and administrative expenses Operating Income (Loss) Other Income (Expense): Interest income Interest expense Equity in earnings of jointventure companies Other-net Income (Loss) Before Provision For Income Tkxes, Minority Interest and Extraordinary Items Provision for (Benefit from) Income Taxes: Current Deferred Income Before Minority Interest and Extraordinary Items Minority Interest: Dividends on preferred stock of subsidiary Other minority interest Income Before Extraordinary Items Extraordinary Items, net of income taxes Net Income Retained Earnings, Beginning of Year Deduct: Cash dividends - common (per share, $1.80 in 1986, 1985 and 1984) Retained Earnings, End of Year Earnings Per Common and Common Equivalent Share*. Primary Before Extraordinary Items Extraordinary Items Net Earnings Fully Diluted Before Extraordinary Items Extraoixlinary Items Net Earnings $ 3,257,095 8 3,233,871 $ 3,0SS,5S3 2,879,638 157,798 307,947 3,345,3S3 (88,288) 2,892,930 148,946 300.774 3,342,650 (108,779) 2,48S,71S 180,985 297.997 2,967,700 I20.S83 126,697 (116,371) 2,126 75,652 88,104 145.661 (95,769) 4,488 (S94) 53.486 114.346 (80.741) 3.218 (17.050) 19.773 (184) (55.293) 140,656 (48,242) (22,992) (71,234) (SO,372) (9.241) (89.613) (87.044) 91.586 4.542 71,050 34.320 136.114 15,900 (1,150) 56,300 2,789 59,089 892,880 15.901 (561) 18,980 11.687 30.667 928.686 15.905 (647) 120.856 __ 120.856 S74.209 66,533 $ 885,436 66.473 S 892.880 66.379 $ 928.686 $ 1.52 8 0.51 $ 3.06 0.08 0.32 -- $ 1.60 S 0.83 $ 3.06 $ 1.52 s 0.51 $ 2.95 0.08 0.32 ____ $ 1.60 s 0.83 $ 2.95 See accompanying notes to consolidated financial statements. McDermott international, inc. CONSOLIDATED STATEMENT OF CHANGES IN FINANCIAL POSITION FOR THE THREE FISCAL YEARS ENDED MARCH 31, 1986 1986 19S5 SOURCE OF FUNDS: Operations: (In thousands) Income before extraordinary items Charges (credits) not affecting working capital: S 56,300 $ 1S.9S0 Depreciation and amortization Deferred income taxes Equity in earnings of joint-venture companies, net of dividends received of $2,795,000 in 1986, $5,835,000 in 1985, and $4,260,000 in 1984 Tax benefit of operating loss carryforwards Gain on sales of government obligations Other-net 157,798 (6,718) 669 2,579 (94,712) (6,598) 14S.946 70,823 1,347 1,725 (17) (38,447) Working capital provided from operations excluding extraordinary gain Extraordinary gain Issuance of common stock Proceeds from sale and exchange of property, plant and equipment Long-term borrowing (including fluctuations 109,318 210 627 11,965 203,357 9,962 798 39,428 under the revolving credit agreement) Reduction in non-current assets and liabilities resulting from exchange rate changes Foreign currency translation adjustments Other - net 386,068 -- 8,103 5,553 431,183 20,131 -- 9,599 $ APPLICATION OF FUNDS: Purchase of government obligations - net Additions to property, plant and equipment Reduction of long-term debt (including fluctuations under the revolving credit agreement) Reduction of non-current income taxes Cash dividends Increase in non-current assets and liabilities resulting from exchange rate changes Acquisition of Coutinho: Non-current assets, principally property, plant and equipment and goodwill Non-current liabilities, principally long-term debt and pension liability Foreign currency translation adjustments 521,844 26,874 298,884 205,879 15,618 66,533 24,764 -- -- -- 714,458 80,727 172,349 343,585 23,327 66,473 -- 99,690 (36,775) 14,409 NET INCREASE (DECREASE) IN WORKING CAPITAL 638,552 763,785 $ (116,708) $ (49,327) $ CHANGES IN COMPONENTS OF WORKING CAPITAL: Increase (decrease) in current assets: Cash and short-term investments Accounts, notes and income tax refund receivable Contracts in progress Inventories Prepaid expenses $ (5,694) $ (121,199) 28,119 (16,611) 11,849 (58,707) 48,050 28,658 19,143 4,628 $ (103,536) 41,772 Increase (decrease) in current liabilities: Notes and accounts payable and accrued liabilities Advance billings on contracts Provision for warranty expense U.S. and foreign income taxes Dividends payable 85,497 (13,309) (8,514) (50,518) 16 225,957 (35,308) (22,892) (76,676) 18 13,172 91,099 NET INCREASE (DECREASE) IN WORKING CAPITAL $ (116,708) $ (49,327) $ 19S4 120,856 180,9S5 26,908 1,042 _ (40,216) 36,582 326,157 _ 916 16,863 175,506 22,235 -- 36,375 578,052 167,661 147,875 80,187 2,268 66,379 -- -- -- 25,721 490,091 87,961 27,242 123,153 (19,928) (33,108) 2,109 99.468 36,417 (97,243) 4,556 67,761 16 11,507 87,961 See accompanying notes to consolidated financial statements. McDermott international, inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE FISCAL YEARS ENDED MARCH 31, 1986 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements are presented in U.S. Dollars in accordance with accounting principles generally accepted in the United States and include the accounts of McDermott International, Inc. and all significant subsidiaries. Investments in joint-venture companies (20% to 50% owned) are accounted for on the equity method. All significant intercompany transactions and accounts have been eliminated. Unless the context otherwise requires, hereinafter "International" will be used to mean McDermott Interna tional, Inc., a Panama corporation, the "Delaware Company" will be used to mean McDermott Incorporated, a Delaware corporation, which is a subsidiary of International, and "McDermott International" will be used to mean the consolidated enterprise. Certain amounts previously reported have been reclassified to conform with the presentation at March 31,19$6. Contracts and Revenue Recognition Contract revenues and related costs for marine construction services, power generation systems and equipment, and the engineering and construction services of the trading segment of McDermott International are principally recognized on a percentage of completion method for individual contracts or components thereof based upon work performed or the ratio of costs incurred to total estimated costs, as applicable to the product or activity involved. Revenues and related costs so recorded, plus accumulated contract cost that exceeds amounts invoiced to customers under the terms ofthe contract are included in contracts in progress. Billings that exceed accumulated contract costs and revenues and costs recognized under percentage ofcompletion are included in advance billings. Most long-term contracts have provisions for progress payments. Contract price and cost estimates are reviewed periodically as the work progresses and adjustments proportionate to the percentage of completion are reflected in income in the period when such estimates are revised. There are no unbilled revenues which will not be billed. Provisions are made currently for all known or anticipated losses. Claims for extra work or changes in scope of work are included in contract revenues when collection is probable. International and certain of its subsidiaries keep books and file tax returns on the completed contract method of accounting. Included in Contracts in Progress are: 1986 19S5 (In thousands) Costs incurred less cost of revenue recognized Revenues recognized less billings to customers Contracts in Progress Included in Advance Billings on Contracts are: $ 188,907 107,904 $ 296,811 5 153.9S5 114.707 S 268,692 Billings to customers less revenues recognized Cost of revenues recognized less costs incurred Advance Billings on Contracts $ 221,776 (45,471) $ 176,305 S 226.056 (36.442) $ 189.614 McDermott International is usually entitled to financial settlements relative to the individual circumstances of deferrals or cancellations of power generation systems and equipment contracts. McDermott International does not recognize such settlements or claims for additional compensation until final settlement is reached. Included in accounts and notes receivable are amounts representing retainages on contracts as follows: 1986 1985 (In thousands) Retainages$ 179,346S 172.093 :3 Retainages expected to be collected after one year $ 74,131 $ 72.S59 Revenues for trading are recognized as individual trades are completed. For trades-in-progress, provisional billings to customers net of costs incurred are