UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission File No. 1-13071

Hanover Compressor Company

(281) 447-8787
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [x] No [  ]

Number of shares of the Common Stock of the registrant outstanding as of July 30, 2004: 85,778,859 shares.

TABLE OF CONTENTS

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Part I. Financial Information

ITEM 1. FINANCIAL STATEMENTS

HANOVER COMPRESSOR COMPANY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HANOVER COMPRESSOR COMPANY

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Hanover Compressor Company (“Hanover”, “we”, “us”, “our” or the “Company”) included herein have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America are not required in these interim financial statements and have been condensed or omitted. It is the opinion of our management that the information furnished includes all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial position, results of operations, and cash flows of Hanover for the periods indicated. The financial statement information included herein should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003. These interim results are not necessarily indicative of results for a full year.

Earnings Per Common Share

Basic earnings (loss) per common share is computed by dividing earnings (loss) available to common stockholders by the weighted average number of shares outstanding for the period. Diluted earnings (loss) per common share is computed using the weighted average number of shares outstanding adjusted for the incremental common stock equivalents attributed to outstanding options and warrants to purchase common stock, restricted stock, convertible senior notes and convertible subordinated notes, unless their effect would be anti-dilutive.

The table below indicates the potential shares of common stock that were included in computing the dilutive potential shares of common stock used in diluted earnings (loss) per common share (in thousands):

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The table below indicates the potential shares of common stock issuable which were excluded from net dilutive potential shares of common stock issuable as their effect would be anti-dilutive (in thousands):

Stock-Based Compensation

Certain of our employees participate in stock option plans that provide for the granting of options to purchase shares of Hanover common stock. In accordance with Statement of Financial Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”), Hanover measures compensation expense for its stock-based employee compensation plans using the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). The following pro forma net income (loss) and income (loss) per share data illustrates the effect on net income (loss) and net income (loss) per share if the fair value method had been applied to all outstanding and unvested stock options in each period (in thousands).

As of June 30, 2004, 446,000 shares of restricted stock were outstanding under our incentive compensation plans. We will recognize compensation expense equal to the fair value of the restricted stock at the date of grant over the vesting period related to these grants. During the three months ended June 30, 2004 and 2003, we recognized $0.4 million and $0.2 million, respectively, in compensation expense related to these grants and during the six months ended June 30, 2004 and 2003, we recognized $0.8 million and $0.3 million, respectively, in compensation expense related to these grants. (See Note 15.)

Reclassifications

Certain amounts in the prior period’s financial statements have been reclassified to conform to the 2004 financial statement classification. These reclassifications had no impact on our consolidated results of operations, cash flows or financial position.

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2. INVENTORIES

Inventory, net of reserves, consisted of the following amounts (in thousands):

As of June 30, 2004 and December 31, 2003 we had inventory reserves of approximately $13.5 million and $12.7 million, respectively.

3. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consisted of the following (in thousands):

4. INVESTMENTS IN NON-CONSOLIDATED AFFILIATES

During the second quarter of 2004, we increased our ownership in CrystaTech, Inc. a process technology company, to 47.24% for approximately $0.3 million.

On March 5, 2004, we sold our 50.384% limited partnership interest and 0.001% general partnership interest in Hanover Measurement Services Company, L.P. to EMS Pipeline Services, L.L.C. for $4.9 million, of which $0.2 million was put in escrow subject to the outcome of post closing working capital adjustments and other matters that have resulted in the $0.2 million being returned to the purchaser. We had no obligation to the purchaser with respect to any post-closing adjustment in excess of the escrowed amount. We accounted for our interest in Hanover Measurement under the equity method. As a result of the sale, we recorded a $0.3 million gain that is included in other revenue.

5. DEBT

Short-term debt consisted of the following (in thousands):

Belleli’s factoring arrangements are typically short term in nature and bore interest at a weighted average rate of 4.3% and 4.0% at June 30, 2004 and December 31, 2003, respectively. Belleli’s revolving credit facilities bore interest at a weighted

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average rate of 4.9% and 3.2% at June 30, 2004 and December 31, 2003, respectively. These revolving credit facilities are all short-term and expire at different times in 2004.

Long-term debt consisted of the following (in thousands):

Maturities of long-term debt (excluding interest to be accrued thereon) at June 30, 2004 are (in thousands):

In June 2004, we issued under our shelf registration statement $200.0 million aggregate principal amount of our 9.0% Senior Notes due 2014, which are fully and unconditionally guaranteed on a senior subordinated basis by our wholly owned subsidiary, Hanover Compressor Limited Partnership (“HCLP”). The net proceeds from this offering and available cash were used to repay the outstanding indebtedness and minority interest obligations of $193.6 million and $6.4 million, respectively, under our 2000A equipment lease that was to expire in March 2005.

We expect that our bank credit facility and cash flow from operations will provide us adequate capital resources to fund our estimated level of capital expenditures for the short term. As of June 30, 2004, we had no outstanding borrowings and approximately $94.1 million in letters of credit outstanding under our bank credit facility. Our bank credit facility permits us to incur indebtedness, subject to covenant limitations, up to a $350 million credit limit, plus, in addition to certain other indebtedness, an additional (a) $40 million in unsecured indebtedness, (b) $50 million of nonrecourse indebtedness of unqualified subsidiaries and (c) $25 million of secured purchase money indebtedness.

As of June 30, 2004, we were in compliance with all material covenants and other requirements set forth in our bank credit facility, the indentures and agreements related to our compression equipment lease obligations and the indentures and agreements relating to our other long-term debt. A default under our bank credit facility or these agreements would trigger cross-default provisions under the agreements relating to certain of our other debt obligations. Such defaults would have a

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material adverse effect on our liquidity, financial position and operations. Giving effect to our $94.1 million in outstanding letters of credit, the liquidity available under our bank credit facility as of June 30, 2004 was approximately $256 million.

In addition to purchase money and similar obligations, the indentures and the agreements related to our compression equipment lease obligations for our 2001A and 2001B sale leaseback transactions, our 8.625% Senior Notes due 2010 and our 9% Senior Notes due 2014 permit us to incur indebtedness up to the $350 million credit limit under our bank credit facility, plus (1) an additional $75 million in unsecured indebtedness and (2) any additional indebtedness so long as, after incurring such indebtedness, our ratio of the sum of consolidated net income before interest expense, income taxes, depreciation expense, amortization of intangibles, certain other non-cash charges and rental expense to total fixed charges (all as defined and adjusted by the agreements governing such obligations), or our “coverage ratio,” is greater than 2.25 to 1.0, and no default or event of default has occurred or would occur as a consequence of incurring such additional indebtedness and the application of the proceeds thereon. The indentures and agreements for our 2001A and 2001B sale leaseback transactions, our 8.625% Senior Notes due 2010 and our 9% Senior Notes due 2014 define indebtedness to include the present value of our rental obligations under sale leaseback transactions and under facilities similar to our compression equipment operating leases. As of June 30, 2004, Hanover’s coverage ratio was less than 2.25 to 1.0, and therefore as of such date we could not incur indebtedness other than under our bank credit facility and up to an additional $75 million in unsecured indebtedness and certain other permitted indebtedness, including certain refinancing of indebtedness.

In May 2003, Hanover reached an agreement that was subject to court approval, to settle securities class actions, ERISA class actions and the shareholder derivative actions. The terms of the settlement became final in March 2004 and provided for Hanover to: (a) make a cash payment of approximately $30 million to the securities settlement fund (of which $26.7 million was funded by payments from Hanover’s directors and officers insurance carriers), (b) issue 2.5 million shares of Hanover common stock, and (c) issue a contingent note with a principal amount of $6.7 million. During the six months ended June 30, 2004 and 2003, we recorded $0.1 million and $43.8 million expense, respectively, for the cost of the litigation settlement. For further details regarding the securities settlement, see our Form 10-Q for the three months ended March 31, 2004.

On April 21, 2004, we issued the $6.7 million contingent note related to the securities settlement. The note is payable, together with accrued interest, on March 31, 2007 but will be extinguished (with no money owing under it) if our common stock trades at or above the average price of $12.25 per share for 15 consecutive trading days at any time between March 31, 2004 and March 31, 2007. We recorded the $3.6 million fair value of the contingent note issued based on the present value of the future cash flows discounted at borrowing rates currently available to us for debt with similar terms and maturities and discounted for the value of the extinguishment feature that is considered an embedded derivative. Using a market-borrowing rate of 9.3%, the principal value and the stipulated interest rate required by the note of 5% per annum, a discount of $0.8 million was computed on the note to be issued. The discount will be amortized to interest expense over the term of the note. In March 2004, we recorded an asset for the value of the embedded derivative, as required by SFAS 133. We estimated the value of the derivative and reduced the amount we included for the estimate of the value of the note by approximately $2.2 million at each of June 30, 2004 and $2.3 million at December 31, 2003. This asset will be marked to market in future periods with any increase or decrease included in our statement of operations as a cost of the litigation settlement. During the three months ended June 30, 2004 we recorded a $0.2 million expense for the change in estimated value of the derivative.

As of December 31, 2003, our balance sheet included a $33.4 million long-term liability related to the Hanover common stock and the fair value of the contingent note payable in connection with the securities settlement. In addition, as of December 31, 2003, our balance sheet included approximately $32.7 million in accrued liabilities and $29.6 million in restricted cash related to the securities settlement. In the first quarter of 2004, we released the escrow settlement fund, which was included on our balance sheet as restricted cash and the related securities settlement accrual, issued the shares and reclassified $29.8 million, the estimated value of our common stock issued, from other liabilities to stockholders’ equity and included the shares in our weighted average outstanding shares used for earnings per share calculations.

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6. ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):

See Note 5 for a discussion of the securities settlement.

7. COMMON STOCKHOLDERS’ EQUITY

In March 2004, we issued and delivered to the escrow agent for the settlement fund 2.5 million shares of Hanover common stock, as required by the settlement. (See Note 5.)

8. ACCOUNTING FOR DERIVATIVES

We use derivative financial instruments to minimize the risks and/or costs associated with financial and global operating activities by managing our exposure to interest rate fluctuations on a portion of our debt and leasing obligations. Our primary objective is to reduce our overall cost of borrowing by managing the fixed and floating interest rate mix of our debt portfolio. We do not use derivative financial instruments for trading or other speculative purposes. The cash flow from hedges is classified in our consolidated statements of cash flows under the same category as the cash flows from the underlying assets, liabilities or anticipated transactions.

For derivative instruments designated as fair value hedges, the gain or loss is recognized in earnings in the period of change together with the gain or loss on the hedged item attributable to the risk being hedged. For derivative instruments designated as cash flow hedges, the effective portion of the derivative gain or loss is included in other comprehensive income, but not reflected in our consolidated statement of operations until the corresponding hedged transaction is settled. The ineffective portion is reported in earnings immediately.

In March 2004, we entered into two interest rate swaps to hedge the risk of changes in fair value of our 8.625% Senior Notes due 2010 resulting from changes in interest rates. These interest rate swaps, under which we receive fixed payments and make floating payments, result in the conversion of the hedged obligation into floating rate debt. The following table summarizes, by individual hedge instrument, these interest rate swaps as of June 30, 2004:

As of June 30, 2004, a total of approximately $1.4 million in other current assets, $13.3 million in long-term liabilities and a $11.9 million reduction of long-term debt was recorded with respect to the fair value adjustment related to these two swaps.

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During 2001, we entered into three interest rate swaps to convert variable lease payments under certain lease arrangements to fixed payments as follows:

These three swaps, which we have designated as cash flow hedging instruments, meet the specific hedge criteria and any changes in their fair values have been recognized in other comprehensive income. During the six months ended June 30, 2004 and 2003, we recorded approximately $6.3 million and $1.1 million, respectively, related to these three swaps ($6.3 million and $0.7 million net of tax) in other comprehensive income. As of June 30, 2004, a total of approximately $7.6 million was recorded in current liabilities and approximately $0.6 million in long-term liabilities with respect to the fair value adjustment related to these three swaps.

On June 1, 2004, we repaid the outstanding indebtedness and minority interest obligations of $193.6 million and $6.4 million, respectively, under our 2000A equipment lease. As a result, the two interest rate swaps maturing on March 11, 2005, each having a notional amount of $100 million, associated with the 2000A equipment lease no longer meet specific hedge criteria and the unrealized gain related to the mark-to-market adjustment prior to June 1, 2004 of $5.3 million will be amortized into interest expense over the remaining life of the swap. In addition, beginning June 1, 2004, changes in the mark-to-market adjustment were recognized as interest expense in the statement of operations. The change in the mark-to-market adjustment for June 2004 was a $0.8 million gain.

Prior to 2001, we entered into two interest rate swaps with notional amounts of $75 million and $125 million and strike rates of 5.51% and 5.56%, respectively. The difference paid or received on the swap transactions was recorded as an accrued liability and recognized in leasing expense in all periods before July 1, 2003, and in interest expense until expiration in July 2003. Because management decided not to designate the interest rate swaps as hedges, we recognized unrealized gains of approximately $4.1 million related to the change in the fair value of these interest rate swaps in lease expense in our statement of operations during the six months ended June 30, 2003.

The counterparties to our interest rate swap agreements are major international financial institutions. We monitor the credit quality of these financial institutions and do not expect non-performance by any counterparty, although such non-performance could have a material adverse effect on us.

9. COMMITMENTS AND CONTINGENCIES

Hanover has issued the following guarantees that are not recorded on our accompanying balance sheet:

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As part of the Production Operators Corporation (“POC”) acquisition purchase price, Hanover may be required to make a contingent payment to Schlumberger based on the realization of certain tax benefits by Hanover through 2016. To date we have not realized any of such tax benefits or made any payments to Schlumberger in connection with them.

Upon the occurrence of a change of control of Hanover, if the change of control or shareholder approval of the change of control occurs before February 9, 2005, which is twelve months after the entry of the final court approval of the securities related settlement that became final in March 2004, we will be obligated to contribute an additional $3 million to the securities settlement fund. (See Note 5.)

On June 25, 1999, we notified the Air Quality Bureau of the Environmental Protection Division, New Mexico Environmental Department (the “Division”), of potential violations of State regulatory and permitting requirements. The potential violations included failure to conduct required performance tests, failure to file required notices and failure to pay annual filing fees for compressor units located on sites for more than one year. We promptly paid the required fees and filed the required notices, correcting the potential violations. On June 12, 2001, after the potential violations had been corrected, the Director of the Division issued a compliance order to us in connection with the potential violations. The compliance order assessed a civil penalty of $15,000 per day per alleged regulatory violation and permit; no total penalty amount was proposed in the compliance order. On October 3, 2003, the Division notified us that the total proposed penalty would be $759,072. However, since the alleged violations had been self-disclosed, the amount was reduced to $189,768. We subsequently responded to the penalty assessment, challenging the basis of the Division’s penalty calculation. As a result of our challenge, the Division agreed to a Stipulated Motion for Time to File Answer and further agreed to meet with us and negotiate a final settlement. On April 8, 2004, Hanover met with Division officials in Santa Fe and agreed to a final settlement of all alleged violations. In June 2004, we paid a penalty of $105,464 in final resolution of this matter.

On June 30, 2004, the Texas Commission on Environmental Quality (TCEQ) informed the Company that it was pursuing an enforcement action against the Company’s subsidiary HCLP for alleged violations of the Texas Health and Safety Code and Commission Rules at the Redwood Hanover Gateway Plant (RHG Plant) in Madison County, Texas. The alleged violations include failure to comply with certain permit limitations relating to sulfur emissions during certain periods in 2003 and 2004 and failure to provide certain required notifications in connection therewith. TCEQ has proposed a settlement of $149,625 in respect of the alleged violations in the form of a proposed Agreed Order dated June 29, 2004. The Company has requested a meeting with the TCEQ to discuss the allegations and to challenge certain assumptions made by the TCEQ. A date for the meeting is pending further communication with TCEQ.

In the ordinary course of business we are involved in various other pending or threatened legal actions, including environmental matters. While management is unable to predict the ultimate outcome of these actions, it believes that any ultimate liability arising from these actions will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

We are involved in a project to build and operate barge-mounted gas compression and gas processing facilities to be stationed in a Nigerian coastal waterway as part of the performance of a contract between an affiliate of The Royal/ Dutch Shell Group (“Shell”) and Global Energy and Refining Ltd. (“Global”), a Nigerian company. We have completed the building of the required barge-mounted facilities. Under the terms of a series of contracts between Global and us, Shell, and several other counterparties, respectively, Global is responsible for the development of the overall project, which will require significant financing. Global has orally informed us that it has completed a financing transaction, although it is not clear to us whether the funds raised by Global will be sufficient to perform its obligations under these contracts. In light of the political environment in Nigeria, Global’s lack of a successful track record with respect to this project and other factors, there is no assurance that Global will be able to comply with its obligations under these contracts. In May 2004, we reached an agreement with Global whereby Global prepaid to us $5.0 million in equipment rental fees that we recorded in other liabilities on our condensed consolidated balance sheet in return for our agreement to waive certain defaults by Global with respect to some of our agreements with them.

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If Shell were to terminate its contract with Global for any reason or we were to terminate our involvement in the project, we would be required to find an alternative use for the barge-mounted facility which could result in a write-down of our investment. At June 30, 2004, we had an investment of approximately $30.4 million associated with the barge-mounted facility and approximately $4.1 million associated with advances to, and our investment in, Global.

10. RELATED-PARTY TRANSACTIONS

We received a letter on March 11, 2004 from the administrative trustee of the GKH Liquidating Trust indicating it and one of its affiliates had decided to distribute 5.8 million shares of the 8.3 million shares of Hanover common stock owned by the GKH Liquidating Trust (formerly held by GKH Investments, L.P. and GKH Private Limited (collectively “GKH”)) and its affiliate to the relevant beneficiaries. We understand that in April 2004 GKH contributed the remaining 2.5 million shares of our common stock held by GKH to the settlement fund. (See Note 5.)

11. NEW ACCOUNTING PRONOUNCEMENTS

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 changes the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2004. On November 7, 2003 the FASB issued Staff Position 150-3 that delayed the effective date for certain types of financial instruments. We do not believe the adoption of the guidance currently provided in SFAS 150 will have a material effect on our consolidated results of operations or cash flow. However, we may be required to classify as debt approximately $22.2 million in sale leaseback obligations that are currently reported as “Minority interest” on our condensed consolidated balance sheet pursuant to FIN 46.

These minority interest obligations represent the equity of the entities that lease compression equipment to us. In accordance with the provisions of our compression equipment lease obligations, the equity certificate holders are entitled to quarterly or semi-annual yield payments on the aggregate outstanding equity certificates. As of June 30, 2004, the yield rates on the outstanding equity certificates ranged from 4.4% to 9.5%. Equity certificate holders may receive a return of capital payment upon termination of the lease or our purchase of the leased compression equipment after full payment of all debt obligations of the entities that lease compression equipment to us. At June 30, 2004, the carrying value of the minority interest obligations approximated the fair market value of assets that would be required to be transferred to redeem the minority interest obligations.

In April 2004, the Emerging Issues Task Force reached a consensus on Issue No. 03-06, “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earning per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 had no effect on our net income (loss) per share.

12. REPORTABLE SEGMENTS

We manage our business segments primarily based upon the type of product or service provided. We have five principal industry segments: Domestic Rentals; International Rentals; Parts, Service and Used Equipment; Compressor and Accessory Fabrication; and Production and Processing Equipment Fabrication. The Domestic and International Rentals segments primarily provide natural gas compression and production and processing equipment rental and maintenance

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services to meet specific customer requirements on Hanover-owned assets. The Parts, Service and Used Equipment segment provides a full range of services to support the surface production needs of customers from installation and normal maintenance and services to full operation of a customer’s owned assets and surface equipment as well as sales of used equipment. The Compressor and Accessory Fabrication Segment involves the design, fabrication and sale of natural gas compression units and accessories to meet unique customer specifications. The Production and Processing Equipment Fabrication Segment designs, fabricates and sells equipment used in the production and treating of crude oil and natural gas and engineering, procurement and construction of heavy wall reactors for refineries and desalination plants.

We evaluate the performance of our segments based on segment gross profit. Segment gross profit for each segment includes direct revenues and operating expenses attributable to that segment. Costs excluded from segment gross profit include selling, general and administrative, depreciation and amortization, leasing, interest, foreign currency translation, provision for cost of litigation settlement, goodwill impairment, other expenses and income taxes. Amounts defined as “Other” include equity in income of non-consolidated affiliates, results of other insignificant operations and corporate related items primarily related to cash management activities. Revenues include sales to external customers. Intersegment sales and any resulting profits are eliminated in consolidation. We no longer include intersegment sales when we evaluate the performance of our segments and have adjusted prior periods to conform to the 2004 presentation.

The following tables present sales and other financial information by industry segment for the three months ended June 30, 2004 and 2003.

The following tables present sales and other financial information by industry segment for the six months ended June 30, 2004 and 2003.

13. DISCONTINUED OPERATIONS AND OTHER ASSETS HELD FOR SALE

During the fourth quarter of 2002, Hanover’s Board of Directors approved management’s plan to dispose of our non-oilfield power generation projects, which were part of our domestic rental business, and certain used equipment businesses, which were part of our parts and service business. These disposals meet the criteria established for recognition as discontinued operations under SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS 144”). SFAS 144 specifically requires that such amounts must represent a component of a business comprised of operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. These businesses are reflected as discontinued operations in our condensed consolidated statement of operations. Due to changes in market conditions, the disposal plan was not completed in 2003. We are continuing to actively market these assets and have made valuation adjustments as a result of the change in market conditions. We have sold

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certain assets related to our used equipment business for total sales proceeds of $5.7 million during the six months ended June 30, 2004 that resulted in a $0.4 million gain. The remaining assets are expected to be sold during the remainder of 2004 and the assets and liabilities are reflected as held-for-sale on our condensed consolidated balance sheet.

          Summary of operating results of the discontinued operations (in thousands):

As a result of our consolidation efforts during 2003, we reclassified certain closed facilities to assets held for sale.

          Summary balance sheet data for assets held for sale as of June 30, 2004 (in thousands):

          Summary balance sheet data for assets held for sale as of December 31, 2003 (in thousands):

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14. INCOME TAXES

During the first six months of 2004, we recorded a net tax provision of $14.5 million compared to a benefit from taxes of $10.5 million for the first six months of 2003. Our effective tax rate for the six months ended June 30, 2004 was (335)%, compared to 30% for the six months ended June 30, 2003. Due to Hanover’s recent domestic tax losses, we cannot reach the conclusion that it is “more likely than not” that certain of our U.S. deferred tax assets would be realized in the near future. Accordingly, our provision for income taxes for the six months ended June 30, 2004 did not include a tax benefit for our estimate of anticipated U.S. losses because the benefit is not anticipated to be realized in the near future.

We reclassified approximately $23.8 million, net of a valuation allowance of $2.4 million, to current deferred income taxes that, at December 31, 2003, had previously been included as part of our net deferred income tax liability. This immaterial reclassification had no impact on our consolidated results of operations, cash flows or shareholders’ equity. Due to our current tax position in the U.S., we have recorded a full valuation allowance, $2.4 million in current deferred income taxes and $23.3 million in non-current deferred tax liability, against our net U.S. deferred tax assets. See Note 13 in “Notes to the Consolidated Financial Statements” in our annual report on Form 10-K for the fiscal year end December 31, 2003 for further information regarding our tax valuation allowances.

15. SUBSEQUENT EVENTS

In July 2004, we granted approximately 1.1 million shares of restricted Hanover common stock under our 2003 Stock Incentive Plan to certain employees, including our executive officers, as part of an incentive compensation plan. Approximately 0.7 million of the shares of restricted stock that were granted will vest over a three-year period at a rate of one-third per year, beginning on the first anniversary of the date of the grant, and approximately 0.4 million of the shares of restricted stock that were granted will vest in July 2007, subject to the achievement of certain pre-determined performance based criteria. In the event of a change of control of Hanover, a portion of these grants are subject to accelerated vesting. Because 0.4 million of the restricted shares vest based on performance, we will record an estimate of the compensation expense to be expensed over three years related to these restricted shares. The compensation expense that will be recognized in our statement of operations will be adjusted for changes in our estimate of the number of restricted shares that will vest as well as changes in our stock price.

In July 2004, Wilpro Energy Services (PIGAP II) Limited (referred to as “PIGAP II”) received a notice of default from the Venezuelan state oil company, PDVSA, alleging that PIGAP II is not in compliance under a services agreement as a result of certain operational issues. PIGAP II is a joint venture, currently owned 70% by a subsidiary of The Williams Companies, Inc. (“Williams”) and 30% by Hanover, that operates a natural gas compression facility in Venezuela. PIGAP II has informed us that it does not believe a basis exists for such notice and that it is contesting the giving of this notice. Nonetheless, the giving of this notice of default could be deemed an event of default under PIGAP II’s outstanding project loans totaling approximately $219 million. We understand, however, that the lenders under the PIGAP II project loan agreement have confirmed to PIGAP II that based on the facts they currently know, they have no intention of exercising any rights or remedies under the PIGAP II project loan agreements until the issues raised in the notice and PIGAP II’s response are clarified. In any event, Hanover has not guaranteed and is not otherwise liable for the PIGAP II project loans and an event of default under such project loans does not trigger a default under Hanover’s debt obligations. Hanover’s net book investment in PIGAP II at June 30, 2004 was approximately $27.9 million and Hanover’s pretax income with respect to PIGAP II for the six months ended June 30, 2004 was approximately $6.6 million.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain matters discussed in this Quarterly Report on Form 10-Q are “forward-looking statements” intended to qualify for the safe harbors from liability established by the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements can generally be identified as such because the context of the statement will include words such as we “believe”, “anticipate”, “expect”, “estimate” or words of similar import. Similarly, statements that describe Hanover’s future plans, objectives or goals or future revenues or other future financial metrics are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those anticipated as of the date of this report. These risks and uncertainties include:

Other factors besides those described in this Form 10-Q could also affect our actual results. You should not unduly rely on the forward-looking statements contained in this Form 10-Q, which speak only as of the date of this Form 10-Q. Except as otherwise required by law, we undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this Form 10-Q or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in our Annual Report on Form 10-K for the year ended December 31, 2003 and the reports we file from time to time with the SEC after the date of this Form 10-Q. All forward-looking statements attributable to Hanover are expressly qualified in their entirety by this cautionary statement.

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GENERAL

Hanover Compressor Company, a Delaware corporation (“we”, “Hanover”, or the “Company”), together with its subsidiaries, is a global market leader in the full service natural gas compression business and is also a leading provider of service, fabrication and equipment for oil and natural gas processing and transportation applications. We sell and rent this equipment and provide complete operation and maintenance services, including run-time guarantees, for both customer-owned equipment and our fleet of rental equipment. Hanover was founded as a Delaware corporation in 1990, and has been a public company since 1997. Our customers include both major and independent oil and gas producers and distributors as well as national oil and gas companies in the countries in which we operate. Our maintenance business, together with our parts and service business, provides solutions to customers that own their own compression and surface production and processing equipment, but want to outsource their operations. We also fabricate compressor and oil and gas production and processing equipment and provide gas processing and treating, gas measurement and oilfield power generation services, primarily to our domestic and international customers as a complement to our compression services. In addition, through our subsidiary, Belleli Energy S.r.l. (“Belleli”), we provide engineering, procurement and construction services primarily related to the manufacturing of heavy wall reactors for refineries and construction of desalination plants, primarily for use in Europe and the Middle East.

Substantially all of our assets and operations are owned or conducted by our wholly owned subsidiary, Hanover Compression Limited Partnership (“HCLP”).

OVERVIEW

Our revenue and other income for the three months ended June 30, 2004 was $296.7 million compared to $276.4 million for the three months ended June 30, 2003. Net loss for the three months ended June 30, 2004 was $9.1 million, or $0.11 per share, compared with a net income of $0.2 million, or $0.00 per share, for the three months ended June 30, 2003. The decrease in our operating results was primarily due to the impact of adoption of FIN 46 and an increase in our provision for income taxes. As a result of the adoption of FIN 46, we recorded approximately $4.2 million in additional depreciation expense associated with the compression equipment operating leases that were consolidated into Hanover’s financials in the third quarter of 2003. Our provision for income taxes for the three months ended June 30, 2004 did not include a tax benefit for our estimate of anticipated U.S. losses. Based on a statutory rate, we estimate that our tax expense was approximately $4.7 million higher because of our current tax position in the United States. This expense is discussed in greater detail under “Income Taxes” below.

Our revenue and other income for the six months ended June 30, 2004 was $571.0 million compared to $550.1 million for the six months ended June 30, 2003. Net loss for the six months ended June 30, 2004 was $18.5 million, or $0.22 per share, compared with a net loss of $26.4 million, or $0.33 per share, for the six months ended June 30, 2003. The improvement in our net income was primarily the result of a $43.7 million decrease in the provision for cost of litigation settlement offset by an approximately $8.5 million increase in additional depreciation related to the adoption of FIN 46 and an increase in our provision for income tax. Our provision for income taxes for the six months ended June 30, 2004 did not include a tax benefit for our estimate of anticipated U.S. losses. Based on a 35% federal U.S. tax rate, we estimate that our tax expense was approximately $14.1 million higher because of our current tax position in the United States. This expense is discussed in greater detail under “Income Taxes” below.

During the six months ended June 30, 2004, we realized continued improvement in our domestic rental fleet utilization, which increased from approximately 76% at December 31, 2003 to 79% at June 30, 2004. During the six months ended June 30, 2004, we also achieved an improvement in backlog in both the compression and production and processing fabrication lines of our business. Our parts, service and used equipment business segment benefited from strong international service and installation revenue and gross profit during the six months ended June 30, 2004, but the base parts and service revenue was lower than anticipated. Hanover believes this lower revenue is due to continued delays in maintenance by our customers because of the current strong gas price environment, particularly in North America.

