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 JUNE 30, 2006

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)

(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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o

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

Number of shares of the Common Stock of the registrant outstanding as of July 25, 2006: 103,170,126 shares.

 

 

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION				3
Item 1. Financial Statements				3
Condensed Consolidated Balance Sheets				3
Condensed Consolidated Statements of Operations				4
Condensed Consolidated Statements of Comprehensive Income (Loss)				5
Condensed Consolidated Statements of Cash Flows				6
Notes to Condensed Consolidated Financial Statements				8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations				22
Item 3. Quantitative and Qualitative Disclosures About Market Risk				37
Item 4. Controls and Procedures				37
PART II. OTHER INFORMATION				37
Item 1. Legal Proceedings				37
Item 1A. Risk Factors				37
Item 4. Submission of Matters to A Vote of Security Holders				37
Item 6: Exhibits				38
SIGNATURES				39
First Amendment to Limited Partnership Credit Agreement
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 SHEETS
(in thousands of dollars, except for par value and share amounts)

		June 30,				December 31,
		2006				2005
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	55,437			$	48,233
Accounts receivable, net of allowance of $4,368 and $4,751, respectively			255,373				243,672
Inventory, net			285,446				251,069
Costs and estimated earnings in excess of billings on uncompleted contracts			111,267				99,166
Prepaid taxes			6,958				8,194
Current deferred income taxes			18,908				13,842
Assets held for sale			2,020				2,020
Other current assets			55,788				38,189
Total current assets			791,197				704,385
Property, plant and equipment, net			1,836,975				1,823,100
Goodwill, net			181,098				184,364
Intangible and other assets			59,710				60,406
Investments in non-consolidated affiliates			90,486				90,741
Total assets		$	2,959,466			$	2,862,996
LIABILITIES AND COMMON STOCKHOLDERS’ EQUITY
Current liabilities:
Short-term debt		$	12,383			$	4,080
Current maturities of long-term debt			954				1,309
Accounts payable, trade			100,196				92,980
Accrued liabilities			138,615				128,805
Advance billings			132,619				89,513
Liabilities held for sale			878				878
Billings on uncompleted contracts in excess of costs and estimated earnings			60,881				35,126
Total current liabilities			446,526				352,691
Long-term debt			1,411,114				1,473,559
Other liabilities			46,121				38,976
Deferred income taxes			86,036				76,115
Total liabilities			1,989,797				1,941,341
Commitments and contingencies (Note 8)
Minority interest			12,084				11,873
Common stockholders’ equity:
Common stock, $.001 par value; 200,000,000 shares authorized; 102,705,537 and 102,392,918 shares issued, respectively			103				102
Additional paid-in capital			1,092,139				1,097,766
Deferred employee compensation — restricted stock grants			—				(13,249	)
Accumulated other comprehensive income			11,278				15,214
Accumulated deficit			(141,965	)			(186,088	)
Treasury stock—386,696 and 366,091 common shares, at cost, respectively			(3,970	)			(3,963	)
Total common stockholders’ equity			957,585				909,782
Total liabilities and common stockholders’ equity		$	2,959,466			$	2,862,996

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

HANOVER COMPRESSOR COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

		Three Months Ended June 30,								Six Months Ended June 30,
		2006				2005				2006				2005
Revenues and other income:
U.S. rentals		$	93,073			$	87,691			$	184,716			$	174,845
International rentals			67,520				55,521				130,026				109,436
Parts, service and used equipment			55,737				50,531				105,008				83,968
Compressor and accessory fabrication			70,128				41,092				124,819				73,616
Production and processing equipment fabrication			103,653				104,297				182,272				193,868
Equity in income of non-consolidated affiliates			5,230				5,158				11,078				9,732
Gain on sale of business and other income			10,330				492				40,549				943
			405,671				344,782				778,468				646,408
Expenses:
U.S. rentals			36,729				32,984				74,820				67,060
International rentals			23,691				17,144				45,023				34,646
Parts, service and used equipment			45,061				36,215				86,123				61,275
Compressor and accessory fabrication			58,482				36,587				105,175				66,204
Production and processing equipment fabrication			89,203				92,429				158,166				171,554
Selling, general and administrative			49,783				43,909				97,838				86,067
Foreign currency translation			(2,236	)			4,955				(3,733	)			5,226
Other			1,204				274				1,204				393
Debt extinguishment costs			—				—				5,902				—
Depreciation and amortization			43,077				45,469				85,045				90,922
Interest expense			29,287				34,662				60,927				70,602
			374,281				344,628				716,490				653,949
Income (loss) from continuing operations before income taxes and minority interest			31,390				154				61,978				(7,541	)
Provision for income taxes			9,546				6,102				17,993				10,643
Income (loss) from continuing operations before minority interest			21,844				(5,948	)			43,985				(18,184	)
Minority interest, net of taxes			(93	)			—				(93	)			—
Income (loss) from continuing operations			21,751				(5,948	)			43,892				(18,184	)
Loss from discontinued operations, net of tax			(63	)			(221	)			(202	)			(492	)
Gain (loss) from sales of discontinued operations, net of tax			16				(247	)			63				(204	)
Income (loss) before cumulative effect of accounting changes			21,704				(6,416	)			43,753				(18,880	)
Cumulative effect of accounting changes, net of tax			—				—				370				—
Net income (loss)		$	21,704			$	(6,416	)		$	44,123			$	(18,880	)
Basic income (loss) per common share:
Income (loss) from continuing operations		$	0.21			$	(0.07	)		$	0.44			$	(0.21	)
Loss from discontinued operations, net of tax			—				—				—				(0.01	)
Cumulative effect of accounting changes, net of tax			—				—				—				—
Net income (loss)		$	0.21			$	(0.07	)		$	0.44			$	(0.22	)
Diluted income (loss) per common share:
Income (loss) from continuing operations		$	0.21			$	(0.07	)		$	0.43			$	(0.21	)
Loss from discontinued operations, net of tax			—				—				—				(0.01	)
Cumulative effect of accounting changes, net of tax			—				—				—				—
Net income (loss)		$	0.21			$	(0.07	)		$	0.43			$	(0.22	)
Weighted average common and equivalent shares outstanding:
Basic			101,017				85,797				100,888				85,744
Diluted			112,052				85,797				111,740				85,744

