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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 
 Form 10-Q
 
 (MARK ONE) x
    
    QUARTERLY REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
 OR o
    
    TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE TRANSITION PERIOD FROM __________________ TO __________________.
  Commission File
No. 1-13071
 
 Hanover Compressor Company (Exact name of registrant as specified in its charter)
 
 Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
    
    76-0625124
(I.R.S. Employer
Identification No.)12001 North Houston Rosslyn, Houston, Texas
(Address of principal executive offices)
    
    77086
(Zip Code)
 (281) 447-8787
(Registrants telephone number, including area code) 
 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes x No o Number of shares of the Common Stock of the registrant outstanding as of
October 29, 2004: 86,819,229 shares.




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##### Table of Contents



TABLE OF CONTENTS PART I. FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTSCONDENSED CONSOLIDATED BALANCE SHEETCONDENSED CONSOLIDATED STATEMENT OF OPERATIONSCONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKITEM 4. CONTROLS AND PROCEDURESPART II. OTHER INFORMATIONITEM 1. LEGAL PROCEEDINGSITEM 6: EXHIBITSSIGNATURESEXHIBIT
INDEXCertification of CEO & CFO Pursuant to Section 302Certification of CEO & CFO Pursuant to Section 906
 2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS HANOVER COMPRESSOR COMPANY
 
 CONDENSED CONSOLIDATED BALANCE SHEET
  September 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    30,693
    
    
    $
    56,619Restricted cashsecurities settlement escrow
    
    
    
    
    
    
    29,649Accounts receivable, net of allowance of $8,357 and $5,460, respectively
    
    
    220,032
    
    
    
    195,183Inventory, net
    
    
    189,321
    
    
    
    155,297Costs and estimated earnings in excess of billings on uncompleted contracts
    
    
    60,482
    
    
    
    50,128Prepaid taxes
    
    
    5,484
    
    
    
    4,677Current deferred income taxes
    
    
    17,998
    
    
    
    23,808Assets held for sale
    
    
    11,261
    
    
    
    17,344Other current assets
    
    
    30,975
    
    
    
    35,105Total current assets
    
    
    566,246
    
    
    
    567,810Property, plant and equipment, net
    
    
    1,943,714
    
    
    
    2,027,654Goodwill, net
    
    
    176,725
    
    
    
    176,629Intangible and other assets
    
    
    56,884
    
    
    
    67,482Investments in non-consolidated affiliates
    
    
    91,737
    
    
    
    88,718Assets held for sale, non-current
    
    
    6,459
    
    
    
    13,981Total assets
    
    $
    2,841,765
    
    
    $
    2,942,274LIABILITIES AND COMMON STOCKHOLDERS EQUITYCurrent liabilities:Short-term debt
    
    $
    16,112
    
    
    $
    32,519Current maturities of long-term debt
    
    
    1,009
    
    
    
    3,511Accounts payable, trade
    
    
    71,010
    
    
    
    53,354Accrued liabilities
    
    
    96,623
    
    
    
    155,441Advance billings
    
    
    33,761
    
    
    
    34,380Liabilities held for sale
    
    
    484
    
    
    
    1,128Billings on uncompleted contracts in excess of costs and estimated earnings
    
    
    31,609
    
    
    
    8,427Total current liabilities
    
    
    250,608
    
    
    
    288,760Long-term debt
    
    
    1,687,166
    
    
    
    1,746,793Other liabilities
    
    
    51,383
    
    
    
    72,464Deferred income taxes
    
    
    56,061
    
    
    
    52,141Total liabilities
    
    
    2,045,218
    
    
    
    2,160,158Commitments
and contingencies (Note 10)Minority interest
    
    
    20,278
    
    
    
    28,628Common stockholders equity:Common stock, $.001 par value; 200,000,000 shares authorized; 87,373,458
and 82,649,629 shares issued, respectively
    
    
    87
    
    
    
    83Additional paid-in capital
    
    
    909,519
    
    
    
    856,020Deferred employee compensation  restricted stock grants
    
    
    (17,935
    )
    
    
    (5,452
    )Accumulated other comprehensive income
    
    
    16,352
    
    
    
    9,227Retained deficit
    
    
    (127,854
    )
    
    
    (104,065
    )Treasury stock363,791 and 252,815 common shares, at cost, respectively
    
    
    (3,900
    )
    
    
    (2,325
    )Total common stockholders equity
    
    
    776,269
    
    
    
    753,488Total liabilities and common stockholders equity
    
    $
    2,841,765
    
    
    $
    2,942,274
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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HANOVER COMPRESSOR COMPANY 
 CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
   Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues and other income:Domestic rentals
    
    $
    85,866
    
    
    $
    82,823
    
    
    $
    256,138
    
    
    $
    241,728International rentals
    
    
    56,579
    
    
    
    49,519
    
    
    
    170,507
    
    
    
    151,973Parts, service and used equipment
    
    
    50,872
    
    
    
    45,581
    
    
    
    137,392
    
    
    
    118,327Compressor and accessory fabrication
    
    
    46,605
    
    
    
    24,039
    
    
    
    118,914
    
    
    
    81,839Production and processing equipment fabrication
    
    
    76,193
    
    
    
    65,202
    
    
    
    192,639
    
    
    
    211,152Equity in income of non-consolidated affiliates
    
    
    5,147
    
    
    
    7,581
    
    
    
    14,906
    
    
    
    16,873Other
    
    
    1,245
    
    
    
    452
    
    
    
    2,983
    
    
    
    3,356322,507
    
    
    
    275,197
    
    
    
    893,479
    
    
    
    825,248Expenses:Domestic rentals
    
    
    37,816
    
    
    
    31,833
    
    
    
    108,305
    
    
    
    94,043International rentals
    
    
    18,129
    
    
    
    17,757
    
    
    
    50,451
    
    
    
    47,682Parts, service and used equipment
    
    
    36,469
    
    
    
    35,307
    
    
    
    101,447
    
    
    
    85,781Compressor and accessory fabrication
    
    
    41,214
    
    
    
    22,347
    
    
    
    107,584
    
    
    
    73,950Production and processing equipment fabrication
    
    
    68,974
    
    
    
    59,095
    
    
    
    170,557
    
    
    
    188,802Selling, general and administrative
    
    
    44,196
    
    
    
    40,164
    
    
    
    125,752
    
    
    
    119,658Foreign currency translation
    
    
    (532
    )
    
    
    1,536
    
    
    
    (1,407
    )
    
    
    1,336Securities related litigation settlement
    
    
    (4,000
    )
    
    
    (3,500
    )
    
    
    (3,903
    )
    
    
    40,253Other
    
    
    556
    
    
    
    2,446
    
    
    
    903
    
    
    
    2,951Depreciation and amortization
    
    
    44,144
    
    
    
    56,199
    
    
    
    131,588
    
    
    
    126,886Leasing expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    43,139Interest expense
    
    
    37,188
    
    
    
    32,849
    
    
    
    108,169
    
    
    
    57,283Goodwill impairment
    
    
    
    
    
    
    35,466
    
    
    
    
    
    
    
    35,466324,154
    
    
    
    331,499
    
    
    
    899,446
    
    
    
    917,230Loss from continuing operations before income taxes
    
    
    (1,647
    )
    
    
    (56,302
    )
    
    
    (5,967
    )
    
    
    (91,982
    )Provision for (benefit from) income taxes
    
    
    3,555
    
    
    
    (7,940
    )
    
    
    18,006
    
    
    
    (18,463
    )Loss from continuing operations
    
    
    (5,202
    )
    
    
    (48,362
    )
    
    
    (23,973
    )
    
    
    (73,519
    )Income (loss) from discontinued operations, net of tax
    
    
    75
    
    
    
    761
    
    
    
    (41
    )
    
    
    1,178Income (loss) from sales or write downs of discontinued operations, net of tax
    
    
    (147
    )
    
    
    (10,908
    )
    
    
    225
    
    
    
    (12,560
    )Cumulative effect of accounting change, net of tax
    
    
    
    
    
    
    (86,910
    )
    
    
    
    
    
    
    (86,910
    )Net loss
    
    $
    (5,274
    )
    
    $
    (145,419
    )
    
    $
    (23,789
    )
    
    $
    (171,811
    )Basic loss per common share:Loss from continuing operations
    
    $
    (0.06
    )
    
    $
    (0.59
    )
    
    $
    (0.28
    )
    
    $
    (0.91
    )Loss from discontinued operations, including sales or write downs, net of tax
    
    
    
    
    
    
    (0.13
    )
    
    
    
    
    
    
    (0.14
    )Cumulative effect of accounting change, net of tax
    
    
    
    
    
    
    (1.07
    )
    
    
    
    
    
    
    (1.07
    )Net loss
    
    $
    (0.06
    )
    
    $
    (1.79
    )
    
    $
    (0.28
    )
    
    $
    (2.12
    )Diluted loss per common share:Loss from continuing operations
    
    $
    (0.06
    )
    
    $
    (0.59
    )
    
    $
    (0.28
    )
    
    $
    (0.91
    )Loss from discontinued operations, including sales or write downs, net of tax
    
    
    
    
    
    
    (0.13
    )
    
    
    
    
    
    
    (0.14
    )Cumulative effect of accounting change, net of tax
    
    
    
    
    
    
    (1.07
    )
    
    
    
    
    
    
    (1.07
    )Net loss
    
    $
    (0.06
    )
    
    $
    (1.79
    )
    
    $
    (0.28
    )
    
    $
    (2.12
    )Weighted average common and common equivalent shares outstanding:Basic
    
    
    85,418
    
    
    
    81,439
    
    
    
    84,527
    
    
    
    80,907Diluted
    
    
    85,418
    
    
    
    81,439
    
    
    
    84,527
    
    
    
    80,907
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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HANOVER COMPRESSOR COMPANY 
 CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
   Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (5,274
    )
    
    $
    (145,419
    )
    
    $
    (23,789
    )
    
    $
    (171,811
    )Other comprehensive income (loss):Change in fair value of derivative financial instruments, net of tax
    
    
    1,222
    
    
    
    2,106
    
    
    
    6,970
    
    
    
    2,794Foreign currency translation adjustment
    
    
    4,053
    
    
    
    407
    
    
    
    155
    
    
    
    12,994Comprehensive income (loss)
    
    $
    1
    
    
    $
    (142,906
    )
    
    $
    (16,664
    )
    
    $
    (156,023
    )
 The accompanying notes are an integral part of these condensed consolidated financial statements. 5




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HANOVER COMPRESSOR COMPANY 
 CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
   Nine Months EndedSeptember 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (23,789
    )
    
    $
    (171,811
    )Adjustments:Depreciation and amortization
    
    
    131,588
    
    
    
    126,886Amortization of debt issuance costs and debt discount
    
    
    90
    
    
    
    90(Income) loss from discontinued operations, net of tax
    
    
    (185
    )
    
    
    11,382Cumulative effect of accounting change, net of tax
    
    
    
    
    
    
    86,910Bad debt expense
    
    
    1,295
    
    
    
    3,030Gain on sale of property, plant and equipment
    
    
    (6,196
    )
    
    
    (528
    )Equity in income of non-consolidated affiliates, net of dividends received
    
    
    (7,014
    )
    
    
    (16,770
    )Gain on derivative instruments
    
    
    (372
    )
    
    
    (2,078
    )Securities related litigation settlement, in excess of cash paid
    
    
    (5,922
    )
    
    
    35,135Goodwill impairment
    
    
    
    
    
    
    35,466Gain on sale of non-consolidated affiliates
    
    
    (300
    )
    
    
    Restricted stock compensation expense
    
    
    1,633
    
    
    
    732Pay-in-kind interest on long-term notes payable
    
    
    15,440
    
    
    
    15,914Deferred income taxes
    
    
    9,970
    
    
    
    (27,276
    )Changes in assets and liabilities, excluding business combinations:Accounts receivable and notes
    
    
    (21,173
    )
    
    
    (615
    )Inventory
    
    
    (29,167
    )
    
    
    3,155Costs and estimated earnings versus billings on uncompleted contracts
    
    
    12,582
    
    
    
    16,319Accounts payable and other liabilities
    
    
    (7,241
    )
    
    
    (23,799
    )Advance billings
    
    
    9,046
    
    
    
    (8,496
    )Prepaid and other
    
    
    8,371
    
    
    
    (584
    )Net cash provided by continuing operations
    
    
    88,656
    
    
    
    83,062Net cash provided by discontinued operations
    
    
    550
    
    
    
    2,202Net cash provided by operating activities
    
    
    89,206
    
    
    
    85,264Cash flows from investing activities:Capital expenditures
    
    
    (57,560
    )
    
    
    (105,189
    )Payments for deferred lease transaction costs
    
    
    
    
    
    
    (1,580
    )Proceeds from sale of property, plant and equipment
    
    
    26,045
    
    
    
    21,970Proceeds from sale of non-consolidated affiliates
    
    
    4,663
    
    
    
    500Cash used to acquire investments in and advances to non -consolidated affiliates
    
    
    (250
    )
    
    
    (401
    )Cash used for business acquisitions
    
    
    
    
    
    
    (15,000
    )Net cash used in continuing operations
    
    
    (27,102
    )
    
    
    (99,700
    )Net cash provided by discontinued operations
    
    
    6,153
    
    
    
    23,729Net cash used in investing activities
    
    
    (20,949
    )
    
    
    (75,971
    )Cash flows from financing activities:Borrowings on revolving credit facility
    
    
    41,000
    
    
    
    98,000Repayments on revolving credit facility
    
    
    (55,000
    )
    
    
    (82,500
    )Payments for debt issue costs
    
    
    (254
    )
    
    
    (831
    )Proceeds from stock options exercised
    
    
    7,719
    
    
    
    5,274Net borrowings (repayments) of other debt
    
    
    (16,613
    )
    
    
    3,307Issuance of 9% senior notes due 2014, net
    
    
    194,125
    
    
    
    Payments of 2000A equipment lease obligations
    
    
    (200,000
    )
    
    
    Payments of 2000B equipment lease obligations
    
    
    (65,000
    )
    
    
    Net cash provided by (used in) continuing operations
    
    
    (94,023
    )
    
    
    23,250Net cash used in discontinued operations
    
    
    
    
    
    
    (18,538
    )Net cash provided (used in) by financing activities
    
    
    (94,023
    )
    
    
    4,712Effect of exchange rate changes on cash and equivalents
    
    
    (160
    )
    
    
    439Net (decrease) increase in cash and cash equivalents
    
    
    (25,926
    )
    
    
    14,444Cash and cash equivalents at beginning of period
    
    
    56,619
    
    
    
    19,011Cash and cash equivalents at end of period
    
    $
    30,693
    
    
    $
    33,455Supplemental
disclosure of noncash transactions:Common stock
issued for securities related litigation settlement
    
    $
    29,800
    
    
    $
    Restricted
common stock issued to employees, net
    
    $
    13,987
    
    
    $
    4,919
 The accompanying notes are an integral part of these condensed consolidated financial statements. 6




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HANOVER COMPRESSOR COMPANY 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of
Hanover Compressor Company (Hanover, we, us, our or the Company)
included herein have been prepared in accordance with accounting principles
generally accepted in the United States of America for interim financial
information and the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with accounting principles
generally accepted in the United States of America are not required in these
interim financial statements and have been condensed or omitted. It is the
opinion of our management that the information furnished includes all
adjustments, consisting only of normal recurring adjustments, which are
necessary to present fairly the financial position, results of operations, and
cash flows of Hanover for the periods indicated. The financial statement
information included herein should be read in conjunction with the consolidated
financial statements and notes thereto included in our Annual Report on Form
10-K for the year ended December 31, 2003. These interim results are not
necessarily indicative of results for a full year. Earnings Per Common Share Basic loss per common share is computed by dividing loss available to common
stockholders by the weighted average number of shares outstanding for the
period. Diluted loss per common share is computed using the weighted average
number of shares outstanding adjusted for the incremental common stock
equivalents attributed to outstanding options and warrants to purchase common
stock, restricted stock, convertible senior notes and convertible subordinated
notes, unless their effect would be anti-dilutive. The table below indicates the potential shares of common stock that were
included in computing the dilutive potential shares of common stock used in
diluted loss per common share (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Weighted average common shares outstandingused in basic loss per common share
    
