Item 1. Business
General
Hanover Compressor Company (the "Company") was incorporated in Delaware in 1990 and is a market leader in full-service natural gas compression and a leading provider of contract natural gas handling service, fabrication and equipment. As of December 31, 1999, the Company operated a fleet of 3,898 compression rental units with an aggregate capacity of approximately 1,458,000 horsepower. The Company's compression services are complemented by its compressor and oil and gas production equipment fabrication operations.
The Company believes it is currently the largest natural gas compression company in the United States on the basis of aggregate rental horsepower with 3,608 rental units having an aggregate capacity of approximately 1,181,000 horsepower at December 31, 1999. Internationally, the Company estimates it is one of the largest providers of compression services in the South American market, primarily in Argentina, Colombia and Venezuela, operating 290 units with approximately 277,000 horsepower at December 31, 1999.
The Company's products and services are important for the production, transportation, processing and storage of natural gas and are provided primarily to energy producers and processors. The Company's decentralized operating structure, technically experienced personnel and high quality compressor fleet, allow the Company to successfully provide reliable and timely customer service. As a result, the Company has experienced substantial growth over the past five years and has developed and maintained a number of long-term customer relationships. This has enabled the Company to maintain an average horsepower utilization rate of approximately 93% over the last five years in comparison to an industry average estimated by the Company to be approximately 83%.
The Company currently competes primarily in the transportable natural gas compression market for units of up to 4,450 horsepower. This market, which includes rental and owner operated units, accounts for over 14.9 million horsepower in the United States and is believed to have grown by approximately 8% compounded rate per annum since 1992. The Company believes that the growth in the domestic gas compression market will continue due to the increased consumption of natural gas, the continued aging of the natural gas reserve base and the attendant decline of wellhead pressures, and the discovery of new reserves.
The rental portion of the domestic gas compression market is currently estimated to comprise approximately 4.8 million horsepower amounting to 37% of the aggregate U.S. horsepower. Growth of rental compression capacity in the U.S. market is primarily driven by the increasing trend toward outsourcing by energy producers
and processors. The Company believes that outsourcing provides the customer greater financial and operating flexibility by minimizing the customer's investment in equipment and enabling the customer to more efficiently resize compression units to meet the changing needs of the well, pipeline or processing plant. In addition, the Company also believes that outsourcing typically provides the customer with more timely and technically proficient service and necessary maintenance which often reduces operating costs. Internationally, the Company believes similar growth opportunities for compressor rental and sales exist due to (i) increased worldwide energy consumption, (ii) implementation of international environmental and conservation laws preventing the flaring of natural gas, and (iii) increased outsourcing by energy producers and processors.
Compressor Rental Fleet
The size and horsepower of the Company's compressor rental fleet owned or operated under lease on December 31, 1999 is summarized in the following table.
Industry Overview
Gas Compression
Typically, compression is required several times during the natural gas production cycle: at the wellhead, gathering lines, into and out of gas processing facilities, into and out of storage, and throughout the intrastate and interstate pipelines.
Over the life of an oil or gas well, natural reservoir pressure and deliverability typically declines as reserves are produced. As the natural reservoir pressure of the well declines below the line pressure of the gas gathering or pipeline system used to transport the gas to market, gas no longer naturally flows into the pipeline. It is at this time that compression equipment is applied to economically boost the well's production levels and allow gas to be brought to market.
In addition to such gas field gathering activities, natural gas compressors are utilized in a number of other applications, all of which are intended to enhance the productivity of oil and gas wells, gas transportation lines and processing plants. Compressors are used to increase the efficiency of a low capacity gas field by providing a central compression point from which the gas can be removed and injected into a pipeline for transmission to facilities for further processing. As gas is transported through a pipeline, compression equipment is applied to allow the gas to continue to flow in the pipeline to its destination. Additionally, compressors are utilized to re-inject associated gas to artificially lift liquid hydrocarbons which increases the rate of crude oil production from oil and gas wells. Furthermore, compression enables gas to be stored in underground storage reservoirs for subsequent extraction during periods of peak demand. Finally, in combination with oil and gas production equipment, compressors are often utilized to process and refine oil and gas into higher value added and more marketable energy sources.
Changing well and pipeline pressures and conditions over the life of a well often require producers to reconfigure their compressor units to optimize the well production or pipeline efficiency. Due to the technical nature of the equipment, a highly trained staff of field service personnel, parts inventory and a diversified fleet of
natural gas compressors are often necessary to perform such functions in the most economic manner. These requirements, however, have typically proven to be an extremely inefficient use of capital and manpower for independent natural gas producers and have caused such firms as well as natural gas processors and transporters to increasingly outsource their non-core compression activities to specialists such as the Company.
The advent of rental and contract compression roughly 40 years ago made it possible for natural gas producers, transporters and processors to improve the efficiency and financial performance of their operations. Compressors leased from specialists generally have a higher rate of mechanical reliability and typically generate greater productivity than those owned by oil and gas operators. Furthermore, because compression needs of a well change over time, outsourcing of compression equipment enables an oil and gas operator to better match variable compression requirements to the production needs throughout the life of the well. Also, certain major domestic oil companies are seeking to streamline their operations and reduce their capital expenditures and other costs. To this end, they have sold certain domestic energy reserves to independent energy producers and are outsourcing facets of their operations. Such initiatives, in the opinion of the Company, are likely to contribute to increased rental of compressor equipment.
Natural gas compressor fabrication involves the design, fabrication and sale of compressors to meet the unique specifications dictated by the well pressure, production characteristics and the particular applications for which compression is sought. Compressor fabrication is essentially an assembly operation in which an engine, compressor, control panel, cooler and necessary piping are attached to a frame called a "skid". A fabricator typically purchases the various compressor components from third party manufacturers but employs its own engineers and design and labor force.
In order to meet customers' needs, gas compressor fabricators typically offer a variety of services to their customers including: (i) engineering, fabrication and assembly of the compressor unit; (ii) installation and testing of the units; (iii) ongoing performance review to assess the need for a change in compression; and (iv) periodic maintenance and replacement parts supply.
Production Equipment
Oil and gas reserves are generally not commercially marketable as produced at the wellhead. Typically, such reserves must be refined before they can be transported to market. Oil and gas production equipment is utilized to separate and treat such oil and gas immediately after it is produced in order to facilitate further processing, transportation and sale of such fuels and derivative energy sources. Oil and gas production equipment is typically installed at the wellhead immediately prior to commencing the large scale production phase of a well and remains at the site through the life of the well.
Market Conditions
The Company believes that the most fundamental force driving the demand for gas compression and production equipment is the growing consumption of natural gas. As more gas is consumed, the demand for compression and production equipment increases.
Additionally, although natural gas has historically been a more significant source of energy in the United States than in the rest of the world, the Company believes that aggregate foreign natural gas consumption (excluding the former Soviet Union) has recently grown. Despite significant growth in energy demand, most non-U.S. energy markets, until recently, have typically lacked the infrastructure to transport natural gas to local markets, and natural gas historically has been flared at the wellhead. Given recent environmental legislation and the construction of numerous natural gas-fueled power plants built to meet international energy demand, the Company believes that international compression markets are experiencing growth.
Natural gas is considered to be the "fuel of the future" because it provides the best mix of environment soundness, economy and availability of any energy source. Rising worldwide energy demand, environmental considerations, the further development of the natural gas pipeline infrastructure and the increasing use of natural gas as a fuel source in power generation are the principal reasons for this steady growth.
While gas compression and production equipment typically must be highly engineered to meet demanding and unique customer specifications, the fundamental technology of such equipment has been stable and has not been subject to significant technological change.
Business Segments
The Company's revenues and income are derived from its four business segments (comprising three operating divisions)--domestic compression rentals, international compression rentals, compressor fabrication and production equipment fabrication. The compression rentals segments have operations primarily in the United States, Canada and South America. For financial data relating to the Company's divisions, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 17 to the Notes to the Consolidated Financial Statements.
Compression Services and Fabrication
The Company provides its customers with a full range of compressor rental, maintenance and contract compression services. As of December 31, 1999, the Company's gas compressor fleet consisted of 3,898 units, ranging from 24 to 4,450 horsepower. The size, type and geographic diversity of this rental fleet enables the Company to provide its customers with a range of compression units that can serve a wide variety of applications, and to select the correct equipment for the job, rather than trying to "fit" the job to its fleet of equipment.