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

HANOVER COMPRESSOR COMPANY

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

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Net income (loss)		$	21,704			$	(6,416	)		$	44,123			$	(18,880	)
Other comprehensive income (loss):
Change in fair value of derivative financial instruments, net of tax			—				—				—				608
Foreign currency translation adjustment			(4,283	)			(1,095	)			(3,936	)			(4,057	)
Comprehensive income (loss)		$	17,421			$	(7,511	)		$	40,187			$	(22,329	)

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

HANOVER COMPRESSOR COMPANY

(in thousands of dollars)

(unaudited)

		Six Months Ended
		June 30,
		2006				2005
Cash flows from operating activities:
Net income (loss)		$	44,123			$	(18,880	)
Adjustments:
Depreciation and amortization			85,045				90,922
Loss from discontinued operations, net of tax			139				696
Cumulative effect of accounting changes, net of tax			(370	)			—
Minority interests			93				—
Bad debt expense			2,249				1,000
Gain on sale of property, plant and equipment			(10,594	)			(1,499	)
Equity in income of non-consolidated affiliates, net of dividends received			255				3,851
Loss on derivative instruments			—				416
(Gain) loss on remeasurement of intercompany balances			(1,539	)			8,917
Net realized gain on trading securities			(1,491	)			—
Zero coupon subordinated notes accreted interest paid by refinancing			(86,084	)			—
Gain on sale of business			(28,476	)			—
Stock compensation expense			4,117				2,223
Pay-in-kind interest on zero coupon subordinated notes			6,282				11,356
Sales of (purchase of) trading securities, net			1,491				—
Deferred income taxes			7,175				3,267
Changes in assets and liabilities, excluding business combinations:
Accounts receivable and notes			(8,588	)			(13,235	)
Inventory			(37,156	)			(18,576	)
Costs and estimated earnings versus billings on uncompleted contracts			14,681				(26,882	)
Prepaid and other current assets			(15,175	)			(7,395	)
Accounts payable and other liabilities			9,678				(1,615	)
Advance billings			42,519				(3,992	)
Other			(3,639	)			(1,576	)
Net cash provided by continuing operations			24,735				28,998
Net cash used in discontinued operations			(139	)			(239	)
Net cash provided by operating activities			24,596				28,759
Cash flows from investing activities:
Capital expenditures			(119,289	)			(54,104	)
Proceeds from sale of property, plant and equipment			19,621				8,973
Proceeds from sale of business			52,125				—
Cash used for business acquisitions			—				(3,426	)
Cash used to acquire investments in and advances to non-consolidated affiliates			—				(500	)
Net cash used in continuing operations			(47,543	)			(49,057	)
Net cash provided by discontinued operations			—				50
Net cash used in investing activities			(47,543	)			(49,007	)
Cash flows from financing activities:
Borrowings on revolving credit facilities			110,500				102,500
Repayments on revolving credit facilities			(88,500	)			(32,500	)
Proceeds from issuance of senior notes			150,000				—
Payments for debt issue costs			(3,832	)			—
Proceeds from warrant conversions and stock options exercised			3,834				3,241
Proceeds (repayments) of other debt, net			7,526				(808	)
Repayment of zero coupon subordinated notes principal			(150,000	)			—

		Six Months Ended
		June 30,
		2006				2005
Payments of 2000B equipment lease obligations			—				(57,589	)
Net cash provided by continuing operations			29,528				14,844
Net cash used in discontinued operations			—				—
Net cash provided by financing activities			29,528				14,844
Effect of exchange rate changes on cash and equivalents			623				(952	)
Net increase (decrease) in cash and cash equivalents			7,204				(6,356	)
Cash and cash equivalents at beginning of period			48,233				38,076
Cash and cash equivalents at end of period		$	55,437			$	31,720

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

HANOVER COMPRESSOR COMPANY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Hanover Compressor Company (“Hanover”, “we”, “us”, “our” or the “Company”) included herein have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America are not required in these interim financial statements and have been condensed or omitted. It is the opinion of our management that the information furnished includes all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial position, results of operations, and cash flows of Hanover for the periods indicated. The financial statement information included herein should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005. These interim results are not necessarily indicative of results for a full year.

Earnings Per Common Share

Basic income (loss) per common share is computed by dividing income (loss) available to common stockholders by the weighted average number of shares outstanding for the period. Diluted income (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 income (loss) per common share (in thousands):

Three Months Ended

Six Months Ended

June 30,

June 30,

2006

2005

2006

2005

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

101,017

85,797

100,888

85,744

Net dilutive potential common stock issuable:

On exercise of options and vesting of restricted stock

1,452

*

*

1,269

*

*

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

9,583

*

*

9,583

*

*

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

112,052

85,797

111,740

85,744

Net income for the diluted earnings per share calculation for the three and six month periods ended June 30, 2006 is adjusted to add back interest expense and amortization financing costs, net of tax, relating to the Company’s convertible senior notes due 2014 totaling $1.8 million and $3.6 million, respectively.

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								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Net dilutive potential common shares issuable:
On exercise of options and vesting of restricted stock			—				2,566				—				2,770
On exercise of options-exercise price greater than average market value at end of period			48				1,326				58				911
On exercise of warrants			—				4				—				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
			9,243				22,674				9,253				22,463

Reclassifications

Certain amounts in the prior period’s financial statements have been reclassified to conform to the 2006 financial statement classification. These reclassifications have no impact on our consolidated results of operations, cash flows or financial position.

2. STOCK OPTIONS AND STOCK-BASED COMPENSATION

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 (“APB No. 25”), and generally requires 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) would be changed to the first annual reporting period that begins after June 15, 2005. We adopted the provisions of SFAS 123(R) on January 1, 2006.

Prior to January 1, 2006, we measured compensation expense for our stock-based employee compensation plans using the intrinsic value method, which follows the recognition and measurement principles of APB No. 25, as permitted by FASB Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R) using the modified prospective transition method. Under that transition method, compensation cost recognized during the six months ended June 30, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value, and (b) compensation cost for any share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value. In accordance with the modified prospective transition method, results for prior periods have not been restated. For the six months ended June 30, 2006 and 2005, stock-based compensation expense of $4.1 million and $2.2 million, respectively, was recognized and included in the accompanying unaudited Condensed Consolidated Statements of Operations. The total income tax benefit recognized for share-based compensation arrangements was zero for each of the six-month periods ended June 30, 2006 and 2005.