    
    85,418
    
    
    
    81,439
    
    
    
    84,527
    
    
    
    80,907Net dilutive potential common shares issuable:On exercise of options and vesting of restricted stock
    
    
    **
    
    
    
    **
    
    
    
    **
    
    
    
    **On exercise of warrants
    
    
    **
    
    
    
    **
    
    
    
    **
    
    
    
    **On conversion of convertible subordinated notes due 2029
    
    
    **
    
    
    
    **
    
    
    
    **
    
    
    
    **On conversion of convertible senior notes due 2008
    
    
    **
    
    
    
    **
    
    
    
    **
    
    
    
    **On conversion of convertible senior notes due 2014
    
    
    **
    
    
    
    
    
    
    
    **
    
    
    
    Weighted average common shares and dilutive potential common shares used in
dilutive loss per common share
    
    
    85,418
    
    
    
    81,439
    
    
    
    84,527
    
    
    
    80,907
 ** Excluded from diluted loss per common share, as the effect would have been anti-dilutive. 7




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The table below indicates the potential shares of common stock issuable which
were excluded from net dilutive potential shares of common stock issuable as
their effect would be anti-dilutive (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net dilutive potential common shares issuable:On exercise of options and vesting of restricted stock
    
    
    2,795
    
    
    
    1,998
    
    
    
    2,298
    
    
    
    1,891On exercise of options-exercise price greater than
average market value at end of period
    
    
    1,074
    
    
    
    1,834
    
    
    
    1,073
    
    
    
    3,991On exercise of warrants
    
    
    4
    
    
    
    4
    
    
    
    4
    
    
    
    4On conversion of convertible subordinated notes due 2029
    
    
    4,825
    
    
    
    4,825
    
    
    
    4,825
    
    
    
    4,825On conversion of convertible senior notes due 2008
    
    
    4,370
    
    
    
    4,370
    
    
    
    4,370
    
    
    
    4,370On conversion of convertible senior notes due 2014
    
    
    9,583
    
    
    
    
    
    
    
    9,583
    
    
    
    22,651
    
    
    
    13,031
    
    
    
    22,153
    
    
    
    15,081
 Stock-Based Compensation Certain of our employees participate in stock option plans that provide for the
granting of options to purchase shares of Hanover common stock. In accordance
with Statement of Financial Standards No. 123, Accounting for Stock-Based
Compensation, (SFAS 123), Hanover measures compensation expense for its
stock-based employee compensation plans using the intrinsic value method
prescribed in APB Opinion No. 25, Accounting for Stock Issued to Employees
(APB 25). The following pro forma net loss and loss per share data
illustrates the effect on net loss and net loss per share if the fair value
method had been applied to all outstanding and unvested stock options in each
period (in thousands). Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss as reported
    
    $
    (5,274
    )
    
    $
    (145,419
    )
    
    $
    (23,789
    )
    
    $
    (171,811
    )Add back: Restricted stock grant expense, net of tax
    
    
    818
    
    
    
    256
    
    
    
    1,583
    
    
    
    476Deduct: Stock-based employee compensation expense
determined under the fair value method, net of tax
    
    
    (1,463
    )
    
    
    (757
    )
    
    
    (3,155
    )
    
    
    (1,799
    )Pro forma net loss
    
    $
    (5,919
    )
    
    $
    (145,920
    )
    
    $
    (25,361
    )
    
    $
    (173,134
    )Loss per share:Basic, as reported
    
    $
    (0.06
    )
    
    $
    (1.79
    )
    
    $
    (0.28
    )
    
    $
    (2.12
    )Basic, pro forma
    
    $
    (0.07
    )
    
    $
    (1.79
    )
    
    $
    (0.30
    )
    
    $
    (2.14
    )Diluted, as reported
    
    $
    (0.06
    )
    
    $
    (1.79
    )
    
    $
    (0.28
    )
    
    $
    (2.12
    )Diluted, pro forma
    
    $
    (0.07
    )
    
    $
    (1.79
    )
    
    $
    (0.30
    )
    
    $
    (2.14
    )
 As of September 30, 2004 and 2003, approximately 1,540,000 and 535,000 shares,
respectively, of restricted stock were outstanding under our incentive compensation
plans. We will recognize compensation expense equal to the fair value of the
restricted stock at the date of grant over the vesting period related to these
grants. During the nine months ended September 30, 2004 and 2003, we recognized
$1.6 million and $0.7 million, respectively, in compensation expense related to
these grants. We record restricted shares forfeited as additions to treasury stock on our Condensed Consolidated Balance Sheet. In July 2004, we granted approximately 1,207,000 shares of restricted Hanover
common stock under our 2003 Stock Incentive Plan to certain employees,
including our executive officers, as part of an incentive compensation plan. 8




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##### Table of Contents



Approximately 690,000 of the shares of restricted stock that were granted will
vest over a three-year period at a rate of one-third per year, beginning on the
first anniversary of the date of the grant, and approximately 517,000 of the
shares of restricted stock that were granted will vest in July 2007, subject to
the achievement of certain pre-determined performance based criteria. In the
event of a change of control of Hanover, a portion of these grants are subject
to accelerated vesting. Because 517,000 of the restricted shares vest based on
performance, we will record an estimate of the compensation expense to be
expensed over three years related to these restricted shares. The compensation
expense that will be recognized in our statement of operations will be adjusted
for changes in our estimate of the number of restricted shares that will vest
as well as changes in our stock price. Reclassifications Certain amounts in the prior periods financial statements have been
reclassified to conform to the 2004 financial statement classification. These
reclassifications have no impact on our consolidated results of operations,
cash flows or financial position. 2. INVENTORIES Inventory, net of reserves, consisted of the following amounts (in thousands): September 30,
    
    December 31,2004
    
    2003Parts and supplies
    
    $
    134,914
    
    
    $
    114,063Work in progress
    
    
    44,545
    
    
    
    29,412Finished goods
    
    
    9,862
    
    
    
    11,822$
    189,321
    
    
    $
    155,297
 As of September 30, 2004 and December 31, 2003 we had inventory reserves of
approximately $13.5 million and $12.7 million, respectively. 3. COMPRESSOR AND PRODUCTION EQUIPMENT FABRICATION CONTRACTS Costs, estimated earnings and billings on uncompleted contracts consisted
of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Costs incurred on uncompleted contracts
    
    $
    425,681
    
    
    $
    366,626Estimated earnings
    
    
    54,128
    
    
    
    47,782479,809
    
    
    
    414,408Less  billings to date
    
    
    (450,936
    )
    
    
    (372,707
    )$
    28,873
    
    
    $
    41,701
 Presented in the accompanying financial statements as follows (in thousands): September 30,
    
    December 31,2004
    
    2003Costs and estimated
earnings in excess of
billings on uncompleted
contracts
    
    $
    60,482
    
    
    $
    50,128Billings on uncompleted
contracts in excess of
costs and estimated
earnings
    
    
    (31,609
    )
    
    
    (8,427
    )$
    28,873
    
    
    $
    41,701
 An increase in the business activity related to our compressor fabrication and
production and processing equipment businesses resulted in increases for both
costs and billings on uncompleted contracts as of September 30, 2004. 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consisted of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Compression equipment, facilities and other rental assets
    
    $
    2,417,016
    
    
    $
    2,407,873Land and buildings
    
    
    81,694
    
    
    
    80,142Transportation and shop equipment
    
    
    78,178
    
    
    
    77,912Other
    
    
    51,539
    
    
    
    41,7412,628,427
    
    
    
    2,607,668Accumulated depreciation
    
    
    (684,713
    )
    
    
    (580,014
    )$
    1,943,714
    
    
    $
    2,027,654
 Cumulative Effect of Accounting Change During the three months ended September 30, 2003, we recorded a cumulative
effect of accounting change of $86.9 million net of tax, related to the
adoption of FIN 46 on July 1, 2003. Prior to July 1, 2003, we entered into five
lease transactions that were recorded as a sale and leaseback of the
compression equipment and were treated as operating leases for financial
reporting purposes. On July 1, 2003, we adopted the provisions of FIN 46 as
they relate to the special purpose entities that lease compression equipment to
us. As a result of the adoption, we added approximately $1,089 million in
compressor equipment assets, $192.3 million of accumulated depreciation
(including approximately $58.6 million of accumulated depreciation related to
periods before the sale and leaseback of the equipment), $1,105.0 million in
debt and $34.6 million in minority interest obligations to our balance sheet,
and we reversed $108.8 million of deferred gains that were recorded on our
balance sheet as a result of the sale leaseback transactions. On July 1, 2003,
we recorded a $133.7 million charge ($86.9 million net of tax) to record the
cumulative effect from the adoption of FIN 46 related to prior period
depreciation of the compression equipment assets. 9




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##### Table of Contents



5. INVESTMENTS IN NON-CONSOLIDATED AFFILIATES During the second quarter of 2004, we increased our ownership in CrystaTech,
Inc. a process technology company, to 47.24% for approximately $0.3 million. On March 5, 2004, we sold our 50.384% limited partnership interest and 0.001%
general partnership interest in Hanover Measurement Services Company, L.P. to
EMS Pipeline Services, L.L.C. for $4.9 million, of which $0.2 million was put
in escrow subject to the outcome of post closing working capital adjustments
and other matters that have resulted in the $0.2 million being returned to the
purchaser. We had no obligation to the purchaser with respect to any
post-closing adjustment in excess of the escrowed amount. We accounted for our
interest in Hanover Measurement under the equity method. As a result of the
sale, we recorded a $0.3 million gain that is included in other revenue. 6. DEBT Short-term debt consisted of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Bellelifactored receivables
    
    $
    8,467
    
    
    $
    13,261Bellelirevolving credit facility
    
    
    7,645
    
    
    
    16,141Other, interest at 5.0%
    
    
    
    
    
    
    3,117Short-term debt
    
    $
    16,112
    
    
    $
    32,519
 Bellelis factoring arrangements are typically short term in nature and bore
interest at a weighted average rate of 4.0% and 4.0% at September 30, 2004 and
December 31, 2003, respectively. Bellelis revolving credit facilities bore
interest at a weighted average rate of 3.7% and 3.2% at September 30, 2004 and
December 31, 2003, respectively. These revolving credit facilities are all
short-term and expire at different times in 2004 and 2005. Long-term debt consisted of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Bank credit facility due December 2006
    
    $
    13,000
    
    
    $
    27,0004.75% convertible senior notes due 2008
    
    
    192,000
    
    
    
    192,0004.75% convertible senior notes due 2014
    
    
    143,750
    
    
    
    143,7508.625% senior notes due 2010
    
    
    200,000
    
    
    
    200,0009.0% senior notes due 2014
    
    
    200,000
    
    
    
    2000A equipment lease notes
    
    
    
    
    
    
    193,6002000B equipment lease notes, interest at 4.7% and 4.1%, due October 2005
    
    
    104,361
    
    
    
    167,4112001A equipment lease notes, interest at 8.5%, due September 2008
    
    
    300,000
    
    
    
    300,0002001B equipment lease notes, interest at 8.8%, due September 2011
    
    
    250,000
    
    
    
    250,000Zero coupon subordinated notes, interest at 11.0%, due March 2007
    
    
    200,941
    
    
    
    185,5017.25% convertible subordinated notes due 2029
    
    
    86,250
    
    
    
    86,250Real estate mortgage, collateralized by certain land and buildings,
payable through September 2004
    
    
    
    
    
    
    2,917Fair value adjustment  fixed to floating interest rate swaps
    
    
    (5,052
    )
    
    
    
 10




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##### Table of Contents



September 30,
    
    December 31,2004
    
    2003Other, interest at various rates, collateralized by equipment and other
assets, net of unamortized discount
    
    
    2,925
    
    
    
    1,8751,688,175
    
    
    
    1,750,304Lesscurrent maturities
    
    
    (1,009
    )
    
    
    (3,511
    )Long-term debt
    
    $
    1,687,166
    
    
    $
    1,746,793
 Maturities of long-term debt (excluding interest to be accrued thereon) at
September 30, 2004 are (in thousands): September 30,20042004
    
    $
    1162005
    
    
    105,5442006
    
    
    14,0022007
    
    
    201,3432008
    
    
    492,045Thereafter
    
    
    875,125$
    1,688,175
 During the third quarter of 2004, we paid off $65.0 million in indebtedness and
minority interest obligations under our 2000B compressor equipment lease. In June 2004, we issued under our shelf registration statement $200.0 million
aggregate principal amount of our 9.0% Senior Notes due 2014, which are fully
and unconditionally guaranteed on a senior subordinated basis by our wholly
owned subsidiary, Hanover Compressor Limited Partnership (HCLP). The net
proceeds from this offering and available cash were used to repay the
outstanding indebtedness and minority interest obligations of $193.6 million
and $6.4 million, respectively, under our 2000A equipment lease that was to
expire in March 2005. We expect that our bank credit facility and cash flow from operations will
provide us adequate capital resources to fund our estimated level of capital
expenditures for the short term. As of September 30, 2004, we had $13.0
million in outstanding borrowings under our bank credit facility. Outstanding
amounts under that facility bore interest at a weighted average rate of 5.7%
and 4.2% at September 30, 2004 and December 31, 2003. As of September 30,
2004, we also had approximately $94.7 million in letters of credit outstanding
under our bank credit facility. Our bank credit facility permits us to incur
indebtedness, subject to covenant limitations, up to a $350 million credit
limit, plus, in addition to certain other indebtedness, an additional (a) $40
million in unsecured indebtedness, (b) $50 million of nonrecourse indebtedness
of unqualified subsidiaries and (c) $25 million of secured purchase money
indebtedness. As of September 30, 2004, we were in compliance with all material
covenants and other requirements set forth in our bank credit facility, the
indentures and agreements related to our compression equipment lease
obligations and the indentures and agreements relating to our other long-term
debt. A default under our bank credit facility or these agreements would
trigger cross-default provisions under the agreements relating to certain of
our other debt obligations. Such defaults would have a material adverse effect
on our liquidity, financial position and operations. Giving effect to our $94.7
million in outstanding letters of credit, the liquidity available under our
bank credit facility as of September 30, 2004 was approximately $242.3 million. In addition to purchase money and similar obligations, the indentures and the
agreements related to our compression equipment lease obligations for our 2001A
and 2001B sale leaseback transactions, our 8.625% Senior Notes due 2010 and our
9% Senior Notes due 2014 permit us to incur indebtedness up to the $350 million
credit limit under our bank credit facility, plus (1) an additional $75 million
in unsecured indebtedness and (2) any additional indebtedness so long as, after
incurring such indebtedness, our ratio of the sum of consolidated net income
before interest expense, income taxes, depreciation expense, amortization of
intangibles, certain other non-cash charges and rental expense to total fixed
charges 11