carried in the current liabilities section of the balance sheet as advance billings on contracts. Depreciation. Maintenance and Repairs and Drydocking Expenses Property, plant and equipment is depreciated on the straight-line method, using estimated economic useful lives of 8 to 40 years for buildings and 2 to 28 years for machinery and equipment. Maintenance, repairs and renewals which do not materially prolong the useful life of an asset are expensed as incurred except for drydocking costs for the marine fleet, which are estimated and accrued over the period oftime between drydockings, and such accruals are charged to operations currently. Investments in Government Obligations At March 31, 1986 McDermott International held $1,098,792,000 (amortized cost) of primarily government securities as a long-term investment, as compared to $977,206,000 (amortized cost) at March 31,1985. The market value of these securities was $1,334,343,000 and $965,361,000 at March 31,1986 and March 31,1985, respectively. The face amount at March 31, 1986 was $1,077,300,000. Amortization of Excess of Cost Over Fair Value of Net Assets of Purchased Businesses The excess of the cost of McDermott International's investments in The Babcock & Wilcox Company (B&W) and Coutinho, Caro & Co. KGaA ("Coutinho") over the fair value of net assets acquired is being amortized on a straight-line basis over forty years and twenty years, respectively. Excess cost arising from business combina tions prior to 1971 which amounts to $6,264,000, is not being amortized because, in the opinion of management, there has been no diminution in value. Warranty Expense McDermott International provides for estimated future warranty expense which may be required to satisfy contractual requirements, primarily of the power generation systems and equipment segment. Such provisions are accrued relative to revenue recognition on the respective contracts. In addition, specific provisions are made where the costs of warranty are expected to significantly exceed such accruals. Research and Development The cost of research and development which is not performed on specific contracts is charged to operations as incurred. Such expense was $34,600,000, $41,100,000 and $34,600,000 in fiscal 1986,1985 and 1984, respectively. In addition, expenditures on research and development activities of approximately $53,400,000, $41,600,000 and $27,000,000 in fiscal 1986,1985 and 1984, respectively, were paid for by customers of McDermott International. Capitalization of Interest Cost In fiscal 19S6.1985 and 1984 total interest cost incurred was $130,258,000,J100,036,000 and $88,159,000, respec tively, of which $13,887,000, $4,267,000 and $7,418,000 was capitalized. Foreign Currency Translation Effective April 1, 1983, McDermott International adopted FASB Statement No. 52, on Foreign Currency Translation. Under that Statement, for certain foreign operations, all balance sheet accounts other than stock holders' equity are translated into U.S. Dollars at current exchange rates, and income statement items are translated at average exchange rates for the year; resulting translation adjustments are recorded in a separate component of stockholders' equity. Certain other foreign currency transaction adjustments continue to be reported in income. The impact of adopting FASB Statement No. 52 in fiscal 1984 was not material. Included in other income (expense) are transaction losses of $9,028,000, $5,645,000 and $15,334,000 for fiscal 1986,1985 and 1984, respectively. 29 Adoption of the Statement resulted in establishing a cumulative foreign exchange translation adjustments account as part of stockholders' equity. The analysis of changes in this account is as follows: (In thousands) Balance March 31,1983 Adjustments to opening balance at April 1, 19S3 Translation adjustments for fiscal 1984___________________________________________________ $-- (17,885) ______ (7,836) Balance March 31, 1984 (25.721) Translation adjustments for fiscal 1985_____________________________________________________________(14,409) Balance March 31, 1985 (40.130) Translation adjustments for fiscal 1986__________________________________________________________ 8.103 Balance March 31, 1986$ (33.027) Earnings Per Share Primary earnings per share are based on the weighted average number ofcommon and common equivalent shares outstanding during the year. Fully diluted earnings per share include the dilutive effect of convertible preferred stock, debentures and warrants. NOTE 2 - ACQUISITION On April 10, 1984, International acquired Coutinho in a business combination accounted for as a purchase. The total cost of acquisition was $80,798,000, which exceeded the fair value of the net assets of Coutinho by $42,646,000, based on exchange rates in effect at March 31,1984. In order to provide for a timely consolidation. Coutinho's assets and liabilities at December 31,1985 and 1984 have been included in McDermott International's Consolidated Balance Sheets at March 31,1986 and 1985, respectively. The operations of Coutinho for the periods January 1, 1985 through December 31, 1985 and April 1, 1984 through December 31,1984 have been included in McDermott International's Consolidated Statement of Income and Retained Earnings for the fiscal years 1986 and 1985, respectively. Assuming that Coutinho had been acquired at the beginning of fiscal 1984, unaudited pi*oforma combined revenues would have been $3,348,189,000 and $3,669,124,000 in fiscal 1985 and 1984, respectively. Combined proforma earnings and earnings per share would not have been materially different from the reported amounts. NOTE 3 - INVENTORIES Inventories are carried at the lower of cost or market. Cost is determined on an average cost basis except for certain materials inventories, for which the last-in first-out (LIFO) method is used. The cost of approximately 35% and 6% of total inventories was determined using the LIFO method at March 31,19S6 and March 31.1985. respectively. Consolidated inventories at March 31, 1986 and 1985 are summarized below: Raw Materials and Supplies Work in Progress 1986 1965 (in thousands) $ 64,686 $ S2.419 97,414 112.192 Finished Goods74,59258.692 $ 236,692$ 253.303 NOTE 4 - PENSION PLANS AND POSTRETIREMENT BENEFITS Pension Plans - McDermott International provides retirement benefits, primarily through non-contributory pension plans, for substantially all of its regular full-time employees, except certain non-resident alien employees of foreign subsidiaries who are not citizens of a European Common Market country or who do no: earn income in the United States, Canada, or the United Kingdom. McDermott International's policy had been to fund the amounts expensed. Its current policy is to.fund applicable pension plans to meet the minimum funding require ments of the Employee Retirement Income Security Act of 1974 (ERISA) and, generally, to fund other pension plans as recommended by the respective plan actuary and in accordance with applicable law. Tbtal pension expense was $1,970,000, $68,657,000 and $72,194,000 in fiscal 1986, 1985 and 1984, respectively, which includes amortization of prior service costs over periods of 30 and 40 years. Based upon a comprehensive study of actuarial assumptions, effective January 1, 1985 (the beginning of each ERISA plan's fiscal year), the actuarial investment rate of return assumptions and the actuarial salary increase assumptions were changed to reflect more closely the past and expected experience of such ERISA plans. The effect of the above changes was to reduce fiscal 19S6 pension expense by approximately $56,300,000, which includes $15,895,000 accrued in fiscal year 1985, and to increase net income by approximately $29,300,000 or $0.79 pei- share. The following table presents information regarding the financial condition of McDermott International's pension plans as defined in FASB No, 36 and estimated by McDermott International and its consulting actuaries on that basis: January 1, 1985 1984 (In thousands) Actuarial present value of accumulated plan benefits: Vested Nonvested Total Net assets available for benefits $ 653,089 66,867 $ 719,956 $ 