UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-Q

(MARK ONE)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM______________ TO______________.

Hanover Compressor Company

Delaware (State or Other Jurisdiction of Incorporation or Organization)		76-0625124 (I.R.S. Employer Identification No.)
12001 North Houston Rosslyn, Houston, Texas (Address of principal executive offices)		77086 (Zip Code)

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 R No £

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No R

Number of shares of the Common Stock of the registrant outstanding as of October 28, 2005: 102,025,540 shares.

 

 

TABLE OF CONTENTS

			Page
PART I. FINANCIAL INFORMATION			3
ITEM 1. FINANCIAL STATEMENTS			3
CONDENSED CONSOLIDATED BALANCE SHEET			3
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS			4
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)			5
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS			6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS			7
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			35
ITEM 4. CONTROLS AND PROCEDURES			37
PART II. OTHER INFORMATION			37
ITEM 1. LEGAL PROCEEDINGS			37
ITEM 5. OTHER INFORMATION			37
ITEM 6: EXHIBITS			38
SIGNATURES			39
EXHIBIT INDEX			40
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO Pursuant to Section 906
Certification of CFO Pursuant to Section 906

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HANOVER COMPRESSOR COMPANY

CONDENSED CONSOLIDATED BALANCE SHEET
(in thousands of dollars, except for par value and share amounts)

		September 30,				December 31,
		2005				2004
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	29,840			$	38,076
Accounts receivable, net of allowance of $7,205 and $7,573, respectively			238,718				205,644
Inventory, net			218,244				184,798
Costs and estimated earnings in excess of billings on uncompleted contracts			100,481				70,103
Prepaid taxes			4,214				6,988
Current deferred income tax			12,286				12,386
Assets held for sale			4,576				5,169
Other current assets			32,585				25,674
Total current assets			640,944				548,838
Property, plant and equipment, net			1,810,944				1,876,348
Goodwill, net			184,409				183,190
Intangible and other assets			52,412				57,070
Investments in non-consolidated affiliates			87,628				90,326
Assets held for sale			4,680				6,391
Total assets		$	2,781,017			$	2,762,163
LIABILITIES AND COMMON STOCKHOLDERS’ EQUITY
Current liabilities:
Short-term debt		$	4,187			$	5,106
Current maturities of long-term debt			1,478				1,430
Accounts payable, trade			67,183				57,402
Accrued liabilities			126,154				118,429
Advance billings			66,213				42,588
Liabilities related to assets held for sale			644				517
Billings on uncompleted contracts in excess of costs and estimated earnings			15,721				20,256
Total current liabilities			281,580				245,728
Long-term debt			1,468,826				1,637,080
Other liabilities			42,797				47,232
Deferred income taxes			62,908				53,290
Total liabilities			1,856,111				1,983,330
Commitments and contingencies (Note 6)
Minority interest			11,873				18,778
Common stockholders’ equity:
Common stock, $.001 par value; 200,000,000 shares authorized; 102,374,472 and 87,653,970 shares issued, respectively			102				88
Additional paid-in capital			1,097,576				913,007
Deferred employee compensation — restricted stock grants			(14,936	)			(15,180	)
Accumulated other comprehensive income			15,970				17,518
Retained deficit			(181,889	)			(148,071	)
Treasury stock—351,432 and 661,810 common shares, at cost			(3,790	)			(7,307	)
Total common stockholders’ equity			913,033				760,055
Total liabilities and common stockholders’ equity		$	2,781,017			$	2,762,163

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

HANOVER COMPRESSOR COMPANY

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands of dollars, except per share amounts)
(unaudited)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2005				2004				2005				2004
Revenues and other income:
U.S. rentals		$	87,703			$	85,866			$	262,548			$	256,138
International rentals			58,208				52,797				167,644				158,896
Parts, service and used equipment			74,027				48,741				157,995				134,537
Compressor and accessory fabrication			51,798				46,605				125,414				118,914
Production and processing equipment fabrication			90,312				76,193				284,180				192,639
Equity in income of non-consolidated affiliates			6,027				5,096				15,759				14,867
Other			1,771				513				2,714				2,527
			369,846				315,811				1,016,254				878,518
Expenses:
U.S. rentals			35,503				37,816				102,563				108,305
International rentals			19,284				16,797				53,930				45,537
Parts, service and used equipment			55,865				34,419				117,140				98,752
Compressor and accessory fabrication			44,418				41,217				110,622				107,584
Production and processing equipment fabrication			83,146				68,974				254,700				170,557
Selling, general and administrative			45,442				43,877				131,509				126,133
Foreign currency translation			1,083				569				6,309				(600	)
Securities related litigation settlement			—				(4,000	)			—				(3,903	)
Other			133				222				526				569
Debt extinguishment costs			7,318				—				7,318				—
Depreciation and amortization			47,535				43,506				138,457				128,882
Interest expense			34,612				37,188				105,214				108,169
			374,339				320,585				1,028,288				889,985
Loss from continuing operations before income taxes			(4,493	)			(4,774	)			(12,034	)			(11,467	)
Provision for income taxes			10,279				2,557				20,922				16,415
Loss from continuing operations			(14,772	)			(7,331	)			(32,956	)			(27,882	)
Income (loss) from discontinued operations, net of tax			(214	)			2,204				(706	)			3,868
Income (loss) from sales or write-downs of discontinued operations, net of tax			48				(147	)			(156	)			225
Net loss		$	(14,938	)		$	(5,274	)		$	(33,818	)		$	(23,789	)
Basic and diluted loss per common share:
Loss from continuing operations		$	(0.16	)		$	(0.09	)		$	(0.37	)		$	(0.33	)
Income (loss) from discontinued operations, net of tax			0.00				0.03				(0.01	)			0.05
Net loss		$	(0.16	)		$	(0.06	)		$	(0.38	)		$	(0.28	)
Weighted average common and equivalent shares outstanding:
Basic			93,888				85,418				88,488				84,527
Diluted			93,888				85,418				88,488				84,527

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

HANOVER COMPRESSOR COMPANY

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
(in thousands of dollars)
(unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Net loss		$	(14,938	)		$	(5,274	)		$	(33,818	)		$	(23,789	)
Other comprehensive income (loss):
Change in fair value of derivative financial instruments, net of tax			—				1,222				609				6,970
Foreign currency translation adjustment			1,900				4,053				(2,157	)			155
Comprehensive income (loss)		$	(13,038	)		$	1			$	(35,366	)		$	(16,664	)

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

HANOVER COMPRESSOR COMPANY

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands of dollars)
(unaudited)

		Nine Months Ended
		September 30,
		2005				2004
Cash flows from operating activities:
Net loss		$	(33,818	)		$	(23,789	)
Adjustments:
Depreciation and amortization			138,457				128,882
(Gain) loss from discontinued operations, net of tax			862				(4,093	)
Bad debt expense			1,568				1,295
Gain on sale of property, plant and equipment			(9,736	)			(6,151	)
Equity in income of non-consolidated affiliates, net of dividends received			2,924				(6,975	)
(Gain) loss on derivative instruments			416				(372	)
Provision (release) of litigation settlement, net of cash used			—				(5,922	)
Gain on sale of non-consolidated affiliates			—				(300	)
Gain on the sale of business			(188	)			—
Restricted stock compensation expense			4,059				1,583
Pay-in-kind interest on long-term notes payable			17,185				15,440
Deferred income taxes			11,749				9,970
Changes in assets and liabilities, excluding business combinations:
Accounts receivable and notes			(43,835	)			(21,721	)
Inventory			(35,956	)			(29,223	)
Costs and estimated earnings versus billings on uncompleted contracts			(41,694	)			12,552
Accounts payable and other liabilities			18,792				(7,012	)
Advance billings			27,508				9,046
Prepaid, effects of exchange rate on accounts denominated in foreign currencies and other			7,171				8,065
Net cash provided by continuing operations			65,464				81,275
Net cash provided by (used in) discontinued operations			(376	)			7,931
Net cash provided by operating activities			65,088				89,206
Cash flows from investing activities:
Capital expenditures			(103,155	)			(57,407	)
Proceeds from sale of property, plant and equipment			38,028				23,401
Proceeds from sale of business			2,500				—
Proceeds from sale of non-consolidated affiliates			—				4,663
Cash used for business acquisitions			(3,426	)			—
Cash used to acquire investments in and advances to non-consolidated affiliates			(500	)			(250	)
Net cash used in continuing operations			(66,553	)			(29,593	)
Net cash provided by discontinued operations			220				8,644
Net cash used in investing activities			(66,333	)			(20,949	)
Cash flows from financing activities:
Borrowings on revolving credit facilities			120,000				41,000
Repayments on revolving credit facilities			(79,000	)			(55,000	)
Proceeds from warrant conversions and stock options exercised			4,829				7,719
Net repayments of other debt			(1,421	)			(16,613	)
Proceeds from equity offering, net of issuance costs			179,202				—
Proceeds from issuance of senior notes, net			—				194,125
Payments of debt issuance costs			—				(254	)
Payments of 2000A compression equipment lease obligations			—				(200,000	)
Payments of 2000B compression equipment lease obligations			(57,589	)			(65,000	)
Payments of 2001A compression equipment lease obligations			(172,177	)			—
Net cash used in continuing operations			(6,156	)			(94,023	)
Net cash used in discontinued operations			—				—
Net cash used in financing activities			(6,156	)			(94,023	)
Effect of exchange rate changes on cash and equivalents			(835	)			(160	)
Net decrease in cash and cash equivalents			(8,236	)			(25,926	)
Cash and cash equivalents at beginning of period			38,076				56,619
Cash and cash equivalents at end of period		$	29,840			$	30,693

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

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, 2004. These interim results are not necessarily indicative of results for a full year.

Earnings Per Common Share

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

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

Three Months Ended

Nine Months Ended

September 30,

September 30,

2005

2004

2005

2004

Weighted average common shares outstanding—used in basic loss per common share

93,888

85,418

88,488

84,527

Net dilutive potential common stock issuable:

On exercise of options and vesting of restricted stock

*

*

*

*

*

*

*

*

On exercise of warrants

*

*

*

*

*

*

*

*

On conversion of convertible subordinated notes due 2029

*

*

*

*

*

*

*

*

On conversion of convertible senior notes due 2008

*

*

*

*

*

*

*

*

On conversion of convertible senior notes due 2014

*

*

*

*

*

*

*

*

Weighted average common shares and dilutive potential common shares— used in diluted loss per common share

93,888

85,418

88,488

84,527

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Net dilutive potential common shares issuable:
On exercise of options and vesting of restricted stock			2,066				2,795				2,534				2,298
On exercise of options-exercise price greater than average market value at end of period			745				1,074				749				1,073
On exercise of warrants			2				4				3				4
On conversion of convertible subordinated notes due 2029			4,825				4,825				4,825				4,825
On conversion of convertible senior notes due 2008			4,370				4,370				4,370				4,370
On conversion of convertible senior notes due 2014			9,583				9,583				9,583				9,583
			21,591				22,651				22,064				22,153

Stock Options and Stock-Based Compensation

Certain of our employees participate in stock incentive plans that provide for the granting of options to purchase shares of Hanover common stock and grants of restricted stock. In accordance with Statement of Financial Standards No. 123, “Accounting for Stock-Based Compensation,” 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”. Except for shares that vest based on performance, we 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. For restricted shares that 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. The treasury stock received from forfeitures of restricted stock is recorded based on the value used to measure our compensation expense for such shares. The following pro forma net loss and loss per share data illustrates the effect on net loss and net loss per share if the fair value method had been applied to all outstanding and unvested stock options in each period (in thousands).

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Net loss as reported		$	(14,938	)		$	(5,274	)		$	(33,818	)		$	(23,789	)
Add back: Restricted stock grant expense			1,836				818				4,059				1,583
Deduct: Stock-based employee compensation expense determined under the fair value method			(2,297	)			(1,463	)			(5,846	)			(3,155	)
Pro forma net loss		$	(15,399	)		$	(5,919	)		$	(35,605	)		$	(25,361	)
Loss per share:
Basic, as reported		$	(0.16	)		$	(0.06	)		$	(0.38	)		$	(0.28	)
Basic, pro forma		$	(0.16	)		$	(0.07	)		$	(0.40	)		$	(0.30	)
Diluted, as reported		$	(0.16	)		$	(0.06	)		$	(0.38	)		$	(0.28	)
Diluted, pro forma		$	(0.16	)		$	(0.07	)		$	(0.40	)		$	(0.30	)

In July 2005, the Board of Directors approved grants of awards under the 2003 Stock Incentive Plan to certain employees, including our executive officers, as part of an incentive compensation program. The grants included, in the aggregate, approximately 0.4 million shares of restricted stock and 0.5 million options to purchase our common stock. The shares of restricted stock and stock options that were granted 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.

Reclassifications
Certain amounts in the prior period’s financial statements have been reclassified to conform to the 2005 financial statement classification. These reclassifications have no impact on our consolidated results of operations, cash flows or financial position.

2. INVENTORY

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

		September 30,				December 31,
		2005				2004
Parts and supplies		$	128,167			$	135,751
Work in progress			79,635				42,708
Finished goods			10,442				6,339
		$	218,244			$	184,798

As of September 30, 2005 and December 31, 2004, we had inventory reserves of approximately $12.5 million and $11.7 million, respectively.

3. PROPERTY, PLANT AND EQUIPMENT

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

		September 30,				December 31,
		2005				2004
Compression equipment, facilities and other rental assets		$	2,401,774			$	2,360,799
Land and buildings			85,879				89,573
Transportation and shop equipment			76,750				78,577
Other			54,173				51,054
			2,618,576				2,580,003
Accumulated depreciation			(807,632	)			(703,655	)
		$	1,810,944			$	1,876,348

As of September 30, 2005, the compression assets owned by entities that lease equipment to us but, pursuant to our adoption of FIN 46, are included in property, plant and equipment in our consolidated financial statements had a net book value of approximately $353.9 million, including improvements made to these assets after the sale leaseback transactions.

4. DEBT

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

		September 30,				December 31,
		2005				2004
Belleli-factored receivables		$	1,163			$	1,011
Belleli-revolving credit facility			3,024				4,095
Short-term debt		$	4,187			$	5,106

Belleli’s factoring arrangements are typically short term in nature and bore interest at a weighted average rate of 3.0% and 4.0% at September 30, 2005 and December 31, 2004, respectively. Belleli’s revolving credit facilities bore interest at a weighted average rate of 3.7% and 4.0% at September 30, 2005 and December 31, 2004, respectively. These revolving credit facilities are callable during 2005.

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

		September 30,				December 31,
		2005				2004
Bank credit facility due December 2006		$	48,000			$	7,000
4.75% convertible senior notes due 2008*			192,000				192,000
4.75% convertible senior notes due 2014*			143,750				143,750
8.625% senior notes due 2010**			200,000				200,000
9.0% senior notes due 2014**			200,000				200,000
2000B compression equipment lease notes, interest at 5.2%, due October 2005			—				55,861
2001A compression equipment lease notes, interest at 8.5%, due September 2008			133,000				300,000
2001B compression equipment lease notes, interest at 8.75%, due September 2011			250,000				250,000
Zero coupon subordinated notes, interest at 11.0%, due March 2007*			223,652				206,467
7.25% convertible subordinated notes due 2029*			86,250				86,250
Fair value adjustment — fixed to floating interest rate swaps			(8,447	)			(5,996	)
Other, interest at various rates, collateralized by equipment and other assets, net of unamortized discount			2,099				3,178
			1,470,304				1,638,510
Less-current maturities			(1,478	)			(1,430	)
Long-term debt		$	1,468,826			$	1,637,080

During September 2005, we redeemed $167.0 million in indebtedness and repaid $5.2 million in minority interest obligations under our 2001A compression equipment lease obligations using proceeds from the August 2005 public offering of our common stock. In connection with the redemption and repayment, the Company expensed $7.3 million related to the call premium and $2.5 million related to unamortized debt issuance costs. The $7.3 million of costs related to the call premium have been classified as debt extinguishment costs and the $2.5 million related to unamortized debt issuance costs have been classified as depreciation and amortization expense on the accompanying Condensed Consolidated Statements of Operations. During February 2005, we repaid our 2000B compression equipment lease obligations using borrowings from our bank credit facility.

As of September 30, 2005, we had $48.0 million of outstanding borrowings and $119.0 million of outstanding letters of credit under our bank credit facility, resulting in $183.0 million of additional capacity under such bank credit facility at September 30, 2005. Outstanding borrowings under this facility bore interest at a weighted average rate of 6.5% and 5.2% at September 30, 2005 and December 31, 2004, respectively. Our bank credit facility permits us to incur indebtedness, subject to covenant limitations, up to a $350 million credit limit, plus, in addition to certain other indebtedness, an additional (a) $40 million in unsecured indebtedness, (b) $50 million of nonrecourse indebtedness of unqualified subsidiaries and (c) $25 million of secured purchase money indebtedness.

As of September 30, 2005, we were in compliance with the 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 a default under the indentures and agreements relating to certain of our other debt obligations would in some situations trigger cross-default provisions under our bank credit facilities or the indentures and agreements relating to certain of our other debt obligations. Such defaults would have a material adverse effect on our liquidity, financial position and operations. Additionally, our bank credit facility requires that the minimum tangible net worth of our wholly-owned subsidiary, Hanover Compression Limited Partnership (“HCLP”), not be less than $702 million. This may limit distributions by HCLP to Hanover in future periods.

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 compression equipment lease obligations, our 8.625% Senior Notes due 2010 and our 9% Senior Notes due 2014 define indebtedness to include the present value of our rental obligations under sale leaseback transactions and under facilities similar to our compression equipment operating leases. As of September 30, 2005, Hanover’s coverage ratio exceeded 2.25 to 1.0, and therefore as of such date it would allow us to incur a limited amount of indebtedness in addition to our bank credit facility and the additional $75 million in unsecured indebtedness and certain other permitted indebtedness, including certain refinancing of indebtedness allowed by such bank credit facility.

5. ACCOUNTING FOR DERIVATIVES

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

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

In March 2004, we entered into two interest rate swaps, which we designated as fair value hedges, to hedge the risk of changes in fair value of our 8.625% Senior Notes due 2010 resulting from changes in interest rates. These interest rate swaps, under which we receive fixed payments and make floating payments, result in the conversion of the hedged obligation into floating rate debt. The following table summarizes, by individual hedge instrument, these interest rate swaps as of September 30, 2005 (dollars in thousands):

														Fair Value of
						Fixed Rate to be				Notional				Swap at
Floating Rate to be Paid		Maturity Date				Received				Amount				September 30, 2005
Six Month LIBOR +4.72%		December 15, 2010					8.625	%		$	100,000			$	(4,344	)
Six Month LIBOR +4.64%		December 15, 2010					8.625	%		$	100,000			$	(4,103	)

As of September 30, 2005, a total of approximately $1.1 million in accrued liabilities, $7.3 million in long-term liabilities and a $8.4 million reduction of long-term debt was recorded with respect to the fair value adjustment related to these two swaps. We estimate the effective floating rate, that is determined in arrears pursuant to the terms of the swap, to be paid at the time of settlement. As of September 30, 2005, we estimated that the effective rate for the six-month period ending in December 2005 would be approximately 9.2%.

During 2001, we entered into interest rate swaps to convert variable lease payments under certain lease arrangements to fixed payments as follows (dollars in thousands):

														Fair Value of
						Fixed Rate to be				Notional				Swap at
Lease		Maturity Date				Paid				Amount				September 30, 2005
March 2000		March 11, 2005					5.2550	%		$	100,000			$	—
August 2000		March 11, 2005					5.2725	%		$	100,000			$	—

These swaps, which we designated as cash flow hedging instruments, met the specific hedge criteria and any changes in their fair values were recognized in other comprehensive income. During the nine months ended September 30, 2005 and 2004, we recorded an

increase to other comprehensive income of approximately $0.6 million and approximately $7.5 million, respectively, related to these two 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 compression equipment lease. As a result, the two interest rate swaps that matured on March 11, 2005, each having a notional amount of $100 million, associated with the 2000A compression equipment lease no longer met specific hedge criteria and the unrealized loss related to the mark-to-market adjustment prior to June 1, 2004 of $5.3 million was 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. During the nine months ended September 30, 2005, $1.5 million was recorded in interest expense.

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 financial institutions’ non-performance, if it occurred, could have a material adverse effect on us.

6. COMMITMENTS AND CONTINGENICES
Hanover has issued the following guarantees that are not recorded on our accompanying balance sheet (dollars in thousands):

						Maximum Potential
						Undiscounted
						Payments as of
		Term				September 30, 2005
Indebtedness of non-consolidated affiliates:
Simco/Harwat Consortium (1)			2005			$	8,763
El Furrial (1)			2013				33,022
Other:
Performance guarantees through letters of credit (2)			2005-2006				101,098
Standby letters of credit			2005-2006				20,249
Commercial letters of credit			2005				3,133
Bid bonds and performance bonds (2)			2005-2011				103,436
						$	269,701

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.

We are substantially self-insured for worker’s compensation, employer’s liability, auto liability, general liability, property damage/loss, and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses up to deductible amounts are estimated and accrued based upon known facts, historical trends and industry averages.

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 (“Cawthorne Channel Project”) as part of the performance of a contract between an affiliate of The Royal/Dutch Shell Group (“Shell”) and Global Gas and Refining Limited (“Global”), a Nigerian company. We have substantially completed the building of the required barge-mounted facilities and are in the commissioning process. Under the terms of a series of contracts between Global and Hanover, Shell, and several other counterparties, respectively, Global is responsible for the development of the overall project. In light of the political environment in Nigeria, Global’s capitalization level, inexperience with projects of a

similar nature and lack of a successful track record with respect to this project and other factors, there is no assurance that Global will be able to comply with its obligations under these contracts.

This project and our other projects in Nigeria are subject to numerous risks and uncertainties associated with operating in Nigeria. Such risks include, among other things, political, social and economic instability, civil uprisings, riots, terrorism, the taking of property without fair compensation and governmental actions that may restrict payments or the movement of funds or result in the deprivation of contract rights. Any of these risks, as well as other risks normally associated with a major construction project, could materially delay the anticipated commencement of operations of the Cawthorne Channel Project or adversely impact any of our operations in Nigeria. Any such delays could affect the timing and decrease the amount of revenue we may realize from our investments in Nigeria. If Shell were to terminate its contract with Global for any reason, or if we were to terminate our involvement in the project, we would be required to find an alternative use for the barge facility which could result in a write-down of our investment. At September 30, 2005, we had an investment of approximately $71 million in projects in Nigeria, a substantial majority of which related to the Cawthorne Channel Project. We currently anticipate making an approximately $1 million additional investment in the Cawthorne Channel Project during 2005. In addition, we have approximately $4 million associated with advances to, and our investment in, Global.

We have significant operations that expose us to currency risk in Argentina and Venezuela. As a result, adverse political conditions and fluctuations in currency exchange rates could materially and adversely affect our business. To mitigate that risk, the majority of our existing contracts provide that we receive payment in, or based on, U.S. dollars rather than Argentine pesos and Venezuelan bolivars, thus reducing our exposure to fluctuations in their value. In February 2003, the Venezuelan government fixed the exchange rate to 1,600 bolivars for each U.S. dollar. In February 2004 and March 2005, the Venezuelan government devalued the currency to 1,920 bolivars and 2,148 bolivars, respectively, for each U.S. dollar. The impact of the devaluation on our results will depend upon the amount of our assets (primarily working capital and deferred taxes) exposed to currency fluctuation in Venezuela in future periods.

For the nine months ended September 30, 2005, our Argentine operations represented approximately 5% of our revenue and 8% of our gross profit. For the nine months ended September 30, 2005, our Venezuelan operations represented approximately 9% of our revenue and 17% of our gross profit. At September 30, 2005, we had approximately $13.9 million and $21.5 million in accounts receivable related to our Argentine and Venezuelan operations.

The economic situation in Argentina and Venezuela is subject to change. To the extent that the situation deteriorates, exchange controls continue in place and the value of the peso and bolivar against the dollar is reduced further, our results of operations in Argentina and Venezuela could be materially and adversely affected which could result in reductions in our net income.

Several compressor rental projects with a customer in Latin America are scheduled to terminate in accordance with the terms of our lease agreements at various times during the remainder of 2005. These projects represent in the aggregate approximately $2.8 million per month in revenues. We are in the process of negotiating extensions of these lease agreements with this customer. While we hope to renew these contracts on favorable terms, we can provide no assurance that these contracts will be renewed on terms that are as favorable to us as the existing lease agreements or at all. If the contracts were not renewed, we would be required to find alternative uses for these assets.

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.

7. RELATED-PARTY TRANSACTIONS

On July 8, 2005, we entered into Amendment No. 2 to the Purchase Agreement dated June 28, 2001 by and among Hanover, HCLP, and Schlumberger Technology Corporation (“STC”), for itself and as successor in interest to Camco International Inc., Schlumberger Surenco S.A. (“Surenco”), and Schlumberger Oilfield Holdings Ltd. (“SOHL”). SOHL, STC and Surenco collectively are referred to as “Schlumberger”. Pursuant to Amendment No. 2, entities affiliated with Schlumberger recently agreed to eliminate Schlumberger’s right to designate a Director to serve on our Board of Directors in order for Schlumberger to position itself to have maximum flexibility in terms of its ownership of its shares of our common stock. Entities affiliated with Schlumberger have in the past, and may in the future, sell shares of our common stock from time to time pursuant to Rule 144 under the Securities Act of 1933.

Ted Collins, Jr., one of our Directors, owns 100% of Azalea Partners, which owns approximately 14% of Energy Transfer Group, LLC (“ETG”). During the nine months ended September 30, 2005 and 2004 and during the twelve months ended December 31, 2004, we recorded sales of approximately $14.5 million, $7.3 million and $7.7 million, respectively, related to compression equipment leases and sales to ETG, including its indirectly wholly owned subsidiary Energy Transfer Technologies, LP. In addition, Hanover and ETG are co-owners of a power generation facility in Venezuela. Under the agreement of co-ownership, each party is responsible for its obligations as a co-owner. Hanover is the designated manager of the facility. As manager, Hanover received revenues related to the facility and distributed to ETG its net share of the operating cash flow of $0.5 million and $0.6 million during the nine months ended September 30, 2005 and 2004.

Mr. Collins is a passive investor in ETG through his ownership of Azalea Partners; he does not serve as an officer, director, or employee of ETG. While Mr. Collins’ relationship with ETG and the Company does not expressly exclude him from being an independent director under the rules of the New York Stock Exchange and the Securities and Exchange Commission, on July 7, 2005, the Governance Committee of the Board of Directors reevaluated Mr. Collins’ independence in light of recent transactions entered into between the Company and ETG to broadly consider whether such additional transactions might be considered a material relationship between Mr. Collins and the Company. The Governance Committee considered the recent increased commercial activity between the Company and ETG, and the potential impact of these transactions on ETG’s revenue. In reviewing the overall relationship, the Governance Committee determined that Mr. Collins should no longer be classified as an independent director. Mr. Collins was therefore removed from the Governance Committee, and Director Gordon T. Hall (who meets the independence requirements of the SEC, NYSE and the Company’s Governance Principles) was elected to the Governance Committee. Such action was ratified by the Board of Directors on July 8, 2005, and was reported to the New York Stock Exchange as required.

8. STOCKHOLDERS’ EQUITY

On August 15, 2005, the Company completed a public offering of 13,154,385 shares of common stock that resulted in approximately $179.2 million of net proceeds for Hanover. Of the 13,154,385 shares of common stock sold by Hanover, 1,715,789 shares of common stock were sold pursuant to the underwriters’ over-allotment option.

9. RECENT ACCOUNTING PRONOUNCEMENTS

In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“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 $11.9 million in sale leaseback obligations that, as of September 30, 2005, were reported as “Minority interest” on our consolidated balance sheet pursuant to FIN 46.

These minority interest obligations represent the equity of the entities that lease compression equipment to us. In accordance with the provisions of our compression equipment lease obligations, the equity certificate holders are entitled to quarterly or semi-annual yield payments on the aggregate outstanding equity certificates. As of September 30, 2005, the yield rates on the outstanding equity certificates ranged from 11.6% to 12.1%. Equity certificate holders may receive a return of capital payment upon termination of the lease or our purchase of the leased compression equipment after full payment of all debt obligations of the entities that lease compression equipment to us. At September 30, 2005, 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 November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). This standard provides clarification that abnormal amounts of idle facility expense, freight, handling costs, and spoilage should be recognized as current-period charges. Additionally, this standard requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this standard are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not expect the adoption of the new standard to have a material effect on our consolidated results of operations, cash flows or financial position.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”). This standard addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123(R) eliminates the ability to account for share-based compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that such transactions be accounted for using a fair-value-based method. SFAS 123(R) is effective as of the first interim or annual reporting period that begins after June 15, 2005. However, on April 14, 2005, the Securities and Exchange Commission announced that the effective date of SFAS 123(R) will be changed to the first annual reporting period that begins after June 15, 2005. The adoption of SFAS 123(R) is not expected to have a significant effect on our financial position or cash flows, but will impact our results of operations. An illustration of the impact on our net income and earnings per share is presented in the “Stock Options and Stock-Based Compensation” section of Note 1 assuming we had applied the fair value recognition provisions of SFAS 123(R) using the Black-Scholes methodology.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, “Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 is based on the principle that exchange of nonmonetary assets should be measured based on the fair market value of the assets exchanged. SFAS 153 eliminates the exception of nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS 153 is effective for nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005. We are currently evaluating the provisions of SFAS 153 and do not believe that our adoption will have a material impact on our consolidated results of operations, cash flows or financial position.

In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”). FIN 47 requires uncertainty about the timing or method of settlement of a conditional asset retirement obligation to be factored into the measurement of the liability when sufficient information exists. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. We are currently evaluating the impact FIN 47 will have on our consolidated results of operations, cash flows or financial position.

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 requires retrospective application for reporting a change in accounting principle in the absence of explicit transition requirements specific to newly adopted accounting principles, unless impracticable. Corrections of errors will continue to be reported under SFAS 154 by restating prior periods as of the beginning of the first period presented. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We are currently evaluating the provisions of SFAS 154 and do not believe that our adoption will have a material impact on our consolidated results of operations, cash flows or financial position.

10. REPORTABLE SEGMENTS

We manage our business segments primarily based upon the type of product or service provided. We have five principal industry segments:

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

We evaluate the performance of our segments based on segment gross profit. Segment gross profit for each segment includes direct revenues and operating expenses. Costs excluded from segment gross profit include selling, general and administrative, depreciation

and amortization, interest, foreign currency translation, provision for cost of litigation settlement, goodwill impairment, other expenses and income taxes. Amounts defined as “Other income” include equity in income of non-consolidated affiliates and corporate related items primarily related to cash management activities. Revenues include sales to external customers. Our chief executive officer does not review asset information by segment.

The following tables present sales and other financial information by industry segment for the three months ended September 30, 2005 and 2004.

		Segments
																		Production
										Parts,				Compressor				and
										service				and				processing
		U.S.				International				and used				accessory				equipment				Other
		rentals				rentals				equipment				fabrication				fabrication				income				Total
		(in thousands)
September 30, 2005:
Revenues from external customers		$	87,703			$	58,208			$	74,027			$	51,798			$	90,312			$	7,798			$	369,846
Gross profit			52,200				38,924				18,162				7,380				7,166				7,798				131,630
September 30, 2004:
Revenues from external customers		$	85,866			$	52,797			$	48,741			$	46,605			$	76,193			$	5,609			$	315,811
Gross profit			48,050				36,000				14,322				5,388				7,219				5,609				116,588

The following tables present sales and other financial information by industry segment for the nine months ended September 30, 2005 and 2004.

		Segments
																		Production
										Parts,				Compressor				and
										service				and				processing
		U.S.				International				and used				accessory				equipment				Other
		rentals				rentals				equipment				fabrication				fabrication				income				Total
														(in thousands)
September 30, 2005:
Revenues from external customers		$	262,548			$	167,644			$	157,995			$	125,414			$	284,180			$	18,473			$	1,016,254
Gross profit			159,985				113,714				40,855				14,792				29,480				18,473				377,299
September 30, 2004:
Revenues from external customers		$	256,138			$	158,896			$	134,537			$	118,914			$	192,639			$	17,394			$	878,518
Gross profit			147,833				113,359				35,785				11,330				22,082				17,394				347,783

11. 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 U.S. 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 for a small piece of our original non-oilfield power generation business has not been completed as of September 30, 2005. We are continuing to actively market these assets and have made valuation adjustments as a result of the change in market conditions. As a result of our consolidation efforts during 2003, we reclassified certain closed facilities to assets held for sale. We have sold certain assets related to our discontinued operations for total sales proceeds of $0.2 million during the nine months ended September 30, 2005. The remaining assets are expected to be sold within the next three to six months 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):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Revenues and other:
U.S. rentals		$	250			$	93			$	320			$	108
International rentals			—				3,782				—				11,611
Parts, service and used equipment			—				2,636				—				9,378
Equity in income of non-consolidated affiliates			—				51				—				39
Other			74				732				79				453
			324				7,294				399				21,589
Expenses:
U.S. rentals			274				240				657				631
International rentals			—				1,332				—				4,914
Parts, service and used equipment			—				2,297				—				6,888
Compressor and accessory fabrication			—				(3	)			—				—
Selling, general and administrative			101				356				280				1,331
Foreign currency translation			—				(1,101	)			5				(807	)
Depreciation and amortization			—				638				—				2,706
Interest expense			163				—				163				—
Other			—				333				—				467
			538				4,092				1,105				16,130
Income (loss) from discontinued operations before income taxes			(214	)			3,202				(706	)			5,459
Provision for income taxes			—				998				—				1,591
Income (loss) from discontinued operations		$	(214	)		$	2,204			$	(706	)		$	3,868

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

          Summary balance sheet data for assets held for sale as of September 30, 2005 (in thousands):

						Non-
						Oilfield
		Used				Power
		Equipment				Generation				Facilities				Total
Current assets		$	2,455			$	2,121			$	—			$	4,576
Property, plant and equipment			—				766				3,914				4,680
Assets held for sale			2,455				2,887				3,914				9,256
Current liabilities			—				644				—				644
Liabilities held for sale			—				644				—				644
Net assets held for sale		$	2,455			$	2,243			$	3,914			$	8,612

          Summary balance sheet data for assets held for sale as of December 31, 2004 (in thousands):

						Non-
						Oilfield
		Used				Power
		Equipment				Generation				Facilities				Total
Current assets		$	2,455			$	2,714			$	—			$	5,169
Property, plant and equipment			—				1,077				5,314				6,391
Assets held for sale			2,455				3,791				5,314				11,560
Current liabilities			—				517				—				517
Liabilities held for sale			—				517				—				517
Net assets held for sale		$	2,455			$	3,274			$	5,314			$	11,043

In October 2005, we sold a facility in Houston, Texas classified as assets held for sale for $5.1 million.

12. INCOME TAXES

During the three months ended September 30, 2005, we recorded a net tax provision of $10.3 million compared to $2.6 million for the three months ended September 30, 2004. Our effective tax rate for the three months ended September 30, 2005 was (229)%, compared to (54)% for the three months ended September 30, 2004. The change in the effective tax rate was primarily due to the U.S. income tax impact of foreign operations, the relative weight of foreign income to U.S. income, and the need to record a $3.1 million valuation allowance against U.K. deferred tax assets in the third quarter of 2005 for which realization is not more likely than not.

During the nine months ended September 30, 2005, we recorded a net tax provision of $20.9 million compared to $16.4 million for the nine months ended September 30, 2004. Our effective tax rate for the nine months ended September 30, 2005 was (174)%, compared to (143)% for the nine months ended September 30, 2004. The change in the effective tax rate was primarily due to the U.S. income tax impact of foreign operations, the relative weight of foreign income to U.S. income, the need to record a $3.1 million valuation allowance against U.K. deferred tax assets in the third quarter of 2005 for which realization is not more likely than not and the reversal of $3.6 million of tax issue based reserves during the second quarter of 2005. These reserves were reversed because we no longer believe that these tax liabilities will be incurred.

As a result of continued operating losses, we are in a net deferred tax asset position for U.S. income tax purposes. Due to our cumulative U.S. 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 future. We will be required to record additional valuation allowances if our U.S. deferred tax asset position is increased and the “more likely than not” criteria of SFAS 109 is not met. In addition, we have recorded valuation allowances for certain international jurisdictions. If we are required to record additional valuation allowances in the United States or any other jurisdictions, our effective tax rate will be impacted, perhaps substantially, compared to the statutory rate. We believe that we will likely be required to record additional valuation allowances in future periods, unless and until we are able to generate additional taxable earnings or implement additional tax planning strategies that would minimize or eliminate the amount of such additional valuation allowance.

13. IMPACT OF HURRICANES

Hurricanes Katrina and Rita caused operational disruptions, including the shutdown of our Gulf Coast facilities for a few days, that negatively impacted our financial performance in the quarter. During the three months ended September 30, 2005, we recorded $0.2 million in depreciation expense and $0.6 million of U.S. Rentals repair expense to record the insurance deductibles related to our estimate of the damage done to units impacted by Hurricanes Katrina and Rita.

We have notified our insurance underwriters of our potential losses and that we will be filing a claim for damages caused by Hurricanes Katrina and Rita, and we have been assigned and have been working with an adjuster for both Hurricanes. We are currently evaluating and documenting the damage caused by these two hurricanes. There are some compressor units we have not been able to access and assess for damage, but because we have expensed our insurance deductibles, we do not believe the impact from these units will be material to our consolidated results of operations, cash flows or financial position.

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 our future plans, objectives or goals or future revenues or other future financial metrics are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those anticipated as of the date of this report. These risks and uncertainties include:

	•		our inability to renew our short-term leases of equipment with our customers so as to fully recoup our cost of the equipment;
	•		a prolonged substantial reduction in oil and natural gas prices, which could cause a decline in the demand for our compression and oil and natural gas production and processing equipment;
	•		reduced profit margins or the loss of market share resulting from competition or the introduction of competing technologies by other companies;
	•		changes in economic or political conditions in the countries in which we do business, including civil uprisings, riots, terrorism, the taking of property without fair compensation and legislative changes;
	•		changes in currency exchange rates;
	•		the inherent risks associated with our operations, such as equipment defects, malfunctions and natural disasters;
	•		our inability to implement certain business objectives, such as:

	•		international expansion including our ability to timely and cost-effectively execute projects in new international operating environments,
	•		integrating acquired businesses,
	•		generating sufficient cash,
	•		accessing the capital markets,
	•		refinancing existing or incurring additional indebtedness to fund our business, and
	•		executing our exit and sale strategy with respect to assets classified on our balance sheet as held for sale;

	•		risks associated with any significant failure or malfunction of our enterprise resource planning system;
	•		governmental safety, health, environmental and other regulations, which could require us to make significant expenditures; and
	•		our inability to comply with covenants in our debt agreements and the decreased financial flexibility associated with our substantial debt.

You should not unduly rely on the forward-looking statements, which speak only as of the date of this Form 10-Q. Other factors in addition to those described in this Form 10-Q could also affect our actual results. Except as 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. In addition to the risks noted above, you should review the factors and risks we describe in our Annual Report on Form 10-K for the year ended December 31, 2004 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 us are expressly qualified in their entirety by this cautionary statement.

GENERAL

Hanover Compressor Company, a Delaware corporation (“we”, “us”, “our”, “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 production, processing and transportation applications. We sell and rent this equipment and provide complete operation and maintenance services, including run-time guarantees, for both customer-owned equipment and our fleet of rental equipment. Hanover was founded as a Delaware corporation in 1990, and has been a public company since 1997. Our customers include both major and independent oil and gas producers and distributors as well as national oil and gas companies in the countries in which we operate. Our maintenance business, together with our parts and service business, provides solutions to customers that own their own compression and surface production and processing equipment, but want to outsource their operations. We also fabricate compressor and oil and gas production and processing equipment and provide gas processing and treating, and oilfield power generation services, primarily to our U.S. 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 and tank farms, 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 third quarter 2005 was $369.8 million compared to third quarter 2004 revenue and other income of $315.8 million. Net loss for the third quarter 2005 was $14.9 million, or $0.16 per share, compared with a net loss of $5.3 million, or $0.06 per share, in the third quarter 2004. Net loss for the third quarter 2005 includes $7.3 million of call premium expenses and $2.5 million of unamortized debt issuance write-off expenses related to the partial redemption and repayment of our 2001A compression equipment lease obligations. Net loss for the third quarter 2004 includes a benefit from the $4.0 million reduction of shareholder litigation settlement expense.

Our revenue and other income for the nine months ended September 30, 2005 was $1,016.3 million compared to revenue and other income of $878.5 million for the nine months ended September 30, 2004. Net loss for the nine months ended September 30, 2005 was $33.8 million, or $0.38 per share, compared with a net loss of $23.8 million, or $0.28 per share, for the nine months ended September 30, 2004. Net loss for the nine months ended September 30, 2005 includes $7.3 million of call premium expenses and $2.5 million of unamortized debt issuance write-off expenses related to the partial redemption and repayment of our 2001A compression equipment lease obligations.

Total compression horsepower at September 30, 2005 was approximately 3,306,000, consisting of approximately 2,454,000 horsepower in the United States and approximately 852,000 horsepower internationally.

At September 30, 2005, Hanover’s total third-party fabrication backlog was approximately $394.8 million compared to approximately $290.9 million at December 31, 2004 and $257.7 million at September 30, 2004. The compressor and accessory fabrication backlog was approximately $95.6 million at September 30, 2005, compared to approximately $56.7 million at December 31, 2004 and $42.7 million at September 30, 2004. The backlog for production and processing equipment fabrication was approximately $299.2 million at September 30, 2005, compared to approximately $234.2 million at December 31, 2004 and $215.0 million at September 30, 2004.

Industry Conditions

The North American rig count increased by 29% to 1,949 at September 30, 2005 from 1,513 at September 30, 2004, and the twelve-month rolling average North American rig count increased by 15% to 1,743 at September 30, 2005 from 1,521 at September 30, 2004. In addition, the twelve-month rolling average New York Mercantile Exchange wellhead natural gas price increased to $7.15 per

MMBtu at September 30, 2005 from $5.51 per MMBtu at September 30, 2004. Despite the increase in natural gas prices and the recent increase in the rig count, U.S. natural gas production levels have not significantly changed. Recently, we have not experienced any significant growth in U.S. rentals of equipment by our customers, which we believe is primarily the result of (i) the lack of immediate availability of compression equipment in the configuration currently in demand by our customers, (ii) increases in purchases of compression equipment by oil and gas companies that have available capital and (iii) the lack of a significant increase in U.S. natural gas production levels. However, improved market conditions have led to improved pricing in the U.S. market.

U.S. Tax Position

As a result of continued operating losses, we are in a net deferred tax asset position for U.S. income tax purposes. Due to our cumulative U.S. 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 future. We will be required to record additional valuation allowances if our U.S. deferred tax asset position is increased and the “more likely than not” criteria of SFAS 109 is not met. In addition, we have recorded valuation allowances for certain international jurisdictions. If we are required to record additional valuation allowances in the United States or any other jurisdictions, our effective tax rate will be impacted, perhaps substantially, compared to the statutory rate. We believe that we will likely be required to record additional valuation allowances in future periods, unless and until we are able to generate additional taxable earnings or implement additional tax planning strategies that would minimize or eliminate the amount of such additional valuation allowance.

RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2004

Summary of Business Segment Results

U.S. Rentals
(in thousands)

		Three months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	87,703			$	85,866				2	%
Operating expense			35,503				37,816				(6	)%
Gross profit		$	52,200			$	48,050				9	%
Gross margin			60	%			56	%			4	%

U.S. rental revenue increased during the three months ended September 30, 2005, compared to the three months ended September 30, 2004, primarily due to improved pricing. Gross profit and gross margin for the three months ended September 30, 2005 increased compared to the three months ended September 30, 2004, primarily due to improved pricing and our efforts to reduce maintenance and repair expense. During the three months ended September 30, 2005, we recorded $0.6 million of repairs related to damage done to units impacted by Hurricanes Katrina and Rita. This lowered our gross margin by approximately 1%.

International Rentals
(in thousands)

		Three months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	58,208			$	52,797				10	%
Operating expense			19,284				16,797				15	%
Gross profit		$	38,924			$	36,000				8	%
Gross margin			67	%			68	%			(1	)%

During the three months ended September 30, 2005, international rental revenue increased, compared to the three months ended September 30, 2004, primarily due to new rental projects that have come on-line during 2005. Gross margin decreased primarily due to additional operating costs incurred during the three months ended September 30, 2005 related to projects in Nigeria.

Parts, Service and Used Equipment
(in thousands)

		Three months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	74,027			$	48,741				52	%
Operating expense			55,865				34,419				62	%
Gross profit		$	18,162			$	14,322				27	%
Gross margin			25	%			29	%			(4	)%

Parts, service and used equipment revenue for the three months ended September 30, 2005 was higher than the three months ended September 30, 2004 primarily due to a $20.3 million sale of used rental equipment related to a gas plant in Madisonville, Texas. Gross margin for the three months ended September 30, 2005 was lower due to a decrease in margins on used rental equipment sales. Parts, service and used equipment revenue includes two business components: (1) parts and service and (2) used rental equipment and installation sales. For the three months ended September 30, 2005, parts and service revenue was $40.7 million with a gross margin of 25%, compared to $36.5 million and 22%, respectively, for the three months ended September 30, 2004. Used rental equipment and installation sales revenue for the three months ended September 30, 2005 was $33.3 million with a gross margin of 24%, compared to $12.2 million with a 50% gross margin for the three months ended September 30, 2004. Our used rental equipment and installation sales revenue and gross margins vary significantly from period to period and are dependent on the sale of used rental equipment, the exercise of purchase options on rental equipment by customers and installation sales associated with the start-up of new projects by customers.

Compression and Accessory Fabrication
(in thousands)

		Three months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	51,798			$	46,605				11	%
Operating expense			44,418				41,217				8	%
Gross profit		$	7,380			$	5,388				37	%
Gross margin			14	%			12	%			2	%

For the three months ended September 30, 2005, compression and accessory fabrication revenue increased as a result of strong market conditions. Gross profit and gross margin increased primarily due to improved pricing and our focus on improving operational efficiencies in our fabrication business. As of September 30, 2005, we had compression and accessory fabrication backlog of approximately $95.6 million compared to $42.7 million at September 30, 2004.

Production and Processing Equipment Fabrication
(in thousands)

		Three months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	90,312			$	76,193				19	%
Operating expense			83,146				68,974				21	%
Gross profit		$	7,166			$	7,219				(1	)%
Gross margin			8	%			9	%			(1	)%

Production and processing equipment fabrication revenue for the three months ended September 30, 2005 was greater than for the three months ended September 30, 2004, primarily due to an improvement in market conditions. Margins were primarily impacted by poor performance on a number of jobs in the three months ended September 30, 2005. As of September 30, 2005, we had a production and processing equipment fabrication backlog of $299.2 million compared to $215.0 million at September 30, 2004.

Expenses

Selling, general, and administrative expense (“SG&A”) for the three months ended September 30, 2005 was $45.4 million, compared to $43.9 million during the three months ended September 30, 2004. The increase was primarily due to an increase in compensation costs. As a percentage of revenue, SG&A for the three months ended September 30, 2005 was 12%, compared to 14% for the three months ended September 30, 2004. As a percentage of revenue, SG&A expense decreased due to our efforts to manage SG&A costs while achieving an increased level of business.

Debt extinguishment costs for the three months ended September 30, 2005 were $7.3 million as a result of the call premium paid in connection with the partial redemption and repayment of the 2001A compression equipment lease obligations in September 2005.

Depreciation and amortization expense for the three months ended September 30, 2005 increased to $47.5 million, compared to $43.5 million for the three months ended September 30, 2004. Depreciation and amortization increased during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004 primarily due to the write-off of $2.5 million of unamortized debt issuance costs related to the partial redemption and repayment of our 2001A compression equipment lease obligations and net additions to property, plant and equipment placed in service since September 30, 2004, principally in rental fleet operations.