The Company bases its gas compressor rental rates on several factors, including the cost and size of the equipment, the type and complexity of service desired by the customer, the length of the contract, and the inclusion of any other services desired, such as installation, transportation and the degree of daily operation. Substantially all of the Company's units are operated pursuant to "contract compression" or "rental with full maintenance" contracts under which the Company performs all maintenance and repairs on such units while under contract. In the United States onshore market, compression rental fleet units are generally leased on minimum terms of 6 to 12 months, which convert to month-to-month at the end of the stipulated minimum period. Historically, the majority of the Company's customers have extended the length of their contracts, on a month-to-month basis, well beyond the initial term. Typically, the Company's compression rental units utilized in offshore and international applications carry substantially longer lease terms than those for onshore domestic applications.
An essential element to the Company's success is its ability to provide its compression services to customers with contractually committed compressor run- times of at least 97%. Historically, run time credits have been insignificant, due largely to the Company's rigorous preventive maintenance program and extensive field service network which permits the Company to promptly address maintenance requirements. The Company's rental compressor maintenance activities are conducted at nine Company facilities staffed by approximately 600 experienced and factory trained maintenance personnel. Such maintenance facilities are situated in close proximity to actual rental fleet deployment to permit superior service response times.
All rental fleet units are serviced at manufacturers' recommended maintenance intervals, modified as required by the peculiar characteristics of each individual job, and the actual operating experience of each compressor unit. Prior to the conclusion of any rental job, the Company field management evaluates the condition of the equipment and, where practical, corrects any problems before the equipment is shipped out from the job site. Although natural gas compressors generally do not suffer significant technological obsolescence, they do require routine maintenance and periodic refurbishing to prolong their useful life. Routine maintenance includes alignment, compression checks, and other parametric checks which indicate a change in the condition of the equipment. In addition, oil and wear-particle analysis is performed on all units prior to their redeployment at specific compression rental jobs. Overhauls are done on a condition-based interval instead of a time-based schedule. In the Company's experience, these rigorous procedures maximize component life and unit availability and minimize avoidable downtime. Typically, the Company overhauls each rental compressor unit for general refurbishment every 36-48 months and anticipates performing a comprehensive overhaul of each rental compressor unit every 60 to 72 months. This maintenance program has provided the Company with a highly reliable fleet of compressors in excellent condition.
The Company's field service mechanics provide all operating and maintenance services for each of the Company's compression units leased on a contract compression or full maintenance basis and are on-call 24 hours a day. Such field personnel receive regular mechanical and safety training both from the Company and its vendors. Each of the Company's field mechanics is responsible for specific compressor unit installations and has at his disposal a dedicated, local parts inventory. Additionally, each field mechanic operates from a fully- equipped service vehicle. Each mechanic's field service vehicle is radio or cellular telephone equipped which allows that individual to be the Company's primary contact with the customer's field operations staff and to be contacted at either his residence or mobile phone 24 hours a day. Accordingly, the Company's field service mechanics are given the responsibility to promptly respond to customer service needs as they arise based on the mechanic's trained judgment and field expertise.
The Company considers itself to be unique in its industry in that its sales and field service organizations enjoy managerial parity within the Company, enabling these two vital organizations to work together in a highly coordinated fashion in order to deliver maximum customer service, responsiveness and reliability. The foundation for Hanover's successful field operations effort is the experience and responsiveness of its approximately 600 member compressor rental field service and shop staff of factory-trained and field-tested compressor mechanics. The Company's field service mechanics are coordinated and supported by regional operations managers who have supervisory responsibility for specific geographic areas.
The Company's compressor fabrication subsidiary doing business as Hanover Maintech, designs, engineers and assembles compression units for sale to third parties as well as for placement in its compressor fleet. As of December 31, 1999, the Company had a compressor unit fabrication backlog for sale to third parties of $2.2 million. All backlog is expected to be produced within a 90-120 day period. In general, units to be sold to third parties are assembled according to each customer's specifications and sold on a turnkey basis. Components for such compressor units are acquired from third party suppliers.
Oil and Gas Production Equipment
The Company, through its wholly-owned subsidiary doing business as Hanover Smith designs, engineers, fabricates and either sells or occasionally rents a broad range of oil and gas production equipment designed to heat, separate, dehydrate and measure crude oil and natural gas. The product line includes line heaters, oil and gas separators, glycol dehydration units and skid mounted production packages designed for both onshore and offshore production facilities. The Company generally maintains standard product inventories in excess of $5 million and is therefore able to meet most customers' rapid response requirements and minimize customer downtime. As of December 31, 1999, the Company had a production equipment fabrication backlog of $2.9 million. All backlog is expected to be produced within a 90-120 day period. The Company also purchases and reconditions used production equipment which is then sold or rented.
Market and Customers
The Company's customer base consists of over 800 U.S. and international companies engaged in all aspects of the oil and gas industry, including major integrated oil and gas companies, large and small independent producers, natural gas processors, gatherers and pipelines. Additionally, the Company has negotiated more than 15 strategic alliances or preferred vendor relationships with key customers pursuant to which the Company receives preferential consideration in customer compressor and oil and gas production equipment procurement decisions in exchange for enhanced product availability, product support, automated procurement practices and limited pricing concessions. No individual customer accounted for more than 10% of the Company's consolidated revenues during 1998 or 1999.
The Company's domestic compressor leasing activities are currently located in Texas, Oklahoma, Arkansas, Louisiana, New Mexico, Mississippi, Alabama, Kansas, Colorado, California, Utah, Wyoming and offshore Gulf of Mexico. International locations include Argentina, Venezuela, Colombia, Trinidad, Bolivia, Mexico, Indonesia and Canada. As of December 31, 1999, approximately 9% and 19% of the Company's compressor horsepower was being used in offshore and international applications, respectively.
Sales and Marketing
The Company's more than 60 salespeople are organized into eight sales regions reporting to three sales vice presidents. The sales vice presidents report to the Company's Senior Vice President of Sales. The Company's sales representatives aggressively pursue the rental and sale market in their respective territories for compressors and production equipment. Each Company salesperson is assigned a customer list on the basis of the experience and personal relationships of the salesperson and the individual service requirements of the customer. This customer and relationship-focused strategy is communicated through frequent direct contact, technical presentations, print literature, print advertising and direct mail. The Company's advertising and promotion strategy is a "concentrated" approach, tailoring specific messages into a very focused presentation methodology.
Additionally, the Company's salespeople coordinate with each other to effectively pursue customers who operate in multiple regions. The salespeople maintain intensive contact with the Company's operations personnel in order to promptly respond to and satisfy customer needs. The Company's sales efforts concentrate on demonstrating the Company's commitment to enhancing the customer's cash flow through superior product design, fabrication, installation, customer service and after-market support.
Upon its receipt of a request for proposal or bid by a customer, the Company assigns a team of sales, operations and engineering personnel to analyze the application and prepare a quotation, including selection of the equipment, pricing and delivery date. The quotation is then delivered to the customer, and if the Company is selected as the vendor, final terms are agreed upon and a contract or purchase order is executed. The Company's engineering and operations personnel also often provide assistance on complex compressor applications, field operations issues or equipment modifications.
Competition
The natural gas compression services and fabrication business is highly competitive. Overall, the Company experiences considerable competition from companies with significantly greater financial resources and, on a regional basis, from several smaller companies which compete directly with the Company. The Company believes it is currently the largest natural gas compression company in the United States on the basis of aggregate rental horsepower.
Compressor industry participants can achieve significant advantages through increased size and geographic breadth. As the number of rental units increases in a rental fleet, the number of sales, engineering, administrative and maintenance personnel required does not increase proportionately. As a result, companies such as Hanover with larger rental fleets have relatively lower operating costs and higher margins due to economies of scale than smaller companies.
One of the significant cost items in the compressor rental business is the amount of inventory required to service rental units. Each rental company must maintain a minimum amount of inventory to stay competitive. As the size of the rental fleet increases, the required amount of inventory does not increase in the same proportion. The larger rental fleet companies can generate cost of capital savings through improved purchasing power and vendor support.
The Company believes that it competes effectively on the basis of price, customer service, including the availability of personnel in remote locations, flexibility in meeting customer needs and quality and reliability of its compressors and related services.
The Company's compressor fabrication business competes with other fabricators of compressor units. The compressor fabrication business is dominated by a few major competitors, several of which also compete with the Company in the compressor rental business. The Company is the largest compressor fabrication company in the United States.
The production equipment business is a highly fragmented business with approximately eight substantial U.S. competitors. Although sufficient information is not available to definitively estimate the Company's relative
position in this market, the Company believes that it is among the top three oil and gas production equipment fabricators in the United States.