On January 1, 2006, we recorded the cumulative effect of the change in accounting related to our adoption of SFAS 123(R) of $0.4 million (net of tax of $0) which relates to the requirement to estimate forfeitures on restricted stock awards.

Prior to the adoption of SFAS 123(R), we recorded deferred compensation in equity when restricted stock was granted. Due to the adoption of SFAS 123(R) on January 1, 2006, we reversed $13.2 million from deferred compensation to additional paid-in-capital.

Prior to the adoption of SFAS 123(R), we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in our Consolidated Statements of Cash Flows. SFAS 123(R) requires the cash flows from the tax benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. There were no excess tax benefits classified as a financing cash inflow in the accompanying Consolidated Statement of Cash Flows for the six months ended June 30, 2006 that would have been classified as an operating cash inflow before we had adopted SFAS 123(R).

As of January 1, 2006, we adopted SFAS 123(R) thereby eliminating pro forma disclosure for periods following such adoption. For purposes of this pro forma disclosure, the value of options is estimated using a Black-Scholes option valuation model and amortized to expense over the options’ vesting periods. Had we used the fair value based accounting method for stock-based compensation expense described by SFAS
123(R) for the three months and six months ended June 30, 2005, our diluted net loss per common and equivalent share for the three months and six months ended June 30, 2005 would have been as set forth in the table below ($ in thousands, except per share data).

		Three Months				Six Months
		Ended				Ended
		June 30, 2005				June 30, 2005
Net loss, before stock-based compensation for employees		$	(6,416	)		$	(18,880	)
Add back: Stock-based compensation expense for employees previously determined under intrinsic value method, net of tax effect			1,168				2,223
Deduct: Stock-based employee compensation expense for employees determined under the fair value method, net of tax			(1,853	)			(3,549	)
Net loss, after effect of stock-based compensation for employees		$	(7,101	)		$	(20,206	)
Net loss per share:
Basic as reported for prior period		$	(0.07	)		$	(0.22	)
Basic after effect of stock-based compensation for employees		$	(0.08	)		$	(0.24	)
Diluted as reported for prior period		$	(0.07	)		$	(0.22	)
Diluted after effect of stock-based compensation for employees		$	(0.08	)		$	(0.24	)

Incentive Plans

Hanover has employee stock incentive plans that provide for the granting of restricted stock and options to purchase common shares. During the second quarter of 2006, stockholders approved the Hanover Compressor Company 2006 Stock Incentive Plan (the “Plan”). Upon adoption of the new Plan, our Board of Directors determined to terminate the authority to make future grants under all previously existing equity compensation plans. At June 30, 2006, approximately six million shares were available for grant in future periods under the Plan. The stock incentive plans provide for various long-term incentive awards, which include stock options, performance shares and restricted stock awards.

In July 2006, the Board of Directors approved grants of awards under the 2006 Long-term Incentive Awards Program to certain employees, including our executive officers, as part of an incentive compensation program. The grants included, in the aggregate, approximately 0.5 million shares of restricted stock or stock-settled restricted stock units, 0.3 million shares (at target) of performance vested restricted stock or stock-settled restricted stock units, and cash awards that vest over a period of three years of approximately $1.3 million. A description of long-term stock-based incentive awards and related activity within each is provided below.

Stock Options

Prior to the adoption of SFAS 123(R), and in accordance with APB No. 25, no stock-based compensation cost was reflected in net income for grants of stock options to employees because we grant stock options with an exercise price equal to the fair market value of the stock on the date of grant. Options granted typically vest over a three to four year period and are exercisable over a ten-year period. For footnote disclosures under SFAS No. 123, the fair value of each option award was estimated on the date of grant using a Black-Scholes option valuation model. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by employees who receive equity awards.

No stock options were granted after January 1, 2006 following the adoption of SFAS 123(R). For future stock option grants, we currently plan to use the Black-Scholes valuation model to calculate the fair value of each stock option award and we will follow the provisions of SFAS
123(R). The Company will use historical data and other pertinent information to estimate the expected volatility for the term of new options and the outstanding period of the option. The risk free interest rate will be based on the U.S. Treasury yield curve in effect at the time of grant.

Upon the adoption of SFAS 123(R), unvested options granted prior to the date of adoption are amortized to expense ratably over the remaining vesting period. For options granted after the date of adoption, the fair value will be amortized to expense ratably over the vesting period.

The following is a summary of stock option activity for the six months ended June 30, 2006 (in thousands, except per share data and years):

										Weighted
										Average
						Weighted				Remaining
						Average Exercise				Contractual				Aggregate
		Shares				Price per Share				Life (in years)				Intrinsic Value
Outstanding at December 31, 2005			3,021			$	11.77
Granted			—			$	—
Exercised			(375	)		$	10.22
Forfeited			(82	)		$	12.36
Outstanding at June 30, 2006			2,564			$	11.97				5.0			$	17,685
Exercisable at June 30, 2006			1,863			$	12.09				3.8			$	12,690

The following table summarizes significant ranges of stock options outstanding and exercisable as of June 30, 2006 (in thousands, except per share data and years):

		Options Outstanding												Options Exercisable
						Weighted
						Average				Weighted								Weighted
						Remaining				Average								Average
						Contractual				Exercise								Exercise
Range of exercise prices		Shares				Life (in years)				Price				Shares				Price
$7.51-10.00			945				2.4			$	9.76				895			$	9.76
$10.01-12.50			964				7.3			$	11.76				320			$	11.71
$12.51-15.00			524				5.4			$	14.44				517			$	14.46
$15.01-17.50			75				5.7			$	17.25				75			$	17.25
$17.51-20.00			21				5.6			$	18.95				21			$	18.95
$22.51-25.00			35				4.7			$	25.00				35			$	25.00
			2,564												1,863

A summary of the status of the Company’s unvested stock options as of June 30, 2006 and changes during the six months ended June 30, 2006 is presented below (shares in thousands):

						Weighted-Average
						Grant Date
		Shares				Fair Value
Unvested stock options:
Unvested at December 31, 2005			914			$	5.31
Granted			—			$	—
Vested			(159	)		$	6.59
Forfeited			(54	)		$	5.30
Unvested at June 30, 2006			701			$	5.05

As of June 30, 2006, there was approximately $2.2 million of unrecognized compensation cost related to unvested options. Such cost is expected to be recognized over a weighted-average period of 1.6 years. Total compensation expense for stock options was $0.4 million and $1.0 million, respectively, for the three and six month periods ended June 30, 2006. The total

intrinsic value of options exercised during the three and six month periods ended June 30, 2006 was $1.6 million and $2.9 million, respectively.

Restricted Stock Awards

For grants of restricted stock and stock-settled restricted stock units, we recognize compensation expense over the vesting period equal to the fair value of the restricted stock at the date of grant. No restricted stock awards were granted in the six months ended June 30, 2006. The weighted-average fair value of restricted stock awards granted during the three and six month periods ended June 30, 2005 was $10.82 and $11.60.

For restricted stock and stock-settled restricted stock units that vest based on performance, we record an estimate of the compensation expense to be expensed over the vesting period related to these grants. The compensation expense recognized in our statements of operations is adjusted for changes in our estimate of the number of performance stock that will vest. After the adoption of SFAS 123(R), performance stock awards are expensed based on the original grant date value of the awards. No performance stock awards were granted during the six months ended June 30, 2006 or 2005.

A summary of the status of the Company’s unvested restricted stock awards (including performance stock) as of June 30, 2006 and changes during the six months ended June 30, 2006 are presented below (shares in thousands):

						Weighted-
						Average
						Grant Date
		Shares				Fair Value
Unvested restricted stock awards:
Unvested at December 31, 2005			1,280			$	11.80
Granted			—			$	—
Vested			(41	)		$	14.94
Forfeited			(94	)		$	11.57
Change in expected vesting of performance awards			41			$	11.39
Unvested at June 30, 2006			1,186			$	11.70

As of June 30, 2006, there was approximately $8.6 million of total unrecognized compensation cost related to unvested restricted stock awards (including performance shares). Such cost is expected to be recognized over a weighted-average period of 1.5 years. Total compensation expense for restricted stock awards was $1.7 million and $1.1 million for the three months ended June 30, 2006 and 2005, respectively. Total compensation expense for restricted stock awards was $3.1 million and $2.2 million for the six months ended June 30, 2006 and 2005, respectively. The total fair value of restricted stock awards vested in the three and six month periods ended June 30, 2006 was $0.3 million and $0.4 million, respectively.

3. INVENTORY

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

		June 30,				December 31,
		2006				2005
Parts and supplies		$	140,651			$	135,310
Work in progress			130,938				105,405
Finished goods			13,857				10,354
		$	285,446			$	251,069

As of June 30, 2006 and December 31, 2005, we had inventory reserves of approximately $13.1 million and $11.8 million, respectively.

4. PROPERTY, PLANT AND EQUIPMENT

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

		June 30,				December 31,
		2006				2005
Compression equipment, facilities and other rental assets		$	2,507,762			$	2,441,119
Land and buildings			91,899				87,604
Transportation and shop equipment			74,271				77,507
Other			54,842				53,824
			2,728,774				2,660,054
Accumulated depreciation			(891,799	)			(836,954	)
		$	1,836,975			$	1,823,100

As of June 30, 2006, 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 $343.6 million, including improvements made to these assets after the sale leaseback transactions.

5. INVESTMENTS IN NON-CONSOLIDATED AFFILIATES

Investments in affiliates that are not controlled by Hanover but where we have the ability to exercise significant influence over the operations are accounted for using the equity method. Our share of net income or losses of these affiliates is reflected in the Consolidated Statements of Operations as Equity in income of non-consolidated affiliates. Our primary equity method investments are comprised of entities that own, operate, service and maintain compression and other related facilities.

Our ownership interest and location of each equity method investee at June 30, 2006 is as follows:

		Ownership
		Interest				Location		Type of Business
PIGAP II			30.0	%		Venezuela		Gas Compression Plant
El Furrial			33.3	%		Venezuela		Gas Compression Plant
Simco/Harwat Consortium			35.5	%		Venezuela		Water Injection Plant

Summarized earnings information for these entities consisted of the following amounts (on a 100% basis, in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Revenues		$	51,168			$	50,757			$	99,748			$	96,304
Operating income			26,137				26,853				51,686				48,811
Net income			9,600				12,256				21,147				27,142

6. DEBT

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

		June 30,				December 31,
		2006				2005
Bank credit facility due November 2010		$	70,000			$	48,000
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
7 1/2% senior notes due 2013**			150,000				—
9.0% senior notes due 2014**			200,000				200,000
2001A equipment lease notes, interest at 8.5%, due September 2008			133,000				133,000
2001B equipment lease notes, interest at 8.75%, due September 2011			250,000				250,000
Zero coupon subordinated notes, interest at 11.0%*			—				229,803
7.25% convertible subordinated notes due 2029*			86,250				86,250
Fair value adjustment — fixed to floating interest rate swaps			(14,150	)			(9,686	)
Other, interest at various rates, collateralized by equipment and other assets, net of unamortized discount			1,218				1,751
			1,412,068				1,474,868
Less-current maturities			(954	)			(1,309	)
Long-term debt		$	1,411,114			$	1,473,559

As of June 30, 2006, we had $70.0 million in outstanding borrowings under our bank credit facility. Outstanding amounts under our bank credit facility bore interest at a weighted average rate of 7.0% and 6.1% at June 30, 2006 and December 31, 2005, respectively. As of June 30, 2006, we also had approximately $143.5 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 $450 million credit limit, plus, in addition to certain other indebtedness, an additional (a) $50 million in unsecured indebtedness, (b) $100 million of indebtedness of international subsidiaries and (c) $35 million of secured purchase money indebtedness. Additional borrowings of up to $236.5 million were available under that facility as of June 30, 2006.

As of June 30, 2006, we were in compliance with all 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 certain of the various indentures and agreements would in some situations trigger cross-default provisions under our bank credit facility 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.

While all of the agreements related to our long-term debt do not contain the same financial covenants, 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, our 7 ¹/₂ % Senior Notes due 2013 and our 9% Senior Notes due 2014 permit us at a minimum, (1) to incur indebtedness, at any time, of up to $400 million under our bank credit facility, plus an additional $75 million in unsecured indebtedness, (2) to incur 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 thereof and (3) to incur certain purchase money and similar obligations. The indentures and agreements for our 2001A and 2001B compression equipment lease obligations, our 8.625% Senior Notes due 2010, our 7 ¹/₂ % Senior Notes due 2013 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, 2006, 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.

7 ¹/₂ % Senior Notes due 2013

In March 2006, we completed a public offering of $150 million aggregate principal amount of 7 ¹/₂ % Senior Notes due 2013. We used the net proceeds from the offering of $146.6 million, together with borrowings under our bank credit facility, to redeem our 11% Zero Coupon Subordinated Notes due March 31, 2007. In connection with the redemption, we expensed $5.9 million related to the call premium. We paid approximately $242 million to redeem our 11% Zero Coupon Subordinated Notes, including the call premium. The offering and sale of the 2013 Senior Notes were made pursuant to an automatic shelf registration statement on Form S-3 filed with the Securities and Exchange Commission. We may redeem up to 35% of the 2013 Senior Notes using the proceeds of certain equity offerings completed before April 15, 2009 at a redemption price of 107.5% of the principal amount, plus accrued and unpaid interest to the redemption date. In addition, we may redeem some or all of the 2013 Senior Notes at any time on or after April 15, 2010 at certain redemption prices together with accrued interest, if any, to the date of redemption.

The 2013 Senior Notes are our general unsecured senior obligations and rank equally in right of payment with all of our other senior debt. The 2013 Senior Notes are effectively subordinated to all existing and future liabilities of our subsidiaries that do not guarantee the 2013 Senior Notes. The 2013 Senior Notes are guaranteed on a senior subordinated basis by HCLP. The 2013 Senior Notes rank equally in right of payment with our 2010 Senior Notes and 2014 Senior Notes and the guarantee of the 2013 Senior Notes by HCLP ranks equally in right of payment with the guarantee of the 2010 Senior Notes and 2014 Senior Notes by HCLP. The indenture under which the 2013 Senior Notes were issued contains various financial covenants which limit, among other things, our ability to incur additional indebtedness or sell assets.

7. 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. Cash flow from hedges are classified in our consolidated statements of cash flows under the same category as the cash flows from the underlying assets, liabilities or anticipated transactions.

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. 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. The following table summarizes, by individual hedge instrument, these interest rate swaps as of June 30, 2006 (dollars in thousands):

												Fair Value of
				Fixed Rate to be				Notional				Swap at
Floating Rate to be Paid		Maturity Date		Received				Amount				June 30, 2006
Six Month LIBOR +4.72%		December 15, 2010			8.625	%		$	100,000			$	(7,210	)
Six Month LIBOR +4.64%		December 15, 2010			8.625	%		$	100,000			$	(6,940	)

As of June 30, 2006, a total of approximately $3.3 million in accrued liabilities, $10.8 million in long-term liabilities and a $14.1 million reduction of long-term debt was recorded with respect to the fair value adjustment related to these two swaps. We estimate the effective floating rate, which is determined in arrears pursuant to the terms of the swap, to be paid at the time of settlement. As of June 30, 2006, we estimated that the effective rate for the six-month period ending in December 2006 would be approximately 10.3%.

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.

8. COMMITMENTS AND CONTINGENCIES

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				June 30, 2006
Indebtedness of non-consolidated affiliates:
Simco/Harwat Consortium (1)			2009			$	6,613
El Furrial (1)			2013				30,020
Other:
Performance guarantees through letters of credit (2)			2006-2010				129,978
Standby letters of credit			2006-2007				13,715
Commercial letters of credit			2006-2007				15,949
Bid bonds and performance bonds (2)			2006-2011				136,858
						$	333,133

As part of our acquisition of Production Operators Corporations (“POC”) in 2001, 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 are estimated and accrued based upon known facts, historical trends and industry averages.

We are involved in a project called the Cawthorne Channel Project in which we operate barge-mounted gas compression and gas processing facilities stationed in a Nigerian coastal waterway as part of the performance of a contract between an affiliate of The Royal/ Dutch Group (“Shell”) and Global Gas and Refining Ltd., a Nigerian entity, (“Global”). We completed the building of the required barge-mounted facilities and the project was declared commercial on November 15, 2005. The contract runs for a ten-year period which commenced when the project was declared commercial, subject to a purchase option, by Global, that is exercisable for the remainder of the term of the contract. Under the terms of a series of contracts between Global and Hanover, Shell, and several other counterparties, respectively, Global is responsible for the overall project.

In the first six months of 2006, violence and local unrest significantly increased in Nigeria. We were notified on February 24, 2006 that as a result of the recent events, Global declared Force Majeure with respect to the Cawthorne Channel Project. We have notified Global that we disputed their declaration of Force Majeure and that we believed local conditions did not relieve Global’s obligations to make monthly rental payments or monthly operations and maintenance fee payments to Hanover under the contract. Due to the uncertainty about the ultimate collection, we have not recognized the March 2006 rents on the Cawthorne Channel Project. The Cawthorne Channel Project was brought back online in April 2006 and was operating for parts, but not all, of the remainder of the second quarter of 2006. The Cawthorne Channel Project has not been operating since approximately June 10, 2006, primarily due to continued local unrest, but we currently expect it to go back online during the third quarter. Due to the 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 can satisfy its obligations under its various contracts, including its contract with us.

The Company recognized revenue in the second quarter of 2006 from the Cawthorne Channel Project under the terms of its contract. During the three and six month periods ended June 30, 2006, we recognized $3.9 and $7.3, respectively, of revenues related to the Cawthorne Channel Project. Collection of our revenues is dependent on delivery of gas to our

facility by Shell. Based on current information, we believe we will recover all of our receivables and our full investment in the Cawthorne Channel Project.

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, kidnapping, 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 including risks arising from the recent increase in violence and local unrest, could adversely impact any of our operations in Nigeria, and could affect the timing and decrease the amount of revenue we may realize from our investments in Nigeria. If Shell does not provide gas to the project or if Shell were to terminate its contract with Global for any reason or if we were to terminate our involvement in the Cawthorne Channel Project, we would be required to find an alternative use for the barge facility which could result in a write-down of our investment and receivables related to this project. At June 30, 2006, we had net assets of approximately $73.7 million related to projects in Nigeria, a majority of which is related to our investment and accounts receivable for the Cawthorne Channel Project.