1,032,165 $ 618,132 76,182 $ 694,314 $ 944,724 In the above table, the assumed rate ofreturn used in determining the actuarial present value ofaccumulated plan benefits was principally at January 1, 1985 and principally 9% at January 1, 1984. In December 1985, the two principal ERISA pension plans were amended to provide that, subject to certain limitations, any excess assets in such plans would be used to increase pension benefits if certain events occurred within a 60 month period following a change in control of International. Postreti rement Health Care and Life Insurance Benefits - McDermott International offers postretirement health care and life insurance benefits to substantially all of its retired regular full-time employees, except certain non-resident alien retired employees who are not citizens of a European Common Market country or who, while employed, did not earn income in the United States, Canada or the United Kingdom. McDermott International shares the cost of providing these benefits with all affected retirees. McDermott International's cost ofproviding such benefits is recognized by expensing the insurance programs' premiums and the self-insured programs' claims as paid. The aggregate amount so expensed totalled $10,755,000, $8,503,000 and $6,754,000 in fiscal years 1986, 1985 and 19S4, respectively. McDermott International has made no provision for recognizing the cost of postre tirement benefits which may eventually be paid to employees who have not yet retired. NOTE 5 - INCOME TAXES Income taxes have been provided based upon the tax laws and rates in the countries in which operations are conducted. Ail income has been earned outside of Panama and McDermott International is not subject to income tax in Panama on income earned outside of Panama. Therefore, there is no expected relationship between the provision for, or benefit from, income taxes and income, or loss, before income taxes. The major reasons for the variations in such relationships is that income is earned within and subject to the taxation laws of various countries, each of which has a regime of taxation which varies from that of any other country (not only with respect to nominal rate but also with respect to the allowability of deductions, credits and other benefits) and because the proportional extent to which income is earned in, and subject to tax by, any particular country or countries varies from year to year. The provision for (benefit from) income taxes consists of: 1986 Current Deferred U.S. - Federal $ (49,789) U-S. - State & Local (4,510) Other than U.S. 6,057 $ (48,242) S (31,232) 4,042 4,198 $ (22.992) 1985 Current Deferred (In thousands) $ 008,851) $ 9,133 2,239 26,240 $ (80,372) (3,926) (14,448) $ (9,241) 1984 Current Deferred $ (131,657) (6,815) 51,428 $ (87,044) $ 69,199 10,589 11,798 $ 91,586 31 The provision for (benefit from) income taxes is based on income before provision for income taxes as follows: 1986 u.s. Other than U.S (194,785) 194,601 ________________________________________________ $ (184) 1985 (In thousands) ___ 1984 $ (224,916) 169,623 $ (128,431) 2(59.087 $ (55.293)___ $ 140,656 U.S. Federal tax credits, principally investment tax credits, are accounted for on the flow-through method. Amounts utilized in fiscal 1986,1985and 1984, were $9,916,000, $6,445,000and $12,609,000, respectively. For U.S. Federal income tax purposes, a net operating loss of $11,100,000 and tax credits, principally investment tax credits, of $58,600,000 at March 31, 1986 are available to reduce taxes payable through 2001. Extraordinary items in 1986 and 1985 include tax benefits of$2,579,000 and $1,725,000, respectively, arising from the utilization of operating loss carryforwards. See Note 6 regarding income taxes provided on extraordinary gains arising from extinguishment of debt. Deferred income taxes are provided in the financial statements due to timing differences between financial and taxable income. The principal timing differences in recognizing certain revenues, expenses and tax credits for tax return and financial statement purposes and their effect on the provision for deferred income taxes were: 1986 1985 (In thousand*:) 1984 Excess tax over financial depreciation Interest capitalized on self-constructed assets Long-term contracts, primarily on the completed contract method for tax purposes Warranty expense Reserve for loss on facility closings and dispositions Interest on proposed tax deficiencies Self insurance Antitrust settlements Supplemental compensation Pension expense Purchased tax benefits Deferred loss on casualty State tax loss carryforwards net of federal tax Tax credits Other $ 35,495 1,196 $ 33,612 1,408 $ 21.615 3.517 (11,421) 2,107 4,258 (11,659) (3,936) 133 (4,203) 8,848 4,284 -- 1,071 (50,047) 882 $ (22,992) (22,06D 8,903 5,600 (6,9901 (9,2951 -- 552 (25,574) 6,520 -- (3,2071 -- 1.291 $ (9.24D 71.482 (7.6501 ($.(>171 (10.83U (8401 4.074 (1.7211 11.471 10.856 (8.0151 ____ -- 0.275 $ 91.588 The Internal Revenue Service has issued notices for years prior to March 31,1983 and a draft report for the year ended March 31,1983 all ofwhich propose substantial additional taxes. McDermott International believes that the outcome of any income taxes ultimately assessed will not have a material adverse effect on its consolidated financial statements. 12 NOTE 6 * LONG-TERM DEBT AND NOTES PAYABLE Long-term debt consists of: Unsecured Debt: S.27# Note due 1991 with annual sinking fund installments of $15,000,000 beginning 1989 10.20# Sinking fund debentures due 1999 with annual sinking fund installments of $2,500,000 10# Subordinated debentures ($149,921,000 face amount in 1986) due 2003 with annual sinking fund installments of $15,000,000 beginning 1994 9%# Debentures due 2004 6.80# Pollution control revenue bonds due 2009 with annual sinking fund installments of $4,250,000 beginning 2006 8V6# Note payable $3,960,000 annually to 1997 9# Note payable $3,300,000 annually to 1991 9# Note payable $1,650,000 annually to 1996 Floating rate note, due four hundred calendar days after demand, interest at daily federal funds rate plus 1.10# (9.16# inclusive at March 31, 1986) Floating rate notes ($150,000,000 face value), interest at LIBOR plus 0.125# (7.625# inclusive at March 31, 1986) due 1992 Floating rate note, due four hundred calendar days after demand, interest at daily federal funds rate plus 0.75# (8.75# inclusive at March 31, 1986) Floating rate note, interest at LIBOR plus 0.75% (8.75# inclusive at March 31, 1986) due 1989 Floating rate note, interest at LIBOR plus 0.5# (8.50# inclusive at March 31,1986) due 1988 Term loan (line of credit revolver loan in fiscal 1985) Other notes payable through 2009 Secured Debt: 10.375# Note payable Capitalized lease obligations Other notes payable through 1996 Less due within one year 19S6 1985 (In thousands) $ 45,000 37,450 $ 45,000 37,550 126,247 6,718 125,426 53,415 17,000 44,160 20,300 18,400 17,000 48,120 23,600 20,050 35,000 149,522 35,000 149,438 50,000 26,500 25,250 175,000 21,568 -- -- 124,000 17,017 157,000 17,514 13,387 986,016 72,756 $ 913.260 17,995 18,496 14,192 746,299 14,051 $ 732,248 33 During fiscal 1986, the Delaware Company's revolving credit agreement with various banks converted to a $200,000,000 term loan. The term loan is repayable in sixteen equal quarterly installments on March 31, June 30, September 30, and December 31. The first such installment was paid on December 31, 1985 and the final installment is due September 30, 1989. The term loan bears interest at the applicable rate of 'U of 1% plus the prime rate, % of 1% plus LIBOR or % of 1% plus the certificate of deposit rate, as elected by the Delaware Company. As of March 31, 1986, $175,000,000 was outstanding, at an interest rate of 8.31%. McDermott International's $157,000,000 long-term loan at an interest rate of 10.375% is secured by a portion of McDermott International's portfolio of government obligations which must amount to a fair market value of at least $108,645,000. The principal is repayable in twenty ascending payments commencing in fiscal 1989. During fiscal 1986, the Delaware Company redeemed at a discount $46,697,000 principal amount of its 9->s Debentures. This purchase in fiscal 1986 resulted in an extraordinary gain of$210,000, net of current income taxes of $179,000. A purchase of 9%% Debentures together with a minor debt extinguishment in fiscal 1985 resulted in an extraordinary gain of $9,962,000 net of current taxes of $8,486,000. Maturities of long-term debt during the five fiscal years subsequent to March 31, 1986 are as follows: 19S7 $72,756,000; 1988 - $68,966,000; 1989 - $112,305,000; 1990 - $92,263,000; 1991 - $41,985,000. Certain consolidated subsidiaries and affiliated companies are restricted, principally as a result of credit agree ment covenants, in their ability to transfer funds to International through intercompany loans, advances or cash dividends. At March 31, 1986, approximately $811,995,000 of the net assets of such subsidiaries and affiliated companies were subject to such restrictions. It is not expected that these restrictions wili have any significant practical effect on International's liquidity. A certain debt agreement contains among other things, requirements as to maintenance of net worth and limitations on the incurrence offuture borrowings. Under the most restrictive of these requirements at March 31. 1986, future borrowings were restricted in an amount equal to $60,499,000. International and certain of its subsidiaries at March 31,1986 had available unused short-term lines of credit from various banks totalling approximately $288,213,000. Current notes payable to banks at March 31,1986 and 1985 were $129,359,000 and $131,770,000. respectively. At March 31,1986, other current notes payable of $61,434,000 were secured by $52,750,000 par value of government obligations. NOTE 7 - CONTINGENCIES AND COMMITMENTS Litigation - In March 1986, legal action involving claims by Exxon Corporation and affiliated companies against Brown & Root, Inc. and the Delaware Company under Sections 1 and 2 of the Sherman Act was settled. This was the last of 79 actions which were filed in or (unless earlier terminated) transferred to the United States District Court for the Eastern District of Louisiana, instituted by or on behalf of purchasers and alleged purchasers of marine construction services in the United States and abroad, alleging a combination and conspiracy to restrain or eliminate competition in marine construction in \iolation of Sections 1 and 2 of the Sherman Act and various state laws through a conspiracy to allocate contracts, fix prices and contract terms and other means. The Delaware Company and International have paid a total of approximately $94,000,000 in settlement of purchasers' claims. International and certain of its officers, directors and subsidiaries are defendants in numerous legal proceedings. Management and general counsel believe that the outcome of these proceedings will net have a material adverse effect upon the consolidated financial statements. '.4 Operating Leases - Future minimum payments required under operating leases that have initial or remaining noncancellable lease terms in excess of one year at March 31, 1986 are as follows: 19S7 - $19,600,000; 1988 $16,100,000; 1989 - $11,800,000; 1990 - $8,500,000; 1991 - $7,200,000; and thereafter - $51,000,000. Future minimum lease payments and leased property undei capital leases are not material. Total rental expense for Fiscal 1986,1985 and 1984 was $76,944,000, $116,644,000 and $105,939,000, respectively. These expense figures include contingent rentals and are net of sublease income, both of which are not material. Other - McDermott International performs significant amounts of work for the U.S. Government under both prime contracts and subcontracts and thus is subject to continuing reviews by governmental agencies. Firm and contemplated commitments for capital expenditures amounted to approximately $87,861,000 at March 31, 1986. Cost reduction programs are being undertaken which may cause near-term operating results to be adversely affected by additional expenses and possible write-downs in operating assets. McDermott International is contingently liable under standby letters of credit totalling $277,177,000 at March 31, 1986 issued in the normal course of business. NOTE 8 - SUBSIDIARY'S REDEEMABLE PREFERRED STOCKS At March 31,1986 and 1985,13,000,000 shares of Delaware Company preferred stock, with a par value of $1 per share, were authorized. Of the authorized shares, 2,825,554 and 3,724,629 shares of Series A and Series B Preferred Stock, respectively, were outstanding at March 31,1986 and 2,825,556 and 3,724,629 shares, respec tively, were outstanding at March 31,1985. The outstanding shares are entitled to $31.25 per share in liquidation. The outstanding shares were issued in connection with the acquisition of B&W and are stated at the mandatory redemption value which approximated market value at the time the shares were issued. Both series of preferred stock are entitled to general voting rights ofone-halfvote for each share. The Board of Directors of the Delaware Company may authorize additional series of preferred stock and may set terms ofeach new series except that the Delaware Company cannot create any series of stock senior to the existing Series A and Series B Preferred Stock without the consent of the holders of at least 50% of the shares of such preferred stock. Each share of the outstanding Series A Preferred Stock is convertible into one share of common stock of International plus $0.10 cash. The shares are redeemable at the option of the Delaware Company on or after March 31 of each ofthe following years, at the following prices, plus accrued dividends: 1986 - $32.35; 1987 - $31.97; 1988 - $31.62; and 1989 through 2008 - $31.25. On March 31,1989 and on March 31 of each subsequent year through 2008, the Delaware Company is obligated to redeem, at a redemption price of$31.25 plus accrued dividends, 5% of the number of shares which are issued at December 31,1988. Based on the number of shares issued at March 31, 1986, the obligation to redeem Series A Preferred Stock is $9,804,000 for each ofthe fiscal years 1989 through 1991. Series B Preferred Stock is redeemable at the option of the Delaw'are Company on or after March 31 ofeach of the following years, at the following prices plus accrued dividends: 1986 - $31.50; and 1987 through 2008 - $31.25. On March 31 of each of the fiscal years 1987 through 1995, March 31 of each of the fiscal years 1996 through 2006, and March 31 of each of the fiscal years 2007 and 2008, the Delaware Company is obligated to redeem 315,877, 252,702 and 189,526 shares of Series B Preferred Stock issued, respectively. The obligation to redeem Series B Preferred Stock is $9,950,000 in fiscal year 1987 and $9,871,000 for each ofthe fiscal years 1988 through 1991. The Delaware Company applied 315,877 shares ofSeries B Preferred Stock that it owned to satisfy the March 31,1986 mandatory sinking fund obligation. Additional shares of Series A or Series B Preferred Stock, equal to the number of shares the Delaware Company is obligated to redeem, may be redeemed on each mandatory redemption date by the Delaware Company, on a non-eumulative basis. The Delaware Company may apply to the mandatory sinking fund obligations any Series A or B Preferred Stock owned, previously redeemed or surrendered for conversion which have not been previously credited against the mandatory sinking fund obligations. At March 31,1986,42,863 shares of Series A Preferred Stock have been converted and the Delaware Company owned 3,449,128 and 2,277,039 shares of Series A and Series B Preferred Stock, respectively. 35 NOTE 9 - CAPITAL STOCK Common Stock - Changes in common stock during the three years ended March 31, 1986 are summarized as follows: Capital in Par Excess of Shares Value Par Value (In thousands except for share data) Balance, March 31, 1983 Shares issued upon conversion of Series A $2.20 cumulative convertible preferred stock Shares issued upon exercise of stock options Shares issued upon exercise of warrants Deferred career executive stock plan expense (net of forfeitures) Balance, March 31, 1984 Shares issued upon conversion of Series A $2.20 cumulative convertible preferred stock Shares issued upon exercise of stock options Shares issued upon exercise of warrants Deferred career executive stock plan expense (net of forfeitures) Balance, March 31, 1985 Shares issued upon conversion of Series A $2.20 cumulative convertible preferred stock Shares issued upon exercise of stock options Shares issued upon exercise of warrants Deferred career executive stock plan expense Balance, March 31,1986 36,861,493 2,260 39,368 1,330 (880) 36,903,571 609 31,284 2,600 (1,540) 36,936,524 2 37,118 80 36,973,724 $ 36.S61 2 40 1 (1) $ 36,903 1 31 2 (1) $ 36.936 3S $ 36.974 $ 310.242 72 796 29 736 S 311.$75 IS 739 53 53S S 313.223 542 2 >>:> $ 313.990 At March 31,1986 and 1985, 58,535,582 and 10,773,021 shares of common stock, respectively, were reserved for issuance in connection with exercise of warrants, exercise of rights, the 1974 Career Executive Stock Plan, exercise of stock options, the 1983 Long-Tbrm Performance Incentive Compensation Program and conversion of Series A Preferred Stock. 36 I nternational Rights - On December 30,1985, each holder ofcommon stock received a dividend distribution ofone Right for each outstanding share of common stock. The Rights currently trade with the common stock and at March 31,1986 International had outstanding Rights to purchase 37,073,724 shares ofits common stock at a price of$50 per share subject to anti-dilution adjustments. The Rights will become exercisable and will detach from the common stock 10 days after a person or a group either becomes the beneficial owner of 20 percent or more of the outstanding common stock, or commences or announces an intention to commence a tender or exchange offer for 30 percent or more of the outstanding common stock. If thereafter the acquiring person or group engages in certain self-dealing transactions, holders of Rights may purchase at the exercise price that number of shares of common stock having a market value equal to twice the exercise price. In the event International merges with or transfers 50 percent or more of its assets or earnings to any person after the Rights become exercisable, holders of Rights may purchase at the exercise price that number ofshares of common stock of the acquiring entity having a market value equal to twice the exercise price. The Rights are redeemable by International and expire on December 30, 1995. International Warrants - At March 31, 1986 and March 31, 1985, International had outstanding warrants to purchase 5,995,990 shares and 5,996,070 shares, respectively, ofits common stock exercisable by the payment per share of$25 cash or $25 principal amount ofthe Delaware Company's 10% Subordinated debentures due 2003. The International warrants expire on April 1,1990 or as early as April 1,1988 ifthe International common stock trades at not less than 125% of the warrant exercise price for a specified period of time. Stock Options - In connection with the acquisition of B&W, options granted under a B&W stock option plan became options to purchase two shares ofthe Delaware Company's common stock. Effective March 15,1983, this plan was adopted as a plan of International. During fiscal 1986,1985 and 1984,35,625, 11,460 and 23,755 non-qualified stock options were exercised at a price of$6,813 or $9,688 per share. No further options can be granted under the plan and at March 31, 1986 no options were outstanding. Long-Term Performance Incentive Compensation Programs - Under the program which was adopted February 8, 1983, the Career Executive Stock Plan Committee (the "Committee") may grant to the officers and key employees options to purchase in the aggregate up to 2,000,000 shares ofcommon stock at 100% ofthe fair market value on the date of grant. Options are exercisable not less than one year and not more than ten years after the date of grant. The Committee may grant stock appreciation rights in connection with the granting of options under the program. Such stock appreciation rights permit the holders thereofto surrender exercisable options in exchange for shares of common stock having a fair market value on the date of such surrender equal to the excess (up to, but not greater than, the fair market value of the underlying shares on the date ofgrant) ofthe fair market value on such date of the shares to which such surrendered option relates over the aggregate option price under the related options. The Committee may, at its discretion, grant holders of stock appreciation rights the right to receive up to 50% of such excess in cash in lieu of shares of common stock. The program also authorizes the Committee to grant performance unit awards which are earned by the achievement of performance standards established by the Committee. Performance units are paid in cash or shares of common stock or both at the discretion ofthe Committee. At March 31,1986,1985 and 1984 stock option and stock appreciation rights awards of 1,031,560, 309,590 and 362,165 shares, respectively, were awarded and outstanding at an average price of $18.3467 per share. During fiscal 1986, 733,320 stock options and stock appreciation rights were awarded. During fiscal 1985 and 1984, no stock options or stock appreciation rights were awarded. Awards relating to 3,755, 2,030 and 15,935 shares were forfeited during fiscal 1986,1985 and 1984, respectively. Charges (credits) to income with respect to stock appreciation rights and performance units were $(2,257,000), $(1,891,000) and $5,030,000 during fiscal 1986. 1985 and 1984, respectively. Career Executive Stock Plan - This plan, which was adopted as a plan of International effective March 15,1983, originally authorized 600,000 shares of common stock to be issued to eligible employees in consideration of thenservices. Employees granted stock under the plan pay $1.00 per share as the option purchase price. Restrictions with respect to issued shares lapse in approximately equal amounts on the second through tenth anniversary dates of the date of issuance. The cost of the plan, based on fair market value on the date of issuance of common stock. is amortized over a ten year period following the date ofissuance. Unamortized career executive stock plan expense included in capital in excess of par value at March 31,1986,1985 and 1984 amounted to $742,000, $965,000 and Sl,54S.OOO, respectively. Upon forfeiture of stock by employees, previous expense attributable to unvested stock is credited to income. During 1986 no shares were forfeited under the plan. During 1985 and 1984,1,540 and 880 shares, respectively, were forfeited under the plan. As of June 30, 1984, no further awards could be made under the plan. Charges to income under the plan were $223,000, $538,000 and $736,000 during fiscal 1986,1985 and 1984. respectively. 37 International Preferred Stock - At March 31,1986 and 1985, 25,000,000 shares of preferred stock were authorized and International had issued 100,000 shares of Series A participating preferred stock (the "Participating Preferred Stock") and 100,000 shares of Series B non-voting preferred stock (the "Non-Voting Preferred Stock"), all of which are owned by the Delaware Company. The annual per share dividend rates for the Participating Preferred Stock and the Non-Voting Preferred Stock are $10 (but no more than ten times the amount of the per share dividend on International common shares) and $20, respectively, payable quarterly, and dividends on such shares are cumulative to the extent not paid. In addition, shares of Participating Preferred Stock are entitled to receive additional dividends whenever dividends in excess of $3.00 per International Share are declared (or deemed to have been declared) in any fiscal year. The Participating Preferred Stock, as a class, shall be entitled to an aggregate number of votes equal to 10% of the total number of votes entitled to be cast on any matter by the stockholders of International. The issuance of additional International preferred stock in the future and the specific terms thereof, such as the dividend rights, conversion rights, voting rights, redemption prices and similar matters, may be authorized by the Board