Government Regulation
The Company is subject to various federal and state laws and regulations relating to environmental protection, including regulations regarding emission controls. These laws and regulations may affect the costs of the Company's operations. As with any owner of property, the Company is also subject to clean-up costs and liability for hazardous materials, asbestos, or any other toxic or hazardous substance that may exist on or under any of its properties.
The Company believes that it is in substantial compliance with environmental laws and regulations and that the phasing in of emission controls and other known regulatory requirements at the rate currently contemplated by such laws and regulations will not have a material adverse effect on the Company's financial condition, results of operations or cash flows.
Notwithstanding, in part because of the Company's rapid growth through acquisitions, the Company may not be in compliance with certain environmental requirements for recently acquired facilities. The Company investigates these issues and takes action where appropriate.
The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), also known as the "Superfund" law, imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons who are considered to be responsible for the release of a "hazardous substance" into the environment. These persons include the owner or operator of the disposal site or sites where the release occurred and companies that disposed or arranged for the disposal of the hazardous substances. Under CERCLA, such persons may be subject to joint and several liability for the costs of cleaning up the hazardous substances that have been released into the environment, for damages to natural resources, and for the costs of certain health studies. Furthermore, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by hazardous substances or other pollutants released into the environment.
The Resource Conservation and Recovery Act ("RCRA") and regulations promulgated thereunder govern the generation, storage, transfer and disposal of hazardous wastes. The Company must comply with RCRA regulations for any of its operations that involve the generation, management, or disposal of hazardous wastes (such as painting activities or the use of solvents).
Stricter standards in environmental legislation that may affect the Company may be imposed in the future, such as proposals to make hazardous wastes subject to more stringent and costly handling, disposal and clean-up requirements. While the Company may be able to pass on the additional costs of complying with such laws to its customers, there can be no assurance that attempts to do so will be successful. Accordingly, new laws or regulations or amendments to existing laws or regulations could require the Company to undertake significant capital expenditures and could otherwise have a material adverse effect on the Company's business, results of operations, cash flows and financial condition.
Executive Officers
The following sets forth, as of March 23, 2000, the name, age and business experience for the last five years of each of the executive officers of the Company.
MICHAEL A. O'CONNOR has served as Chairman of the Board and a director of the Company since January 1992. Mr. O'Connor also serves as an officer and a director of certain subsidiaries of the Company.
MICHAEL J. MCGHAN has served as President and Chief Executive Officer of the Company since October 1991. Mr. McGhan has served as a director of the Company since March 1992. Mr. McGhan also serves as an officer and as a director of certain subsidiaries of the Company.
CURTIS BEDRICH has served as Chief Financial Officer and Treasurer of the Company since November 1991. Mr. Bedrich also serves as an officer of certain subsidiaries of the Company.
WILLIAM S. GOLDBERG has served as Executive Vice President and director of the Company since May 1991. Mr. Goldberg has been employed by GKH Investments, L.P., a Delaware limited partnership (the "Fund") and GKH Private Limited (collectively with the Fund, "GKH") since 1988 and has served as Managing Director of GKH since June 1990. The Fund is the Company's largest stockholder. Mr. Goldberg also serves as an officer and a director of certain affiliates of the Company. Mr. Goldberg is also a director of DVI, Inc.
Employees
As of December 31, 1999, the Company had approximately 1,433 employees. No employees are represented by labor unions and the Company believes that its relations with its employees are satisfactory.
Item 2.
Item 2. Properties
The Company owns its corporate offices in Houston, Texas, which are housed in a combination corporate office and compressor fabrication complex, including a 192,000 square foot plant located on approximately 28 acres. The Company also owns (i) a 11,700 square foot combination office and maintenance facility located on 6.5 acres in Yukon, Oklahoma, (ii) a 8,000 square foot combination office and maintenance facility situated on 6 acres in Pocola, Oklahoma, (iii) 12,000 square feet of maintenance facilities situated on 3.5 acres in Midland, Texas, (iv) a 5,000 square foot sales and service facility situated on one acre located in Corpus Christi, Texas, (v) a 345,000 square foot manufacturing facility in Davis, Oklahoma, (vi) a 16,750 square foot facility situated on 9.2 acres in Kilgore, Texas, (vii) a 210,000 square foot production equipment manufacturing facility located on 82 acres in Columbus, Texas (viii) a 35,000 square foot combination of office, warehouse and maintenance facility situated on 17 acres in Broussard, Louisiana and, (viiii) a 19,000 square foot office and maintenance facility located on 15.3 acres in Farmington, New Mexico. The Company also leases a maintenance facility of 19,000 square feet in Victoria, Texas under a five year lease. In addition, the Company has a three year lease on a 190,000 square foot fabrication facililty in Houston, Texas with an option to purchase the facility at the end of the lease.
The Company's executive offices are located at 12001 North Houston Rosslyn, Houston, Texas 77086 and its telephone number is (281) 447-8787.
Item 3.
Item 3. Legal Proceedings
The Company is not currently involved in any material litigation or proceeding and is not aware of any such litigation or proceeding threatened against it.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of the Company's shareholders during the fourth quarter of its fiscal year ended December 31, 1999.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Common Stock began trading on the New York Stock Exchange on July 1, 1997 under the symbol "HC." The following table sets forth the range of the high and low on market prices for the Common Stock, for the periods indicated.
As of December 31, 1999, there were 28,752,937 shares of Common Stock outstanding, held by approximately 233 stockholders of record.
The Company has not paid any cash dividends on its Common Stock since its formation and does not anticipate paying such dividends in the foreseeable future. The Board of Directors anticipates that all cash flow generated from operations in the foreseeable future will be retained and used to develop and expand the Company's business. The Company's $200 million credit facility with The Chase Manhattan Bank, as agent (the "Bank Credit Agreement") limits the amount of dividends payable by the Company (without the lender's prior approval) on its Common Stock to no more than 25% of the Company's net income for the period from January 1, 1998 until December 15, 2002. In addition, the Company's 7% Subordinated Notes due 2000 (the "Subordinated Notes") prohibit the payment of cash dividends on the Company's capital stock without the lenders' prior written consent. Any future determinations to pay cash dividends on the Common Stock will be at the discretion of the Company's Board of Directors and will be dependent upon the Company's results of operations and financial condition, credit and loan agreements in effect at that time and other factors deemed relevant by the Board of Directors.
In December 1999, the Company issued $86,250,000 of 7.25% Mandatorily Redeemable Convertible Preferred Securities (the "Convertible Preferred Securities") through Hanover Compressor Capital Trust, a Delaware business trust and subsidiary of the Company. The Convertible Preferred Securities have a liquidation amount of $50 per unit. The Convertible Preferred Securities mature in 30 years but may be redeemed partially or in total any time on or after December 20, 2002. The Convertible Preferred Securities also provide for annual cash distributions at the rate of 7.25%, payable quarterly in arrears, however, payments may be deferred up to 20 quarters subject to certain restrictions. Each Convertible Preferred Security is convertible into 1.3986 shares of Hanover common stock, subject to adjustment for certain events.
Set forth below is certain information with respect to all securities of the Company sold by the Company in 1999 which were not registered under the Securities Act of 1933, as amended.
Item 6.
Item 6. Selected Financial Data
SELECTED FINANCIAL DATA (HISTORICAL) (Dollars and shares in thousands, except per share data)
The following table presents certain selected financial data for the Company for each of the five years in the period ended December 31, 1999. The selected financial data have been derived from the audited consolidated financial statements of the Company. The following information should be read together with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company.
- -------- (1) The selected historical financial information includes the results of operations of the Company and its wholly-owned subsidiaries. During 1995, the Company acquired Astra Resources Compression, Inc., a significant subsidiary. (2) In order to more accurately reflect the estimated useful lives of natural gas compressor units in the rental fleet; effective January 1, 1996 the Company changed the lives over which these units are depreciated from 12 to 15 years. The effect of this change was a decrease in depreciation expense of $2.6 million and an increase in net income of $1.5 million ($.07 per diluted common share) for the year ended December 31, 1996. (3) Diluted earnings per share in 1996 was $.46 per share before the effects of charging retained earnings for $1.8 million relating to dividends on redeemable preferred stock and one time charges to retained earnings for (i) $3.8 million related to the exchange of all Series A preferred stock for subordinated notes and (ii) $1.4 million related to the conversion of all Series B preferred stock to Common Stock. (4) EBITDA consists of the sum of consolidated net income before interest expense, lease expense, distributions on mandatorily redeemable preferred securities, income tax, and depreciation and amortization. The Company believes that EBITDA is a meaningful measure of its operating performance and is also used to measure the Company's ability to meet debt service requirements. EBITDA should not be considered as an alternative performance measure prescribed by generally accepted accounting principles.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Management's discussion and analysis of the results of operations and financial condition of the Company should be read in conjunction with the Consolidated Financial Statements and related Notes thereto.