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##### Table of Contents



(all as defined and adjusted by the agreements governing such obligations), or
our coverage ratio, is greater than 2.25 to 1.0, and no default or event of
default has occurred or would occur as a consequence of incurring such
additional indebtedness and the application of the proceeds thereon. The
indentures and agreements for our 2001A and 2001B compression equipment lease
obligations, our 8.625% Senior Notes due 2010 and our 9% Senior Notes due 2014
define indebtedness to include the present value of our rental obligations
under sale leaseback transactions and under facilities similar to our
compression equipment operating leases. As of September 30, 2004, Hanovers
coverage ratio was less than 2.25 to 1.0, and therefore as of such date we
could not incur indebtedness other than under our bank credit facility and up
to an additional $75 million in unsecured indebtedness and certain other
permitted indebtedness, including certain refinancing of indebtedness. In May 2003, Hanover reached agreement that was subject to court approval, to
settle securities class actions, ERISA class actions and the shareholder
derivative actions. The terms of the settlement became final in March 2004 and
provided for Hanover to: (a) make a cash payment of approximately $30 million
to the securities settlement fund (of which $26.7 million was funded by
payments from Hanovers directors and officers insurance carriers), (b) issue
2.5 million shares of Hanover common stock, and (c) issue a contingent note
with a principal amount of $6.7 million. The contingent feature
was determined to be a derivative that we recorded as an asset, as
required by SFAS 133. During the nine months ended September
30, 2004 and 2003, respectively, we recorded income of $3.9 million and a $40.3
million charge, respectively, for the cost of the litigation settlement. For
further details regarding the securities settlement, see our Form 10-Q for the
three months ended March 31, 2004. In April 2004, we issued the $6.7 million contingent note related to the
securities settlement. The note was payable, together with accrued interest, on
March 31, 2007 but was extinguished (with no money owing under it) under the
terms of the note since our common stock traded above the average price of
$12.25 per share for 15 consecutive trading days during the third quarter of
2004. As a result of the cancellation of the note in the third quarter of 2004,
we reversed the note and the embedded derivative, which resulted in a $4.0
million reduction to the cost of the securities-related litigation. As of December 31, 2003, our accompanying balance sheet included a $33.4
million long-term liability related to the Hanover common stock and the fair
value of the contingent note payable in connection with the securities
settlement. In addition, as of December 31, 2003, our balance sheet included
approximately $32.7 million in accrued liabilities and $29.6 million in
restricted cash related to the securities related settlement. In the first
quarter of 2004, we released the escrow settlement fund, which was included on
our balance sheet as restricted cash and securities settlement accrual, issued
the shares and reclassified $29.8 million, the estimated value of our common
stock issued, from other liabilities to stockholders equity and included the
shares in our weighted average outstanding shares used for earnings per share
calculations. 12




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##### Table of Contents



7. ACCRUED LIABILITIES Accrued liabilities consisted of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Accrued salaries, bonuses and other employee benefits
    
    $
    25,065
    
    
    $
    30,179Accrued income and other taxes
    
    
    19,752
    
    
    
    15,948Current portion of interest rate swaps
    
    
    5,768
    
    
    
    11,703Securities settlement accrual
    
    
    633
    
    
    
    32,692Accrued interest
    
    
    18,113
    
    
    
    23,228Accrued other
    
    
    27,292
    
    
    
    41,691$
    96,623
    
    
    $
    155,441
 See Note 6 for a discussion of the securities settlement. 8. COMMON STOCKHOLDERS EQUITY In March 2004, we issued and delivered to the escrow agent for the settlement
fund 2.5 million shares of Hanover common stock, as required by the settlement.
In July 2004, we granted approximately 1.2 million shares of restricted
Hanover common stock under our 2003 Stock Incentive Plan to certain employees,
including our executive officers, as part of an incentive compensation plan.
(See Note 1.) 9. ACCOUNTING FOR DERIVATIVES We use derivative financial instruments to minimize the risks and/or costs
associated with financial and global operating activities by managing our
exposure to interest rate fluctuations on a portion of our debt and leasing
obligations. Our primary objective is to reduce our overall cost of borrowing
by managing the fixed and floating interest rate mix of our debt portfolio. We
do not use derivative financial instruments for trading or other speculative
purposes. The cash flow from hedges is classified in our consolidated
statements of cash flows under the same category as the cash flows from the
underlying assets, liabilities or anticipated transactions. For derivative instruments designated as fair value hedges, the gain or loss is
recognized in earnings in the period of change together with the gain or loss
on the hedged item attributable to the risk being hedged. For derivative
instruments designated as cash flow hedges, the effective portion of the
derivative gain or loss is included in other comprehensive income, but not
reflected in our consolidated statement of operations until the corresponding
hedged transaction is settled. The ineffective portion is reported in earnings
immediately. In March 2004, we entered into two interest rate swaps, which we designated as
fair value hedges, to hedge the risk of changes in fair value of our 8.625%
Senior Notes due 2010 resulting from changes in interest rates. These interest
rate swaps, under which we receive fixed payments and make floating payments,
result in the conversion of the hedged obligation into floating rate debt. The
following table summarizes, by individual hedge instrument, these interest rate
swaps as of September 30, 2004: 13




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##### Table of Contents



Fair Value ofFixed Rate to be
    
    
    
    
    
    Swap atFloating Rate to be Paid
    
    Maturity Date
    
    Received
    
    Notional Amount
    
    September 30, 2004Six Month LIBOR +4.72%
    
    December 15, 2010
    
    
    8.625
    %
    
    $
    100,000,000
    
    
    $
    (2,908
    )Six Month LIBOR +4.64%
    
    December 15, 2010
    
    
    8.625
    %
    
    $
    100,000,000
    
    
    $
    (2,144
    )
 As of September 30, 2004, a total of approximately $1.7 million in other
current assets, $6.8 million in long-term liabilities and a $5.1 million
reduction of long-term debt was recorded with respect to the fair value
adjustment related to these two swaps. We estimate the effective
floating rate, that is determined in arrears pursuant to the terms of
the swap, to be paid at the time of settlement. As of September 30,
2004 we estimated that the effective rate to be paid (in December
2004) will be approximately 7.1%. During 2001, we entered into three interest rate swaps to convert variable
lease payments under certain lease arrangements to fixed payments as follows: Fair Value ofSwap atLease
    
    Maturity Date
    
    Fixed Rate to be Paid
    
    Notional Amount
    
    September 30, 2004March 2000
    
    March 11, 2005
    
    
    5.2550
    %
    
    $
    100,000,000
    
    
    $
    (1,397
    )August 2000
    
    March 11, 2005
    
    
    5.2725
    %
    
    $
    100,000,000
    
    
    $
    (1,407
    )October 2000
    
    October 26, 2005
    
    
    5.3975
    %
    
    $
    100,000,000
    
    
    $
    (3,133
    )
 These three swaps, which we have designated as cash flow hedging instruments,
meet the specific hedge criteria and any changes in their fair values have been
recognized in other comprehensive income. During the nine months ended
September 30, 2004 and 2003, we recorded approximately $7.5 million and $4.3
million, respectively, related to these three swaps ($7.5 million and $2.8
million, respectively, net of tax) in other comprehensive income. As of
September 30, 2004, a total of approximately $5.8 million was recorded in
current liabilities and approximately $0.2 million in long-term liabilities
with respect to the fair value adjustment related to these three swaps. On June 1, 2004, we repaid the outstanding indebtedness and minority interest
obligations of $193.6 million and $6.4 million, respectively, under our 2000A
equipment lease. As a result, the two interest rate swaps maturing on March
11, 2005, each having a notional amount of $100 million, associated with the
2000A equipment lease no longer meet specific hedge criteria and the unrealized
loss related to the mark-to-market adjustment prior to June 1, 2004 of $5.3
million will be amortized into interest expense over the remaining life of the
swap. In addition, beginning June 1, 2004, changes in the mark-to-market
adjustment are recognized as interest expense in the statement of operations. Prior to 2001, we entered into two interest rate swaps with notional amounts of
$75 million and $125 million and strike rates of 5.51% and 5.56%, respectively.
The difference paid or received on the swap transactions was recorded as an
accrued liability and recognized in leasing expense in all periods before July
1, 2003, and in interest expense until expiration in July 2003. Because
management decided not to designate the interest rate swaps as hedges, we
recognized unrealized gains of approximately $4.1 million related to the change
in the fair value of these interest rate swaps in lease expense in our
statement of operations during the nine months ended September 30, 2003. The counterparties to our interest rate swap agreements are major international
financial institutions. We monitor the credit quality of these financial
institutions and do not expect non-performance by any counterparty, although
such non-performance could have a material adverse effect on us. 14




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10. COMMITMENTS AND CONTINGENCIES Hanover has issued the following guarantees that are not recorded on our
accompanying balance sheet: Maximum PotentialUndiscountedPayments as ofTerm
    
    September 30, 2004Indebtedness of non-consolidated affiliates:Simco/Harwat Consortium (1)
    
    
    2005
    
    
    $
    11,793El Furrial (1)
    
    
    2013
    
    
    
    37,023Other:Performance guarantees through letters of credit (2)
    
    
    2004-2007
    
    
    
    85,803Standby letters of credit
    
    
    2004
    
    
    
    22,986Bid bonds and performance bonds (2)
    
    
    2004-2007
    
    
    
    101,585$
    259,190
   (1)
    
    We have guaranteed the amount included above, which is a percentage of the total debt of
this non-consolidated affiliate equal to our ownership percentage in such affiliate.(2)
    
    We have issued guarantees to third parties to ensure performance of our obligations, some of
which may be fulfilled by third parties. As part of the Production Operators Corporation (POC) acquisition purchase
price, Hanover may be required to make a contingent payment to Schlumberger
based on the realization of certain tax benefits by Hanover through 2016. To
date we have not realized any of such tax benefits or made any payments to
Schlumberger in connection with them. Upon the occurrence of a change of control of Hanover, if the change of control
or shareholder approval of the change of control occurs before February 9,
2005, which is twelve months after the entry of the final court approval of the
securities related settlement that became final in March 2004, we will be
obligated to contribute an additional $3 million to the securities settlement
fund. (See Note 6.) On June 30, 2004, the Texas Commission on Environmental Quality (TCEQ) informed
the Company that it was pursuing an enforcement action against the Companys
subsidiary, HCLP, for alleged violations of the Texas Health and Safety Code
and Commission Rules at the Redwood Hanover Gateway Plant (RHG Plant) in
Madison County, Texas. The alleged violations include failure to comply with
certain permit limitations relating to sulfur emissions during certain periods
in 2003 and 2004 and failure to provide certain required notifications in
connection therewith. TCEQ has proposed a settlement of $149,625 in respect of
the alleged violations in the form of a proposed Agreed Order dated June 29,
2004. The Company requested a meeting with the TCEQ to discuss the allegations
and to challenge certain assumptions made by the TCEQ. Such meeting occurred on
August 18, 2004 in which we presented our revised calculations and other
responses to the TCEQ, the result of which was a settlement of the action for
$46,200 that is subject to publication of the proposed Agreed Order by the TCEQ
for a 30-day public comment period and final approval by the TCEQ. The comment
period commenced on October 8, 2004 and will end on November 8, 2004. The
Agreed Order is currently set for hearing on November 10, 2004, if approved at
the hearing, the Agreed Order will become final. On July 6, 2004 the California South Coast Air Quality Management District (the
CSAD) informed the Company that the CSAD was pursuing an enforcement action
against the Companys subsidiary, HCLP for alleged violations involving failure
to comply with the permitted emission limitations applicable to certain of
HCLPs compressed natural gas (CNG) fueling stations located in the State of
California. The alleged violations center on excess emissions of oxides of
nitrogen and carbon monoxide from twelve natural gas-fired internal combustion
engines. The CSAD initially estimated they would 15




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##### Table of Contents



seek a penalty against us of
approximately $200,000. After settlement
discussions over the last several months, we believe that HCLP now has an
agreement in principle with CSAD to settle the matter for a $50,000 penalty and
a future obligation to replace two HCLP trucks with CNG vehicles. The Company
is waiting for the final resolution letter confirming the settlement from CSAD. In the ordinary course of business we are involved in various other pending or
threatened legal actions, including environmental matters. While management is
unable to predict the ultimate outcome of these actions, it believes that any
ultimate liability arising from these actions will not have a material adverse
effect on our consolidated financial position, results of operations or cash
flows. We are involved in a project to build and operate barge-mounted gas compression
and gas processing facilities to be stationed in a Nigerian coastal waterway as
part of the performance of a contract between an affiliate of The Royal/ Dutch
Shell Group (Shell) and Global Energy and Refining Ltd. (Global), a
Nigerian company. We have completed the building of the required barge-mounted
facilities. Under the terms of a series of contracts between Global and us,
Shell, and several other counterparties, respectively, Global is responsible
for the development of the overall project. In light of the political
environment in Nigeria, Globals capitalization level and lack of a successful
track record with respect to this project and other factors, there is no
assurance that Global will be able to comply with its obligations under these
contracts. In May 2004, we reached an agreement with Global whereby Global
prepaid to us $5.0 million in equipment rental fees that we recorded in other
liabilities on our condensed consolidated balance sheet in return for our
agreement to waive certain defaults by Global with respect to some of our
agreements with them. If Shell were to terminate its contract with Global for any reason or we were
to terminate our involvement in the project, we would be required to find an
alternative use for the barge-mounted facility which could result in a
write-down of our investment. At September 30, 2004, we had an investment of
approximately $33.8 million associated with the barge-mounted facility and
approximately $4.2 million associated with advances to, and our investment in,
Global. In July 2004, Wilpro Energy Services (PIGAP II) Limited (referred to as PIGAP
II) received a notice of default from the Venezuelan state oil company, PDVSA,
alleging that PIGAP II is not in compliance under a services agreement as a
result of certain operational issues. PIGAP II is a joint venture, currently
owned 70% by a subsidiary of The Williams Companies, Inc. (Williams) and 30%
by Hanover, that operates a natural gas compression facility in Venezuela.
PIGAP II has informed us that it does not believe a basis exists for such
notice and that it is contesting the giving of this notice. Nonetheless, the
giving of this notice of default could be deemed an event of default under
PIGAP IIs outstanding project loans totaling approximately $207.7 million. We
understand, however, that the lenders under the PIGAP II project loan agreement
have confirmed to PIGAP II in writing that based on the facts they currently
know, they have no intention of exercising any rights or remedies under the
PIGAP II project loan agreements until the issues raised in the notice and
PIGAP IIs response are clarified, but have cautioned PIGAP II to refrain from
undertaking any extraordinary expenses or restricted payments until the issue
has been fully resolved. In any event, Hanover has
not guaranteed and is not otherwise liable for the PIGAP II project loans and
an event of default under such project loans does not trigger a default under
Hanovers debt obligations. Hanovers net book investment in PIGAP II at
September 30, 2004 was approximately $30.9 million and Hanovers pretax income
with respect to PIGAP II for the nine months ended September 30, 2004 was
approximately $9.6 million. 11. RELATED-PARTY TRANSACTIONS We received a letter on March 11, 2004 from the administrative trustee of the
GKH Liquidating Trust indicating it and one of its affiliates had decided to
distribute 5.8 million shares of the 8.3 million shares of Hanover common stock
owned by the GKH Liquidating Trust (formerly held by GKH Investments, L.P. and
GKH Private Limited, collectively GKH) and its affiliate to the relevant
beneficiaries. We understand that in April 2004 GKH contributed the remaining
2.5 million shares of our common stock held by GKH to the settlement fund. (See
Note 6.) 16




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12. NEW ACCOUNTING PRONOUNCEMENTS In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity (SFAS 150).
SFAS 150 changes the accounting for certain financial instruments that, under
previous guidance, issuers could account for as equity. SFAS 150 requires that
those instruments be classified as liabilities in statements of financial
position. SFAS 150 is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective for interim periods
beginning after June 15, 2004. On November 7, 2003 the FASB issued Staff
Position 150-3 that delayed the effective date for certain types of financial
instruments. We do not believe the adoption of the guidance currently provided
in SFAS 150 will have a material effect on our consolidated results of
operations or cash flow. However, we may be required to classify as debt
approximately $20.3 million in sale leaseback obligations that, as of September
30, 2004, were reported as Minority interest on our condensed consolidated
balance sheet pursuant to FIN 46. These minority interest obligations represent the equity of the entities that
lease compression equipment to us. In accordance with the provisions of our
compression equipment lease obligations, the equity certificate holders are
entitled to quarterly or semi-annual yield payments on the aggregate
outstanding equity certificates. As of September 30, 2004, the yield rates on
the outstanding equity certificates ranged from 4.9% to 10.0%. Equity
certificate holders may receive a return of capital payment upon termination of
the lease or our purchase of the leased compression equipment after full
payment of all debt obligations of the entities that lease compression
equipment to us. At September 30, 2004, the carrying value of the minority
interest obligations approximated the fair market value of assets that would be
required to be transferred to redeem the minority interest obligations. In April 2004, the Emerging Issues Task Force reached a consensus on Issue No.
03-06, Participating Securities and the Two-Class Method Under FASB Statement
No. 128, Earnings Per Share (EITF 03-06). EITF 03-06 addresses a number of
questions regarding the computation of earnings per share by companies that
have issued securities other than common stock that contractually entitle the
holder to participate in dividends and earnings of the company when, and if, it
declares dividends on its common stock. The issue also provides further
guidance in applying the two-class method of calculating earnings per share,
clarifying what constitutes a participating security and how to apply the
two-class method of computing earning per share once it is determined that a
security is participating, including how to allocate undistributed earnings to
such a security. EITF 03-06 is effective for fiscal periods beginning after
March 31, 2004. The adoption of EITF 03-06 did not have an effect on our net
income (loss) per share. In September 2004, the Emerging Issues Task Force reached a consensus on Issue
No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per
Share, which changes the treatment of contingently convertible debt
instruments in the calculation of diluted earnings per share. Contingently
convertible debt instruments are financial instruments that include a
contingent feature, such as a feature by which the debt becomes convertible
into common shares of the issuer if the issuers common stock price has
exceeded a predetermined threshold for a specified time period. Prior to the
new consensus, most issuers excluded the potential dilutive effect of the
conversion feature from diluted earnings per share until the contingency
threshold is met. EITF Issue No. 04-08 provides that these debt instruments
should be included in the earnings per share computation (if dilutive)
regardless of whether the contingent feature has been met. This change does not
have any effect on net income (loss), but may affect the related per share
amounts. The new rules will be effective for reporting periods ending after
December 15, 2004. We are currently evaluating the impact of adoption of EITF
04-08 on our earnings (loss) per share. In October 2004, the Emerging Issues Task Force reached a consensus on Issue
No. 04-10, Determining Whether to Aggregate Operating Segments That Do Not
Meet the Quantitative Thresholds, which clarifies the guidance in paragraph 19
of SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information. According to EITF Issue No. 04-10, operating segments that do not
meet the quantitative thresholds can be aggregated only if aggregation is
consistent with the objective and basic principles of SFAS No. 131, the
segments have similar economic characteristics, 17




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and the segments share a majority of the aggregation criteria listed in items
(a)-(e) in paragraph 17 of SFAS No. 131. The consensus applies to fiscal years
ending after October 13, 2004. We are currently evaluating the impact of
applying this guidance. 13. REPORTABLE SEGMENTS We manage our business segments primarily based upon the type of product or
service provided. We have five principal industry segments: Domestic Rentals;
International Rentals; Parts, Service and Used Equipment; Compressor and
Accessory Fabrication; and Production and Processing Equipment Fabrication. The
Domestic and International Rentals segments primarily provide natural gas
compression and production and processing equipment rental and maintenance
services to meet specific customer requirements on Hanover-owned assets. The
Parts, Service and Used Equipment segment provides a full range of services to
support the surface production needs of customers from installation and normal
maintenance and services to full operation of a customers owned assets and
surface equipment as well as sales of used equipment. The Compressor and
Accessory Fabrication Segment involves the design, fabrication and sale of
natural gas compression units and accessories to meet unique customer
specifications. The Production and Processing Equipment Fabrication Segment
designs, fabricates and sells equipment used in the production and treating of
crude oil and natural gas and engineering, procurement and construction of
heavy wall reactors for refineries and desalination plants. We evaluate the performance of our segments based on segment gross profit.
Segment gross profit for each segment includes direct revenues and operating
expenses attributable to that segment. Costs excluded from segment gross profit
include selling, general and administrative, depreciation and amortization,
leasing, interest, foreign currency translation, provision for cost of
litigation settlement, goodwill impairment, other expenses and income taxes.
Amounts defined as Other include equity in income of non-consolidated
affiliates, results of other insignificant operations and corporate related
items primarily related to cash management activities. Revenues include sales
to external customers. Intersegment sales and any resulting profits are
eliminated in consolidation. We no longer include intersegment sales when we
evaluate the performance of our segments and have adjusted prior periods to
conform to the 2004 presentation. Our chief executive officer does
not review asset information by segment. 18




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The following tables present sales and other financial information by industry
segment for the three months ended September 30, 2004 and 2003. Parts, service
    
    
    
    
    
    ProductionDomestic
    
    International
    
    and used
    
    Compressor
    
    equipmentrentals
    
    rentals
    
    equipment
    
    fabrication
    
    fabrication
    
    Other
    
    Consolidated(in thousands)September 30, 2004:Revenues from external customers
    
    $
    85,866
    
    
    $
    56,579
    
    
    $
    50,872
    
    
    $
    46,605
    
    
    $
    76,193
    
    
    $
    6,392
    
    
    $
    322,507Gross profit
    
    
    48,050
    
    
    
    38,450
    
    
    
    14,403
    
    
    
    5,391
    
    
    
    7,219
    
    
    
    6,392
    
    
    
    119,905September 30, 2003:Revenues from external customers
    
    $
    82,823
    
    
    $
    49,519
    
    
    $
    45,581
    
    
    $
    24,039
    
    
    $
    65,202
    
    
    $
    8,033
    
    
    $
    275,197Gross profit
    
    
    50,990
    
    
    
    31,762
    
    
    
    10,274
    
    
    
    1,692
    
    
    
    6,107
    
    
    
    8,033
    
    
    
    108,858
 The following tables present sales and other financial information by industry
segment for the nine months ended September 30, 2004 and 2003. Parts, service
    
    
    
    ProductionDomestic
    
    International
    
    and used
    
    Compressor
    
    equipmentrentals
    
    rentals
    
    equipment
    
    fabrication
    
    fabrication
    
    Other
    
    Consolidated(in thousands)September 30, 2004:Revenues from external customers
    
    $
    256,138
    
    
    $
    170,507
    
    
    $
    137,392
    
    
    $
    118,914
    
    
    $
    192,639
    
    
    $
    17,889
    
    
    $
    893,479Gross profit
    
    
    147,833
    
    
    
    120,056
    
    
    
    35,945
    
    
    
    11,330
    
    
    
    22,082
    
    
    
    17,889
    
    
    
    355,135September 30, 2003:Revenues from external customers
    
    $
    241,728
    
    
    $
    151,973
    
    
    $
    118,327
    
    
    $
    81,839
    
    
    $
    211,152
    
    
    $
    20,229
    
    
    $
    825,248Gross profit
    
    
    147,685
    
    
    
    104,291
    
    
    
    32,546
    
    
    
    7,889
    
    
    
    22,350
    
    
    
    20,229
    
    
    
    334,990
 14. DISCONTINUED OPERATIONS AND OTHER ASSETS HELD FOR SALE During the fourth quarter of 2002, Hanovers Board of Directors approved
managements plan to dispose of our non-oilfield power generation projects,
which were part of our domestic rental business, and certain used equipment
businesses, which were part of our parts and service business. These disposals
meet the criteria established for recognition as discontinued operations under
SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets,
(SFAS 144). SFAS 144 specifically requires that such amounts must represent a
component of a business comprised of operations and cash flows that can be
clearly distinguished, operationally and for financial reporting purposes, from
the rest of the entity. These businesses are reflected as discontinued
operations in our condensed consolidated statement of operations. Due to
changes in market conditions, the disposal plan was not completed in 2003. We
are continuing to actively market these assets and have made valuation
adjustments as a result of the change in market conditions. We have sold
certain assets related to our used equipment business for total sales proceeds
of $6.2 million during the nine months ended September 30, 2004 that resulted
in $0.2 million in income, net of write downs of approximately
$0.7 million of assets held for sale. In
the nine months ended September 2004, we sold certain assets held for sale
including a fabrication facility that was closed as part of the
consolidation of our fabrication operations in 2003 and was
classified as an
asset held for sale on our balance sheet. We received proceeds of $6.8
million from these sales that resulted in a $0.2 million gain and is reflected in
other revenue. We expect to sell the majority of remaining assets
within the next 6
months and the assets and liabilities are reflected as held-for-sale on our
condensed consolidated balance sheet. 19




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Summary of operating results of the discontinued operations (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues and other:Domestic rentals
    
    $
    93
    
    
    $
    1,018
    
    
    $
    108
    
    
    $
    4,394Parts, service and used equipment
    
    
    505
    
    
    
    5,468
    
    
    
    6,523
    
    
    
    12,755Equity in income of non-consolidated affiliates
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    550Other
    
    
    
    
    
    
    16
    
    
    
    (3
    )
    
    
    (77
    )598
    
    
    
    6,502
    
    
    
    6,628
    
    
    
    17,622Expenses:Domestic rentals
    
    
    240
    
    
    
    179
    
    
    
    631
    
    
    
    972Parts, service and used equipment
    
    
    247
    
    
    
    3,575
    
    
    
    4,193
    
    
    
    8,334Selling, general and administrative
    
    
    37
    
    
    
    1,425
    
    
    
    1,712
    
    
    
    5,380Interest expense
    
    
    
    
    
    
    196
    
    
    
    
    
    
    
    796Other
    
    
    (1
    )
    
    
    
    
    
    
    133
    
    
    
    371523
    
    
    
    5,375
    
    
    
    6,669
    
    
    
    15,853Income (loss) from discontinued operations before
income taxes
    
    
    75
    
    
    
    1,127
    
    
    
    (41
    )
    
    
    1,769Provision for income taxes
    
    
    
    
    
    
    366
    
    
    
    
    
    
    
    591Income (loss) from discontinued operations
    
    $
    75
    
    
    $
    761
    
    
    $
    (41
    )
    
    $
    1,178
 As a result of our consolidation efforts during 2003, we reclassified certain
closed facilities to assets held for sale. Summary balance sheet data for assets held for sale as of September 30, 2004
(in thousands): Non-OilfieldUsed
    
    PowerEquipment
    
    Generation
    
    Facilities
    
    TotalCurrent assets
    
    $
    2,375
    
    
    $
    8,886
    
    
    $
    
    
    
    $
    11,261Property, plant and equipment
    
    
    
    
    
    
    1,145
    
    
    
    5,314
    
    
    
    6,459Assets held for sale
    
    
    2,375
    
    
    
    10,031
    
    
    
    5,314
    
    
    
    17,720Current liabilities
    
    
    
    
    
    
    484
    
    
    
    
    
    
    
    484Liabilities held for sale
    
    
    
    
    
    
    484
    
    
    
    
    
    
    
    484Net assets held for sale
    
    $
    2,375
    
    
    $
    9,547
    
    
    $
    5,314
    
    
    $
    17,236
 Summary balance sheet data for assets held for sale (including assets related
to discontinued operations) as of December 31, 2003 (in thousands): Non-OilfieldUsed
    
    PowerEquipment
    
    Generation
    
    Facilities
    
    TotalCurrent assets
    
    $
    6,820
    
    
    $
    10,524
    
    
    $
    
    
    
    $
    17,344Property, plant and equipment
    
    
    924
    
    
    
    1,386
    
    
    
    11,671
    
    
    
    13,981Assets held for sale
    
    
    7,744
    
    
    
    11,910
    
    
    
    11,671
    
    
    
    31,325Current liabilities
    
    
    
    
    
    
    1,128
    
    
    
    
    
    
    
    1,128Liabilities held for sale
    
    
    
    
    
    
    1,128
    
    
    
    
    
    
    
    1,128Net assets held for sale
    
    $
    7,744
    
    
    $
    10,782
    
    
    $
    11,671
    
    
    $
    30,197
 20




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15. INCOME TAXES During the first nine months of 2004, we recorded a net tax provision of $18.0
million compared to a benefit from taxes of $18.5 million for the first nine
months of 2003. Our effective tax rate for the nine months ending September 30,
2004 was (302)%, compared to 20% for the nine months ended September 30, 2003.
Due to Hanovers recent domestic tax losses, we cannot reach the conclusion
that it is more likely than not that certain of our U.S. deferred tax assets
will be realized in the near future. Accordingly, our provision for income
taxes for the nine months ended September 30, 2004 did not include a full tax
benefit for our estimate of anticipated U.S. losses because the benefit is not
anticipated to be realized in the near future. We reclassified approximately $23.8 million, net of a valuation allowance of
$2.4 million, to current deferred income taxes that, at December 31, 2003, had
previously been included as part of our net deferred income tax liability. This
immaterial reclassification had no impact on our consolidated results of
operations, cash flows or shareholders equity. Due to our current tax position
in the U.S., we recorded a full valuation allowance, $2.4 million in current
deferred income taxes and $23.3 million in non-current deferred tax liability,
against our net U.S. deferred tax assets. See Note 13 in Notes to the
Consolidated Financial Statements in our annual report on Form 10-K for the
fiscal year end December 31, 2003 for further information regarding our tax
valuation allowances. 16. SUBSEQUENT EVENTS On November 2, 2004, we
sold the compression
rental assets of our Canadian subsidiary, Hanover Canada Corporation, to
Universal Compression Canada, a subsidiary of Universal Compression Holdings,
Inc., for approximately $56.9 million. Additionally, we have agreed to sell our ownership interest
in Collicutt Energy Services Ltd. (CES) for approximately $2.6 million to an
entity owned by Steven Collicutt. Hanover owns approximately 2.6 million shares
in CES and this transaction is anticipated to close prior to year-end
2004. As of September 30, 2004, these assets were carried on our
Condensed Consolidated Balance Sheet at approximately $59.6 million
including $57.9 million of fixed assets. For the nine months ended September 30, 2004, we
reported approximately $4.6 million in income before tax from these assets. The
results of these operations will be reported as discontinued operations. During October 2004, we sold an asset held for sale related to our discontinued
power generation business for approximately $7.5 million and expect to realize
a gain of approximately $0.7 million. This asset was sold to a subsidiary of
The Wood Group. The Wood Group owns 49.5% of the Simco/Harwat Consortium, a
joint venture gas compression project in Venezuela in which we hold a 35.5%
ownership interest. 21




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain matters discussed in this Quarterly Report on Form 10-Q are
forward-looking statements intended to qualify for the safe harbors from
liability established by the Private Securities Litigation Reform Act of 1995
and Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements can generally be identified as such because the
context of the statement will include words such as we believe, anticipate,
expect, estimate or words of similar import. Similarly, statements that
describe Hanovers future plans, objectives or goals or future revenues or
other future financial metrics are also forward-looking statements. Such
forward-looking statements are subject to certain risks and uncertainties that
could cause our actual results to differ materially from those anticipated as
of the date of this report. These risks and uncertainties include:  
    
    our inability to renew our short-term leases of equipment with our customers so as to fully recoup our cost of the equipment;  
    
    a prolonged substantial reduction in oil and natural gas prices, which could cause a decline in the demand for our compression and oil and natural gas
production equipment;  
    
    reduced profit margins or the loss of market share resulting from competition or the introduction of competing technologies by other companies;  
    
    legislative changes or changes in economic or political conditions in the countries in which we do business;  
    
    the inherent risks associated with our operations, such as equipment defects, malfunctions and failures and natural disasters;  
    
    our inability to implement certain business objectives, such as:  
    
    integrating acquired businesses,  
    
    implementing our new enterprise resource planning systems,  
    
    generating sufficient cash,  
    
    accessing the capital markets,  
    
    refinancing existing or incurring additional indebtedness to fund our business, and  
    
    executing our exit and sale strategy with respect to assets classified on our
balance sheet as discontinued operations and held for sale;  
    
    governmental safety, health, environmental and other regulations, which could require us to make significant expenditures; and  
    
    our inability to comply with covenants in our debt agreements and the decreased financial flexibility associated with our substantial debt. Other factors besides those described in this Form 10-Q could also affect our
actual results. You should not unduly rely on the forward-looking statements
contained in this Form 10-Q, which speak only as of the date of this Form 10-Q.
Except as otherwise required by law, we undertake no obligation to publicly
revise any forward-looking statement to reflect 22




