Archrock Inc (AROC) 2004 Q2 法說會逐字稿

Good morning. Welcome to the Hanover Compressor Company Second Quarter 2004 Financial Results Conference Call. With us this morning are Chad Deaton, President and CEO, and John Jackson, Sr. VP and CFO. Today's call is being recorded. Earlier today, Hanover released their financial results for the second quarter ending June 30, 2004. If you have not received a copy, you can find the information at the Hanover website, www.hanover-co.com. I want to remind listeners that the news release Hanover issued this morning, the company's prepared remarks on this conference call, and the related question and answer session include forward-looking statements, . These forward-looking statements include projections and expectations of the company, and represent the company's current belief. Various factors could cause Hanover results to differ materially from those predicted in forward-looking statements. Information concerning the factors which could cause Hanover's actual results to differ materially from those in the forward-looking statements, can be found in the earnings press release as well as the company's SEC Form 10-K for the year ended December 31, 2003, the company's SEC Form 10-Q for the three months ended March 31, 2004, and the company's other SEC filings. After the speaker's remarks, there will be a question and answer period. [OPERATOR INSTRUCTIONS] I will now turn the call over to our host, Mr. Chad Deaton. Mr. Deaton, you may begin your conference.

Thank you and good morning. I would like to welcome you to Hanover's second quarter conference call. I'm going to, as usual, start by providing an update on some of the second quarter operational highlights, and then we will review some of the current business conditions, and look at some of the things going forward. As mentioned, with me today is John Jackson. I'm going to take a minute to -- for those that did not see the prerelease that went out earlier, I would like to welcome John as a new Board member to Hanover. For those that of you that have followed Hanover for the last couple of years, I think, and I speak for the Board as well, this is a well deserved recognition for John and we are very glad to have you on the board, John. Congratulations. That doesn't get him out of still doing his CFO responsibilities, though, so following my discussion, John will go into the financial details.

Regarding the second quarter highlights, I would like to begin by saying as I said at the end of the first quarter, I repeat it at the end of the second quarter, I am pleased with the progress we are making, that two quarters now that we are clean, fairly solid. For the quarter we generated EBITDA of 77.6 million. It's a slight increase over the first quarter results of 76.5 million. But if you will recall, as we mentioned in last quarter's call, the Q1 EBITDA last quarter was aided by about $4 million EBITDA gain, due to a couple of large installation projects that were quite profitable for us in the international arena. If you consider that, I think this does make the Q2 performance all that more encouraging for us. The 76.--- 77.6 million for the quarter also represents a 9% increase over the last year's second quarter EBITDA which came in at 70.8 million. Some of the bright spots of the quarter included the improvements we saw in utilization, both domestically and internationally. We saw improved international revenues and margins. And we saw increased revenues, and I would say improving margins, in our fabrication line of business. Breaking it down domestically, our utilization increased from 78% at the end of the first quarter, to 79% as of the end of the 2004 June quarter.

We see overall compression rental demand picking up across all the domestic regions, but I do want to say I see it becoming a very competitive marketplace as we are seeing some new competitors, some startups, enter into the compression rental market. Also with these very strong gas prices, we have seen our customers that are now generating some very significant excess cash flow, which in some regions, is leading to higher demands for the sale of equipment, rather than the rental of equipment. And this is example. This is in the western United States, where we have seen a very strong demand over the last three to six months, for the client to purchase the compression and gas production in treating facilities, while the rental market has been improving, but it's doing it at a much slower pace.

Overall, we feel good about the domestic market. We are optimistic about the prospects in the second half of the year, and, in fact ,we see a good number of domestic opportunities for the second half, that are going to be driven by other products and services of the business other than compression. We are forecasting increased activity for gas treating and processing plant sales, and strong demand for the rental of some small gas treating facilities, and this is particularly true for the U.S. gulf coast operation. If you look at compression, three stage compression continues to be very much in demand. And we continue to focus on retrofitting some idle single stage and two stage units, and converting these to three stage. The cost to retrofit these these units has placed some pressure on domestic rental margins over the last few months, but we feel in the second half of the year we will see the benefit of these units going to rent. John, I believe, will talk more detail about this later.

For international, if we look internationally, we had a strong quarter in our rental business. It increased activity in our basic base parts and service business. During the quarter, and we talked about it last quarter, we had 22,000 horsepower in Brazil that we anticipated coming online and it did come on in the quarter. And, we also had--which is encouraging--increased parts sales in the Far East. We did have one project that we had been talking about that we had expected to start up in the second quarter, and that's the Oguta [PHONETIC] facility in Nigeria, and it has been delayed. We now feel that project probably will not start up until the end of Q4 or early 2005. But we do have a contract and it is moving ahead but it's going slower than what we expected. There is a second project in Nigeria as well. It's the Nigerian Otomura [PHONETIC] barge. If you recall, it's been shut down for over a year. We had some problems about a year ago where some of the local tribes boarded the barge and did quite a bit of damage. We are back under contract with the client to get that up and running. And we are now doing that work to get to that point. We think that maybe by the end of the year, possibly early 2005, that barge will come online as well. So with the Oguta and the Otomura-- it should add about 540,000 per month in revenue starting at the beginning of 2005.