GENERAL
The Company's operations consist of providing gas compression services through renting, maintaining and operating natural gas compressors and engineering, fabricating and selling gas compression and oil and gas production equipment. See "Business".
The following table summarizes revenues, expenses and gross profit percentages for each of the Company's business segments (Dollars in millions):
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998.
Revenues
The Company's total revenues increased by $35.0 million, or 12%, to $317.0 million during 1999 from $282.0 million during 1998. The increase resulted from growth of the Company's natural gas compressor rental fleet but was offset by decreases in compressor fabrication and production equipment fabrication revenues.
Revenues from rentals increased by $45.1 million, or 31%, to $192.7 million during 1999 from $147.6 million during 1998. Domestic revenues from rentals increased by $29.1 million, or 27%, to $136.5 million during 1999 from $107.4 million during 1998. International revenues from rentals increased by $16.0 million, or 40%, to $56.2 million during 1999 from $40.2 million during 1998. At December 31, 1999 the compressor rental fleet consisted of approximately 1,458,000 horsepower, a 37% increase over the 1,067,000 horsepower in the rental fleet at December 31, 1998. Domestically, the rental fleet increased by 289,000 horsepower, or 32%, during 1999 and internationally by 103,000 horsepower, or 59%. The increase in both domestic and international rental revenues resulted primarily from expansion of the Company's rental fleet.
Revenue from parts and service increased by $10.6 million, or 44% to $34.5 million during 1999 from $23.9 million during 1998. Revenues from the fabrication and sale of compressor equipment to third parties decreased by $14.9 million, or 22%, to $52.5 million during from $67.4 million during 1998. An aggregate of 147,000 horsepower was sold during 1999. In addition, 130,000 horsepower was fabricated and placed in the rental fleet during 1999. The Company believes the revenue decrease during 1999 was due in part to a project where a customer supplied its own engines, which are typically provided by the Company, and in part to lower energy prices earlier in 1999, which reduced the demand for compressors thereby adversely impacting sales prices.
Revenues from the fabrication and sale of production equipment decreased by $9.5 million, or 25%, to $28.0 million during 1999 from $37.5 million during 1998 primarily due to the decline in well completions resulting from lower energy prices during the first half of 1999. The Company recognized gains on sales of assets of $5.9 million during 1999 compared to $2.6 million during the 1998. The increase is primarily due to the increase in horsepower sold from the rental fleet to
customers exercising options to purchase equipment they previously had rented. During 1999 the Company sold approximately 20,000 horsepower compared to 14,000 horsepower during 1998.
Expenses
Operating expenses of the rentals segment increased by $15.6 million, or 32% to $65.0 million during 1999 from $49.4 million during 1998. The increase resulted primarily from the corresponding 31% increase in revenues from rentals over the corresponding period in 1998. The gross profit percentage from rentals was 66% during 1999 and 67% during 1998. Operating expenses of parts and service increased $4.4 million, or 25% to $21.7 million during 1999 from $17.3 million during 1998, which relates to the 44% increase in parts and service revenue. The gross profit percentage from parts and service increased to 37% during 1999 from 27% in 1998. Operating expenses of compressor fabrication decreased by $14.4 million, or 25% to $43.7 million from $58.1 million during 1998. The gross profit margin on compression fabrication increased to 17% during 1999, from 14% during 1998. Production equipment fabrication operating expenses decreased by $5.0 million, or 19%, during 1999 to $20.8 million from $25.8 million during 1998. The decrease in operating expenses is reflective of the corresponding change in production equipment fabrication revenues during 1999. The gross profit margin attributable to production equipment fabrication decreased to 26% during 1999, from 31% during 1998.
Selling, general and administrative expenses increased by $7.2 million, or 27% to $33.8 million during 1999. The increase is attributable to increased personnel and other administrative and selling expenses associated with the increase in operating activity in the Company's rentals business segments, as described above.
Depreciation and amortization expense increased by $.2 million, or 1% during 1999 to $37.3 million. The increase in depreciation on the additions to the rental fleet was offset by the decrease in depreciation as a result of the equipment leases entered into in July 1998 and June 1999.
Interest expense decreased by $2.9 million, or 25% during 1999 to $8.8 million. The decrease in interest expense was due in part to utilization of proceeds from the equipment lease which was used to reduce indebtedness under the Bank Credit Agreement and the capitalization of interest expense on assets that are under construction.
The Company incurred compression equipment lease expense of $22.1 million during 1999 and $6.2 million during 1998. As a result of the Equipment Leases, the Company expects to incur annual operating leasing expense of approximately $30 million.
Income Taxes
The provision for income taxes increased by $3.8 million, or 20%, to $23.1 million during 1999 from $19.3 million during 1998. The increase resulted primarily from the corresponding increase in income before taxes. The Company's effective income tax rate was approximately 36.4% during 1999 and 38.8% during 1998. The decrease in average effective income rates is due to expected benefits from a foreign sales corporation established in 1998.
Net Income and Earnings Per Share
Net income increased $10.1 million, or 33%, to $40.4 million for 1999 from $30.4 million in 1998 for the reasons discussed above.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenues
Revenues from rentals increased by $46.9 million, or 47% to $147.6 million due to growth in the rental fleet. At December 31, 1998 the compressor rental fleet consisted of approximately 1,067,000 horsepower, a 37% increase over the 781,000 horsepower in the rental fleet at December 31, 1997. Domestically, the rental fleet increased by 224,000 horsepower, or 34%, during 1998 and internationally by 61,000 horsepower, or 54%. Revenue from parts and service increased by $13.6 million, or 133% to $23.9 million as a result of increased
marketing focus on parts and services and the increase in growth in the rental fleet. Revenues from compressor fabrication amounted to $67.4 million, increasing by 36% over 1997. An aggregate of 113,000 horsepower was sold during 1998. In addition, 88,000 horsepower was fabricated and placed in the rental fleet during 1998. Revenues from the fabrication of production equipment remained relatively unchanged with an increase of $0.4 million from 1997, or 1% to $37.5 million during 1998. The change in 1998 production equipment revenue was negligible as a result of declining well completions.
Expenses
Operating expenses of the rentals segment increased by $14.3 million, or 41% to $49.4 million during 1998. The gross profit percentage from rentals increased to 67% during 1998 from 65% in 1997. Operating expenses of parts and service increased $11.0 million, or 173% to $17.3 million during 1998, which relates to the 133% increase in parts and service revenue. The gross profit percentage from parts and service decreased to 27% during 1998 from 38% in 1997. Operating expenses of compressor fabrication increased by $16.5 million, or 40% to $58.1 million, which relates to the 36% increase in compression fabrication revenue achieved during 1998. In addition, the gross profit margin on compression fabrication decreased to 14% during 1998, from 16% during 1997. Production equipment fabrication operating expenses decreased by $0.6 million, or 2%, during 1998 to $25.8 million. The decrease in operating expenses is reflective of the corresponding change in production equipment fabrication revenues during 1998. The gross profit margin attributable to production equipment fabrication increased to 31% during 1998, up from 29% during 1997.
Selling, general and administrative expenses increased by $5.8 million, or 28% to $26.6 million during 1998. The increase is attributable to increased personnel and other administrative and selling expenses associated with the increase in operating activity in the Company's rentals and compression fabrication operating segments as well as increased administrative costs relating to being a public reporting entity. Depreciation and amortization expense increased by $8.7 million, or 31% during 1998 to $37.1 million as the Company continued to expand its rental fleet with capital expenditures and net business acquisitions that amounted to approximately $212.0 million. In addition, the company sold certain compression equipment with a book value of approximately $158.0 million in July, 1998 under a sale and lease back arrangement. See "LIQUIDITY AND CAPITAL RESOURCES" for a description of the Equipment Lease. Consequently, the Company incurred compression equipment lease expense of $6.2 million during 1998. As a result of the Equipment Lease, the Company expects to incur annual operating lease expense of approximately $14 million. Interest expense increased by $1.0 million, or 9% during 1998 to $11.7 million.
Income Taxes
The Company's effective income tax rate was approximately 39% during 1998 and during 1997. Accordingly, the provision for income taxes increased by $7.9 million, or 70%, during 1998 to $19.3 million as a result of income before income taxes increasing by 69% during 1998 over 1997.