Total compression horsepower at June 30, 2004 was approximately 3,481,000, consisting of approximately 2,568,000 horsepower in the United States and approximately 913,000 horsepower internationally. Our total compression horsepower utilization rate at June 30, 2004 was approximately 83%, compared to utilization of approximately 81% at December 31, 2003 and approximately 79% at June 30, 2003. Domestic and international utilization at June 30, 2004 was approximately

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79% and 96%, respectively, compared to approximately 76% and 94%, respectively, at December 31, 2003, and approximately 73% and 94%, respectively, at June 30, 2003.

At June 30, 2004, Hanover’s total third-party fabrication backlog, excluding Belleli, was approximately $104 million compared to approximately $46 million at December 31, 2003 and $84 million at June 30, 2003. Backlog for Belleli at June 30, 2004 was approximately $162 million, compared to approximately $107 million at December 31, 2003 and $77 million at June 30, 2003. The compressor and accessory fabrication backlog was approximately $54 million at June 30, 2004, compared to approximately $28 million at December 31, 2003 and $37 million at June 30, 2003. The backlog for production and processing equipment fabrication, excluding Belleli, was approximately $50 million at June 30, 2004, compared to approximately $18 million at December 31, 2003 and $47 million at June 30, 2003.

Industry Conditions

The North American rig count increased by 5% to 1,441 at June 30, 2004 from 1,375 at June 30, 2003, and the twelve-month rolling average North American rig count increased by 23% to 1,500 at June 30, 2004 from 1,215 at June 30, 2003. In addition, the twelve-month rolling average New York Mercantile Exchange wellhead natural gas price increased to $5.31 per Mcf at June 30, 2004 from $4.79 per Mcf at June 30, 2003. During 2003, we did not experience any significant growth in domestic rentals or purchases of equipment and services by our customers, which we believe is primarily the result of the lack of a significant increase in U.S. natural gas production levels. However, with several non-operational issues behind us, we are focused on improving our sales success ratio on new bid opportunities and continue to anticipate some revenue growth in 2004.

Facility Consolidation

We had previously announced our plan to reduce our U.S. headcount by approximately 500 employees worldwide and to close four fabrication facilities. During the year ended December 31, 2002, we accrued approximately $2.7 million in employee separation costs related to the reduction in workforce. During the year ended December 31, 2003, we paid approximately $2.0 million in employee separation costs, implemented further cost saving initiatives and closed two facilities in addition to the four fabrication facilities we closed pursuant to our original reduction plan. During the first six months of 2004, we paid an additional $0.7 million in employee separation costs related to the completion of these activities. From December 31, 2002 to June 30, 2004, our U.S. workforce has decreased by approximately 700 employees.

U.S. Tax Position

As a result of recent operating losses, we were in a net deferred tax asset position (for U.S. income tax purposes) for the first time in 2003. Due to our recent domestic tax losses, we could not reach the conclusion that it was “more likely than not” that certain of our U.S. deferred tax assets would be realized in the near future. Accordingly, for 2003 we provided a $25.7 million deferred tax valuation allowance against our net U.S. deferred tax asset. We will be required to record additional valuation allowances if our domestic deferred tax asset position is increased and the “more likely than not” criteria of SFAS 109 continues to not be met. If we are required to record additional valuation allowances, our effective tax rate will be above the statutory rate. Our preliminary analysis leads us to believe that we will likely be required to record additional valuation allowances in 2004, and we may be required to record additional valuation allowances in future periods.

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RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30, 2003

Summary of Business Segment Results

Domestic Rentals
(in thousands)

Domestic rental revenue increased during the three months ended June 30, 2004, compared to the three months ended June 30, 2003, due primarily to improved utilization in our compression rental fleet. We believe that our utilization increased due to an improvement in market conditions and our focus on putting idle units into service. Utilization of our domestic compression rental fleet increased to approximately 79% at June 30, 2004 from approximately 73% at June 30, 2003. Our utilization increased due to a 3% increase in contracted units, the retirement of units to be sold or scrapped and the deployment of units into international operations. Gross margin for the three months ended June 30, 2004 decreased slightly, compared to the three months ended June 30, 2003, due to increased maintenance and repair expense and increased start up costs associated with bringing idle compression units online.

International Rentals
(in thousands)

During the three months ended June 30, 2004 international rental revenue and gross profit increased, compared to the three months ended June 30, 2003, primarily due to increased compression and processing plant rental activity in Argentina, Brazil and Mexico. Gross margin for the three months ended June 30, 2004 increased when compared to the three months ended June 30, 2003, primarily due to (a) lower repair and maintenance expense that is expected to increase in the second half of 2004 and (b) the receipt of approximately $0.9 million in additional contractual inflation adjustments in Venezuela and approximately $1.1 million in negotiated start up payments received in Brazil associated with a compression rental project that was scheduled to start up in the first quarter of 2004 but was delayed by the customer. The inflation and negotiated start up payment increased our international rental gross margin by 1% during the three months ended June 30, 2004.