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circumstances or events after the date of this Form 10-Q or to reflect the
occurrence of unanticipated events. You should, however, review the factors and
risks we describe in our Annual Report on Form 10-K for the year ended December
31, 2003 and the reports we file from time to time with the SEC after the date
of this Form 10-Q. All forward-looking statements attributable to Hanover are
expressly qualified in their entirety by this cautionary statement. GENERAL Hanover Compressor Company, a Delaware corporation, (we, Hanover, or the
Company) together with its subsidiaries, is a global market leader in the
full service natural gas compression business and is also a leading provider of
service, fabrication and equipment for oil and natural gas processing and
transportation applications. We sell and rent this equipment and provide
complete operation and maintenance services, including run-time guarantees, for
both customer-owned equipment and our fleet of rental equipment. Hanover was
founded as a Delaware corporation in 1990, and has been a public company since
1997. Our customers include both major and independent oil and gas producers
and distributors as well as national oil and gas companies in the countries in
which we operate. Our maintenance business, together with our parts and service
business, provides solutions to customers that own their own compression and
surface production and processing equipment, but want to outsource their
operations. We also fabricate compressor and oil and gas production and
processing equipment and provide gas processing and treating and oilfield power
generation services, primarily to our domestic and international customers as a
complement to our compression services. In addition, through our subsidiary,
Belleli Energy S.r.l. (Belleli), we provide engineering, procurement and
construction services primarily related to the manufacturing of heavy wall
reactors for refineries and construction of desalination plants, primarily for
use in Europe and the Middle East. Substantially all of our assets and operations are owned or conducted by our
wholly owned subsidiary, Hanover Compression Limited Partnership (HCLP). OVERVIEW Our revenue and other income for the three months ended September 30, 2004 was
$322.5 million compared to $275.2 million for the three months ended September
30, 2003. Net loss for the three months ended September 30, 2004 was $5.3
million, or $0.06 per share, compared with a net loss of $145.4 million, or
$1.79 per share, for the three months ended September 30, 2003. The relative
improvement in our operating results was primarily due the inclusion in the
three months ended September 30, 2003 of a cumulative effect of accounting
change of $133.7 million ($86.9 million net of tax), the write-down of certain
non-core assets as discontinued operations of $16.3 million ($10.6 million
after tax), impairments recorded for rental fleet assets to be sold or scrapped
of $14.4 million ($9.8 million after tax) and a $35.5 million goodwill
impairment charge associated with Belleli. In addition, our provision for
income taxes for the three months ended September 30, 2004 did not include a
full tax benefit for our estimate of anticipated U.S. losses. Based on a 35%
federal U.S. tax rate, we estimate that our tax expense was approximately $4.7
million higher because of our current tax position in the United States. This
expense is discussed in greater detail under Income Taxes below. Our revenue and other income for the nine months ended September 30, 2004 was
$893.5 million compared to $825.2 million for the nine months ended September
30, 2003. Net loss for the nine months ended September 30, 2004 was $23.8
million, or $0.28 per share, compared with a net loss of $171.8 million, or
$2.12 per share, for the nine months ended September 30, 2003. The improvement
in our operating results was primarily the result of the inclusion in the nine
months ended September 30, 2003 of the charges taken in the third quarter of
2003 discussed above and a $40.3 million ($26.2 million after tax) provision
for the estimated settlement cost of the securities-related litigation recorded
in the first quarter of 2003. The improvement during 2004 also reflects
approximately $8.5 million in additional depreciation expense related to the
adoption of FIN 46 that was recorded during the nine months ended September 30,
2004. In addition, our provision for income taxes for the nine months ended
September 30, 2004 did not include a full tax benefit for our estimate of
anticipated U.S. losses. Based on a 35% federal U.S. tax rate, we estimate that
our tax expense was approximately $18.8 million higher because of our current
tax position in the United States. This expense is discussed in greater detail 23




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under Income Taxes below. During the nine months ended September 30, 2004, our domestic and international
rental operations experienced an improvement in revenues, which we attribute to
stronger market conditions. However, our domestic rental business gross margin
was lower than we anticipated and was impacted by poor performance primarily at
one of our domestic geographic business units. We are working to improve
these gross margins. In addition, during the nine months ended September 30,
2004, we achieved an improvement in backlog in both the compression and
production and processing fabrication lines of business. Our parts,
service and used equipment business segment benefited from strong international
service and installation revenue and gross profit, but our base parts and
service revenue was lower than anticipated. While this business
started to pick up in the
third quarter of 2004, we believe that we experienced lower revenue in the
first half of this year due to delays in maintenance by our customers because
of the strong gas price environment, particularly in North America. Our third quarter 2004 reported utilization declined by approximately 2%
compared to the reported utilization for the second quarter of 2004. This was
primarily due to a correction we made in July 2004 as we refined our procedures
used to calculate horsepower for utilization percentages, and discovered that
some units were previously double counted in this calculation. As a result, we believe
that our actual utilization percentage from second quarter 2004 to third quarter 2004
did not significantly change. We believe that our utilization percentage is a
helpful measure in understanding our long-term trends relating to our rental
fleet, but utilization statistics should not be considered as an alternative to
reported financial information presented in accordance with generally accepted
accounting principles, and may not be comparably calculated from one company to
another. Total compression horsepower at September 30, 2004 was approximately 3,483,000,
consisting of approximately 2,569,000 horsepower in the United States and
approximately 914,000 horsepower internationally. We estimate that our total
compression horsepower utilization rate in September, 2004 was approximately
82%, compared to utilization of approximately 81% in December 2003 and
approximately 80% in September, 2003. Domestic and international utilization in
September 2004 was approximately 76% and 96%, respectively, compared to
approximately 76% and 94%, respectively, in December 2003, and approximately
75% and 94%, respectively, in September 2003. At September 30, 2004, Hanovers total third-party fabrication backlog,
excluding Belleli, was approximately $115 million compared to approximately $46
million at December 31, 2003 and $61 million at September 30, 2003. Backlog for
Belleli at September 30, 2004 was approximately $143 million, compared to
approximately $107 million at December 31, 2003 and $66 million at September
30, 2003. The compressor and accessory fabrication backlog was approximately
$43 million at September 30, 2004, compared to approximately $28 million at
December 31, 2003 and $29 million at September 30, 2003. The backlog for
production and processing equipment fabrication, excluding Belleli, was
approximately $72 million at September 30, 2004, compared to approximately $18
million at December 31, 2003 and $32 million at September 30, 2003. Industry Conditions The North American rig count increased by 5% to 1,513 at September 30, 2004
from 1,441 at September 30, 2003, and the twelve-month rolling average North
American rig count increased by 16% to 1,521 at September 30, 2004 from 1,307
at September 30, 2003. In addition, the twelve-month rolling average New York
Mercantile Exchange wellhead natural gas price increased to $5.51 per Mcf at
September 30, 2004 from $5.24 per Mcf at September 30, 2003. During the nine
months ended September 30, 2004, we experienced an 8% increase in revenues and
other income as a result of an improvement in market conditions and our focus
on improving our sales success ratio on new bid opportunities. Facility Consolidation We had previously announced our plan to reduce our U.S. headcount by
approximately 500 employees worldwide and to close four fabrication facilities.
During the year ended December 31, 2002, we accrued approximately $2.7 million
in employee separation costs related to the reduction in workforce. During the
year ended December 31, 2003, we paid approximately $2.0 million in employee
separation costs, implemented further cost saving initiatives and closed two
facilities in addition to the four fabrication facilities we closed pursuant to
our original reduction plan. During the first nine months of 2004, we paid an
additional $0.7 million in employee separation costs related to the completion
of these activities. From December 31, 2002 to September 30, 2004, our U.S.
workforce has decreased by approximately 700 employees. 24




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##### Table of Contents



U.S. Tax Position As a result of recent operating losses, we were in a net deferred tax asset
position (for U.S. income tax purposes) for the first time in 2003. Due to our
recent domestic tax losses, we could not reach the conclusion that it was more
likely than not that certain of our U.S. deferred tax assets will be realized
in the near future. Accordingly, for 2003 we provided a $25.7 million deferred
tax valuation allowance against our net U.S. deferred tax asset. We will be
required to record additional valuation allowances if our domestic deferred tax
asset position is increased and the more likely than not criteria of SFAS 109
continues to not be met. If we are required to record additional valuation
allowances, our effective tax rate will be above the statutory rate. Our
preliminary analysis leads us to believe that we will likely be required to
record additional valuation allowances in 2004, and we may be required to
record additional valuation allowances in future periods. Canada Asset Sale On November 2, 2004, we
sold the compression
rental assets of our Canadian subsidiary, Hanover Canada Corporation, to
Universal Compression Canada, a subsidiary of Universal Compression Holdings,
Inc., for approximately $56.9 million. Additionally, we have agreed to sell our ownership interest
in Collicutt Energy Services Ltd. (CES) for approximately $2.6 million to an
entity owned by Steven Collicutt. Hanover owns approximately 2.6 million shares
in CES and this transaction is anticipated to close prior to year-end 2004. As of September 30, 2004, these assets were carried on our
Condensed Consolidated Balance Sheet at approximately $59.6 million
including $57.9 million of fixed assets. For the nine months ended September 30, 2004, we
reported approximately $4.6 million in income before tax from these assets. The
results of these operations will be reported as discontinued operations. RESULTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2003 Summary of Business Segment Results Domestic Rentals
(in thousands) Three months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    85,866
    
    
    $
    82,823
    
    
    
    4
    %Operating expense
    
    
    37,816
    
    
    
    31,833
    
    
    
    19
    %Gross profit
    
    $
    48,050
    
    
    $
    50,990
    
    
    
    (6
    )%Gross margin
    
    
    56
    %
    
    
    62
    %
    
    
    (6
    )%
 Domestic rental revenue increased during the three months ended September 30,
2004, compared to the three months ended September 30, 2003, due primarily to
improvement in market conditions. Gross profit and gross margin for the three months ended September 30, 2004
decreased compared to the three months ended September 30, 2003, due to
increased maintenance and repair expense primarily at one of our three domestic 25




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##### Table of Contents



geographic business units. We are working to improve this business units
results. The decrease in margin at this business unit decreased our overall
domestic rental margin by approximately 4%. International Rentals
(in thousands) Three months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    56,579
    
    
    $
    49,519
    
    
    
    14
    %Operating expense
    
    
    18,129
    
    
    
    17,757
    
    
    
    2
    %Gross profit
    
    $
    38,450
    
    
    $
    31,762
    
    
    
    21
    %Gross margin
    
    
    68
    %
    
    
    64
    %
    
    
    4
    %
 During the three months ended September 30, 2004 international rental revenue
and gross profit increased, compared to the three months ended September 30,
2003, primarily due to increased compression and processing plant rental
activity in Argentina, Brazil, Mexico and Venezuela. Gross margin for the three
months ended September 30, 2004 increased when compared to the three months
ended September 30, 2003, primarily due to operating efficiencies achieved as a
result of the increase in sales without requiring a corresponding increase in
operating expenses. Parts, Service and Used Equipment
(in thousands) Three months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    50,872
    
    
    $
    45,581
    
    
    
    12
    %Operating expense
    
    
    36,469
    
    
    
    35,307
    
    
    
    3
    %Gross profit
    
    $
    14,403
    
    
    $
    10,274
    
    
    
    40
    %Gross margin
    
    
    28
    %
    
    
    23
    %
    
    
    5
    %
 Parts, service and used equipment revenue for the three months ended September
30, 2004 was higher than the three months ended September 30, 2003 due
primarily to increased demand resulting from stronger industry conditions.
Gross profit and gross margin for the three months ended September 30, 2004 was
higher than the results for the three months ended September 30, 2003 primarily
due to a high margin sale of a gas plant. For the three months ended September
30, 2004, parts and service revenue was $36.7 million with a gross margin of
23%, compared to $29.7 million and 33%, respectively, for the three months
ended September 30, 2003. The decrease in margins was primarily due to a
decrease in margins by our domestic parts and service business, which has not
performed as anticipated and, thus, we are working to improve its results. Used
rental equipment and installation sales revenue in the three months ended
September 30, 2004 was $14.2 million with a gross margin of 43%, compared to
$15.9 million with a 3% gross margin for the three months ended September 30,
2003. Our used rental equipment and installation sales and gross margins vary
significantly from period to period and are dependent on the exercise of
purchase options on rental equipment by customers and the start-up of new
projects by customers. 26




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##### Table of Contents



Compression and Accessory Fabrication
(in thousands) Three months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    46,605
    
    
    $
    24,039
    
    
    
    94
    %Operating expense
    
    
    41,214
    
    
    
    22,347
    
    
    
    84
    %Gross profit
    
    $
    5,391
    
    
    $
    1,692
    
    
    
    219
    %Gross margin
    
    
    12
    %
    
    
    7
    %
    
    
    5
    %
 For the three months ended September 30, 2004, compression fabrication revenue
and gross profit increased primarily due to our increased focus on fabrication
that led to increased sales. Gross profit and gross margin increased during the
three months ended September 30, 2004, compared to three months ended September
30, 2003, due primarily to improved operating efficiencies in our fabrication
centers partially as a result of higher sales volumes. Production and Processing Equipment Fabrication
(in thousands) Three months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    76,193
    
    
    $
    65,202
    
    
    
    17
    %Operating expense
    
    
    68,974
    
    
    
    59,095
    
    
    
    17
    %Gross profit
    
    $
    7,219
    
    
    $
    6,107
    
    
    
    18
    %Gross margin
    
    
    9
    %
    
    
    9
    %
    
    
    0
    %
 Production and processing equipment fabrication revenue and gross profit for
the three months ended September 30, 2004 was higher than for the three months
ended September 30, 2003, primarily due to increased Belleli revenue. Included
in production and processing equipment fabrication revenue and expense for the
three months ended September 30, 2004 was $38.5 million in revenue and $34.6
million in expense for Belleli, compared to $27.1 million in revenue and $24.6
million in expense for Belleli for the three months ended September 30, 2003. Other Income Equity in income of non-consolidated affiliates decreased by $2.5 million to
$5.1 million during the three months ended September 30, 2004, from $7.6
million during the three months ended September 30, 2003. This decrease is
primarily due to a decrease in income related to our equity interest in PIGAP
II. PIGAP II experienced an increase in interest expense during the three
months ended September 30, 2004 compared to the three months ended September
30, 2003 as a result of the completion of PIGAP IIs project financing in
October 2003. Expenses Selling, general, and administrative expense (SG&A) for the three months
ended September 30, 2004 was $44.2 million, compared to $40.2 million during
the three months ended September 30, 2003. The increase in SG&A was primarily
due to the inclusion of approximately $2.0 million in costs incurred related to
the implementation of section 404 of the Sarbanes-Oxley Act. As a percentage of
revenue, SG&A in the third quarter of 2004 was 14%, compared to 15% for the
same period a year earlier. 27




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##### Table of Contents



Depreciation and amortization expense for the three months ended September 30,
2004 decreased to $44.1 million, compared to $56.2 million for the same period
a year ago. Third quarter 2004 depreciation and amortization decreased
primarily due to $14.4 million of impairments recorded during the three months
ended September 30, 2003 for rental fleet assets to be sold or scrapped which
was partially offset by (a) increased depreciation expense due to additions to
the rental fleet, including maintenance capital, placed in service during the
first nine months of 2004 and during 2003 and (b) approximately $0.4 million in
additional amortization expense to write-off deferred financing costs
associated with the repayment of a portion of our 2000B compression equipment
lease obligations. During the third quarter of 2003, we recorded a $35.5 million non-cash charge
for goodwill impairment associated with Belleli. As a result of the war in
Iraq, the strengthening of the Euro and generally unfavorable economic
conditions, we determined that the estimated fair value of Belleli had declined
significantly during 2003. Upon gaining complete control of Belleli in August
2003 and assessing our long-term growth strategy, we determined that these
general factors in combination with the specific economic factors impacting
Belleli had significantly and adversely impacted the timing and amount of the
future cash flows that we expected Belleli to generate. Interest expense increased by $4.3 million, or 13%, to $37.2 million during the
three months ended September 30, 2004 as compared to the three months ended
September 30, 2003. The increase was primarily due to an increase in the
overall effective interest rate on outstanding debt to 6.3% from 5.3% during
the three months ended September 30, 2004 and 2003, respectively. Foreign currency translation for the three months ended September 30, 2004 was
a gain of $0.5 million, compared to a loss of $1.5 million for the three months
ended September 30, 2003. The foreign currency translation gain was primarily
due to foreign currency gain related to our Canadian operations. The following
table summarizes the exchange gains and losses we recorded for assets exposed
to currency translation (in thousands): Three Months EndedSeptember 30,2004
    
    2003Canada
    
    $
    911
    
    
    $
    47Argentina
    
    
    (420
    )
    
    
    (800
    )Venezuela
    
    
    (134
    )
    
    
    (346
    )All other countries
    
    
    175
    
    
    
    (437
    )Exchange gain (loss)
    
    $
    532
    
    
    $
    (1,536
    )
 Provision for Securities Litigation Settlement In May 2003, Hanover reached agreement that was subject to court approval, to
settle securities class actions, ERISA class actions and the shareholder
derivative actions. The terms of the settlement became final in March 2004 and
provided for Hanover to: (a) make a cash payment of approximately $30 million
to the securities settlement fund (of which $26.7 million was funded by
payments from Hanovers directors and officers insurance carriers), (b) issue
2.5 million shares of Hanover common stock, and (c) issue a contingent note
with a principal amount of $6.7 million. For further details regarding the
securities settlement, see our Form 10-Q for the three months ended March 31,
2004. In April 2004, we issued the $6.7 million contingent note related to the
securities settlement. The note was payable, together with accrued interest, on
March 31, 2007 but was extinguished (with no money owing under it) under the
terms of the note since our common stock traded above the average price of
$12.25 per share for 15 consecutive trading days during the third quarter of
2004. As a result of the cancellation of the note in the third quarter of 2004,
we reversed the note and the embedded derivative, which resulted in a $4.0
million reduction to the cost of the securities-related litigation. 28




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##### Table of Contents



During the three months ended September 30, 2003, we recorded a $3.5 million
reduction of the estimated litigation settlement expense for the change in
market value of the 2.5 million shares of Hanover common stock that were issued
by Hanover as part of the securities related litigation settlement. Income Taxes During the three months ended September 30, 2004, we recorded a net tax
provision of $3.6 million compared to a benefit for taxes of $7.9 million for
the three months ended September 30, 2003. Our effective tax rate for the three
months ended September 30, 2004 was (216)%, compared to 14% for the three
months ended September 30, 2003. The increase in effective rate was primarily
due to the impact of valuation allowances provided in the U.S. and the weight
of foreign income to U.S. income (loss). Due to Hanovers recent domestic tax
losses, we cannot reach the conclusion that it is more likely than not that
certain of our U.S. deferred tax assets will be realized in the near future.
Accordingly, our provision for income taxes for the three months ended
September 30, 2004 did not include a full tax benefit for our estimate of
anticipated U.S. losses because the benefit is not anticipated to be realized
in the near future. Based on 35% federal U.S. tax rate, we estimate that our
tax expense for the three months ended September 30, 2004 was approximately
$4.7 million higher because of our current tax position in the U.S. Cumulative Effect of Accounting Change During the three months ended September 30, 2003, we recorded a cumulative
effect of accounting change of $86.9 million net of tax, related to the
adoption of FIN 46 on July 1, 2003. Prior to July 1, 2003, we entered into five
lease transactions that were recorded as a sale and leaseback of the
compression equipment and were treated as operating leases for financial
reporting purposes. On July 1, 2003, we adopted the provisions of FIN 46 as
they relate to the special purpose entities that lease compression equipment to
us. As a result of the adoption, we added approximately $1,089 million in
compressor equipment assets, $192.3 million of accumulated depreciation
(including approximately $58.6 million of accumulated depreciation related to
periods before the sale and leaseback of the equipment), $1,105.0 million in
debt and $34.6 million in minority interest obligations to our balance sheet,
and we reversed $108.8 million of deferred gains that were recorded on our
balance sheet as a result of the sale leaseback transactions. On July 1, 2003,
we recorded a $133.7 million charge ($86.9 million net of tax) to record the
cumulative effect from the adoption of FIN 46 related to prior period
depreciation of the compression equipment assets. NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 2003 Summary of Business Segment Results Domestic Rentals
(in thousands) Nine months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    256,138
    
    
    $
    241,728
    
    
    
    6
    %Operating expense
    
    
    108,305
    
    
    
    94,043
    
    
    
    15
    %Gross profit
    
    $
    147,833
    
    
    $
    147,685
    
    
    
    0
    %Gross margin
    
    
    58
    %
    
    
    61
    %
    
    
    (3
    )%
 Domestic rental revenue increased during the nine months ended September 30,
2004, compared to the nine months ended September 30, 2003, due primarily to
improvement in market conditions. 29




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##### Table of Contents



Gross margin for the nine months ended September 30, 2004
decreased compared to the nine months ended September 30, 2003, due to
increased maintenance and repair expense and increased start up costs
associated with bringing idle compression units online. International Rentals
(in thousands) Nine months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    170,507
    
    
    $
    151,973
    
    
    
    12
    %Operating expense
    
    
    50,451
    
    
    
    47,682
    
    
    
    6
    %Gross profit
    
    $
    120,056
    
    
    $
    104,291
    
    
    
    15
    %Gross margin
    
    
    70
    %
    
    
    69
    %
    
    
    1
    %
 During the nine months ended September 30, 2004 international rental revenue
and gross profit increased, compared to the nine months ended September 30,
2003, primarily due to increased compression and processing plant rental
activity in Argentina, Brazil and Mexico. Parts, Service and Used Equipment
(in thousands) Nine months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    137,392
    
    
    $
    118,327
    
    
    
    16
    %Operating expense
    
    
    101,447
    
    
    
    85,781
    
    
    
    18
    %Gross profit
    
    $
    35,945
    
    
    $
    32,546
    
    
    
    10
    %Gross margin
    
    
    26
    %
    
    
    28
    %
    
    
    (2
    )%
 Parts, service and used equipment revenue for the nine months ended September
30, 2004 was higher than the nine months ended September 30, 2003 due primarily
to increased demand resulting from stronger industry conditions. For the nine
months ended September 30, 2004, parts and service revenue was $97.3 million
with a gross margin of 25%, compared to $90.6 million and 31%, respectively,
for the nine months ended September 30, 2003. The decrease in margins was
primarily due to a decrease in margins by our domestic parts and service
business, which has not performed as anticipated and, thus, we are working to
improve its results. Used rental equipment and installation sales revenue in
the nine months ended September 30, 2004 was $40.1 million with a gross margin
of 29%, compared to $27.7 million with a 16% gross margin for the nine months
ended September 30, 2003. Our used rental equipment and installation sales and
gross margins vary significantly from period to period and are dependent on the
exercise of purchase options on rental equipment by customers and the start-up
of new projects by customers. 30




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##### Table of Contents



Compression and Accessory Fabrication
(in thousands) Nine months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    118,914
    
    
    $
    81,839
    
    
    
    45
    %Operating expense
    
    
    107,584
    
    
    
    73,950
    
    
    
    45
    %Gross profit
    
    $
    11,330
    
    
    $
    7,889
    
    
    
    44
    %Gross margin
    
    
    10
    %
    
    
    10
    %
    
    
    0
    %
 For the nine months ended September 30, 2004, compression fabrication revenue
and gross profit increased primarily due to our increased focus on fabrication
that led to increased sales. Production and Processing Equipment Fabrication
(in thousands) Nine months endedSeptember 30,
    
    Increase2004
    
    2003
    
    (Decrease)Revenue
    
    $
    192,639
    
    
    $
    211,152
    
    
    
    (9
    )%Operating expense
    
    
    170,557
    
    
    
    188,802
    
    
    
    (10
    )%Gross profit
    
    $
    22,082
    
    
    $
    22,350
    
    
    
    (1
    )%Gross margin
    
    
    11
    %
    
    
    11
    %
    
    
    0
    %
 Production and processing equipment fabrication revenue for the nine months
ended September 30, 2004 was lower than for the nine months ended September 30,
2003, primarily due to a decrease in orders received from our customers in the
second half of 2003 which led to lower revenues in the first half of 2004. We
believe our consolidation efforts, management changes and non-operational
issues impacted our 2003 sales efforts. However, we are focusing on improving
our sales success ratio on new bid opportunities which has resulted in the 2004
improvement in our production and processing equipment backlog. Expenses SG&A for the nine months ended September 30, 2004 was $125.8 million, compared
to $119.7 million in the nine months ended September 30, 2003. The increase in
SG&A was primarily due to the inclusion of approximately $3.6 million of
additional costs related to our efforts in connection with the implementation
of Section 404 of the Sarbanes-Oxley Act. We expect to incur approximately
$1.8 to $2.1 million of additional costs in the fourth quarter of 2004 in
connection with these efforts. Depreciation and amortization expense for the nine months ended September 30,
2004 increased to $131.6 million, compared to $126.9 million for the same
period a year ago. Depreciation and amortization for the nine months ended
September 30, 2004, increased primarily due to (a) additional depreciation
expense of approximately $8.5 million associated with the compression equipment
operating leases that were consolidated into Hanovers financial statements
beginning in the third quarter 2003 (b) increased depreciation expense due to
additions to the rental fleet, including maintenance capital, placed in service
during the nine months ended September 30, 2004 and during the last quarter of
2003 and (c) approximately $1.4 million in additional amortization expense to
write-off deferred financing costs associated with the June 2004 refinancing of
our 2000A compression equipment lease obligations and early payoff of a portion
of our 2000B compression equipment lease obligations. During the nine months
ended September 30, 2003, we recorded 31




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##### Table of Contents



approximately $14.4 million of impairments related to our rental fleet assets
to be sold or scrapped. During the nine months ended September 30, 2003, we recorded a $35.5 million
non-cash charge for goodwill impairment associated with Belleli. As a result of
the war in Iraq, the strengthening of the Euro and generally unfavorable
economic conditions, we determined that the estimated fair value of Belleli has
declined significantly during 2003. Upon gaining complete control of Belleli in
August 2003 and assessing our long-term growth strategy, we determined that
these general factors in combination with the specific economic factors
impacting Belleli had significantly and adversely impacted the timing and
amount of the future cash flows that we expected Belleli to generate. Beginning in July 2003, payments accrued under our sale leaseback transactions
are included in interest expense as a result of consolidating on our balance
sheet the entities that lease compression equipment to us. As a result, during
the nine months ended September 30, 2004 as compared to the nine months ended
September 30, 2003, our interest expense increased $50.9 million to $108.2
million and our leasing expense decreased $43.1 million to $0. The increase in
interest and leasing expense was primarily due to an increase in the overall
effective interest rate on outstanding debt to 6.1% from 5.5% during
the nine months ended September 30, 2004 and 2003, respectively. Foreign currency translation for the nine months ended September 30, 2004 was a
gain of $1.4 million, compared to a loss of $1.3 million for the nine months
ended September 30, 2003. The following table summarizes the exchange gains
(losses) we recorded for assets exposed to currency translation (in thousands): Nine Months EndedSeptember 30,2004
    
    2003Canada
    
    $
    850
    
    
    $
    177Argentina
    
    
    (868
    )
    
    
    1,082Venezuela
    
    
    1,299
    
    
    
    (1,866
    )All other countries
    
    
    126
    
    
    
    (729
    )Exchange gain (loss)
    
    $
    1,407
    
    
    $
    (1,336
    )
 Provision for Securities Litigation Settlement In May 2003, Hanover reached agreement that was subject to court approval, to
settle securities class actions, ERISA class actions and the shareholder
derivative actions. The terms of the settlement became final in March 2004 and
provided for Hanover to: (a) make a cash payment of approximately $30 million
to the securities settlement fund (of which $26.7 million was funded by
payments from Hanovers directors and officers insurance carriers), (b) issue
2.5 million shares of Hanover common stock, and (c) issue a contingent note
with a principal amount of $6.7 million. For further details regarding the
securities settlement, see our Form 10-Q for the three months ended March 31,
2004. In April 2004, we issued the $6.7 million contingent note related to the
securities settlement. The note was payable, together with accrued interest, on
March 31, 2007 but was extinguished (with no money owing under it) under the
terms of the note since our common stock traded above the average price of
$12.25 per share for 15 consecutive trading days during the third quarter of
2004. As a result of the cancellation of the note in the third quarter of 2004,
we reversed the note and the embedded derivative, which resulted in a $4.0
million reduction to the cost of the securities-related litigation. During the
nine months ended September 30, 2004, we recorded a $3.9 million reduction in
the cost of the securities related litigation settlement primarily due to the
cancellation of the $6.7 million note, net of the value of the embedded
derivative. During the nine months ended September 30, 2003, we recorded a $40.3 million
charge to record the estimated cost of the securities related litigation
settlement. 32




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##### Table of Contents



Income Taxes During the nine months ended September 30, 2004, we recorded a net tax
provision of $18.0 million compared to a benefit from taxes of $18.5 million
for the nine months ended September 30, 2003. Our effective tax rate for the
nine months ended September 30, 2004 was (302)%, compared to 20% for the nine
months ended September 30, 2003. The increase in effective rate was primarily
due to the impact of valuation allowances provided in the U.S. and the weight
of foreign income to U.S. income (loss). Due to Hanovers recent domestic tax
losses, we cannot reach the conclusion that it is more likely than not that
certain of our U.S. deferred tax assets will be realized in the near future.
Accordingly, our provision for income taxes for the nine months ended September
30, 2004 did not include a full tax benefit for our estimate of anticipated
U.S. losses because the benefit is not anticipated to be realized during 2004.
Based on a 35% federal U.S. tax rate, we estimate that our tax expense for the
nine months ended September 30, 2004 was approximately $18.8 million higher
because of our current tax position in the U.S. Cumulative Effect of Accounting Change During the nine months ended September 30, 2003, we recorded a cumulative
effect of accounting change of $86.9 million net of tax, related to the
adoption of FIN 46 on July 1, 2003. Prior to July 1, 2003, we entered into five
lease transactions that were recorded as a sale and leaseback of the
compression equipment and were treated as operating leases for financial
reporting purposes. On July 1, 2003, we adopted the provisions of FIN 46 as
they relate to the special purpose entities that lease compression equipment to
us. As a result of the adoption, we added approximately $1,089 million in
compressor equipment assets, $192.3 million of accumulated depreciation
(including approximately $58.6 million of accumulated depreciation related to
periods before the sale and leaseback of the equipment), $1,105.0 million in
debt and $34.6 million in minority interest obligations to our balance sheet,
and we reversed $108.8 million of deferred gains that were recorded on our
balance sheet as a result of the sale leaseback transactions. On July 1, 2003,
we recorded a $133.7 million charge ($86.9 million net of tax) to record the
cumulative effect from the adoption of FIN 46 related to prior period
depreciation of the compression equipment assets. LIQUIDITY AND CAPITAL RESOURCES Our unrestricted cash balance amounted to $30.7 million at September 30, 2004
compared to $56.6 million at December 31, 2003. Working capital increased to
$315.6 million at September 30, 2004 from $279.1 million at December 31, 2003.
The increase in working capital was primarily the result of an increase in
accounts receivable and inventory due to an improvement in market conditions
that has led to increased sales in our businesses. Our cash flow from operating, investing and financing activities, as reflected
in the Condensed Consolidated Statement of Cash Flows, are summarized in the
table below (dollars in thousands): Nine Months EndedSeptember 30,2004
    
    2003Net cash provided by (used in) continuing operations:Operating activities
    
    $
    88,656
    
    
    $
    83,062Investing activities
    
    
    (27,102
    )
    
    
    (99,700
    )Financing activities
    
    
    (94,023
    )
    
    
    23,250Effect of exchange rate changes on cash and cash equivalents
    
    
    (160
    )
    
    
    439Net cash provided by discontinued operations
    
    
    6,703
    
    
    
    7,393Net change in cash and cash equivalents
    
    $
    (25,926
    )
    