Net Income and Earnings Per Share
Net income increased $12.3 million, or 68%, to $30.4 million for 1998 from $18.1 million in 1997 for the reasons discussed above. Weighted average shares outstanding was affected by the additional shares issued in conjunction with the Company's initial public offering which were outstanding for all of 1998.
LIQUIDITY AND CAPITAL RESOURCES
In June 1999 and in July 1998, the Company completed two individual $200 million sale and lease back transactions of certain compression equipment. The transactions are recorded as a sale and lease back of the equipment and are recorded as operating leases. Under both agreements, the equipment was sold and leased back by the Company for a 5 year period and will continue to be deployed by the Company under its normal operating procedures. At any time, the Company has options to repurchase the equipment at fair market value. The Company has substantial residual value guarantees under the agreements (approximately $333 million for both transactions) that are due upon termination of the leases and which may be satisfied by a cash payment or the exercise of the Company's purchase options. The equipment sold in the June 1999 transaction had a book value
of approximately $162 million and resulted in a gain of approximately $38 million. The equipment sold in the July 1998 transaction had a book value of $158 million and resulted in a gain of approximately $42 million. Both gains are deferred until the end of the respective lease terms.
In December 1999, the Company issued $86.3 million of 7.25% Convertible Preferred Securities through Hanover Compressor capital Trust, a Delaware business trust and subsidiary of the Company. The Convertible Preferred Securities have a liquidation amount of $50 per unit. The Convertible Preferred Securities mature in 30 years but may be redeemed partially or in total any time on or after December 20, 2002.
The Company's cash balance amounted to $5.8 million at December 31, 1999 compared to $11.5 million at December 31, 1998. Primary sources of cash during 1999 were cash provided by internal operations of $68.2 million, net proceeds of $200 million from the sale of compression equipment under the Equipment Lease and net proceeds of $82.9 million from the private offering of the Convertible Preferred Securities. Principal uses of cash during the year ended December 31, 1999 were capital expenditures of $282.9 million, business combinations and investments in unconsolidated entities of $40.2 million and $279.1 million repayment of long-term debt.
Total current assets increased from $165.1 million at December 31, 1998 to $192.5 million at December 31, 1999 primarily as a result of increases in accounts receivable and inventories. Accounts receivable at December 31, 1999 increased by $23.5 million to $93.7 million. The increase corresponds with 18% increase in total revenue of $94.3 million realized by the Company during the three months ended December 31, 1999 compared to $79.8 million during the three months ended December 31, 1998. In addition, inventories increased by $3.5 million to $66.5 million at December 31, 1999. The increase in inventories reflects increases in parts and supplies, work in progress and finished goods as the level of activity in the Company's domestic and international rental and maintenance increased over 1998. Working capital at December 31, 1999 was also affected by an $32.8 million increase in total current liabilities at December 31, 1999 to $84.6 million. The 63% increase in total current liabilities results largely from the increase in vendor accounts payable caused by the expansion of the Company's operating activities and also due to the Subordinated Notes in the aggregate principal amount of $15.4 million becoming due on December 31, 2000.
The amounts invested in property, plant and equipment and business combinations during 1999 was $318.2 million which resulted in the addition of approximately 391,000 horsepower to the rental fleet. At December 31, 1999, the rental fleet consisted of 1,181,000 horsepower domestically and 277,000 in the international rental fleet. Current plans are to spend in excess of $250 million during 2000, exclusive of any major acquisition, in continued expansion of the rental fleet. Historically, the Company has funded capital expenditures with a combination of internally generated cash flow, borrowings under the revolving credit facility, lease transactions and raising additional equity. As of December 31, 1999 the Company had approximately $138 million of credit capacity remaining on its $200 million Bank Credit Agreement (7.7% rate at December 31, 1999). In March 2000, the Company finalized a third sale and lease back transaction. Under the agreement, the Company received $100 million proceeds from the sale of the compression equipment at closing and may sell an additional $100 million of equipment to the Trust during the next twelve months. The equipment sold will be leased back by the Company for a five-year period and will continue to be deployed by the Company under its normal operating procedures. Hanover has the option to repurchase the equipment from the Trust at any time. The Company feels it has adequate capital resources to fund its estimated level of capital expenditures for the year 2000.
Impact of Year 2000
The Company did not experience any material problems during the rollover to the year 2000 that affected operations and does not anticipate any year 2000 compliance problems in the future. The Company completed its year 2000 readiness in conjunction with normal expansion and upgrades of its computer systems and hardware. The costs related to the year 2000 were not material to the Company's operating results, cash flows or financial position.
New Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS 133 requires that, upon adoption, all derivative instruments (including certain
derivative instruments embedded in other contracts) be recognized in the balance sheet at fair value, and that changes in such fair values be recognized in earnings unless specific hedging criteria are met. Changes in the values of derivatives that meet these hedging criteria will ultimately offset related earnings effects of the hedged item pending recognition in earnings. SFAS 133 is effective for the Company beginning in 2001. The impact of SFAS 133 on the Company's financial statements will depend on a variety of factors, including future interpretive guidance from the FASB, the future level of actual foreign currency transactions, the extent of our hedging activities, the type of hedging instruments used and the effectiveness of such instruments. However management does not believe the effect of adoption will have a material effect on the Company's results of operations, cash flows or financial position.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed to interest rate and foreign currency risk. The Company periodically enters into interest rate swaps to manage its exposure to fluctuations in interest rates. At December 31, 1999, the fair market value of these interest rate swaps is approximately $2.9 million. The Company does not use derivative financial instruments to mitigate foreign currency risk.
Item 8.
Item 8. Financial Statements and Supplementary Data
In this report, the consolidated financial statements and supplementary data appearing on pages through are incorporated in this item 8 by reference. See Index to the Financial Statements at 19.
Item 9.
Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information included or to be included in the Company's definitive proxy statement for its 2000 Annual Meeting of Stockholders under the captions "Nominees for Election as Directors," and "Section 16(a) Beneficial Ownership Reporting Compliance" is incorporated by reference herein.
Item 11.
Item 11. Executive Compensation
The information included or to be included under the caption "Executive Compensation" in the Company's definitive proxy statement for its 2000 Annual Meeting of Stockholders is incorporated by reference herein.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information included or to be included under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive proxy statement for its 2000 Annual Meeting of Stockholders is incorporated by reference herein.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information included or to be included under the caption "Certain Relationships and Related Transactions" in the Company's definitive proxy statement for its 2000 Annual Meeting of Stockholders is incorporated by reference herein.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a)The following documents are filed as part of this report:
1. FINANCIAL STATEMENTS--The financial statements listed in the accompanying Index to Consolidated Financial Statements are filed as part of this annual report and such Index to Consolidated Financial Statements is incorporated herein by reference.
2. FINANCIAL STATEMENT SCHEDULES--All schedules are omitted because the required information is inapplicable or the information is presented in the Consolidated Financial Statements or related notes.
3. EXHIBITS--The exhibits listed on the accompanying Index to Exhibits are filed as part of this annual report and such Index to Exhibits is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Hanover Compressor Company
/s/ Michael J. McGhan By: _________________________________ Michael J. McGhan President and Chief Executive Officer
Date: March 27, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
E-1
E-2
- -------- (1) Such exhibit previously filed as an exhibit to the registration Statement (File No. 333-27953) on Form S-1, as amended, under the exhibit number indicated in brackets [ ], and is incorporated by reference. (2) Such exhibit previously filed as an exhibit to the Company's Annual Report on Form 10-K for the Year Ended 1997 under the exhibit number indicated in brackets [ ], and is incorporated by reference. (3) Such exhibit previously filed as an exhibit to the Company's Current Report on Form 8-K dated July 22, 1998, under the exhibit number indicated in brackets [ ], and is incorporated by reference. (4) Such exhibit previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the Third Quarter of 1998, under the exhibit number indicated in brackets [ ], and is incorporated by reference. (5) Compensatory plan or arrangement required to be filed. (6) Such exhibit previously filed as an exhibit to the Registration Statement (File No. 333-30344) on Form S-3 under the exhibit number indicated in brackets [ ], and is incorporated by reference. (7) Such exhibit previously filed as an exhibit to the Company's Annual Report on Form 10-K for the Year Ended 1998 under the exhibit number indicated in brackets [ ], and is incorporated by reference. (8) Such exhibit previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the Second Quarter of 1999, under the exhibit number indicated in brackets [ ], and is incorporated by reference. *Filed herewith.
E-3
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Hanover Compressor Company
In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income and comprehensive income, of cash flows and of common stockholders' equity present fairly, in all material respects, the financial position of Hanover Compressor Company and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
Houston, Texas March 8, 2000
HANOVER COMPRESSOR COMPANY
Consolidated Balance Sheet
December 31, 1999 and 1998
The accompanying notes are an integral part of these financial statements.