Regarding Nigeria, John and I have been going back and forth about really whether to mention this, but at the risk of being premature, I will go out on a limb, and announce that barring any unforeseen problems, and that's my forward looking statement, we are going to ship the Cawthorne Channel barge to Nigeria, we have signed the contract. It should be loaded up in early August, the first two weeks of August. It will take a month, month and a half to get over there. But right now we are looking at possible startup, beginning early 2005, for the Cawthorne Channel barge. That's a contract that, once up and running, should generate $1.1 million a month in revenue for us.

This is a project that everybody knows about, it's a significant investments of the company for several years, it's been sitting idle for quite sometime. We have challenged the international group to get it to work and I have to congratulate them. They've done an excellent job, made a lot of progress on this with the client, and as I said, we are due to ship early August.

On another topic, during the first half of the year, we were more conservative in pursuing growth capital projects, as part of our strategy was to make sure that we are going meet our debt pay down targets. John will discuss later, but we are comfortable with our progress on the debt pay down front, and you will see us-- and we expect to be more active in the second half of the year, in pursuing growth capital projects that meet the return criteria that we have established for the company.

We see continued strong demand in our traditional Latin America markets, particularly Mexico and Argentina. But we also are starting to see some new and encouraging activity in other international markets, and particularly I refer to the Middle East. A good number of these new opportunities are what we would say "beyond compression," as they include equipment other than just compressors. If we look at our success we had the last few months, and what we see going forward, we clearly-- there is no doubt that we are all the more confident that our total solutions focus is the right strategy for the company, and it's especially true as we begin to try to penetrate new markets such as in the Middle East and Russia. It's also been encouraging in the last few months, that even in the U.S., we are starting to see several projects that gas treating facilities in compression are being joined together in more of a total solutions project.

We stated on previous calls that Russia and the former Soviet Union, FSU countries will continue to be a focus for Hanover, as we try penetrate this market, and of course, our strategy as we said was to do this through the sale of equipment, rather than exposure of our capital and rental within the countries. Year to date, we signed orders in Russia, and the FSU, for a little over $20 million. This includes a recent awarding of a processing plant in one of the eastern European former Soviet Union countries. Our bidding activity is up substantially from last year in the order of magnitude of 3 to 4 times. It's still a little early to say how successful we will be, but we were encouraged. The $20 million in the first half is significantly the highest revenue that we've ever generated in Russia. So we see it going in the right direction, again it's mostly in the processing and treating side, but it is moving correctly. I said before, you will hear me say it over and over. Russia is not for the weak of heart. We are there. We are making progress, but we continue to monitor it and watch the rule of law and see what happens.

I mentioned earlier that we continue to see steady improvement in our fabrication business lines. Total backlog at the end of the quarter was 266 million and this compares to 221 million at the end of March of this year. And if you look back a year ago, the quarter was 158 million the same time last year. The majority of this increase sequentially is coming from the Belleli operation; its backlog increased by about 38 million. Most of that was in the quarter for a large tank for our farm project in the Middle East. We are expecting Belleli's backlog for Q3 to be flat to slightly down. But we do see, or anticipating an increase, in Q4 as several contracts should be signed, so we should be returning to a strong backlog at that time.

For the quarter of the backlog, for compression and the rest of our production and processing equipment, for the fabrication side has shown slight improvements, but over what was a very strong level in March. Currently we expect the strong activity levels in all the fabrication business lines to continue into the third quarter. We just finished our second quarter QPR quarterly performance review of operations and sales group, and we are confident enough that the fabrication backlog is strong enough, that in three of our manufacturer's centers we have gone to second shifts. This should help us, in the first quarter we did have quite a bit of overtime, and we will be able to reduce some of that.

John will touch on margins in more detail in a minute, but I did want to say that there is still room for improvement, but I am pleased with the progress we are making on manufacturing margins, especially in the production and processing fabrication side. I think you saw in the quarter that our margins were at 14%, and it was a good solid 14% across the quarter. Compression fabrication margins still lower than what we want, but again, if you look at the quarter, we see the margins increase month-to-month, and we see improvement in those margins even more hopefully over the next couple quarters. I think all this being said, we are starting to see the results some of the consolidation and rationalization efforts and also the increased focus that our sales force is putting as far as penetrating the market.

Lastly, before I hand it to John, I want to say that again as I started off the call, I think we are moving in the right direction. There was improvement in the quarter. We clearly still have a long ways to go. The good news is that the QPR-- every manager that was in there presented, knows where we want to go and feels we will get there. We do have targets that we are trying to reach, and we have made some significant strides over the last year to year and a half. All that's being said, while our employee base is striving hard to improve our operational and financial results, they have had to deal with some very significant management changes that we have done in the last year. We had a fairly high employee turnover as we continue to clean up the company. Of course, the significant systems conversion that is ongoing with Oracle, and finally the increased demands, which we can't overstate from the new regulations that we are receiving and trying to get through this [INAUDIBLE] implementation, which is taking a tremendous amount of management and employees' time. I think our employees have done an excellent job this year. I know a lot of them listen to this call, these calls. And I will take the opportunity now to make sure and recognize and thank all of them for their efforts and hard work, and I think with each quarter, it's continuing to pay off. So, John, I will turn it over to you.

Thank you, Chad. I'm going to step like I usually do through the income statement briefly and touch on some of the quarter-to-quarter issues, and a little bit on where we are going guidance-wise, and what we see in the third and fourth quarter as we move ahead.

Starting with the domestic rental business: I do see the revenue drop quarter on quarter, there were some anomalies on the revenue line between quarters both last year, and the first quarter and second quarter this year, getting some billings aligned, as well getting [INAUDIBLE] as more accruals aligned. On a normalized run rate, just for people, I think will be between 85 and $86 million as we move ahead, and I think that's how the quarters shape up into the future, depending on what happens with utilization. Going to the margin side of the equation, we do have 58% margins this quarter, I think we had about 59 last quarter, so we remain in that area.

As Chad mentioned, we have had some conversion of units going from two stage to three stage, or one stage to three stage that we have been spending time on the shops, as well as the utilization has picked up, we have been spending a fair bit of time in the shops doing some overhaul work that's been expensed, that has put pressure on margins as the business activity has picked up. We -- in addition to that, we have some maintenance cost in the front half of the year, that are higher than we would like to see at the normalized run rate, and we are working hard on that to improve that area. So I think we still have the opportunity over the longer haul to move these margins and the 60, 61% range and that will be our target to get to by the end of the year, sort of an exit rate at that 60 to 61% range. I think we are looking to see gradual improvement in these margins to get back to where we said we would like to be on an ongoing basis.

On the international side, we've seen the revenue up there, we've had a couple of unusuals in the quarter, that were mentioned in the press release, that were a couple million dollars worth of revenue. In addition to that, we did have the Brazil project come online, it was 22,000 [INAUDIBLE] that came online in the second quarter and that gave us a boost to revenue there. The margins are pretty strong at 74%. If you take those unusuals out, a couple million dollars worth, that still takes you down to about 73.

We do have a mismatch as far as the timing of some significant overhauls. We really had hardly any in the front half of the year internationally of a significant nature, and as we look at the second half of the year, we do have overhauls that will be expensed versus capitalized, because of the nature of them, and we anticipate that to put some pressure on margins internationally, just because of the increased expense that would move us into the upper 60s, which I think has been our longer term trend as to be in the 67 to 70% range. I think we will be back down there in the second half of the year, as we had this increased maintenance expense come in in the second half. In the third quarter, we don't see any significant projects coming online in the third quarter. Chad had mentioned the Nigeria projects, in the fourth quarter, first quarter next year kind of thing, and we will talk about capital in a little bit as I get to those comments.

On the parts and service side, revenues and margins decrease, absolute margins decrease quarter on quarter, and Chad mentioned we had some significant installation activity in Latin America in the first quarter that was nonrepetitive, but we were able to replace a fair bit of that with base parts and service business, both internationally and domestically, we saw activity pick up in both those areas and we did see, just on a base parts and service business, excluding sales and installations, we did see those margins improve also in the quarter from 24% to 28%. So we like what we see going on there.

Moving into the compression fabrication area, we did see revenue activity pick up quite a bit. Margins are almost flat, they are actually up slightly on an absolute basis quarter to quarter. But the exit rate in the quarter was more around the 10% range versus the entry rate in the quarter was low single digits.

As we look ahead, the jobs we have in the backlog, and the margins we have on them, and the activity of balancing our shop load space with two shifts instead of overtime, we anticipate being able to get to more of that 10% margin range as early as the third quarter, and that's certainly our goal on the compression side. That's a much more competitive business, but we still see a lot of activity there, that we think we are going to be able to drive those margins up, and maintain that backlog and activity level that you've seen.

Production and procession equipment side: We saw the revenue increased there from quarter to quarter. Again, that's reflective of the ramp up in backlog that we saw at the beginning of the year. Belleli had a slight increase, but what we anticipate seeing going into the third quarter, is more revenue in production of processing equipment, both on the base business but also from the Belleli business. Chad mentioned the growth in Belleli's backlog, but the type of activity they work on, it takes longer for that backlog to hit the revenue line, and we should start seeing some of that backlog build from the front half of this year, begin to move into the revenue line in third and fourth quarter this year. We anticipate seeing Belleli's revenue up in the second half of this year. So we think those margins that you are seeing should be in the 13 to 14%; that we would continue to expect to see those kind of margins, as we move into the second half of the year.

Moving to SG&A, we were up slightly from all kinds of things that move into SG&A, but mainly what I wanted to focus on in this area is we had about a -- almost a million dollar increase in SG&A quarter on quarter because of our Sarbanes cost. I think on the last call we thought we would spend around 2 to $3 million on Sarbanes. Our estimate has changed pretty drastically on that now that we have some specific estimates in from our audit firms that are helping us on this, and the audit firms that are going to have to opine on this, we anticipate our full year costs now to be in the 4 to $6 million range, and we've expensed it the first half of the year at about 1.5 million, because the work is second half loaded to the year. That's why the expense is in rateable. We will see a lot of activity. We are seeing a lot of activity in the third quarter and into the fourth quarter, as we finish the work and as our auditors get through this process. We would anticipate seeing SG&A up a little bit, a million or two over what we saw this quarter, in both the third and fourth quarter, driven by the Sarbanes activity. Looking at depreciation, it's up about a million dollars, quarter on quarter, slightly above that. But a million dollars of that is from the write off of the [INAUDIBLE] fees that we noted in the press release, associated with the refinancing of debt we did in May, so that came in as a one time event.

And then jumping to some your favorite line, the tax line, we had a $4.7 million valuation allowance in the quarter. Last quarter it was $9 million, $9.4 million or so. We did some tax planning in the quarter to try to reduce the effect of that. So we got a full year -- half year catchup on that, and that's why it was so low to 4.7. I think last quarter we said you should anticipate the effect of this being 7 to $10 million of additional expense per quarter, we think with what we have done so far, we think we can revise that down to 6 to 8 million on a run rate going forward, and we are still actively pursuing different options here to continue to drive this down lower. But right now we would say you should plan on 6 to $8 million of additional tax expense, and again I want to stress this is non-cash; we aren't paying this, but we are just not able to recognize U.S. benefit on our U.S. jurisdictional losses. That equates to 7 to 9 cents a share based on our current shares outstanding.

So let's jump to cash flow and liquidity for a minute. Through June, we had paid down approximately $30 million of gross debt. If you look at our changing cash, our cash moved down about $5 million, so we paid down about 25 net of our change in cash. We do have the zero coupon note that accretes, so if you are just looking at the balance sheet in total, we did have accretion during the year so far through June of about $10 million. Also, part of our debt paydown hits the minority interest section, because our synthetic leases have some of that debt reflected in equity, so when we do pay off debt, you can't see it all in the debt line. In addition to that, in July we paid a $30 million off on the initial $173 million that's maturing next October in synthetic leases. We paid 30 of that off and it will be down to 143 now. We believe that we will be in great shape to meet our $60 million gross debt paydown pre-accretion for the year.

The question that we continue to receive is, do you think you will pay down more debt? Where will you be? And I will get to that as I talk about capital here. But from a covenant perspective, we have no constraints for accessing our revolver. We have $250 million in availability on revolver, and nothing drawn on it, and no reason that we couldn't if we needed to.

Capital for the quarter was about $20 million. That puts us year to date at 37 million. Maintenance was $20 million year to date, 9 for the quarter. We continue to have reined in capital in the front half of the year, and I think that what we have been trying to demonstrate is that our maintenance capital really is in the $50 million range, plus or minus, and we can grow EBITDA and maintain a low capital base to improve the operations of the company.

So, our focus in the front half of the year was run the company, let's get what we can out of what we already have, and I think last year we did about $275 million give or take of EBITDA. This year we are running at a 300 and change pace. So we have been able to drive up EBITDA 10, 15% without spending a lot of capital. We really wanted to focus on the debt paydown and stabilize the organization. We feel like we have done that. We feel like now as we move ahead, we are looking at incremental cash flow being-- choosing between whether we pay down debt, and what's available on the capital horizon, on the growth horizon. We have talked to our folks earlier this week, and we had our quarterly review; we said we really want to get more active now at looking at growth prospects and growth opportunities, where they might be, and how much capital might be needed to do that, and we will balance those against the ability to pay down debt. So, we are maintaining from a guidance perspective our 100 to $150 million Cap Ex target, even though we spent $37 million year to date. If we don't have the right projects there to spend in the second half of the year, or to spend all of that, we will just pay down more debt and leave ourselves the option to spend that into next year.

We are also very comfortable with our target of $60 million debt paydown on a gross basis. We have in essence done that through July, and I think we will be able to keep our revolver run drawn by the end of the year as we finish that up. And then on the EBITDA guidance, we said 280 to 315, obviously we are at 154, halfway through the year. We aren't going to change our EBITDA guidance, but clearly we anticipate being in the very high end of that guidance as we go through the rest of the year. And then we will see where we are at the end of the third quarter and update it from there.

Finally, cash from operations in Q2, was about $50 million. In Q1 we were, in essence, at zero. We have a lot of working capital growth, as the business activity ramped up. DSO grew on us. We have been able to bring DSO back down to where it's been. We have been able to maintain the second quarter, in spite of the fact we've been growing, we maintained flat working capital in the second quarter, and we were able to really convert the EBITDA into cash from operations, and that's our goal as we move forward is to continue to monitor and maintain as slim a working capital number as possible. We did generate $50 million on that front. With that, I think we will turn it over to questions.

Thank you. I would like to remind everyone in order to ask a question, please press the star followed by the number 1 on your telephone key pad at this time. Your question has already been asked and answers, you may withdraw your question by pressing star and the 2 key. If you are a speaker phone pick up your handset before presenting your question. We will pause to compile the Q&A roster.

Thank you Mr. Deaton. Your first question comes from Ken Sill with CSFB.

Good morning. And nice to see continuing progress on the operating side. The tax rate stuff is enough to make everybody's head spin, I guess.

We are working on it.

On the compressor packaging side, looking back at history, you guys used to be able to get kind of mid teens, low to mid teens margins on the packaging side, and I guess you are saying you are expecting an exit rate this year, kind of, 10%. Do you guys think you can back into that low to mid teens in what is apparently still a relatively competitive environment?

The mid teens bothers me more than the low teens and I -- I think we will do better than 10% hopefully in the second half of the year as we -- like we go to the second shift, cut overtime. The volumes up. We have done a lot in terms of the purchasing side by changing out some of the purchasing people. We are paying a lot more attention to what we are paying for products as we build these things. I would like to shoot for the 12, 13% range is what I hopefully would like to get to. John, your comment?

I think that right now based on what we see and the competition, I would say that's reasonable target to shoot for. But the 15 to 17% on compression fab, I think is something we don't see in the near term.

I was hoping 12 to 13-- 15 was probably not--

I'm just conservative finance guy. Trying to tell you guys 10, 11 and hopefully get to 12 or 13.

Well, that's the right answer. And then you do have some unusual items, I guess, the million dollars write off of the deferred financing cost. A little bit of mark to market on the litigation settlement. Should we be applying a tax rate if we pull those items out, or put them in at gross numbers? Would you tax them at 35%?

No, those are-- because they are U.S. based they will flow through pre-tax, after tax as you see them. So if you pull them out, just pull them out on an after tax basis.

At the same rate they go in. There is no tax--

Dollar value they go in.

That makes that a lot simpler. And then Schlumberger comes off at a lockup, I guess, of 8.7 million shares they've got coming up here in August. Do you have any idea what their intentions are with that?

No. We talk to Schlumberger all the time, they are happy with the way, the direction that the company is going, but we know nothing whether if they would hold that or do something with it, Ken.

Okay. Well, I'll let some other people ask questions. Thank you.

Your next question comes from [INAUDIBLE] with Simmons.

Good morning, guys. Could you touch a little bit more on domestic pricing for the remainder of the-- domestic pricing of the rental business -- for the remainder of the year?

We see the pricing being a little more competitive than what I thought we would be seeing at this time. We have tried on a couple of occasions to go out. We are seeing some, depending on the equipment, the larger horsepower, we are getting some improvement there, because that equipment is just getting tired between us and our major competition. But in other areas, as we try to increase some pricing, the competition, the pressure is still strong. So I would -- we have not realized as much price improvement as what we had hoped to see, considering our activity and our utilization has gone up.

Is the competition mostly coming from kind of mom and pop companies? Or is it coming from your other major competitor?

I think it's coming from both. You know, the smaller horsepower equipment obviously is coming from the startups. But some of the larger projects are still pretty price competitive when you get ready to sit down and start negotiating them.

Great. And then last question, you touched on growth prospects for the future. In terms of growth prospects and the Cap Ex that's required for that. What kind of return and criteria are you looking for, and secondly what kind of -- what geographic -- any capacity has in domestically or it just pretty much international base initiatives?

Well, I think either one would be okay with us. We certainly stated in the past and I think we continued to re-iterate that, that our plan is more of the 75% or so of our growth capital of being internationally and 25% domestically. To the extent we can put equipment back to work here, and that requires some capital to do that along the way. We would certainly do that. In addition to that, I think internationally, we still see a lot of opportunity in Latin America. We have just been very cautious to participate in the front half of the year, based on my earlier comments, but we still think we can go there. We continue to want to branch beyond Latin America, not forego Latin America, but branch beyond it. As far as return profiles, obviously in the U.S. your return profiles are lower and they are more competitive. Internationally, it's sort of geographic or country-specific. We have return parameters, and we look at it very closely, and then we evaluate whether it's all new capital, or whether we're using some-- used out of the U.S. So, I don't want to get into specific numbers, but they do vary by country, based on risk premiums that we assign to them, as well as what the cash on cash return is, using used equipment and so forth. But they are much higher internationally.

I just want to add that one of the things that we have seen in the last three to four months, and listen to us two quarters ago, clearly, as John said, most of our capital we looked at going internationally, but in the last three or four months we have seen a lot of projects in the U.S. that have come forward that aren't necessarily compression, but more in the gas treatment and processing side that are very encouraging. And we are looking to be more aggressive going after a couple of those.

Thanks. That's very helpful.

Thank you. Your next question comes from Jim Wicklund with Banc of America Securities.

Good morning. John, if you're going to get more aggressive with growth capital in the second half of the year, the 154 year to date, and 315. That's not much of a stretch. When will that -- from my side anyway-- for you guys it's a little more difficult--.

Takes awhile to get the revenue coming in.

And that's what I was going to ask. What is the time frame differences, if you spend whatever additional capital you spend on the second half of the year, and like John said 25% domestic, 75% international, when does my revenue generation start from those, and by sector?

If you talk internationally, you are talking six to nine months. Domestically, that could be a little shorter depending on the project, because of just logistics, and availability, and being able to get it in and not having to ship it. So I would say three to six months, depending on the project, domestically, and six to nine internationally.

Okay. Second question. Chad, you were talking about how it's not just compression opportunities in the U.S., it's total solution kind of stuff, and separation and all. You guys started getting, Hanover started getting, into the separation business, Latin America and all, several years ago before, and went for a couple years before telling anybody they were doing it. How much is that a part of your overall business, and how much would you like to see that be a part in total of your domestic business? Versus compression.

If you look at our rental income, it's about 20% of our rental income is coming from noncompression. Internationally. Domestically we operate quite a few small treating and gas processing plants but it's probably 5 to 10% of that revenue domestically. Now, what I was referring to that is encouraging in the last three or four months, is that domestically we are seeing some larger gas plants and gas treating facilities that we're becoming more involved with to either build, own and operate or maybe just operate for the client. And that's quite encouraging what we are seeing in the U.S. gas market.

Thank you. That's very helpful. Last question. John, you have paid off 30 million of your 173 due next October. Your outlook of the financial markets, how does that end up getting paid, redeemed, refinanced?

If we look at that, we are down to 143. Assuming we paid off nothing else this year, we did commit to 60 million a year for three years, so let's talk about $60 million more for next year, so that puts you down in the 80 range and we have an unfunded revolver, so, sans any [INAUDIBLE] sales or any other source of cash, we would probably just draw on our revolver.

And the differential between your rate, your implied rate, on the synthetic versus your revolver?

We have a piece of it floating and a piece that's fixed. On the piece we were talking about, we are probably talking about 250 basis points lower.

Okay.

Lower. Yeah. Because the revolver is 250 basis points, it's floating. Assuming your static interest rate environment.

Yeah, okay. Thanks. Not bad.

Your next question comes from Glen Primack with Broadview Advisers.

Good morning. Couple questions. One, on the procurement front, have you centralized purchasing yet or are you in the process of doing that, and then the second question, more I guess, related to demand that you are seeing in the U.S., both U.S. and international it seems like there are a lot of projects for pipeline. Would your business lag when big bids are coming in for pipeline construction? Will that happen at the same time?

Well, in the first thing, yes, we have centralized purchasing. We have a new team in there that are pulling that together. And I mentioned that earlier, that we are starting to see what we think will be benefits from that.

But you can't quantify what --

No, not yet. And as far as the pipeline, I guess it depends on where you are talking, and which country, obviously these are large transmission pipelines; it really doesn't affect us because that's all centrifugal compression. It depends on what's feeding into it. If it's well head compression, and things like that, then obviously we will lag until those come online.

Your next question comes from Jason Selch with Wanger Asset Management.

I think you were talking about $4 million a quarter in Sarbanes Oxley expenses in the second half. And I was wondering what are you referring to? And I'm also interested in knowing what you expect the entire Sarbanes Oxley expense to be in 2004. And is that an ongoing expense, or is that a part of all the settlement and it goes away? Could you explain this?

Sure. What we-- perhaps I wasn't clear. Let me try and clarify what I said. We anticipate full year '04 third party vendor cost on Sarbanes 404 to be somewhere between 4 and 6 million. We have already charged through the income statement a million and a half. So we have another 2 1/2 to 4 1/2 of expense to go in the second half of the year. Because a lot of the work is weighted to the second half of the year, to complete, and the auditors have to come up with an opinion. And what's happening is, 404 is the second half of the Sarbanes Oxley Act that was passed two years ago. The first part of is was the 302 section of it which required officers to certify the financials. That went into effect immediately. And then there was a couple of year lag to then come in and make-- or have the companies go in and document all their internal controls, write them down, test them, and assess whether they had any material weaknesses in their internal control environment. In addition to that, your auditor has to come in and also do that, and give an opinion on whether they think there is a material weakness or not. So for the first time in history in America, we'll have two opinions from our auditors. We'll have one on the financials, which will be all stand alone, then you'll have one on the internal control environment, on whether it's an ok internal control environment, or whether it has material weaknesses to it. That will be a separate opinion. And that will be done, for this year's 10K. And that, as Chad said, is taking a lot of management's time and focus, because this is spanning, you know, every area, whether it's purchasing, or contracting, or sales, as well as finance. You have to document what you do to make sure you have a controlled environment, so that it can be tested. And that's why we have a lot of people across the organization. In companies this size, our size, I don't think we're unusual, in that not a lot of companies this size go in and write down every control procedure they have, and document it and test it-- it's just not something that's never been done before. So there's been a lot of work across the organization to get this documentation done.

And is that an expense? This is like a Y2K type of thing? It occurs before the regulation and it doesn't occur next year?

I forgot the second part of your question. The depth and breadth of the cost should diminish. However, there will be an opinion required every year, into a the future, by our outside auditors, so there will be work done by our outside auditors, as well as internally, to maintain where you are and test it each year. Let's say we are talking about 4 to 6 this year, we are hoping this is going to be between a million and a half and 2 next year. So we expect to cut $4 million off this, 4 to $5 million off this next year; it's just unknown how much it will be on a go-forward basis but it won't be at this level.

And then in addition to that, didn't you have a lot of expenses in the first half relating to the settlement, and those aren't going to be continuing into '05, are they?

No, we didn't have a lot of costs, and to the extent we had some cash costs, but they were already previously accrued and we just--there was some cash that we used to pay, you know, final legal bills and so forth, but no, there was no [INAUDIBLE] expense.

Okay. Well, thank you very much.

Okay.

Your next question comes from Eric Johnston with Deutsche Bank.

All my questions have been answered. Thanks.

The next question is a follow-up question from Ken Sill with CSFB.

Jason's question reminded me; you guys have been spending money on the Oracle system, and I thought that was going to be done by mid year, and yet it sounded like in your initial comments they are still-- as is typical I guess for IT projects-- that one is still going on.

Yes, that's true. I would say, though, that the bulk of the major installations that were done -- for example, all U.S. operations are on Oracle. All manufacturing is on Oracle in the U.S. and in the U.K. and Canada. Canada is on Oracle. The U.K. is on Oracle. Venezuela has gone on Oracle and Argentina has gone on Oracle. What we have is some of our smaller foreign countries still to go. Not to diminish the amount of work that's there because there's still a fair amount of work. But we've got Brazil, Mexico, Colombia, that kind of thing to go. What's happening is with the Sarbanes 404-02 is we are pushing out some of that because what we would have expected to do is keep converting some of these countries one by one. But you have to finish your process, and test it, and not change it to make sure your controls work. So I think what you're going to see a lot of companies do is slow down or stop any system change work in the second half of the year, because you can't change it and then go test it again and find out it doesn't work and then you fail your opinions. So we slowed that down and pushed it out. But they are on the smaller-end countries that shouldn't have a major impact as far as the financial and operating effect of it.

So Oracle expenses are actually going to be down in the second half, but that's being more than offset by this Sarbanes Oxley stuff going up, I guess?

Yeah. Yeah, I don't know-- I think you are right, they should be down because we aren't doing as large and as major installations, but we will still have some as we prepare for like one more conversion.

The first half. Shouldn't be that high.

They will be down.

And then on a housekeeping items, D&A should be back down, a little bit-- a million bucks sequentially because you won't have the unamortized expense?

You mean DD&A? [PHONETIC] Yeah, it should be down, that million dollars equivalent. Although, as we do pay down on the October maturity, to the extent we pay that down more than what we have done already, for example, you have to write off the pro rata portion of the unamortized beyond that, so there will be a little bit there, but it will be down, let's call it half a million.

What are you guys expecting for interest expense this quarter with the new debt issuance?

I would say it's going to be pretty close to in line with what you saw in the second quarter, maybe up just slightly with the new debt issuance. But we are paying down debt, but I think it comes close to offsetting itself.

Okay, thanks.

Your next question comes from Jean Vendice with SAC Capital.

I have a couple more balance sheet related questions I guess. The first is, I guess your debt is at like $1.76 billion, and your expected EBITDA is 300 million. So you are still at six times. And if you look at your operating cash flow, I think you said for the year it should be around 60 million? And your run rate interest expense is like 140 million. So your coverage ratios, I mean, still looks pretty level to me, but it sounds like you are ready to stop the focus on debt reduction and instead focus, you know, on investment in the company. Do you have-- are you comfortable with this level of leverage, and if not do you have a target leverage or target credit rating that you want to be at?

Let me back up. The $50 million of cash flow is what we generated in the second quarter. We would hope to be more in the 150 range for the year, and we committed quite sometime ago to $60 million a year as a minimum. What we are saying is that, no, we aren't taking our focus off debt reduction, but we put almost an exclusive focus in the front half of the year on debt reduction at the expense of not really looking at any growth, trying to make sure that we got at least the 60 million done. I think internally we are looking at a lot of things to try and drive debt down further faster. However, what we committed to is $60 million a year for three years, and we are not comfortable at our leverage levels, and we just felt like there are opportunities here to improve the performance of the company by spending some capital, balancing that with debt paydown, and trying to drive those numbers down. So, by no means, I don't want anybody to take away from this call that we decided that we have done enough, and let's move on and grow the company again at full speed ahead. We are definitely trying to find the balance of growth and debt reduction.

We think -- we are certainly optimistic looking forward with the way the activity is, and other small assets that maybe sold; and we are going be able to continue to pay down debt at the same time we we're going to find some good projects to continue to grow the company. It will be a combination.

Okay, do you have sort of a long term target leverage-- whether I don't know how you measure debt to cap or debt to EBITDA or-- but do you have any sort of longer term targets or credit rating target?

We would like to get our debt to cap down to the low 50s.

That's long term goal. We not going to do it in one transaction or two. It will be moving from upper 60s to lower 60s to upper 50s and that's -- we do lay that out on kind of a three year horizon, and what we can do to chip away at that and start knocking that down-- and that's coverage ratios, that's multiples of EBITDA six times, debt six times EBITDA, however you want to look at it. We are driving all those to more favorable. It's a next three year window.

Okay.

Your next question comes from Jeffrey Stewart with Reed, Connor and Birdwell.

Yeah, good morning. I was saying a follow-up question, I'm curious what percentage of your domestic compression business you said was coming from [INAUDIBLE] projects.

What percentage of the domestic?

Yeah, I think you said it was about 20% internationally.

It's in the 5 to 10% range.

And you expect that to grow this year?

No. It's not going to go -- international is where this is going to grow. But we see more -- we are more optimistic about the opportunities in the U.S. than what we were just a few months ago.

And you see this helping margins, or maybe source of compression margins?

It should help the margins. There is not going to be any difference on the rental margins. It should be as good as compression, and in some cases maybe even a little bit better.

Okay, thanks.

Your next question comes from Martha Tuttle with Prudential.

Good morning. One housekeeping question, I know you mentioned the cap ex but I didn't hear it. I know you said the first half was 37. Maintenance was 50, what is your target again for the full year?

We have given guidance of 100 to 150 on full year Cap ex total, with 50 to 60 being maintenance.

Can you comment more about the domestic compression business? You were talking about new entrance into that market, maybe pressuring the segment in the second half, Could you elaborate a bit on that please?

There are small startup companies that-- including some of the ex-employees of Hanover-- that have raised some private money to enter into the compression business. Again, it's usually in the smaller horsepower range. But it does put some pricing pressure on the business.

I wonder what they see in that segment?

I don't know. Obviously there has to be some volume associated with this business to be able to have the size that's needed to be able handle the clients across domestically; if they needed to swap out compressors anywhere in the country, you need to be able to do that for them. This is one of the whole ideas why there are two large companies out there today to be able to handle that. But I think this is typical in any oil field cycle that I ever been associated with, when times tend to get better, people tend to step in and start from the pumping business to the logging business to the compression business. And it is a cyclic business, and when it turns and goes down, it will put pressure on those people to survive, and that's a cycle that we watched for the last 40 years, especially domestically.

But I think your overall conclusion was that you think you could make up the pressure that you see in that segment from other areas?

I'm not concerned about it. I think domestically we continue to be optimistic about the rest of this year and we don't really see -- I don't personally see specially gas prices taking all that much of a threat. They are high now, they may drop to some degree, but I think we've got fairly decent gas prices for a long time to come domestically, and to go back to it, internationally, obviously we only operate mostly in the United States and Latin America. And so the rest of the world is sitting out there, and eventually as compression and gas processing and treating, gas is becoming a fuel of the future as we talked about in the past. So there's plenty of opportunities. I don't see a lack of opportunity for a company like Hanover over the next several years.

Thank you so much.

At this time there are no further questions. Do you have any closing remarks?

No, thank you for attending and we will see you next quarter.

Thanks.

Thank you for participating in today's Hanover Compressor company second quarter 2004 financial results conference call.