Parts, Service and Used Equipment
(in thousands)

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Parts, service and used equipment revenue and gross profit for the three months ended June 30, 2004 was higher than the three months ended June 30, 2003 due primarily to increased international service and installation sales which were partly offset by a decrease in revenue from our domestic parts and service business. We believe our North American customers have delayed maintenance in order to keep their equipment on-line for longer periods due to the increase in price of natural gas. Gross margin for the three months ended June 30, 2004 was lower than the results for the three months ended June 30, 2003 primarily due to the higher margin on a used equipment sales in the second quarter of 2003. For the three months ended June 30, 2004, parts and service revenue was $35.4 million with a gross margin of 28%, compared to $30.8 million and 27%, respectively, for the three months ended June 30, 2003. Used rental equipment and installation sales revenue in the three months ended June 30, 2004 was $6.5 million with a gross margin of 4%, compared to $4.2 million with a 19% gross margin for the three months ended June 30, 2003. Our used rental equipment and installation sales and gross margins vary significantly from period to period and are dependent on the exercise of purchase options on rental equipment by customers and the start-up of new projects by customers.

Compression and Accessory Fabrication
(in thousands)

For the three months ended June 30, 2004, compression fabrication revenue and gross profit increased primarily due to our increased focus on fabrication that led to increased sales. Gross margin declined during the three months ended June 30, 2004, compared to three months ended June 30, 2003, due primarily to continued strong competition for new orders that negatively impacted sales prices and the resulting gross margin.

Production and Processing Equipment Fabrication
(in thousands)

Production and processing equipment fabrication revenue for the three months ended June 30, 2004 was slightly lower than for the three months ended June 30, 2003, primarily due to a decrease in orders from our customers in the second half of 2003. We believe our consolidation efforts, management changes and non-operational issues impacted our sales efforts. However, we are focusing on improving our sales success ratio on new bid opportunities that has resulted in the recent improvement in our backlog. Gross profit and gross margin for production and processing equipment fabrication for the three months ended June 30, 2004 increased, compared to the second quarter 2003, due primarily to improvements in Belleli’s operating performance.

Other Income

Equity in income of non-consolidated affiliates decreased by $1.5 million to $4.9 million during the three months ended June 30, 2004, from $6.4 million during the three months ended June 30, 2003. This decrease is primarily due to a decrease in results from our equity interest in PIGAP II, which experienced an increase in interest expense during the three months ended June 30, 2004 compared to the three months ended June 30, 2003 as a result of the completion of PIGAP II’s project financing in October 2003.

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Expenses

Selling, general, and administrative expense (“SG&A”) for the three months ended June 30, 2004 was $41.7 million, compared to $40.2 million during the three months ended June 30, 2003. As a percentage of revenue, SG&A in the second quarter 2004 was 14%, compared to 15% for the same period a year earlier.

Depreciation and amortization expense for the three months ended June 30, 2004 increased to $44.5 million, compared to $36.1 million for the same period a year ago. Second quarter 2004 depreciation and amortization expense increased primarily due to (a) additional depreciation expense of approximately $4.2 million associated with the compression equipment operating leases that were consolidated into Hanover’s financial statements in the third quarter 2003, (b) increased depreciation expense due to additions to the rental fleet, including maintenance capital, placed in service during the first six months of 2004 and during 2003, and (c) approximately $1.0 million in additional amortization expense to write-off deferred financing costs associated with the June 2004 refinancing of our 2000A compression equipment lease obligations.

Beginning in July 2003, payments accrued under our sale leaseback transactions were included in interest expense as a result of consolidating on our balance sheet the entities that lease compression equipment to us. As a result, during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003, our interest expense increased $23.4 million to $35.7 million and our leasing expense decreased $20.8 million to $0.

Foreign currency translation for the three months ended June 30, 2004 was a loss of $0.6 million, compared to a gain of $0.6 million for the three months ended June 30, 2003. The foreign currency translation loss was primarily due to foreign currency loss in our Canadian operations. The following table summarizes the exchange gains and losses we recorded for assets exposed to currency translation (in thousands):

Provision for Securities Litigation Settlement

During the three months ended June 30, 2004, we recorded a $0.2 million increase in the cost of the securities related litigation settlement to mark-to-market the change in value of the embedded derivative related to the shareholder note recorded. During the three months ended June 30, 2003, we recorded a $1.7 million charge to adjust the estimated expense for the change in market value of the 2.5 million shares of Hanover common stock that were issued by Hanover as part of the securities related litigation settlement.

Income Taxes

During the three months ended June 30, 2004, we recorded a net tax provision of $6.8 million compared to a provision for taxes of $1.2 million for the three months ended June 30, 2003. Our effective tax rate for the three months ended June 30, 2004 was (262)%, compared to 72% for the three months ended June 30, 2003. The increase in effective rate was primarily due to the impact of valuation allowances provided in the U.S. and the weight of foreign income to U.S. income (loss). Due to Hanover’s recent domestic tax losses, we cannot reach the conclusion that it is “more likely than not” that certain of our U.S. deferred tax assets will be realized in the near future. Accordingly, our provision for income taxes for the three months ended June 30, 2004 did not include a tax benefit for our estimate of anticipated U.S. losses because the benefit is not anticipated to be realized in the near future. Based on 35% federal U.S. tax rate, we estimate that our tax expense for the three months ended June 30, 2004 was approximately $4.7 million higher because of our current tax position in the U.S.

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SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDED JUNE 30, 2004

Summary of Business Segment Results

Domestic Rentals
(in thousands)