    $
    14,444
 The increase in cash provided by operating activities for the nine months ended
September 30, 2004 as compared to the 33




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nine months ended September 30, 2003 was primarily due to an increase in
distributions from our non-consolidated affiliates. During the nine months
ended September 30, 2004 and 2003, we received distributions of $7.9 million
and $0.1 million, respectively, from our non-consolidated affiliates. The decrease in cash used in investing activities during the nine months ended
September 30, 2004 as compared to the nine months ended September 30, 2003 was
primarily attributable to a decrease in capital expenditures, a decrease in
cash used for business acquisitions and $4.7 million in proceeds received from
the sale of our interest in Hanover Measurement Services Company, LP. The increase in cash used in financing activities during the nine months ended
September 30, 2004 as compared to the cash provided by financing activities in
the nine months ended September 30, 2003 was primarily due to the net reduction
of debt during the first nine months of 2004, including the repayment, during
the third quarter of 2004, of approximately $65 million towards the 2000B
compression equipment lease obligations. We may carry out new customer projects through rental fleet additions and other
related capital expenditures. We generally invest funds necessary to make these
rental fleet additions when our idle equipment cannot economically fulfill a
projects requirements and the new equipment expenditure is matched with
long-term contracts whose expected economic terms exceed our return on capital
targets. During the nine months ended September 30, 2004 we spent $57.6 million
on capital expenditures for rental equipment fleet additions and equipment
maintenance. We plan to spend approximately $25 million to $50 million on
capital expenditures in the fourth quarter of 2004. Since capital expenditures
are largely discretionary, we believe we would be able to significantly reduce
them, in a reasonably short time frame, if expected cash flows from operations
were not realized. Historically, we have funded our capital requirements with a
combination of internally generated cash flow, borrowings under a bank credit
facility, sale leaseback transactions, raising additional equity and issuing
long-term debt. During the nine months ended September 30, 2004, there have
been no significant changes to our obligations to make future payments under
existing contracts except for the net repayment of $14.0 million in borrowings
under our bank credit facility, the issuance of $200 million Senior Notes in
June 2004 and repayment of our 2000A compression equipment lease obligations as
discussed below and the early repayment of $65 million of our 2000B compression
equipment lease obligations. In addition, our purchase order
commitments due within twelve months have increased to approximately $111.8 million as a
result of the increase in the backlog related to our fabrication
operations. As part of our business, we are a party to various financial guarantees,
performance guarantees and other contractual commitments to extend guarantees
of credit and other assistance to various subsidiaries, investees and other
third parties. To varying degrees, these guarantees involve elements of
performance and credit risk that are not included on our consolidated balance
sheet. The possibility of our having to honor these commitments is largely
dependent upon future operations of various subsidiaries, investees and other
third parties, or the occurrence of certain future events. We would record a
reserve for these guarantees if events occurred that required one to be
established. Our bank credit facility provides for a $350 million revolving credit facility
in which advances bear interest at (a) the greater of the administrative
agents prime rate, the federal funds effective rate, or the base CD rate, or
(b) a eurodollar rate, plus, in each case, a specified margin. A commitment fee
equal to 0.625% times the average daily amount of the available commitment
under the bank credit facility is payable quarterly to the lenders
participating in the bank credit facility. Our bank credit facility contains
certain financial covenants and limitations on, among other things,
indebtedness, liens, leases and sales of assets. As of September 30, 2004, we were in compliance with all material
covenants and other requirements set forth in our bank credit facility, the
indentures and agreements related to our compression equipment lease
obligations and the indentures and agreements relating to our other long-term
debt. A default under our bank credit facility or these agreements would
trigger cross-default provisions under the agreements relating to certain of
our other debt obligations. Such defaults would have a material adverse effect
on our liquidity, financial position and operations. While there is no
assurance, we believe based on our current projections for 2004 that we will be
in compliance with the financial covenants in our bank credit facility and the
agreements related to our compression equipment lease obligations. 34




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We expect that our bank credit facility and cash flow from operations will
provide us adequate capital resources to fund our estimated level of capital
expenditures at least for the short term. As of September 30, 2004, we had
$13.0 million in outstanding borrowings under our bank credit facility.
Outstanding amounts under that facility bore interest at a weighted average
rate of 5.7%. As of September 30, 2004, we also had approximately $94.7 million
in letters of credit outstanding under our bank credit facility. Our bank
credit facility permits us to incur indebtedness, subject to covenant
limitations, up to a $350 million credit limit, plus, in addition to certain
other indebtedness, (with letters of credit treated as indebtedness) an
additional (a) $40 million in unsecured indebtedness, (b) $50 million of
nonrecourse indebtedness of unqualified subsidiaries and (c) $25 million of
secured purchase money indebtedness. Giving effect to our $94.7 million in
outstanding letters of credit, the liquidity available under our bank credit
facility as of September 30, 2004 was approximately $242.3 million. In June 2003, we filed a shelf registration statement with the SEC pursuant to
which we may from time to time publicly offer equity, debt or other securities
in an aggregate amount not to exceed $700 million. The SEC subsequently
declared the shelf registration statement effective on November 19, 2003, and
in December 2003 we issued approximately $344 million in securities under our
shelf registration statement. In June 2004, we issued an additional $200
million aggregate principal amount of 9.0% Senior Notes due 2014, which are
fully and unconditionally guaranteed on a senior subordinated basis by our
wholly owned subsidiary, HCLP. The net proceeds from this offering and
available cash were used to repay the outstanding indebtedness and minority
interest obligations of $193.6 million and $6.4 million, respectively, under
our 2000A equipment lease that was to expire in March 2005. Subject to market
conditions, the shelf registration statement will be available to offer one or
more series of additional debt or other securities. In addition to purchase money and similar obligations, the indentures and the
agreements related to our compression equipment lease obligations for our 2001A
and 2001B sale leaseback transactions, our 8.625% Senior Notes due 2010 and our
9% Senior Notes due 2014 permit us to incur indebtedness up to the $350 million
credit limit under our bank credit facility, plus (a) an additional $75 million
in unsecured indebtedness and (b) any additional indebtedness so long as, after
incurring such indebtedness, our ratio of the sum of consolidated net income
before interest expense, income taxes, depreciation expense, amortization of
intangibles, certain other non-cash charges and rental expense to total fixed
charges (all as defined and adjusted by the agreements governing such
obligations), or our coverage ratio, is greater than 2.25 to 1.0, and no
default or event of default has occurred or would occur as a consequence of
incurring such additional indebtedness and the application of the proceeds
thereon. The indentures and agreements related to our 2001A and 2001B
compression equipment lease obligations, our 8.625% Senior Notes due 2010 and
our 9% Senior Notes due 2014 sale leaseback transactions define indebtedness to
include the present value of our rental obligations under sale leaseback
transactions and under facilities similar to our compression equipment
operating leases. As of September 30, 2004, Hanovers coverage ratio was less
than 2.25 to 1.0, and therefore as of such date we could not incur indebtedness
other than under our bank credit facility and up to an additional $75 million
in unsecured indebtedness and certain other permitted indebtedness, including
certain refinancing of indebtedness. As of October 19, 2004, our credit ratings as assigned by Moodys Investors
Service, Inc. (Moodys) and Standard & Poors Ratings Services (Standard &
Poors) were: StandardMoodys
    
    & PoorsOutlook
    
    
    Stable
    
    
    
    StableSenior implied rating
    
    
    B1
    
    
    
    BB-Bank credit facility due December 2006
    
    
    Ba3
    
    
    
    4.75% convertible senior notes due 2008
    
    
    B3
    
    
    
    4.75% convertible senior notes due 2014
    
    
    B3
    
    
    
    B8.625% senior notes due 2010
    
    
    B3
    
    
    
    B
 35




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StandardMoodys
    
    & Poors9.0% senior notes due 2014
    
    
    B3
    
    
    
    B2001A equipment lease notes, interest at 8.5%, due September 2008
    
    
    B2
    
    
    
    2001B equipment lease notes, interest at 8.8%, due September 2011
    
    
    B2
    
    
    
    Zero coupon subordinated notes, interest at 11%, due March 31, 2007
    
    
    Caa1
    
    
    
    B
    -7.25% convertible subordinated notes due 2029*
    
    
    Caa1
    
    
    
    Senior secured
    
    
    
    
    
    
    B
    +Senior unsecured
    
    
    
    
    
    
    B
  *
    
    Rating is on the Mandatorily Redeemable Convertible Preferred Securities that were
issued by Hanover Compressor Capital Trust, our wholly owned subsidiary. See
discussion of the impact of FIN 46 in Managements Discussion and Analysis of
Financial Condition and Results of Operations  New Accounting Pronouncements under
Item 7 of our annual report on Form 10-K for the year ended December 31, 2003. We do not have any credit rating downgrade provisions in our debt agreements or
the agreements related to our compression equipment lease obligations that
would accelerate their maturity dates. However, a downgrade in our credit
rating could materially and adversely affect our ability to renew existing, or
obtain access to new, credit facilities in the future and could increase the
cost of such facilities. Should this occur, we might seek alternative sources
of funding. In addition, our significant leverage puts us at greater risk of
default under one or more of our existing debt agreements if we experience an
adverse change to our financial condition or results of operations. Our ability
to reduce our leverage depends upon market and economic conditions, as well as
our ability to execute liquidity-enhancing transactions such as sales of
non-core assets or our equity securities. We use derivative financial instruments to minimize the risks and/or costs
associated with financial and global operating activities by managing our
exposure to interest rate fluctuation on a portion of our debt and leasing
obligations. Our primary objective is to reduce our overall cost of borrowing
by managing the fixed and floating interest rate mix of our debt portfolio. We
do not use derivative financial instruments for trading or other speculative
purposes. The cash flow from hedges is classified in our consolidated
statements of cash flows under the same category as the cash flows from the
underlying assets, liabilities or anticipated transactions. For derivative instruments designated as fair value hedges, the gain or loss is
recognized in earnings in the period of change together with the gain or loss
on the hedged item attributable to the risk being hedged. For derivative
instruments designated as cash flow hedges, the effective portion of the
derivative gain or loss is included in other comprehensive income, but not
reflected in our consolidated statement of operations until the corresponding
hedged transaction is settled. The ineffective portion is reported in earnings
immediately. In March 2004, we entered into two interest rate swaps, which we designated as
fair value hedges, to hedge the risk of changes in fair value of our 8.625%
Senior Notes due 2010 resulting from changes in interest rates. These interest
rate swaps, under which we receive fixed payments and make floating payments,
result in the conversion of the hedged obligation into floating rate debt. The
following table summarizes, by individual hedge instrument, these interest rate
swaps as of September 30, 2004: Fair Value ofFixed Rate to be
    
    
    
    
    
    Swap atFloating Rate to be Paid
    
    Maturity Date
    
    Received
    
    Notional Amount
    
    September 30, 2004Six Month LIBOR +4.72%
    
    December 15, 2010
    
    
    8.625
    %
    
    $
    100,000,000
    
    
    $
    (2,908
    )Six Month LIBOR +4.64%
    
    December 15, 2010
    
    
    8.625
    %
    
    $
    100,000,000
    
    
    $
    (2,144
    )
 36




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As of September 30, 2004, a total of approximately $1.7 million in other
current assets, $6.8 million in long-term liabilities and a $5.1 million
reduction of long-term debt was recorded with respect to the fair value
adjustment related to these two swaps. We estimate the effective
floating rate, that is determined in arrears pursuant to the terms of
the swap, to be paid at the time of settlement. As of September 30,
2004 we estimated that the effective rate to be paid (in December
2004) will be approximately 7.1%. During 2001, we entered into three additional interest rate swaps to convert
variable lease payments under certain lease arrangements to fixed payments as
follows: Fair Value ofSwap atLease
    
    Maturity Date
    
    Fixed Rate to be Paid
    
    Notional Amount
    
    September 30, 2004March 2000
    
    March 11, 2005
    
    
    5.2550
    %
    
    $
    100,000,000
    
    
    $
    (1,397
    )August 2000
    
    March 11, 2005
    
    
    5.2725
    %
    
    $
    100,000,000
    
    
    $
    (1,407
    )October 2000
    
    October 26, 2005
    
    
    5.3975
    %
    
    $
    100,000,000
    
    
    $
    (3,133
    )
 These three swaps, which we have designated as cash flow hedging instruments,
meet the specific hedge criteria, and any changes in their fair values have
been recognized in other comprehensive income. During the nine months ended
September 30, 2004 and 2003, we recorded approximately $7.5 million and $4.3
million, respectively, related to these three swaps ($7.5 million and $2.8
million, respectively, net of tax) in other comprehensive income. As of
September 30, 2004, a total of approximately $5.8 million was recorded in
current liabilities and approximately $0.2 million in long-term liabilities
with respect to the fair value adjustment related to these three swaps. On June 1, 2004, we repaid the outstanding indebtedness and minority interest
obligations of $193.6 million and $6.4 million, respectively, under our 2000A
equipment lease. As a result, the two interest rate swaps maturing on March
11, 2005, each having a notional amount of $100 million, associated with the
2000A equipment lease no longer meet specific hedge criteria and the unrealized
gain related to the mark-to-market adjustment prior to June 1, 2004 of $5.3
million will be amortized into interest expense over the remaining life of the
swap. In addition, beginning June 1, 2004, changes in the mark-to-market
adjustment were recognized as interest expense in the statement of operations. Prior to 2001, we entered into two interest rate swaps with notional amounts of
$75 million and $125 million and strike rates of 5.51% and 5.56%, respectively.
The difference paid or received on the swap transactions was recorded as an
accrued liability and recognized in leasing expense in all periods before July
1, 2003, and in interest expense until their expiration July 1, 2003. Because
management decided not to designate the interest rate swaps as hedges, we
recognized unrealized gains of approximately $4.1 million related to the change
in the fair value of these interest rate swaps in lease expense in our
statement of operations during the nine months ended September 30, 2003. The counterparties to the interest rate swap agreements are major international
financial institutions. We monitor the credit quality of these financial
institutions and do not expect non-performance by any counterparty, although
such non-performance could have a material adverse effect on us. We have significant operations that expose us to currency risk in Argentina and
Venezuela. To mitigate that risk, the majority of our existing contracts
provide that we receive payment in or based on U.S. dollars rather than
Argentine pesos and Venezuelan bolivars, thus reducing our exposure to
fluctuations in the value of these currencies relative to the U.S. dollar. In
February 2003, the Venezuelan government fixed the exchange rate to 1,600
bolivars for each U.S. dollar. In February 2004, the government devalued the
currency by approximately 17%. The impact of any further devaluation on our
results will depend upon the amount of our net assets or liabilities exposed to
currency fluctuation in Venezuela in future periods. For the nine months ended September 30, 2004, our Argentine operations
represented approximately 5% of our revenue 37




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and 9% of our gross profit. For the nine months ended September 30, 2004, our
Venezuelan operations represented approximately 12% of our revenue and 21% of
our gross profit. At September 30, 2004, we had approximately $18.8 million and
$26.9 million in accounts receivable related to our Argentine and Venezuelan
operations, respectively. The following table summarizes the exchange gains (losses) we recorded for
assets exposed to currency translation (in thousands): Nine Months EndedSeptember 30,2004
    
    2003Canada
    
    $
    850
    
    
    $
    177Argentina
    
    
    (868
    )
    
    
    1,082Venezuela
    
    
    1,299
    
    
    
    (1,866
    )All other countries
    
    
    126
    
    
    
    (729
    )Exchange
gain (loss)
    
    $
    1,407
    
    
    $
    (1,336
    )
 In December 2002, opponents of Venezuelan President Hugo Chávez initiated a
country-wide strike by workers of the national oil company in Venezuela. This
strike, a two-month walkout, had a significant negative impact on Venezuelas
economy and temporarily shut down a substantial portion of Venezuelas oil
industry. As a result of the strike, Venezuelas oil production dropped
substantially. In addition, exchange controls have been put in place that put
limitations on the amount of Venezuelan currency that can be exchanged for
foreign currency by businesses operating inside Venezuela. In May 2003, after
nine months of negotiation, the Organization of the American States brokered an
agreement between the Venezuelan government and its opponents. Although the
accord does offer the prospect of stabilizing Venezuelas economy, if another
national strike is staged, exchange controls remain in place, or economic and
political conditions in Venezuela continue to deteriorate, our results of
operations in Venezuela could be materially and adversely affected, which could
result in reductions in our net income. As a result of the disruption of our
operations in Venezuela, during the fourth quarter of 2002, our international
rental revenues decreased by approximately $2.7 million. In the nine months
ended September 30, 2003, we recognized approximately $2.7 million of billings
to Venezuelan customers that were not recognized in 2002 due to concerns about
the ultimate receipt of those revenues. In July 2004, Wilpro Energy Services (PIGAP II) Limited (referred to as PIGAP
II) received a notice of default from the Venezuelan state oil company, PDVSA,
alleging that PIGAP II is not in compliance under a services agreement as a
result of certain operational issues. PIGAP II is a joint venture, currently
owned 70% by a subsidiary of The Williams Companies, Inc. (Williams) and 30%
by Hanover, that operates a natural gas compression facility in Venezuela.
PIGAP II has informed us that it does not believe a basis exists for such
notice and that it is contesting the giving of this notice. Nonetheless, the
giving of this notice of default could be deemed an event of default under
PIGAP IIs outstanding project loans totaling approximately $207.7 million. We
understand, however, that the lenders under the PIGAP II project loan agreement
have confirmed to PIGAP II in writing that based on the facts they currently
know, they have no intention of exercising any rights or remedies under the
PIGAP II project loan agreements until the issues raised in the notice and
PIGAP IIs response are clarified, but have cautioned PIGAP II to refrain from
undertaking any extraordinary expenses or restricted payments until the issue
has been fully resolved. In any event, Hanover has
not guaranteed and is not otherwise liable for the PIGAP II project loans and
an event of default under such project loans does not trigger a default under
Hanovers debt obligations. Hanovers net book investment in PIGAP II at
September 30, 2004 was approximately $30.9 million and Hanovers pretax income
with respect to PIGAP II for the nine months ended September 30, 2004 was
approximately $9.6 million. The economic situation in Argentina and Venezuela is subject to change. To the
extent that the situation deteriorates, exchange controls continue in place and
the value of the peso and bolivar against the dollar is reduced further, our
results of operations in Argentina and Venezuela could be materially and
adversely affected which could result in reductions in our net income. 38




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We are involved in a project to build and operate barge-mounted gas compression
and gas processing facilities to be stationed in a Nigerian coastal waterway as
part of the performance of a contract between an affiliate of The Royal/ Dutch
Shell Group (Shell) and Global Energy and Refining Ltd. (Global), a
Nigerian company. We have completed the building of the required barge-mounted
facilities. Under the terms of a series of contracts between Global and us,
Shell, and several other counterparties, respectively, Global is responsible
for the development of the overall project. In light of the political
environment in Nigeria, Globals capitalization level and lack of a successful
track record with respect to this project and other factors, there is no
assurance that Global will be able to comply with its obligations under these
contracts. In May 2004, we reached an agreement with Global whereby Global
prepaid to us $5.0 million in equipment rental fees, that we recorded in other
liabilities on our condensed consolidated balance sheet, in return for our
agreement to waive certain defaults by Global with respect to some of our
agreements with them. If Shell were to terminate its contract with Global for any reason or we were
to terminate our involvement in the project, we would be required to find an
alternative use for the barge-mounted facility which could result in a
write-down of our investment. At September 30, 2004, we had an investment of
approximately $33.8 million associated with the barge-mounted facility and
approximately $4.2 million associated with advances to, and our investment in,
Global. NEW ACCOUNTING PRONOUNCEMENTS In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity (SFAS 150).
SFAS 150 changes the accounting for certain financial instruments that, under
previous guidance, issuers could account for as equity. SFAS 150 requires that
those instruments be classified as liabilities in statements of financial
position. SFAS 150 is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective for interim periods
beginning after June 15, 2004. On November 7, 2003 the FASB issued Staff
Position 150-3 that delayed the effective date for certain types of financial
instruments. We do not believe the adoption of the guidance currently provided
in SFAS 150 will have a material effect on our consolidated results of
operations or cash flow. However, we may be required to classify as debt
approximately $20.3 million in sale leaseback obligations that, as of September
30, 2004, were reported as Minority interest on our condensed consolidated
balance sheet pursuant to FIN 46. These minority interest obligations represent the equity of the entities that
lease compression equipment to us. In accordance with the provisions of our
compression equipment lease obligations, the equity certificate holders are
entitled to quarterly or semi-annual yield payments on the aggregate
outstanding equity certificates. As of September 30, 2004, the yield rates on
the outstanding equity certificates ranged from 4.9% to 10.0%. Equity
certificate holders may receive a return of capital payment upon termination of
the lease or our purchase of the leased compression equipment after full
payment of all debt obligations of the entities that lease compression
equipment to us. At September 30, 2004, the carrying value of the minority
interest obligations approximated the fair market value of assets that would be
required to be transferred to redeem the minority interest obligations. In April 2004, the Emerging Issues Task Force reached a consensus on Issue No.
03-06, Participating Securities and the Two-Class Method Under FASB Statement
No. 128, Earnings Per Share (EITF 03-06). EITF 03-06 addresses a number of
questions regarding the computation of earnings per share by companies that
have issued securities other than common stock that contractually entitle the
holder to participate in dividends and earnings of the company when, and if, it
declares dividends on its common stock. The issue also provides further
guidance in applying the two-class method of calculating earnings per share,
clarifying what constitutes a participating security and how to apply the
two-class method of computing earning per share once it is determined that a
security is participating, including how to allocate undistributed earnings to
such a security. EITF 03-06 is effective for fiscal periods beginning after
March 31, 2004. The adoption of EITF 03-06 did not have an effect on our net
income (loss) per share. 39




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In September 2004, the Emerging Issues Task Force reached a consensus on Issue
No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per
Share, which changes the treatment of contingently convertible debt
instruments in the calculation of diluted earnings per share. Contingently
convertible debt instruments are financial instruments that include a
contingent feature, such as a feature by which the debt becomes convertible
into common shares of the issuer if the issuers common stock price has
exceeded a predetermined threshold for a specified time period. Prior to the
new consensus, most issuers excluded the potential dilutive effect of the
conversion feature from diluted earnings per share until the contingency
threshold is met. EITF Issue No. 04-08 provides that these debt instruments
should be included in the earnings per share computation (if dilutive)
regardless of whether the contingent feature has been met. This change does not
have any effect on net income (loss), but may affect the related per share
amounts. The new rules will be effective for reporting periods ending after
December 15, 2004. We are currently evaluating the impact of adoption of EITF
04-08 on our earnings (loss) per share. In October 2004, the Emerging Issues Task Force reached a consensus on Issue
No. 04-10, Determining Whether to Aggregate Operating Segments That Do Not
Meet the Quantitative Thresholds, which clarifies the guidance in paragraph 19
of SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information. According to EITF Issue No. 04-10, operating segments that do not
meet the quantitative thresholds can be aggregated only if aggregation is
consistent with the objective and basic principles of SFAS No. 131, the
segments have similar economic characteristics, and the segments share a
majority of the aggregation criteria listed in items (a)-(e) in paragraph 17 of
SFAS No. 131. The consensus applies to fiscal years ending after October 13,
2004. We are currently evaluating the impact of applying this guidance. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to interest rate and foreign currency risk. Hanover and its
subsidiaries periodically enter into interest rate swaps to manage our exposure
to fluctuations in interest rates. At September 30, 2004, the fair market value
of our interest rate swaps, excluding the portion attributable to and included
in accrued interest, was a liability of approximately $11.0 million. At September 30, 2004 we were a party to three interest rate swaps to convert
variable lease payments under certain lease arrangements to fixed payments as
follows (dollars in thousands): Fair Value of theCompany Pays
    
    
    
    
    
    Swap atMaturity Date
    
    Fixed Rate
    
    Notional Amount
    
    September 30, 20043/11/2005
    
    
    
    5.2550
    %
    
    $
    100,000
    
    
    $
    (1,397
    )3/11/2005
    
    
    
    5.2725
    %
    
    $
    100,000
    
    
    $
    (1,407
    )10/26/2005
    
    
    
    5.3975
    %
    
    $
    100,000
    
    
    $
    (3,133
    )
 At September 30, 2004 we were a party to two interest rate swaps to convert
fixed rate debt to floating rate debt as follows (dollars in thousands): Fair Value of theCompany Receives
    
    
    
    
    
    Swap atMaturity Date
    
    Fixed Rate
    
    Notional Amount
    
    September 30, 200412/15/2010
    
    
    
    8.625
    %
    
    $
    100,000
    
    
    $
    (2,908
    )12/15/2010
    
    
    
    8.625
    %
    
    $
    100,000
    
    
    $
    (2,144
    )
 At September 30, 2004, due to these two swaps, we were exposed to variable
interest rates, which fluctuate with market interest rates, on $200 million in
notional debt. Assuming a hypothetical 10% increase in the variable rates from
those in effect at September 30, 2004, the increase in our annual interest
expense with respect to such swaps would be approximately $1.4 million. 40




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At September 30, 2004, we were exposed to variable rental rates, which
fluctuate with market interest rates, on a portion of the equipment leases we
entered into in 2001 and 2000. Assuming a hypothetical 10% increase in the
variable rates from those in effect at September 30, 2004, the increase in
annual interest expense on the equipment lease notes would be approximately
$0.2 million. We are also exposed to interest rate risk on borrowings under our bank credit
facility under which interest may be accrued on advances at a floating interest
rate. At September 30, 2004, $13.0 million was outstanding bearing interest at
a weighted average effective rate of 5.7% per annum. Assuming a hypothetical
10% increase in the weighted average interest rate from those in effect at
September 30, 2004, the increase in annual interest expense for advances under
this facility would be approximately $0.1 million. We have significant operations that expose us to currency risk in Argentina and
Venezuela. To mitigate that risk, the majority of our existing contracts
provide that we receive payment in or based on U.S. dollars rather than
Argentine pesos and Venezuelan bolivars, thus reducing our exposure to
fluctuations in the value of those currencies relative to the U.S. dollar. In
February 2003, the Venezuelan government fixed the exchange rate to 1,600
bolivars for each U.S. dollar. In February 2004, the government devalued the
currency by approximately 17%. The impact of any further devaluation on our
results will depend upon the amount of our net assets or liabilities exposed to
currency fluctuation in Venezuela in future periods. For the nine months ended September 30, 2004, our Argentine operations
represented approximately 5% of our revenue and 9% of our gross profit. For the
nine months ended September 30, 2004, our Venezuelan operations represented
approximately 12% of our revenue and 21% of our gross profit. At September 30,
2004, we had approximately $18.8 million and $26.9 million in accounts
receivable related to our Argentine and Venezuelan operations, respectively. The following table summarizes the exchange gains (losses) we recorded for
assets exposed to currency translation (in thousands): Nine Months EndedSeptember 30,2004
    
    2003Canada
    
    $
    850
    
    
    $
    177Argentina
    
    
    (868
    )
    
    
    1,082Venezuela
    
    
    1,299
    
    
    
    (1,866
    )All other countries
    
    
    126
    
    
    
    (729
    )Exchange gain (loss)
    
    $
    1,407
    
    
    $
    (1,336
    )
 The economic situation in Argentina and Venezuela is subject to change. To the
extent that the situation deteriorates, exchange controls continue in place and
the value of the peso and bolivar against the dollar is reduced further, our
results of operations in Argentina and Venezuela could be materially and
adversely affected which could result in reductions in our net income. 41




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ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures.Hanovers principal
executive officer, who is also currently our principal financial officer,
evaluated the effectiveness of our disclosure controls and procedures (as
defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of
September 30, 2004. Based on the evaluation, our principal executive officer
and principal financial officer believes that our disclosure controls and
procedures were effective to ensure that material information was accumulated
and communicated to our management, including our principal executive officer
and principal financial officer, as appropriate to allow timely decisions
regarding required disclosure. (b) Changes in Internal Controls.Under the direction of our President and
Chief Executive Officer and in connection with our implementation of Section
404 of the Sarbanes-Oxley Act, we continued the process of reviewing our
internal controls and procedures for financial reporting and have changed or
are in the process of improving controls and procedures, including
changes relating to: information systems (including controls over access to the
systems and segregation of duties); human resources; internal audit; tax
accounting; planning and analysis; reconciliation of accounts; approval of
expenditures; preparation, approval and closing of significant agreements and
transactions; integration of acquired businesses and assets (including
integration of certain financial and accounting systems related thereto);
policies and procedures related to purchasing, inventory and project
management; standardization of internal controls and policies across the
organization; and the development, implementation and enhancements of corporate
governance policies and procedures. This review is ongoing, and the review to
date constitutes the evaluation required by Rule 13a-15(d) of the Securities
Exchange Act of 1934. 42




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PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS On June 30, 2004, the Texas Commission on Environmental Quality (TCEQ) informed
the Company that it was pursuing an enforcement action against the Companys
subsidiary, HCLP, for alleged violations of the Texas Health and Safety Code
and Commission Rules at the Redwood Hanover Gateway Plant (RHG Plant) in
Madison County, Texas. The alleged violations include failure to comply with
certain permit limitations relating to sulfur emissions during certain periods
in 2003 and 2004 and failure to provide certain required notifications in
connection therewith. TCEQ has proposed a settlement of $149,625 in respect of
the alleged violations in the form of a proposed Agreed Order dated June 29,
2004. The Company requested a meeting with the TCEQ to discuss the allegations
and to challenge certain assumptions made by the TCEQ. Such meeting occurred on
August 18, 2004 in which we presented our revised calculations and other
responses to the TCEQ, the result of which was a settlement of the action for
$46,200 that is subject to publication of the proposed Agreed Order by the TCEQ
for a 30-day public comment period and final approval by the TCEQ. The comment
period commenced on October 8, 2004 and will end on November 8, 2004. The
Agreed Order is currently set for hearing on November 10, 2004, if approved at
the hearing, the Agreed Order will become final. On July 6, 2004 the California South Coast Air Quality Management District (the
CSAD) informed the Company that the CSAD was pursuing an enforcement action
against the Companys subsidiary, HCLP for alleged violations involving failure
to comply with the permitted emission limitations applicable to certain of
HCLPs compressed natural gas (CNG) fueling stations located in the State of
California. The alleged violations center on excess emissions of oxides of
nitrogen and carbon monoxide from twelve natural gas-fired internal combustion
engines. The CSAD initially estimated they would seek a penalty
against us of approximately $200,000. After settlement discussions over the last several
months, we believe that HCLP now has an agreement in principle with CSAD to
settle the matter for a $50,000 penalty and a future obligation to replace two
HCLP trucks with CNG vehicles. The Company is waiting for the final resolution
letter confirming the settlement from CSAD. In the ordinary course of business we are involved in various other pending or
threatened legal actions, including environmental matters. While management is
unable to predict the ultimate outcome of these actions, it believes that any
ultimate liability arising from these actions will not have a material adverse
effect on our consolidated financial position, results of operations or cash
flows. 43




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ITEM 6: EXHIBITS Exhibits  31.1
    
    Certification of the Chief Executive Officer
and Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of
2002(1)32.1
    
    Certification of the Chief Executive Officer
and Chief Financial Officer pursuant to 18
U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002(2)  (1)
    
    Filed herewith.(2)
    
    Furnished herewith. 44




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SIGNATURES  Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. HANOVER COMPRESSOR COMPANY Date: November 4, 2004 By:
    
    /s/ JOHN E. JACKSONJohn E. JacksonChief Executive Officer and President(Principal Executive Officer and Principal Financial Officer)
 45




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EXHIBIT INDEX  31.1
    
    Certification of the Chief Executive Officer and Chief
Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002(1)32.1
    
    Certification of the Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350
as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002(2)  (1)
    
    Filed herewith.(2)
    
    Furnished herewith. 46