HANOVER COMPRESSOR COMPANY
Consolidated Statement of Income and Comprehensive Income
Years Ended December 31, 1999, 1998 and 1997
The accompanying notes are an integral part of these financial statements.
HANOVER COMPRESSOR COMPANY
Consolidated Statement of Cash Flows
Years Ended December 31, 1999, 1998 and 1997
The accompanying notes are an integral part of these financial statements.
HANOVER COMPRESSOR COMPANY
Consolidated Statement of Cash Flows
Years Ended December 31, 1999, 1998 and 1997
The accompanying notes are an integral part of these financial statements.
HANOVER COMPRESSOR COMPANY
Consolidated Statement of Common Stockholders' Equity
Years Ended December 31, 1999, 1998 and 1997
(in thousands of dollars, except share data)
The accompanying notes are an integral part of these financial statements.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999, 1998 and 1997
1. The Company, Business and Significant Accounting Policies
Hanover Compressor Company and its subsidiaries ("Hanover" or the "Company") is a leading provider of a broad array of natural gas compression rental, operations, parts and maintenance services in the United States and select international markets. Hanover's compression services are complemented by its compressor and oil and gas production equipment fabrication operations. Hanover is a Delaware corporation originally formed on October 17, 1990. In December 1999, the Company adopted a holding company structure and merged into the new holding company that assumed the name of Hanover Compressor Company. The charter and by-laws of the new holding company are substantially the same as the old Company.
On June 6, 1997, the Board of Directors approved an increase of authorized shares of preferred stock and common stock to 3,000,000 and 100,000,000 shares, respectively. In addition, the Board of Directors approved a 158-for-1 stock split of the Company's common stock. The stock split has been effected in the form of a stock dividend. All share and per share information included herein reflects the stock split.
On June 30, 1997, Hanover issued 5,158,691 shares of common stock for cash of $92,020,000 (net of approximately $1,771,000 of equity issuance costs) in connection with the Company's initial public offering (the Offering).
Principles of Consolidation
The accompanying consolidated financial statements include Hanover and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates in the Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, as well as the disclosures of contingent assets and liabilities. Because of the inherent uncertainties in this process, actual future results could differ from those expected at the reporting date. Management believes that the estimates are reasonable.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Revenue Recognition
Revenue from equipment rentals is recorded when earned over the period of rental and maintenance contracts which generally range from one month to five years. Parts and service revenue is recorded as products are delivered or services are performed for the customer.
Compressor and production equipment fabrication revenue is recognized using the percentage-of-completion method. The Company estimates percentage-of- completion for compressor fabrication on a direct labor hour-to-total labor hour basis. Production equipment fabrication percentage-of-completion is estimated using the cost-to-total cost basis.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash and cash equivalents and accounts receivable. The Company believes that the credit risk in temporary cash investments that the Company has with financial institutions is minimal. Trade accounts receivable are due from companies of varying size engaged principally in oil and gas activities in the United States, Canada and South America. The Company reviews the financial condition of customers prior to extending credit and generally does not obtain collateral for receivables. Payment terms are on a short-term basis and in accordance with industry standards. Trade accounts receivable are recorded net of estimated doubtful accounts of $1,730,000 and $1,212,000 at December 31, 1999 and 1998, respectively. The Company considers this credit risk to be limited due to these companies financial resources.
Inventory
Inventory consists of parts used for fabrication or maintenance of natural gas compression units and production equipment, and also includes compression units and production equipment that are held for sale. Inventory is stated at the lower of cost or market using the average-cost method.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost and are depreciated using the straight-line method over their estimated useful lives as follows:
Major improvements that extend the useful life of an asset are capitalized. Repairs and maintenance are expensed as incurred. When property, plant and equipment is sold, retired or otherwise disposed of, the cost and related accumulated depreciation are eliminated and the gain or loss is recognized. Depreciation expense was $34,696,000, $35,768,000 and $27,789,000 in 1999, 1998 and 1997, respectively.
Assets under construction of $18,937,000 and $6,984,000 are included in compression equipment at December 31, 1999 and 1998, respectively. Interest is capitalized in connection with the compression equipment and facilities that are constructed for the Company's use in its rental operations. The capitalized interest is recorded as part of the assets to which it relates and is amortized over the asset's estimated useful life. In 1999, $1,533,000 of interest cost was capitalized. No interest was capitalized for 1998 and 1997.
Long-Lived Assets
The Company reviews for the impairment of long-lived assets, including property, plant and equipment, and goodwill whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss exists when estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. The impairment loss recognized represents the excess of the assets carrying value as compared to its estimated fair market value.
Intangible and Other Assets
Investments in affiliated corporations in which the Company does not have a controlling interest are accounted for using the equity method. The excess of cost over net assets of acquired businesses is recorded as
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
goodwill and amortized on a straight-line basis over 15 years commencing on the dates of the respective acquisitions. Accumulated amortization was $3,822,000 and $1,810,000 at December 31, 1999 and 1998, respectively.
Included in intangible and other assets are debt issuance costs, net of accumulated amortization, totaling $1,099,000 and $1,186,000 at December 31, 1999 and 1998, respectively. Such costs are amortized over the period of the respective debt agreements.
Stock-Based Compensation
In accordance with Statement of Financial Accounting Standards No. 123 (FAS 123) "Accounting for Stock-Based Compensation," the Company measures compensation expense for its stock-based employee compensation plans using the intrinsic value method prescribed in APB Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees," and has provided in Note 12, pro forma disclosures of the effect on net income and earnings per share as if the fair value-based method prescribed by FAS 123 had been applied in measuring compensation expense.
Income Taxes
The Company accounts for income taxes using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, all expected future events are considered other than enactments of changes in the tax law or rates.
Foreign Currency Translation
The financial statements of subsidiaries outside the U.S., except those located in highly inflationary economies, are measured using the local currency as the functional currency. Assets, including goodwill, and liabilities of these subsidiaries are translated at the rates of exchange at the balance sheet date. Income and expense items are translated at average monthly rates of exchange. The resulting gains and losses from the translation of accounts are included in accumulated other comprehensive income. For subsidiaries located in highly inflationary economies, translation gains and losses are included in net income. The resulting translation adjustment for the year ended December 31, 1997 was not significant.
Earnings Per Common Share
Basic earnings per common share is computed using the weighted average number of shares outstanding for the period. Diluted earnings per common share is computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to outstanding options and warrants to purchase common stock.
Included in diluted shares are common stock equivalents relating to options of 1,648,000, 1,230,000 and 1,153,000 in 1999, 1998 and 1997, respectively, and warrants of 356,000, 393,000 and 569,000 in 1999, 1998 and 1997, respectively. The common stock equivalents excluded from the computation of diluted earnings per share as the effect would be anti-dilutive were approximately 106,000 and 146,000 in 1999 and 1998. No common stock equivalents were anti-dilutive in 1997.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
Comprehensive Income
Components of comprehensive income are net income and all changes in equity during a period except those resulting from transactions with owners. Accumulated other comprehensive income consists of the foreign currency translation adjustment.
Financial Instruments
The Company utilizes off-balance sheet derivative financial instruments with the principal objective being to minimize the risks and/or costs associated with financial and global operating activities by managing its exposure to interest rate fluctuation on a portion of its variable rate debt and leasing obligations. The Company does not utilize derivative financial instruments for trading or other speculative purposes. The Company designates and assigns the financial instruments as hedges of specific assets, liabilities or anticipated transactions. The cash flow from hedges is classified in the Consolidated Statements of Cash Flows under the same category as the cash flows from the underlying assets, liabilities or anticipated transactions. The cash flow from hedges is classified in the Consolidated Statements of Cash Flows under the same category as the cash flows from the underlying assets, liabilities or anticipated transactions. The carrying amounts reported in the balance sheet for all financial instruments approximate fair value. See Notes 7 and 8.
Reclassifications
Certain amounts in the prior years' financial statements have been reclassified to conform to the 1999 financial statement classification. These reclassifications have no impact on net income.
2. Business Combinations
Acquisitions were accounted for under the purchase method of accounting. Results of operations of companies acquired are included from the dates of such acquisitions. The Company allocates the cost of the acquired business to the assets acquired and the liabilities assumed based upon fair value estimates thereof. These estimates are revised during the allocation period as necessary when information regarding contingencies becomes available to define and quantify assets acquired and liabilities assumed. The allocation period varies for each acquisition but does not exceed one year. To the extent contingencies are resolved or settled during the allocation period, such items are included in the revised purchase price allocation. After the allocation period, the effect of changes in such contingencies is included in results of operations in the periods the adjustments are determined. The Company's management does not believe potential deviations between its fair value estimates and actual fair values to be material.