Interest expense for the three months ended September 30, 2005 decreased to $34.6 million, compared to $37.2 million for the three months ended September 30, 2004. The decrease in interest expense was primarily due to a decrease in our average debt balance, partially offset by an increase in the overall effective interest rate on outstanding debt to 8.7% from 8.4% during the three months ended September 30, 2005 and 2004, respectively.

Foreign currency translation for the three months ended September 30, 2005 was a loss of $1.1 million, compared to a loss of $0.6 million for the three months ended September 30, 2004. The increase in foreign currency translation losses was primarily related to the re-measurement of our international subsidiaries’ dollar denominated inter-company debt. The increase in the translation loss in Canada was primarily due to the re-measurement of intercompany debt.

The following table summarizes the exchange gains and losses we recorded for assets exposed to currency translation (in thousands):

		Three Months Ended
		September 30,
		2005				2004
Canada		$	(1,447	)		$	(189	)
Argentina			(112	)			(420	)
Venezuela			304				(134	)
Italy			(273	)			100
All other countries			445				74
Exchange gain/(loss)		$	(1,083	)		$	(569	)

We had intercompany advances outstanding to our subsidiary in Italy of approximately $99.7 million and $22.3 million at September 30, 2005 and September 30, 2004, respectively. These advances are denominated in U.S. dollars. The impact of the remeasurement of these advances on our statement of operations will depend on the outstanding balance in future periods. A 10% increase or decrease in the Euro relative to the U.S. Dollar would result in a foreign currency translation gain or loss of approximately $10.0 million.

In May 2003, Hanover reached agreement that was subject to court approval, to settle securities class actions, ERISA class actions and the shareholder derivative actions. The terms of the settlement became final in March 2004 and provided for Hanover to: (a) make a cash payment of approximately $30 million to the securities settlement fund (of which $26.7 million was funded by payments from Hanover’s directors and officers insurance carriers), (b) issue 2.5 million shares of Hanover common stock, and (c) issue a contingent note with a principal amount of $6.7 million.

In April 2004, we issued the $6.7 million contingent note related to the securities settlement. The note was payable, together with accrued interest, on March 31, 2007 but was extinguished (with no money owing under it) under the terms of the note since our common stock traded above the average price of $12.25 per share for 15 consecutive trading days during the third quarter of 2004. As

a result of the cancellation of the note in the third quarter of 2004, we reversed the note and the embedded derivative, which resulted in a $4.0 million reduction to the cost of the securities-related litigation.

Income Taxes

During the three months ended September 30, 2005, we recorded a net tax provision of $10.3 million compared to $2.6 million for the three months ended September 30, 2004. Our effective tax rate for the three months ended September 30, 2005 was (229)%, compared to (54)% for the three months ended September 30, 2004. The change in the effective tax rate was primarily due to the U.S. income tax impact of foreign operations, the relative weight of foreign income to U.S. income, and the need to record a $3.1 million valuation allowance against U.K. deferred tax assets in the third quarter of 2005 for which realization is not more likely than not.

As a result of continued operating losses, we are in a net deferred tax asset position for U.S. income tax purposes. Due to our cumulative U.S. 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 future. We will be required to record additional valuation allowances if our U.S. deferred tax asset position is increased and the “more likely than not” criteria of SFAS 109 is not met. In addition, we have recorded valuation allowances for certain international jurisdictions. If we are required to record additional valuation allowances in the United States or any other jurisdictions, our effective tax rate will be impacted, perhaps substantially, compared to the statutory rate. We believe that we will likely be required to record additional valuation allowances in future periods, unless and until we are able to generate additional taxable earnings or implement additional tax planning strategies that would minimize or eliminate the amount of such additional valuation allowance.

Discontinued Operations

During the fourth quarter 2002, we reviewed our business lines and our Board of Directors approved management’s recommendation to exit and sell our non-oilfield power generation and certain used equipment business lines. Income (loss) from discontinued operations decreased $2.3 million to a net loss of $0.2 million during the three months ended September 30, 2005, from income of $2.1 million during the three months ended September 30, 2004. The decrease in income (loss) from discontinued operations was primarily due to the sale of our Canadian rental fleet in the fourth quarter of 2004.

NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2004

Summary of Business Segment Results

U.S. Rentals
(in thousands)

		Nine months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	262,548			$	256,138				3	%
Operating expense			102,563				108,305				(5	)%
Gross profit		$	159,985			$	147,833				8	%
Gross margin			61	%			58	%			3	%

U.S. rental revenue increased during the nine months ended September 30, 2005, compared to the nine months ended September 30, 2004, due primarily to improvement in market conditions that has led to an improvement in pricing. Gross profit and gross margin for the nine months ended September 30, 2005 increased compared to the nine months ended September 30, 2004, primarily due to improved pricing in 2005 and our efforts to reduce maintenance and repair expenses.

International Rentals
(in thousands)

		Nine months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	167,644			$	158,896				6	%
Operating expense			53,930				45,537				18	%
Gross profit		$	113,714			$	113,359				0	%
Gross margin			68	%			71	%			(3	)%

During the nine months ended September 30, 2005, international rental revenue increased, compared to the nine months ended September 30, 2004, primarily due to new rental projects that have come on-line in 2005. Gross margin decreased primarily due to additional operating costs incurred in the first nine months of 2005 related to projects in Nigeria.

Parts, Service and Used Equipment
(in thousands)

		Nine months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	157,995			$	134,537				17	%
Operating expense			117,140				98,752				19	%
Gross profit		$	40,855			$	35,785				14	%
Gross margin			26	%			27	%			(1	)%

Parts, service and used equipment revenue for the nine months ended September 30, 2005 were higher than the nine months ended September 30, 2004 primarily due to improved business conditions and an increase in used rental equipment and installation sales. Gross margin percentage for the nine months ended September 30, 2005 decreased primarily due to lower margins on used equipment sales. Parts, service and used equipment revenue includes two business components: (1) parts and service and (2) used rental equipment and installation sales. For the nine months ended September 30, 2005, parts and service revenue was $110.5 million with a

gross margin of 26%, compared to $97.1 million and 25%, respectively, for the nine months ended September 30, 2004. Used rental equipment and installation sales revenue for the nine months ended September 30, 2005 was $47.5 million with a gross margin of 25%, compared to $37.4 million with a 31% gross margin for the nine months ended September 30, 2004. Our used rental equipment and installation sales revenue and gross margins vary significantly from period to period and are dependent on the sale of used rental equipment, the exercise of purchase options on rental equipment by customers and installation sales associated with the start-up of new projects by customers.

Compression and Accessory Fabrication
(in thousands)

		Nine months ended
		September 30,								Increase
		2005				2004				(Decrease)
Revenue		$	125,414			$	118,914				5	%
Operating expense			110,622				107,584				3	%
Gross profit		$	14,792			$	11,330				31	%
Gross margin			12	%			10	%			2	%