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.

9. RELATED-PARTY TRANSACTIONS

Ted Collins, Jr., a Director of the Company, owns 100% of Azalea Partners, which owns approximately 15% of Energy Transfer Group, LLC (“ETG”). In the first quarter of 2006, we entered into an agreement to be ETG’s exclusive manufacturer of Dual Drive compressors and to provide marketing services for ETG. During the six months ended June 30, 2006 and 2005, we recorded revenue of approximately $21.7 million and $6.0 million, respectively, related to sales to ETG. As of June 30, 2006 and December 31, 2005, we had receivable balances due from ETG of $8.1 million and $1.1 million, respectively. 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. In addition, 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 $0.3 million for the six months ended June 30, 2006 and 2005, respectively.

10. 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. The adoption of the guidance currently provided in SFAS 150 did not have a material effect on our consolidated results of operations or cash flow. However, upon further guidance from the FASB, we may be required to classify as debt approximately $11.9 million in sale leaseback obligations that, as of June 30, 2006, 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 June 30, 2006, the yield rates on the outstanding equity certificates ranged from 13.1% to 13.5%. 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, 2006, 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 overheads 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. The adoption of SFAS 151 did not 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 requires 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) would be changed to the first annual reporting period that begins after June 15, 2005. The adoption of SFAS 123(R) did not have a material impact on our financial position or cash flows, but impacted our results of operations. See Note 2 for a discussion of the impact of the adoption of SFAS 123(R).

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. The adoption of SFAS 153 did not have a material impact 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. The adoption of SFAS 154 did not have a material impact on our consolidated results of operations, cash flows or financial position.

In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Instruments — an amendment of FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of FASB No. 133, (c) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (e) amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We are currently evaluation the provisions of SFAS 155 and do not believe that our adoption will have a material impact on our consolidated results of operations, cash flows or financial position.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). This Interpretation is effective for fiscal years beginning after December 15, 2006. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We are currently evaluating the provisions of FIN 48.

11. REPORTABLE SEGMENTS

We manage our business segments primarily based upon the type of product or service provided. We have six principal industry segments: U.S. Rentals; International Rentals; Parts, Service and Used Equipment; Compressor and Accessory Fabrication; Production and Processing — Belleli; and Production and Processing — Surface 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 — Surface Equipment Fabrication segment designs, fabricates and sells equipment used in the production and treating of crude oil and natural gas. Production and Processing — Belleli provides engineering, procurement and construction services primarily related to the manufacturing of heavy wall reactors for refineries and construction of desalinization plants and tank farms. During 2005, we determined that Production and Processing — Belleli should become a separate reportable segment from our Production and Processing — Surface Equipment Fabrication reportable segment due to differing long term economic characteristics. We have adjusted prior periods to conform to the current presentation.

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, gain on sales of a business and corporate related items primarily related to cash management activities. Revenues include sales to external customers. We do not include intersegment sales when we evaluate the performance of our segments. 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 June 30, 2006 and 2005.

																		Production and
										Parts,				Compressor				Processing
										service and				and				Surface
		U.S.				International				used				accessory				equipment								Other
		rentals				rentals				equipment				fabrication				fabrication				Belleli				income				Total
														(in thousands)
June 30, 2006:
Revenue from external customers		$	93,073			$	67,520			$	55,737			$	70,128			$	46,868			$	56,785			$	15,560			$	405,671
Gross profit			56,344				43,829				10,676				11,646				8,532				5,918				15,560				152,505
June 30, 2005:
Revenue from external customers		$	87,691			$	55,521			$	50,531			$	41,092			$	56,495			$	47,802			$	5,650			$	344,782
Gross profit			54,707				38,377				14,316				4,505				8,105				3,763				5,650				129,423

The following tables present sales and other financial information by industry segment for the six months ended June 30, 2006 and 2005.

																		Production and
										Parts,				Compressor				Processing
										service and				and				Surface
		U.S.				International				used				accessory				equipment								Other
		rentals				rentals				equipment				fabrication				fabrication				Belleli				income				Total
														(in thousands)
June 30, 2006:
Revenue from external customers		$	184,716			$	130,026			$	105,008			$	124,819			$	83,216			$	99,056			$	51,627			$	778,468
Gross profit			109,896				85,003				18,885				19,644				14,416				9,690				51,627				309,161
June 30, 2005:
Revenue from external customers		$	174,845			$	109,436			$	83,968			$	73,616			$	101,631			$	92,237			$	10,675			$	646,408
Gross profit			107,785				74,790				22,693				7,412				14,778				7,536				10,675				245,669

12. ASSETS HELD FOR SALE AND DISPOSITIONS

In February 2006, we sold our U.S. amine treating rental assets to Crosstex Energy Services L.P. (“Crosstex”) for approximately $51.5 million and recorded a pre-tax gain of $28.4 million that is included in gain on sale of business and other income in the attached condensed consolidated statement of operations. Our U.S. amine treating rental assets had revenues of approximately $7.6 million in 2005. Because Hanover leased back from Crosstex one of the facilities sold in this transaction, approximately $3.3 million of additional gain was deferred into future periods. We also entered into a three-year strategic alliance with Crosstex. The disposal of these assets did not meet the criteria established for recognition as discontinued operations under SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS 144”).

During the first quarter of 2006, Hanover’s Board of Directors approved management’s plan to dispose of the assets used in our fabrication facility in Canada, which was part of our Production and Processing- Surface Equipment Fabrication segment. These assets were sold in May 2006 as part of management’s plan to improve overall operating efficiency in this line of business. The Canadian assets were sold for approximately $10.1 million and we recorded a pre-tax gain of approximately $8.0 million as a result of the transaction in gain on sale of business and other income in the attached condensed consolidated statement of operations. The disposal of these assets did not meet the criteria established for recognition as discontinued operations under SFAS 144.

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 met the criteria established for recognition as discontinued operations under 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 consolidated statements of operations.

Due to changes in market conditions, we have made valuation adjustments and the disposal plan for a small piece of our original non-oilfield power generation business was not completed as of June 30, 2006. We are continuing to actively market this asset. The remaining asset is expected to be sold within the next three to six months and the asset 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								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Revenues and other:
U.S. rentals		$	—			$	67			$	15			$	70
Other			—				5				—				5
			—				72				15				75
Expenses:
U.S. rentals			62				219				134				383
Selling, general and administrative			1				75				83				179
Foreign currency translation			—				—				—				5
Other			—				(1	)			—				—
			63				293				217				567
Loss from discontinued operations before income taxes			(63	)			(221	)			(202	)			(492	)
Provision for income taxes			—				—				—				—
Loss from discontinued operations		$	(63	)		$	(221	)		$	(202	)		$	(492	)

Summary balance sheet data for assets held for sale (in thousands):

		June 30,				December 31,
		2006				2005
Current asset		$	2,020			$	2,020
Current liabilities			(878	)			(878	)
Net assets held for sale		$	1,142			$	1,142

13. INCOME TAXES

During the three months ended June 30, 2006, we recorded a net tax provision of $9.5 million compared to $6.1 million for the three months ended June 30, 2005. Our effective tax rate for the three months ended June 30, 2006 was 30%, compared to 3,962% for the three months ended June 30, 2005. During the six months ended June 30, 2006, we recorded a net tax provision of $18.0 million compared to $10.6 million for the six months ended June 30, 2005. Our effective tax rate for the six months ended June 30, 2006 was 29%, compared to (141)% for the six months ended June 30, 2005. The change in the effective tax rates was primarily due to our current U.S. tax position and the change in the weight of our U.S. income (loss), including the gain on the sale of our U.S. amine treating business that was recorded in the first quarter of 2006, compared to total income (loss). During the six months ended June 30, 2006, we recorded pre-tax income in the U.S. and therefore were able to realize the benefit from net operating loss carryforwards and capital loss carryforwards that previously we had provided a valuation allowance against. Our tax provision for the six months ended June 30, 2006 includes approximately $2.7 million in deferred tax expense related to the enactment of the Texas Margins tax. In addition, our tax provision for the three months ended June 30, 2005 included the reversal of $3.6 million of tax issue based reserves. These reserves were reversed because we no longer believe that these tax liabilities will be incurred.

On May 18, 2006, the Governor of Texas signed into law House Bill 3 (“HB-3”) which modifies the existing Texas franchise tax law. The modified franchise tax will be computed by subtracting either costs of goods sold or compensation expense, as defined in HB-3, from gross revenue to arrive at a gross margin. The resulting gross margin will be taxed at a one percent tax rate. HB-3 has also expanded the definition of tax paying entities to include limited partnerships thereby now subjecting us to a new state tax expense. HB-3 becomes effective for activities occurring on or after January 1, 2007. We believe that this tax should still be accounted for as an income tax, following the provisions of SFAS 109, because it has the characteristics of an income tax. Accordingly, a deferred tax liability of $2.7 million has been established for future liabilities under this new tax in the current period.

As a result of prior operating losses, we are in a net deferred tax asset position for U.S. income tax purposes. Due to our cumulative U.S. tax losses, we can not 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 and we have recorded a valuation allowance on our net U.S. deferred tax asset position. Although we expect U.S. pre-tax earnings in 2006, including the gain on the sale of our U.S. amine treating business, we have not reached the conclusion that we can overcome the “more likely than not” criteria of SFAS 109 to reverse the valuation allowance on our remaining net U.S. deferred tax assets. In addition, we have recorded valuation allowances for certain international jurisdictions. If we are required to record and/or release additional valuation allowances in the United States or any other jurisdiction, our effective tax rate will be impacted, perhaps substantially, compared to the statutory rate.

Pursuant to Section 382 of the Internal Revenue Code of 1986, as amended (“IRC”) , the annual utilization of our net operating loss carryforward may be limited if there is a 50 percentage point change in ownership of Hanover within a three-year period by certain stockholders owning 5% or more of our stock. We do not believe that a 50 percentage point change in ownership has occurred during the three year period ended June 30, 2006. It is possible that subsequent transactions involving our capital stock could result in such a limitation.

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 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, kidnappings, 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, and
	•		refinancing existing or incurring additional indebtedness to fund our business;

	•		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.

Other factors in addition to those described in this Form 10-Q could also affect our actual results. You should carefully consider the risks and uncertainties described above and those described in this Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in evaluating our forward-looking statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this Form 10-Q. 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. You should, however, review the factors and risks we describe in our Annual Report on Form 10-K for the year ended December 31, 2005 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, together with its subsidiaries (“we”, “us”, “our”, “Hanover”, or the “Company”), 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 desalinization plants and tank farms, primarily for use in Europe and the Middle East.

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

OVERVIEW

Our revenue and other income for the second quarter 2006 was $405.7 million compared to second quarter 2005 revenue and other income of $344.8 million. Net income for the second quarter 2006 was $21.7 million, or $0.21 per share, compared with a net loss of $6.4 million, or $0.07 per share, in the second quarter 2005. Our revenue and net income increased due to improved market conditions and our focus on improving sales and margins. In addition, the second quarter of 2006 benefited from an $8.0 million pre-tax gain on the sale of our fabrication facilities in Canada.

Our revenue and other income for the six months ended June 30, 2006 was $778.5 million compared to revenue and other income of $646.4 million for the six months ended June 30, 2005. Net income for the six months ended June 30, 2006 was $44.1 million, or $0.43 per share, compared with a net loss of $18.9 million, or $0.22 per share, for the six months ended June 30, 2005. Our revenue and net income increased due to improved market conditions and our focus on improving sales and margins. In addition, results for the six months ended June 30, 2006 benefited from a pre-tax gain of $28.4 million on the sale of our U.S. amine treating business in the first quarter of 2006 and an $8.0 million pre-tax gain on the sale of our fabrication facilities in Canada during the second quarter of 2006. Results for the six months ended June 30, 2006 were also impacted by debt extinguishment costs of $5.9 million related to the call premium to repay our 11% Zero Coupon Subordinated Notes due March 31, 2007 in the first quarter of 2006.

Total compression horsepower at June 30, 2006 was approximately 3,322,000, consisting of approximately 2,435,000 horsepower in the United States and approximately 887,000 horsepower internationally.

At June 30, 2006, Hanover’s total third-party fabrication backlog was approximately $714.5 million compared to approximately $373.1 million at December 31, 2005 and $260.4 million at June 30, 2005. Our compressor and accessory fabrication backlog was approximately $193.0 million at June 30, 2006, compared to approximately $85.4 million at December 31, 2005 and $67.5 million at June 30, 2005. Our backlog for production and processing equipment fabrication was approximately $521.5 million at June 30, 2006, compared to approximately $287.7 million at December 31, 2005 and $192.9 million at June 30, 2005.

Industry Conditions

The North American rig count increased by 26% to 2,073 at June 30, 2006 from 1,648 at June 30, 2005, and the twelve-month rolling average North American rig count increased by 22% to 2,019 at June 30, 2006 from 1,650 at June 30, 2005. In addition, the twelve-month rolling average U.S. wellhead natural gas price increased to $7.95 per Mcf at June 30, 2006 from $5.80 per Mcf at June 30, 2005. 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 significant growth in U.S. rentals of equipment, 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, and (ii) increase in purchase of compression equipment by oil and gas companies that have available capital. However, improved market conditions have led to improved pricing and demand for compression equipment in the U.S. market. In response, we have converted one of our facilities to refurbish approximately 200,000 horsepower of idle U.S. compression assets so we can deploy these units in both our U.S. and international rental businesses. To date, the compression units from the first phase of this project have primarily been deployed on international projects; but, we expect that this program, along with the addition of new rental units, will increase our available U.S. horsepower over the next twelve months.

U.S. Tax Position

As a result of prior operating losses, we are in a net deferred tax asset position for U.S. income tax purposes. Due to our cumulative U.S. tax losses, we can not 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 and we have recorded a valuation allowance on our net U.S. deferred tax asset position. During the six months ended June 30, 2006, we recorded pre-tax income in the U.S. and therefore were able to realize the benefit from net operation loss carryforwards and capital loss carryforwards that previously we had provided a valuation allowance against. Although we expect U.S. pre-tax earnings in 2006, including the gain on the sale of our U.S. amine treating business, we have not reached the conclusion that we can overcome the “more likely than not” criteria of SFAS 109 to reverse the valuation allowance on our remaining net U.S. deferred tax assets. If we are required to record and/or release additional valuation allowances in the United States or any other jurisdiction, our effective tax rate will be impacted, perhaps substantially, compared to the statutory rate.

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2006 COMPARED TO THREE MONTHS ENDED JUNE 30, 2005

Summary of Business Line Results

U.S. Rentals
(in thousands)

		Three months ended
		June 30,								Increase
		2006				2005				(Decrease)
Revenue		$	93,073			$	87,691				6	%
Operating expense			36,729				32,984				11	%
Gross profit		$	56,344			$	54,707				3	%
Gross margin			61	%			62	%			(1	)%

U.S. rental revenue increased during the three months ended June 30, 2006, compared to the three months ended June 30, 2005, due primarily to improvement in market conditions that has led to an improvement in pricing. Gross margin for the three months ended June 30, 2006 benefited from price increases, but was offset by expenses of approximately $1.6 million related to our program to refurbish approximately 200,000 horsepower of idle U.S. compression equipment and the impact of recording increased incentive compensation expenses of approximately $1.0 million after the adoption of SFAS 123(R).

International Rentals
(in thousands)

		Three months ended
		June 30,								Increase
		2006				2005				(Decrease)
Revenue		$	67,520			$	55,521				22	%
Operating expense			23,691				17,144				38	%
Gross profit		$	43,829			$	38,377				14	%
Gross margin			65	%			69	%			(4	)%

During the three months ended June 30, 2006, international rental revenue and gross profit increased, compared to the three months ended June 30, 2005, primarily due to increased rental activity in Venezuela, Argentina and Nigeria. Gross margin decreased primarily due to higher repair and maintenance costs in Venezuela, Argentina and Brazil.

Parts, Service and Used Equipment
(in thousands)

		Three months ended
		June 30,								Increase
		2006				2005				(Decrease)
Revenue		$	55,737			$	50,531				10	%
Operating expense			45,061				36,215				24	%
Gross profit		$	10,676			$	14,316				(25	)%
Gross margin			19	%			28	%			(9	)%

Parts, service and used equipment revenue for the three months ended June 30, 2006 were higher than the three months ended June 30, 2005 primarily due to higher parts and service revenues in the U.S. and an increase in installation sales. Gross profit and gross margin for the three months ended June 30, 2006 were lower than the three months ended June 30, 2005 primarily due to reduced margins on parts and service revenues and installation 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 June 30, 2006, parts and service revenue was $41.9 million with a gross margin of 21%, compared to $38.6 million and 27%, respectively, for the three months ended June 30, 2005. The decrease in parts and service margin was due to lower margins realized in the U.S. from certain jobs that were completed during the quarter. Used rental equipment and installation sales revenue for the three months ended June 30, 2006 was $13.8 million with a gross margin of 14%, compared to $11.9 million with a 32% gross margin for the three months ended June 30, 2005. Our used rental equipment and installation sales revenue and gross margins vary significantly from period to period and are dependent on 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
		June 30,								Increase
		2006				2005				(Decrease)
Revenue		$	70,128			$	41,092				71	%
Operating expense			58,482				36,587				60	%
Gross profit		$	11,646			$	4,505				159	%
Gross margin			17	%			11	%			6	%

For the three months ended June 30, 2006, compression and accessory fabrication revenue, gross profit and gross margin increased primarily due to improved market conditions that led to higher sales levels and improved pricing. As of June 30, 2006, we had compression fabrication backlog of $193.0 million compared to $67.5 million at June 30, 2005 .

Production and Processing Equipment Fabrication
(in thousands)

		Three months ended
		June 30,								Increase
		2006				2005				(Decrease)
Revenue		$	103,653			$	104,297				(1	)%
Operating expense			89,203				92,429				(3	)%
Gross profit		$	14,450			$	11,868				22	%
Gross margin			14	%			11	%			3	%

Production and processing equipment fabrication revenue for the three months ended June 30, 2006 was slightly lower than for the three months ended June 30, 2005, primarily due to the timing of projects awarded. Gross profit and gross margin increased due to an improvement in market conditions that led to improved pricing and an improvement in operating efficiencies. As of June 30, 2006, we had a production and processing equipment fabrication backlog of $521.5 million