Year Ended December 31, 1999
In July 1999, the Company purchased preferred stock and a purchase option for the common stock of CDI Holdings, Inc. and its subsidiary Compressor Dynamics, Inc. ("CDI"). In August 1999, the Company exercised its option to purchase CDI. The total cost for CDI was approximately $18,525,000 in cash.
In August 1999, the Company purchased the stock of Victoria Compression Services, Inc., Contract Engineering and Operating, Inc. and Unit Partners, Inc. ("CEO") for approximately $16,786,000 in cash, 91,850 shares of the Company's treasury stock valued at $3,300,000 and notes payable of approximately $452,000.
Year Ended December 31, 1998
In June 1998, the Company purchased the stock of Arkoma Compression Services, Inc. for approximately $17,245,000 in cash. In October 1998, the Company purchased the stock of Eureka Energy Systems, Inc. for approximately $25,335,000 in cash.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
The pro forma information set forth below assumes acquisitions in 1999 and 1998 are accounted for had the purchases occurred at the beginning of 1998. The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisitions been consummated at that time (in thousands, except per share amounts):
Year Ended December 31, 1997
In September 1997, Hanover purchased Wagner Equipment, Inc. and Gas Tech Compression Services, Inc. for approximately $6,287,000 in cash. Results of operations for 1997 were not materially impacted by the transaction.
3. Inventory
Inventory consisted of the following amounts (in thousands):
4. Compressor and Production Equipment Fabrication Contracts
Costs, estimated earnings and billings on uncompleted contracts are as follows (in thousands):
Presented in the accompanying financial statements as follows (in thousands):
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
5. Intangible and Other Assets
Intangible and other assets consisted of the following (in thousands)
Amortization of goodwill and other intangible assets totaled $2,641,000, $1,386,000 and $650,000 in 1999, 1998 and 1997, respectively.
At December 31, 1999 and 1998, the Company's investments in unconsolidated subsidiaries included a 35% interest in Collicutt Mechanical Services, Ltd.; a 35% interest in the Consortium Cosacol/Hanover (the "Consortium"); and a non- controlling 60% interest in the Hanover/Enron Joint Venture. In September 1999, the Company acquired a 20% interest in Meter Acquisition Company LP, LLLP for approximately $2,200,000 and a non-controlling 52.5% interest in Hanover Measurement Services Company, LP for approximately $2,700,000. The Company had a 33% interest in a joint venture with Wartsila Diesel International Ltd., OY that was dissolved in 1998. There were no distributions or dividends received during the year ended December 31, 1998. Equity in income of joint ventures was $1,188,000 and $1,369,000 for 1999 and 1998, respectively and a loss of $206,000 for 1997 and is included in other revenues.
In December 1998, the Company restructured its relationship in the Consortium. The Company purchased all of the capitalized construction from the Consortium for 150,000 shares of Hanover common stock valued at $3,300,000. The capitalized construction was transferred to property, plant and equipment in 1999. In addition, the Company acquired a 10% interest in Cosacol for $2,000,000 in cash.
In December 1998, the Company advanced $8,000,000 to Transportadora de Gas del Sur S.A. ("TGS"), an Argentina company for a 25% interest in a joint venture. In 1999, the Company withdrew from the joint venture and the $8,000,000 was repaid.
In November 1997, Hanover acquired 35% of the common stock of Collicutt Mechanical Services, Ltd. for approximately $5,608,000 in cash. The investment is accounted for using the equity method of accounting. The excess of the Company's investment over the underlying net equity of $703,000 is being amortized on a straight-line basis over ten years and is included in other assets at December 31, 1999 and 1998.
The notes receivable result primarily from customers for sales of equipment or advances to other parties in the ordinary course of business. The notes vary in length, are non-interest bearing or bear interest at rates ranging from prime to 15% and are collateralized by equipment.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
6. Accrued Liabilities
Accrued liabilities are comprised of the following (in thousands):
7. Long-Term Debt
Long-term debt consisted of the following (in thousands):
The Company's primary credit agreement provides for a $200,000,000 revolving credit facility that matures on December 17, 2002. Advances bear interest at the bank's prime or a negotiated rate (7.7% and 6.9% at December 31, 1999 and 1998, respectively). A commitment fee of 0.35% per annum on the average available commitment is payable quarterly.
The credit agreement contains certain financial covenants and limitations on, among other things, indebtedness, liens, leases and sales of assets. The credit agreement also limits the payment of cash dividends on the Company's common stock to 25% of net income for the respective period.
The subordinated promissory notes mature on December 31, 2000 and bear interest at 7%, payable semi-annually.
Maturities of long-term debt at December 31, 1999 are (in thousands): 2000-- $15,967; 2001--$722; 2002--$66,093; 2003--$380; 2004--$328 and $2,158 thereafter.
In January 1998 and in connection with the revolving credit facility, the Company entered into a two-year interest rate swap transaction to manage interest rate exposure with a notional amount of $75,000,000 and a strike rate of 5.43%. The differential paid or received on the swap transaction was recognized as an adjustment to interest expense. This swap transaction was cancelled in July 1998.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
8. Leasing Transactions
In June 1999 and in July 1998, the Company completed two individual $200,000,000 sale and lease back transactions of certain compression equipment. The transactions are recorded as a sale and lease back of the equipment and are recorded as operating leases. Under both agreements, the equipment was sold and leased back by the Company for a 5 year period and will continue to be deployed by the Company under its normal operating procedures. At any time, the Company has options to repurchase the equipment at fair market value. The Company has substantial residual value guarantees under the agreements (approximately $333,000,000 for both transactions) that are due upon termination of the leases and which may be satisfied by a cash payment or the exercise of the Company's purchase options. The equipment sold in the June 1999 transaction had a book value of approximately $162,014,000 and resulted in a gain of approximately $37,986,000. The equipment sold in the July 1998 transaction had a book value of $158,007,000 and resulted in a gain of approximately $41,993,000. Both gains are deferred until the end of the respective lease terms. Should the Company not exercise its purchase options under the agreements, the deferred gains will be recognized to the extent they exceed any required payments under the residual value guarantees and any other requirements under the agreements. The Company incurred transaction costs of approximately $1,799,000 and $1,423,000 for the 1999 and 1998 transactions, respectively. These costs are included in intangible and other assets and are being amortized over the respective lease terms.
Both lease agreements call for variable quarterly rental payments that vary with the London Interbank Borrowing Rate. The following provides future minimum lease payments under the leasing arrangement exclusive of any guarantee payments (in thousands): 2000--$30,300; 2001--$30,700; 2002-- $30,700; 2003--23,300; 2004--$7,900.
In July 1998 and in connection with the 1998 leasing transaction, the Company entered into two-year swap transactions to manage lease rental exposure with notional amounts of $75,000,000 and $125,000,000 and strike rates of 5.51% and 5.56%, respectively. The differential paid or received on the swap transactions is recognized as an adjustment to leasing expense. The counterparty to this contractual arrangement is a major financial institution with which the Company also has other financial relationships. The Company is exposed to credit loss in the event of nonperformance by this counterparty. However, the Company does not anticipate nonperformance by this party and no material loss would be expected from their nonperformance. The fair market value of these interest rate swaps at December 31, 1999 is approximately $2,900,000 based on market quotes.
9. Income Taxes
The components of income before income taxes were as follows (in thousands):
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
The provision for income taxes consisted of the following (in thousands):
The income tax expense for 1999, 1998 and 1997 resulted in effective tax rates of 36.4%, 38.8% and 38.5%, respectively. The reasons for the differences between these effective tax rates and the U.S. statutory rate of 35% are as follows (in thousands):
Deferred tax assets (liabilities) are comprised of the following (in thousands):
The Company has net operating loss carryforwards at December 31, 1999 of $21,400,000 expiring in 2006 to 2018. In addition, the Company has an alternative minimum tax credit carryforward of $19,005,000 that does not expire.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
In 1999, the company recorded approximately $8,627,000 additional deferred income tax liability resulting from the CDI and CEO acquisitions. See Note 2 for a description of the transactions.
The Company has not recorded a deferred income tax liability for additional income taxes that would result from the distribution of earnings of its foreign subsidiaries if they were actually repatriated. The Company intends to indefinitely reinvest the undistributed earnings of its foreign subsidiaries.