of Directors of International without stockholder approval, except to the extent such approval may be required by applicable rules of the New York Stock Exchange or applicable law. If additional preferred stock is issued, such additional shares will rank senior to International common stock as to dividends and upon liquidation. NOTE 10 - SEGMENT REPORTING McDermott International operates primarily in four industry segments -- Marine Construction Services; Power Generation Systemsand Equipment; Engineered Materials; and Trading. Marine Construction Services principally involves the construction of specialized offshore platforms and marine pipelines used for development drilling, production and transportation of oil and gas. Power Generation Systems and Equipment includes individually engineered complete fossil fuel boilers, nuclear steam systems, nuclear fuel and nuclear fuel assemblies, specially engineered accessories and components, control and performance computers, replacement parts and customer services and associated equipment for electric utility applications as well as fossil fuel boilers for industrial processes and power generation. Engineered Materials consists of tubular and insulating products designed and manufactured from basic and raw materials. Tubular products include stainless, alloy and carbon steel, seamless and welded tubes, tubular and solid shapes, extrusions, special metal tubes, and seamless rolled rings. Insulating products include specially engineered and vacuum formed ceramic fibers, insulating and specialty firebrick, fire protection insulation, plastics, mortars, castables and special oxide refractories. Trading consists primarily of buying and selling iron and steel products, non-ferrous materials, chemical products, cables and equipment for electric power distribution, tools, machinery and utility vehicles, aromatics, olefins, plastics and fine chemicals, as well as the engineering and construction operations of Coutinho. Identifiable assets by industry segment are those assets that are used in operations in each segment. Corporate assets are principally cash, short-term investments and marketable securities. Intersegment sales are accounted for at prices which are generally established by reference to similar transac tions with unaffiliated customers. Revenues attributable to transactions with unconsolidated joint-venture companies were $53,403,000. $22,327,000 and $20,172,000 in fiscal 1986,19S5 and 1984, respectively. In addition, interest income of $10,160,000 on a note from ajoint-venture company and a gain ofapproximately $5,100,000 on the sale ofcertain fixed assets to joint-venture companies were recognized in fiscal year 1985. In each of the fiscal years 1986,1985 and 19S4, the U.S. Government accounted for approximately 13% of total revenues. These revenues are included in the Power Generation Systems and Equipment segment. S Operating income (loss) does not reflect provisions of $5,290,000, $3,807,000 and $41,398,000 made by McDermott International in fiscal 1986, 1985 and 1984, respectively, to cover the closing of certain of its marine, power generation systems and equipment and engineered materials facilities. Such provisions are included in the other income (expense) section of the income statement as other-net. Operating income (loss) in fiscal 1984 includes amounts of $27,996,000 in marine construction services and $3,560,000 in engineered materials, for accelerated depreciation on equipment which was considered to be obsolete and have diminished cost effectiveness. Segment Information For the Three Fiscal Years Ended March 31, 1986. 1. Information about McDermott International's Operations in Different Industry Segments. Revenues^ Marine Construction Sendees Power Generation Systems & Equipment Engineered Materials Trading Intersegment Transfer Eliminations Total Revenues 1986 $ 908,186 1,447,394 310,814 655,145 (64,444) $ 3,257,095 (In thousands) 1985 $ 1,045,938 1,413,481 385,592 435,924 (47.064) $ 3,233,871 1984 $ 1,191,349 1,579,327 373,778 -- (55,871) $ 3,088,583 Operating Income (Loss)^ Marine Construction Services Power Generation Systems & Equipment Engineered Materials Trading Total Operating Income (Loss) $ (30,196) $ (8,293) $ 91,121 37,747 15,345 135,477 (31,289) (39,843) (19,222) (536) (4.137) -- $ (24.274) $ (36,928) $ 207,376 (1) Segment revenues include intersegment transfers as follows: Marine Construction Services Power Generation Systems & Equipment Engineered Materials Trading Total $ 12,028 2,809 34,036 15,571 $ 64,444 $ $ 607 41,961 4.496 47,064 $ $ ____ 334 55,537 -- 55,871 (2) Reconciling items between Operating Income (Loss) and Income (Loss) Before Provision for Income 'Ifexes, Minority Interest and Extraordinary Items are General Corporate Expenses and Other Income (Expense). Capital Expenditures Marine Construction Services Power Generation Systems & Equipment Engineered Materials Trading Corporate Total Capital Expenditures 1986 $ 231,408 36,102 21,791 2,376 7,207 $ 298,884 (In thousands) 1985 $ 107,514 39,212 21,693 550 3,380 $ 172,349 1984 $ 54,158 28,049 62.436 -- 3,232 $ 147.S75 Depreciation and Amortization Marine Construction Services Power Generation Systems & Equipment Engineered Materials Trading Corporate Total Depreciation and Amortization $ 90,008 35,119 23,471 4,123 5,077 $ 157,798 $ 83,184 32,678 22,928 2,656 7,500 $ 148,946 S 116.288 35.709 21.616 -- i .312 S 180.985 Identifiable Assets Marine Construction Services Power Generation Systems & Equipment Engineered Materials Trading Corporate Total Identifiable Assets $ 1,166,129 1,179,135 504,521 285,683 1,215,474 $ 4,350,942 $ 1,039,835 1,177,221 525,6S2 229,780 1,208,166 $ 4,180,684 $ 1.015.057 1.174.994 oc>ot Oo -- 1.255.360 $ 3.981.114 2. Information about McDermott International's Operations in Different Geographic Areas. (In thousands) Revenues (1) - United States - Europe and West Africa - Other Foreign - Total 1986 $ 1,956,842 812,446 487,807 $ 3,257,095 1985 $ 1,967,866 697,709 568,296 $ 3,233,S71 1984 S 1.975.232 433.697 679.654 $ 3.088.583 Operating Income (Loss) (2) - United States - Europe and West Africa - Other Foreign - Total $ (53,510) 32,611 (3,375) $ (24,274) $ (109,314) 30,455 41,931 $ (36.928) s 37.263 64,772 10*5.341 $ 207.376 Identifiable Assets - United States - Europe and West Africa - Other Foreign - Corporate - Total $ 1,898,988 857,293 379,187 1,215,474 $ 4,350,942 $ 1,894,195 653,344 424,979 1,208.166 $ 4,180.684 $ 1.853.895 482.671 389.188 1.255.360 $ 3.981.114 (1) Transfers between geographic areas are immaterial and not separately stated. (2) Reconciling items between Operating Income (Loss) by Geographic Areas and Income (Loss) Before Provi sion for Income Taxes, Minority Interest and Extraordinary Items are General Corporate Expenses and Other Income (Expense). 40 NOTE 11 - QUARTERLY FINANCIAL DATA The following tables set forth selected unaudited quarterly financial information for the years ended March 31, 1986 and 1985: June 30, 1985 1986 Quarter Ended Sept. 30, Dec. 31, 1985 19S5 (In thousands except for per share amounts) March 31, 1986 Revenues Operating income (loss) Income (loss) before extraordinary items Net income (loss) $ 773, 530 (48,852) (1,077) (1,077) $ 802,944 (23,191) 357 357 $ 829,117 (1,415) 38,750 38,750 $ 851,504 (14,830) 18,270 21,059 Earnings (loss) per share: Primary Before extraordinary items Net income (loss) Fullv Diluted Before extraordinary items Net income (loss) (0.03) (0.03) (0.03) (0.03) 0.01 0.01 0.01 0.01 1.05 1.05 1.01 1.01 0.49 0.57 0.49 0.57 For the quarter ended March 31,1986, net income includes charges of $15, 386,000 relating to the settlement of certain antitrust civil litigation and gains of $24,340,000 for sale of government obligations. Revenues Operating income (loss) Income (loss) before extraordinary items Net income (loss) Earnings (loss) per share: Primary Before extraordinary items Net income (loss) Fully Diluted Before extraordinary items Net income (loss) June 30, 1984 1985 Quarter Ended Sept. 30, Dec. 31, 1984 1984 (In thousands except for per share amounts) $ 707,319 2,813 $ 812,823 (29,529) $ 823,855 (14,664) 22,952 22,952 2,094 2,094 48,544 48,544 March 31, 1985 $ 889,874 (67,399) (54,610) (42,923) 0.58 0.58 0.58 0.58 0.06 0.06 0.06 0.06 1.18 (1.48) 1.18 (1.16) 1.14 (1.48) 1.14 (1.16) For the quarter ended March 31,1985, net loss includes charges of$22,289,000 relating to the settlement ofcertain antitrust civil litigation, $6,102,000 for unfavorable performance on a major contract in domestic marine opera tions and $3,815,000 for increased workers' compensation benefits due primarily to increased liabilities in certain self insured programs. Net loss also reflects higher than anticipated operating costs in most areas of McDermott International's business. Net loss also reflects an extraordinary gain of $11,687,000 resulting primarily from the extinguishment of certain debt (see Note 6). 41 NOTE 12 - EFFECTS OF CHANGING PRICES (Unaudited) In compliance with FASB Statement No. 33, "Financial Reporting and Changing Prices" (as amended by FASB Statement No. 82), certain supplementary information relating to the effects of changing prices is presented below. The information adjusted for changes in specific prices is calculated by adjusting cost of sales and depreciation expense for changes in those prices that relate to property, plant and equipment, and inventory being used in the activities of the business. No other items of revenue or expense in the Condensed Consolidated Statement of Income are adjusted. Depreciation expense included in income adjusted for changes in specific prices is computed using the same depreciation methods and depreciable lives as are used for conventional financial statements. Any comparison between the conventional financial statements and the required supplemental disclosures must be viewed with caution. The amounts shown adjusted for changes in specific prices include the use of estimates and assumptions. Changes in individual prices are caused in part by changes in the general purchasing power of the dollar and in part by other supply and demand factors including technological change. The benefit from income taxes remains unchanged because tax laws do not allow McDermott International to claim tax deductions related to these adjustments. The gain from the decline in purchasing power of net amounts owed reflects the fact that total liabilities having a future fixed cash settlement exceeded total assets with similar characteristics. This unrealized gain theoretically represents the fact that net liabilities can be repaid with dollars having a lesser value than at the beginning of the year due to inflation. The increase (decrease) in specific prices of inventories and property, plant and equipment represents the difference between the current cost amounts at the beginning of the year and the end of the year. Part of the difference is attributable to inflation in general and part is attributable to economic factors affecting the individual prices of the particular assets owned. To the extent that the difference has been realized by a sale during the year, it is included in income from operations on a current cost basis. The unrealized portion does not represent receipt (disbursement) of cash and should not be considered as providing (reducing) funds for reinvestment or dividend distribution in the current period. The net assets shown under changes in specific prices are adjusted only for changes in inventory and property, plant and equipment. 42 CONDENSED CONSOLIDATED STATEMENT OF INCOME ADJUSTED FOR EFFECTS OF CHANGING PRICES FISCAL YEAR ENDED MARCH 31.1986 (In thousands except for per share amounts) As Reported in the Conventional Financial Statements Adjusted for Changes in Specific Prices (Current Costs) Revenues Cost and Expenses Cost of operations Depreciation and amortization Selling, general and administrative expenses Other Income $ 3,257,095 2,879,638 157,798 307,947 88.104 $ 3,257,095 2,887,029 199,526 307,947 88,104 Income (Loss) Before Provision for Income Thxes, Minority Interest and Extraordinary Items Benefit from Income Taxes Minority Interest Extraordinary Gain, Net of T&x (184) 71,234 (14,750) 2,789 (49,303) 71,234 (14,750) 2,789 Net Income $ 59,089 $ 9,970 Income per common and common equivalent share (Primary) $ 1.60 $ 0.27 Gain from decline in purchasing power of net amounts owed $ 11,573 Increase in current cost of inventory and property, plant and equipment held during the year (based on specific price changes)* Effects of increase in general price level Increase in current cost of inventory and property, plant and equipment held during the year (based on specific price changes) net of changes in the general price level $ 66,125 $ (39,202) $ 26,923 Net assets at year end $ 1,204,373 $ 1,508,811 * At March 31,1986 current cost ofinventory was $248,917 and current cost ofproperty, plant and equipment, net of accumulated depreciation was $1,598,145. 43 FIVE-YEAR COMPARISON OF SELECTED SUPPLEMENTARY FINANCIAL DATA ADJUSTED FOR EFFECTS OF CHANGING PRICES (In thousands except for indices and per share amounts) (In average for the year dollars) Net income (loss) 1986 $ 9,970 For Fiscal Year Ended March 31, 1985 1984 1983 Adjusted for Changes in Specific Prices (Current Costs) $ (20,685) $ 33,709 $ (9.472) Net income (loss) per common and common equivalent share .27 (0.56) .98 (0.26) Net assets at year end 1,508,811 1,590,777 1,733,005 1,854,566 Increase (decrease) in current cost of inventory and prop erty, plant and equipment held during the year, (based on specific price changes) net of changes in the general price level Other information: 26,923 85,924 (1,175) (30,055) Gain from decline in purchasing power of net amounts owed 11,573 16,407 24,083 26,160 Cash dividends per common share 1.80 1.86 1.93 2.01 Market price per common share at year end 16% 26% 33% 20% Average consumer price index 324.7 313.9 301.7 291.7 19S2 S 101.119 2.73 1,996.261 31.474 54.113 1.91 25% 277.4 44 Item 9. DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There are no family relationships between any of the executive officers, directors or persons nominated to be such, and no executive officer was elected to his position pursuant to any arrangement or understanding between himself and any other person. Information required by this item with respect to directors and executive officers is incorporated by reference to the material appearing under the headings "Election of Directors" in the Proxy Statement for the 1986 Annual Meeting of Shareholders. Item 11. EXECUTIVE COMPENSATION Information required by this item is incorporated by reference to the material appearing under the heading "Cash Compensation of Executive Officers and Certain Relationships and Related Transactions" in the Proxy State ment for the 1986 Annual Meeting of Shareholders. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Proxy Statement for the 1986 Annual Meeting of Shareholders. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is incorporated by reference to the material appearing under the heading "Cash Compensation of Executive Officers and Certain Relationships and Related Transactions" in the Proxy State ment for the 1986 Annual Meeting of Shareholders. 45 PART IV Item 14. EXHIBITS. FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Consolidated Financial Statements PAGE Report of Certified Public Accountants Consolidated Balance Sheet March 31, 1986 and 1985 Consolidated Statement of Income and Retained Earnings For The Three Fiscal Years Ended March 31, 1986 Consolidated Statement of Changes in Financial Position For The Three Fiscal Years Ended March 31, 1986 Notes to Consolidated Financial Statements 23 24 26 27 28 Consolidated Financial Schedules All required schedules will be filed by amendment to this Form 10-K on Form 8. Exhibit Index Z Articles of Incorporation and By-Laws {Items 3(a) and 3(b) are incorporated by reference to Exhibit 3 to the Company's annual report on Form 10-K, as amended, for the fiscal year ended March 31, 1983). (a) The Company's Restated Certificate of Incorporation (b) The Company's By-Laws 4(a) Warrant Agreement (incorporated by reference to Exhibit 4 to the Company's annual report on Form 10-K, as amended, for the fiscal year ended March 31, 1983). 4(b) Rights Agreement (incorporated by reference to Exhibit 1 to the Company's registration statement on Form 8-A, dated December 27, 1985). 10 Material Contracts (Exhibits 10(a) through 10(b) and 10(d) through 10(g) are incorporated by reference to Exhibit 10 to the Company's annual report on Form 10-K, as amended, for the fiscal year ended March 31, 1983 and Exhibit 10(c) is incorporated by reference to Exhibit 10 to the Company's annual report on Form 10-K, as amended, for the fiscal year ended March 31, 1984). (a) Supplemental Executive Retirement Plan (b) 1983 Long-Term Performance Incentive Compensation Program (c) Supplemental Compensation Plan (d) Restoration of Retirement Income Plan for Certain Participants in the Retirement Plan for Employees of McDermott International, Inc. (e) Career Executive Stock Plan -- 1974 (f) 1972 Stock Option Plan (g) Intercompany Agreement (h) Trust for Supplemental Executive Retirement Plan (including employment agreement with J.E. Cunningham) will be filed by amendment to this Form 10-K on Form 8. 11 Statement Re Computation of Per Share Earnings 22 Significant Subsidiaries of the Registrant 24 Consent of Certified Public Accountants 47 49 50 FORM 8-K REPORTS Report on Form 8-K, Item 5 was reported, but no financial statements were filed in connection with International's current report on Fonn S-K dated April 4, 1986. McDermott international, inc. STATEMENT RE COMPUTATION OF PER SHARE EARNINGS FOR THE THREE FISCAL YEARS ENDED MARCH 31,19S6 (In thousands, except shares and per share amounts) Primary 1986 1985 Net Income Interest and amortization of debt expense on 10% Subordinated debentures due 2003 (net of taxes) Net income for primary computation $ 59,089 $ 30,667 ____ S 59,089 ____ $ 30,667 EXHIBIT 11 1984 $ 120,856 6,337 $ 127,193 Weighted average number of common shares outstanding during the year Common stock equivalents of stock options, stock appreciation rights and performance units based on "treasury stock" method Shares applicable to warrants 36,958,187 36,926,227 36,902,499 24,056 -- 137,262 -- 111,855 4,507,515 Weighted average number of common and common equivalent shares outstanding during the year Earnings per common and common equivalent share 36,982,243 37,063,489 41,521,869 $ 1.60 $ 0.83 $ 3.06 47 Net income Intei'est and amortization of debt expense on 10% Subordinated debentures due 2003 (net of taxes) Dividends on Subsidiary's Series A S2.20 Cumulative Convertible Preferred Stock assuming conversion to Common Stock Fully Diluted 1986 $ 59,089 EXHIBIT U CONTINUED 1985 $ 30,667 19S4 $ 120.856 8.445 6,221 Net income for fully diluted computation $ 59,089 $ 30,667 S 135.522 Weighted average number of common shares outstanding during the year Common stock equivalents of stock options, stock appreciation rights and performance units based on "treasury stock" method Shares applicable to warrants Shares applicable to Subsidiary's Series A $2.20 Cumulative Convertible Preferred Stock 36,958,187 36,926,227 36.902,499 24,071 -- 143,310 -- 191,45S 5,998,670 2,827,995 Weighted average number of common and common equivalent shares outstanding during the year, assuming full dilution 36,982,258 37,069,537 45,920.622 Earnings per common and common equivalent shares assuming full dilution $ 1.60 $ 0.S3 $ 2.95 Fully diluted earnings per share includes only computations which cause dilution. 48 EXHIBIT 22 McDermott international, inc. SIGNIFICANT SUBSIDIARIES OF THE REGISTRANT FISCAL YEAR ENDED MARCH 31,1986 Name of Company Organized Under the Laws of Percentage of Voting Shares Owned McDermott International Investments Co., Panama 100 Northern Marine Services, Inc. Panama 100 McDermott Incorporated Marine Contractors, Inc. The Babcock & Wilcox Company Delaware Panama Delaware 92 100 100 The subsidiaries omitted from the foregoing list do not, considered in the aggregate, constitute a significant subsidiary. 49 CONSENT OF CERTIFIED PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement (Form S-3 No. 33-4631 and 22-15078) of McDermott Incorporated and in the related Prospectus and in the Registration Statement (Form S-8 No. 2-83692) of McDermott International, Inc. and in the related Prospectus of our report dated May 23, 1986 with respect to the consolidated financial statements of McDermott International, Inc. included in this Annual Report (Form 10-K) for the year ended March 31, 1986. ARTHUR YOUNG & COMPANY New Orleans, Louisiana May 23, 1986 50 SIGNATURES OF THE REGISTRANT Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. McDermott international, inc. (Registrant) May 28, 1986 By: s/J. E. Cunningham J. E. Cunningham Chairman of the Board and Chief Executive Officer May 28, 1986 By: s/John A. Lynott John A. Lynott Executive Vice President, Chief Financial and Administrative Officer May 28, 1986 By: s/E. A. Robidoux E. A. Robidoux Vice President and Controller 51 SIGNATURES OF DIRECTORS Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. s/T. D- Barrow T. D. Barrow Director May 28, 1986 s/J. E- Cunningham_______ J. E. Cunningham Chairman of the Board and Chief Executive Officer, and Director May 28, 1986 s/James L. Putt_________________________ James L. Dutt Director May 28, 1986 s/R. E. Howson______________ R. E. Howson President and Chief Operating Officer, McDermott Marine Construction, and Director May 28, 1986 s/James A, Hunt_____________ James A. Hunt Director May 28, 1986 s;John A. Lynott_____________ John A. Lynott Executive Vice President, Chief Financial and Administrative Officer, and Director May 28, 1986 s/J. H. Macdonald J. H. Macdonald Director May 28, 1986 52 s/John A. Morgan John A. Morgan Director May 28, 1986 s/John D. Ritchie John D. Ritchie Director May 28, 1986 s/William T. Seawell William T. Seawell Director May 28, 1986 s/Walter B. Shaw______ Walter B. Shaw Director May 28,1986 s/Walter Q. Spencer Walter 0. Spencer Director May 28, 1986 s/John B. Tweedy______ John B. Tweedy Director May 28, 1986 s/Walter M. Vannoy Walter M. Vannoy President and Chief Operating Officer. Babcock & Wilcox, and Director May 28, 1986 s/Russell L. Wagner Russell L. Wagner Director May 28, 1986 Transfer Agents and Registrars Morgan Guaranty Trust Company of New York 30 West Broadway New York, New York 10015 First City National Bank of Houston Post Office Box 809 Houston, Texas 77002 Common Stock of McDermott International, Inc. Series A $2.20 Cumulative Convertible Preferred Stock of McDermott Incorporated Series B $2.60 Cumulative Preferred Stock of McDermott Incorporated Trustees and Paying Agents Morgan Guaranty Trust Company of New York 30 West Broadway New York, New York 10015 9%% Debentures Due March 15, 2004 10.20% Sinking Fund Debentures Due December 1,1999 Floating Rate Notes Due March 1992 Pittsburgh National Bank Post Office Box 340747 Pittsburgh, Pennsylvania 15230 6.80% Pollution Control Revenue Bonds, Series A Due February 1, 2009 Trustee, Paying Agent, Warrant Agent, and Exchange Agent Bankers Trust Company Post Office Box 318 Church Street Station New York, New York 10015 10% Subordinated Debentures Due April 1, 2003 * Warrants to purchase Common Stock of McDermott International, Inc. Certified Public Accountants Arthur Young & Company 1340 Poydras Street New Orleans, Louisiana 70112 (504) 581-3131 Annual Meeting The Annual Meeting of the Stockholders of McDermott International, Inc. for the fiscal year ended March 31, 1986 will be held at the Royal Orleans Hotel, New Orleans, Louisiana on Tuesday, August 12,1986 at 9:30 a.m. local time. Information Additional information about the company, including financial statement schedules and exhibits to the Annual Report to share holders on Form 10-K for the fiscal year ended March 31, 1986, may be obtained, without charge, by writing: Corporate Secretary McDermott International, Inc. 1010 Common Street New Orleans, Louisiana 70112 (504) 587-5400 Inquiries regarding stockholder account matters should be addressed to: Morgan Guaranty Trust Company of New York 30 West Broadway New York, New York 1C015 (212) 587-6515 McDermott International, me. 1010 Common Street New Orleans, LA 70112 (504) 587-5400