10. Mandatorily Redeemable Convertible Preferred Securities
In December 1999, the Company issued $86,250,000 of unsecured 7.25% Manditorily Redeemable Convertible Preferred Securities (the "Convertible Preferred Securities") through Hanover Compressor Capital Trust, a Delaware business trust and subsidiary of the Company. The Convertible Preferred Securities have a liquidation amount of $50 per unit. The Convertible Preferred Securities mature in 30 years but the Company may redeem the Convertible Preferred Securities partially or in total any time on or after December 20, 2002. The Convertible Preferred Securities also provide for annual cash distributions at the rate of 7.25%, payable quarterly in arrears, however, payments may be deferred up 20 quarters subject to certain restrictions. During 1999, the Company accrued financing costs of approximately $288,000 related to Convertible Preferred Securities. Each Convertible Preferred Security is convertible into 1.3986 shares of Hanover common stock, subject to adjustment for certain events. The Company incurred transaction costs of approximately $3,310,000 which are included in other assets and will be amortized over the term of the Convertible Preferred Securities.
11. Common Stockholders' Equity
Notes Receivable-Employee Stockholders
Under various stock purchase plans, the Company's employees are eligible to purchase shares of Hanover stock at fair market value in exchange for cash and/or notes receivable. The notes are collateralized by the common stock and the general credit of the employee, bear interest at a prime rate, and are generally payable on demand or at the end of a four-year period. The notes have been recorded as a reduction of common stockholders' equity.
In addition and in connection with the Company's initial public offering, the Company issued 264,785 shares of common stock to employees at the Offering price of $19.50 in exchange for employee notes receivable.
Other
As of December 31, 1999, warrants to purchase approximately 344,000 shares of common stock at $.01 per share were outstanding. The warrants expire in August 2005.
During 1998, the Company initiated a stock buyback program authorized to repurchase up to 450,000 of the Company's outstanding shares to assist with future business acquisitions and for general corporate purposes. In 1998, the Company repurchased 294,200 shares at an average price of $20.22.
In February 1997, Hanover issued 5,152 shares of common stock for cash to a trust for the benefit of a member of the Company's outside legal counsel.
See Notes 1, 2, 5 and 12 for a description of other common stock transactions.
12. Stock Options
The Company has employee stock option plans that provide for the granting of options to purchase common shares. The options are generally issued at fair market value on the date of grant and are exercisable over a ten-
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
year period. Vesting of stock options issued prior to June 1997 was accelerated as a result of completion of the initial public offering. Accordingly, during 1997 the Company recognized a charge of $269,000 related to unamortized compensation expense on options issued at less than fair market value on the date of grant. No compensation expense was recorded in 1999 and 1998.
Of the options granted in 1999 and 1998, 350,000 vest 100% on July 1, 2001 and 160,000 vested immediately. The remaining options granted to employees vest over the following schedule, which may accelerate upon a change in the Company's controlling ownership.
The following is a summary of stock option activity for the years ended December 31, 1999, 1998 and 1997:
Options Outstanding December 31, 1999
The following table summarizes significant ranges of outstanding and exercisable options at December 31, 1999:
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
The weighted average fair value at date of grant for options where the exercise price equals the market price of the stock on the grant date was $12.19, $8.31 and $8.58, per option during 1999, 1998 and 1997, respectively. The fair value of options at date of grant was estimated using the Black- Scholes model with the following weighted average assumptions:
Stock-based compensation costs computed in accordance with FAS 123, would have reduced net income by $2,194,000, $825,000 and $842,000 in 1999, 1998 and 1997, respectively. The pro forma impact on net income would have reduced basic and diluted earnings per share by $.07 in 1999 and $.03 per share in 1998 and 1997. The pro forma effect on net income for 1999, 1998 and 1997 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995.
13. Benefit Plans
The Company's 401(k) retirement plan provides for optional employee contributions up to the IRS limitation and discretionary employer matching contributions. The Company made matching contributions of $399,000 and $273,000 during the years ended December 31, 1999 and 1998, respectively. The Company did not make a matching contribution for the year ended December 31, 1997.
14. Related Party Transactions
Hanover and GKH Partners, L.P., a major stockholder of the Company, have entered into an agreement whereby in exchange for investment banking and financial advisory services rendered and to be rendered by the major stockholder, the Company has agreed to pay a fee to GKH Partners, L.P. equal to .75% of the equity value of the Company determined and payable at such time as (1) a disposition of shares of the Company's common stock resulting in GKH Partners, L.P. owning less than 25% of the outstanding common stock or (2) any other transaction occurs resulting in the effective sale of the Company or its business by the current owners.
In connection with stock offerings to management, the Company has received notes from employees for shares purchased. The total amounts owed to the Company at December 31, 1999 and 1998 are $3,387,000 and $10,146,000, respectively. Total interest accrued on the loans is $203,000 and $548,000 as of December 31, 1999 and 1998, respectively.
The Company had a credit agreement with Joint Energy Developments Investments Limited Partnership ("JEDI"), a common stockholder, that was repaid in 1997. Interest expense in 1997 was $1,388,000. The Company also leases compressors to affiliates of Enron Capital and Trade Resources Corp., an affiliate of JEDI. Rentals of $8,776,000, $6,801,000 and $1,034,000 were paid by affiliates of Enron in 1999, 1998 and 1997, respectively. In addition, compression fabrication of $6,320,000 was paid by affiliates of Enron in 1999. An affiliate of Enron also owns interests in Meter Acquisition Company LP, LLLP and Hanover Measurement Services Company, L.P.
The Company leases compressors to other companies owned or controlled by or affiliated with related parties. Rental revenues billed to these related parties totaled $902,000, $859,000 and $1,035,000 during 1999, 1998 and 1997, respectively.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
See Note 5 for related party investments and Note 11 for a description of common stock transactions with related parties.
15. Commitments and Contingencies
Rent expense excluding lease payments for the leasing transactions described in Note 8 for 1999, 1998 and 1997 was approximately $1,320,000, $455,000 and $376,000, respectively. Commitments for future minimum rental payments exclusive of those disclosed in Note 8 are not significant at December 31, 1999.
In the ordinary course of business the Company is involved in various pending or threatened legal actions. 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 the Company's consolidated financial position, operating results or cash flows.
The Company has no commitments or contingent liabilities which, in the judgment of management, would result in losses that would materially affect the Company's consolidated financial position, operating results or cash flows.
16. Subsequent Event
In March 2000, the Company completed a sale and lease back of certain compression equipment. The lease back of the equipment will be recorded as an operating lease. Under the agreement, the Company received $100 million proceeds from the sale of the compression equipment at closing and may sell an additional $100 million of equipment to the Trust during the next twelve months. The equipment sold will be leased back by the Company for a five-year period and will continue to be deployed by the Company under its normal operating procedures. Hanover has the option to repurchase the equipment from the Trust at any time and has substantial residual value guarantees.
17. Industry Segments and Geographic Information
The Company manages its business segments primarily on the type of product or service provided. The Company has four principal industry segments: Rentals--Domestic, Rentals--International, Compressor Fabrication and Production Equipment Fabrication. The Rentals Segments provides natural gas compression rental and maintenance services to meet specific customer requirements. The Compressor Fabrication Segment involves the design, fabrication and sale of natural gas compression units to meet unique customer specifications. The Production Equipment Fabrication Segment designs, fabricates and sells equipment utilized in the production of crude oil and natural gas.
The Company evaluates the performance of its segments based on segment gross profit. Segment gross profit for each segment includes direct operating expenses. Costs excluded from segment gross profit include selling, general and administrative, depreciation and amortization, leasing, interest, distributions on company-obligated mandatorily redeemable preferred securities and income taxes. Amounts defined as "Other" include sales of property, plant and equipment, results of other insignificant operations, corporate related items primarily related to cash management activities and parts and service operations which are not separately managed. Revenues include sales to external customers and intersegment sales. Intersegment sales are accounted for at cost and are eliminated in consolidation. Identifiable assets are tangible and intangible assets that are identified with the operations of a particular segment or geographic region, or which are allocated when used jointly. Capital expenditures include fixed asset purchases.
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
No single customer accounts for 10% or more of the Company's revenues for all periods presented. One vendor accounted for approximately $32,900,000 of the Company's purchases in 1998.
The following tables present sales and other financial information by industry segment and geographic region for the years ended December 31, 1999, 1998 and 1997.
Industry Segments
HANOVER COMPRESSOR COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
December 31, 1999, 1998 and 1997
Geographic Data
HANOVER COMPRESSOR COMPANY
Selected Quarterly Financial Data (unaudited)
The table below sets forth selected unaudited financial information for each quarter of the last two years: