Archrock Inc (AROC) 2005 Q4 法說會逐字稿

Hello, and welcome to the Universal Compression earnings conference call. (Operator Instructions) At the request of Universal Compression, this conference call is being recorded. Should you object, please disconnect at this time. I will now turn the call over to Mr. David Oatman, Vice President of Investor Relations for Universal Compression. Sir, you may begin.

Thank you. Good morning, everyone. Welcome to the Universal Compression earnings conference call for the three months ended December 31, 2005. We’ve prepared a summary page of financial and statistical data about the quarter in our earnings release which is posted to our UniversalCompression.com website under the Investor Relations tab.

As we have in the past, during this call we will discuss some non-GAAP measures in reviewing our performance such as EBITDA as adjusted. You will find a reconciliation of these measures to GAAP measures in the summary page of the earnings release.

As a reminder, in addition to providing statements of historical fact, today’s conference call will include certain comments that are not statements of historical fact, but instead constitute forward-looking statements. Investors are cautioned that there are risks, uncertainties and other factors that may cause the Company’s actual performance to be significantly different from the expectations stated or implied by any comments that we make today.

These forward-looking statements are affected by, among other things, the risk factors in forward-looking statements described in the Company’s annual report on Form 10-K for the year ended March 31, 2005; and those set forth from time to time in the Company’s filings with the SEC which are available through the Company’s website and through the SEC’s Edgar System website at www.SEC.gov. The Company expressly disclaims any intention or obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise.

I will now turn the call over to Mr. Steve Snider, Universal’s President and Chief Executive Officer.

Thank you, David and good morning, everyone. Joining me today is our Chief Financial Officer, Michael Anderson. I will provide summary comments about our results, operating highlights and outlook, and Michael will follow with more detail about our financial results and guidance.

We are continuing to see significant investment by our customers in natural gas production and distribution systems. With these continuing strong industry conditions, we are happy to report that our activity levels remain high, our new order flow is robust and we are pricing more aggressively for our services.

We are pleased with the December quarter results which include record levels of revenue, EBITDA as adjusted and EPS. For the three months ended December 31, 2005 our diluted EPS of $0.60 increased 36% over the prior year period. For the 12 month period ended December 31st, Universal's financial results include revenues of $807 million, EBITDA of $263 million and adjusted EPS of $2.15. All strong increases over the prior 12-month period. As we announced last month, we've changed our fiscal year end from March 31 to December 31.

With continuing strong demand for our products and services, we expect revenues of $910 million to $935 million in calendar 2006, an increase of 13% to 16% as compared to calendar 2005. For EPDS we expect $0.58 to $0.62 in the March quarter, and $2.65 to $2.80 for the full calendar year of 2006. Both the first quarter and full year periods include costs associated with equity-based compensation. This level of earnings would represent a 23% to 30% increase over adjusted calendar 2005 results.

The industry's increasing demand for new, large horsepower compressors has strained the manufacturing capacity of our key suppliers. The delivery period for components, such as engines and compressor frames has increased significantly, and in some cases is currently more than one year. Consequently, our customers are pre-committing to contract compression and fabrication sale units for delivery well into the future, in order to meet their field development requirements.

Highlighting the continuing strong demand for compression from our customers, our compressor fabrication backlog increased from $114 million at September 30th to $145 million at December 31st. Currently, our fabrication backlog is $255 million. We believe our leading industry position and strong financial profile provide us with a competitive advantage due to our ability to secure these scarce components and meet growing market demand.

Now I will provide operating highlights for each of our business segments. In domestic contract compression, our working horsepower grew about 38,000 horsepower from September 30th to December 31st, 2005. Our domestic spot utilization was 91.9% at December 31st, and is currently at 91.6%. Comparing the December quarter with the prior year period, the gross profit dollars generated by domestic contract compression increased 17%, while our average working domestic horsepower increased 5%. Profitability has been enhanced by utilization improvement and price increases, which helped to offset cost increases, particularly in the areas of labor and lube oil. We expect to continue to selectively adjust rates in accordance with market conditions.

We also continue to be active in our international contract compression segment. In the December quarter, we started approximately 25,000 horsepower in Argentina, Bolivia and Indonesia. Furthermore, we have several new international contract compression projects that are expected to commence operations over the next year to year-and-a-half. These projects generally involve new, large horsepower units and like most of our international projects, we will be operating under long-term contracts. These units will be located in Brazil, Argentina, Indonesia and Mexico.

Looking forward, we are optimistic about the development of additional international contract compression projects, although these new projects and horsepower growth will be somewhat offset during the last half of 2006 by the likely exercise of a customer purchase option on a 25,000 horsepower compression facility in Latin America.

International fleet totaled 584,000 horsepower at December 31st, and international utilization was 93.7% at December 31st, and is now 93.1%. During the December quarter, we commenced a gas processing and treatment plant operation in South America. We successfully designed and constructed the plant for a major customer, and installed about 9,000 horsepower of gas compression along with it. We are optimistic about opportunities to provide similar gas processing and treatment plant services in select energy markets around the world, and we will continue to pursue these types of opportunities.

Looking at our total operating statistics, our overall spot contract compression utilization, including both international and domestic was 92.3% at December 31st, and is currently 92.0%.

We continue to be bullish about the near and long-term growth prospects for our domestic and international contract compression operations. The outlook for calendar 2006 is very positive, as we expect to add approximately 200,000 horsepower to our fleet and continue our strong growth rates in the U.S. and international markets.

Let's now move to our fabrication segment, which has benefited from operational enhancements and more aggressive pricing during the past six months. We have improved the profitability of our fabrication operations through a combination of process improvements, improved project selection and increased pricing discipline. Our pricing power has been enhanced by the overall tightness in the market for key components used in compressor packages. Looking ahead, we expect fabrication margins for the year in the 10% to 12% range, although the March quarter will likely be at the low end of that range, due to some inefficiencies in our current quarter production schedule with regard to component supply deliveries.

Based upon current order schedules, we believe this component delivery situation will ease beginning next month, and we continue to aggressively price new bids.

Our Houston fabrication facility is almost completely booked to the end of 2006, and we are now filling production slots for early 2007. With our large backlog for both fleet and sale units, we are currently expanding our Houston fabrication facility by approximately 25,000 square feet to increase our large horsepower unit capabilities.

Our after-market service segment also had a good December quarter in which revenues increased 13% sequentially and 16% compared to prior year periods. Margins are relatively flat as compared to the previous quarter.

Many of our large customers frequently request us to enter new geographic markets, and this month we entered the market in Africa by purchasing a small, international after-market service company. This company has had sales and service operations in the region for more than 10 years, and will add new revenue and customers, and enhance Universal's ability to deliver products and services to our existing customers. We are excited about this international expansion and will continue to pursue opportunities to broaden our international infrastructure and service offering.

The outlook for 2006 is positive, due to robust domestic and international energy markets, and our strong operational and financial positions. With the continued support of our employees, customers, suppliers and stockholders we will continue to focus on providing the best services in the gas compression industry, and we look forward to growing the business in the coming years. I will now turn the call over to Michael for a review of our financial results and guidance. Michael.

Thanks, Steve and good morning, everyone. I am sure that by now you have all received and reviewed our press release that we issued earlier this morning. In my summary of financial results for the three months ended December 31st, 2005 the primary comparison period will be the three months ended September 30th as well as the guidance we provided at November 1st. I will also talk about our year-over-year performance in comparing to the three months ended December 31st, 2004 highlighting the growth that we have seen in the business.

Total revenues were $225 million in the three months ended December 31st, 2005. That represents a 24% increase sequentially, and it is a 17% increase on a year-over-year basis. All of the segments were up by double-digit increases on a year-over-year basis.

Looking at our domestic contract compression business, revenue was $87 million for the quarter, that was a bit above our guidance and is an increase of 6% sequentially and a very strong 15% increase compared to the year ago quarter. Gross margin in the domestic segment was 64.8% in the December quarter. That was a bit higher than the prior quarter level. Both revenues and margins were benefited by strong market demand, as well as an acceleration of the majority of our planned January price increase into December. We also benefited in this segment by about 1.5 points in margin due to some year end employee benefit adjustments.

Looking at the international contract compression segment, it was another good quarter. Revenue was $33.5 million in the December quarter. That is up 8% on a sequential basis and up 20% compared to the prior year period. International contract compression gross margin was almost 77% in the December quarter. That was above guidance and above the prior quarter. The international segment benefited from some positive inventory adjustments that added 2 or 3 points to margin.

We do continue to face increased cost pressures in certain markets, primarily in Argentina with higher labor costs, and we expect international contract compression margins to be in the low to mid 70% range in the March 2005 quarter. That would be consistent with the margin we have been producing over the past couple of quarters.

Fabrication. In these operations, revenue was $60 million in the December quarter, that was somewhat above our guidance, and this revenue is more than double what we generated in the September quarter. It is also a 17% increase compared to the prior year period. Now if you remember, shipments were low during the September 2005 period due to the adjustment of our fabrication operations and our strategy that we had initiated in early 2005. If you look at the fabrication gross margin of 13% in the December quarter, those were somewhat higher than expected due to some improved efficiency rates and some beneficial cost production efforts. By comparison, we recorded fabrication margins of 12% in the September quarter.

In the after market services business segment, December quarter revenue was a bit better than expected at around $45 million. That is up 13% sequentially and up 16% compared to the prior year period. A good portion of our increased performance was related to the beginnings of rebuilding infrastructure in the Gulf Coast region. We are certainly hopeful that this type of work will continue to boost revenues in the segment. Margins remained in the 20% area.

SG&A expenses increased from $21 million in the September quarter to $23.8 million in the December quarter, due to expected increases and costs associated with our new ERP system, as well as business development activities. We will continue to see increases in SG&A during 2006 related to both of these efforts.

EBITDA as adjusted was a record $74.5 million in the December quarter. That is an increase of 13% on a sequential basis, and is 22% on a year-over-year basis. Interest expense was $14.7 million in the December quarter, compared to $13 million in the September 2005 quarter. The December quarter included about $1.6 million in transaction costs related to the refinancing of our ABS facility that we had completed back in October.

Now due to the borrowings associated with the stock buyback that we completed in the middle of December, as we look forward we expect that interest expense will continue in the $14.5 million to $15 million per quarter level in 2006.

Regarding income tax expense, we had a 37.3% effective rate in the December quarter. That is up from 35.2% in the September quarter, as we had some year end adjustments related to a greater portion of our income for the year coming from the domestic sector, which has a slightly higher effective tax rate than the international business. Now despite a higher tax rate during this quarter, we continue to expect our overall tax rate to be somewhere between 35.5% and 36% going forward.

We generated diluted EPS of $0.60 in the December quarter and that was at the high end of our guidance range. It is also up 11% from the September quarter and it is up 36% over the year earlier period. In analyzing the $0.60 per share figure, the benefits during the quarter from better gross margin in certain segments were generally equally offset by some of the negatives, such as the debt refinancing costs and the higher tax rate. So overall, we believe that the $0.60 is fairly reflective of ongoing operations.

Net capital expenditures were $34 million in the December quarter. That is down from $35 million in the September quarter. CapEx during the December quarter included about $17 million in growth CapEx, $11 million in maintenance overhauls and $9 million in other expenditures.

As expected, growth capital spending in the December quarter was weighted towards the domestic markets. It was about 60% domestic and 40% international. Capital spending included about $2.5 million for the repackaging of existing units.

Now as you all know, during December Wetherford International sold its remaining 6.75 million share ownership position in Universal. Now utilizing the flexibility from the September amendment of our senior secured credit agreement, we repurchased 2.4 million shares from this offering at a price of $41 per share. The sale of the shares by Wetherford removed a perceived overhang in the market for our stock, and we also believe that this additional float has contributed to greater average trading volume in Universal Compression shares in recent months. We also believe the repurchase of shares by the Company is a good investment. It allows us to better optimize our capital structure around the 15% debt to cap, and 3.5X debt to EBITDA level, and we expect the repurchase to be accretive to our EPS during 2006.

Debt to capitalization was 53% on December 31, and it is up compared to 47% a quarter ago, due mainly to the financing of the stock buyback in December. Total debt, which include capital lease obligations, was $923 million on December 31st. That compares to $819 million a quarter ago.

Now it is interesting to note that while debt to EBITDA increased from 3.2X at September 30th to 3.5X at December 31st, this ratio actually declined from the beginning of the fiscal year, despite doing a $100 million stock buyback.

Our working capital investment, which excludes cash and debt, was $120 million at December 31st. That is up somewhat from $104 million at September 30th, and that reflects higher business levels, really across the board. Cash position was $43 million at December 31st.

The revolver, which again extends into 2010, had $80 million drawn against it on December 31. We had approximately $90 million in unutilized credit availability at December 31.

As a result of all of the refinancing activities that have taken place over the past couple of years, we now have about 60% of our debt fixed. We have no debt facilities that mature before 2010, and we have a weighted average life of our debt of about six years. Our average cost of debt today is about 6.25%. Importantly, we expect to file our 10-K for the nine-month transition period some time next week.

Let me talk for a few minutes now about the guidance for the first quarter ending March 31, 2006 and for the full year 2006. Of course, as a reminder, since we changed our fiscal year from March to December, as I talk about first quarter guidance it will now relate to the calendar March quarter and the full year numbers will of course relate to the calendar 2006.

Revenue for the first quarter is expected to be $215 million to $225 million. Specifically, domestic contract compression revenue is expected to increase to approximately $91 million to $92 million in the quarter. That would give the domestic contract compression business a very healthy 18% to 24% year-over-year revenue growth rate. International contract compression revenues is expected to be relatively unchanged on a sequential basis, as we expect few new starts during the March quarter. Still, this would give the international contract compression business a 16% or 17% year-over-year growth rate.

Gross margins are expected to be around 64% for domestic, and in the low to mid 70% range for the international contract compression segment. Fabrication revenue is expected to be approximately $50 million to $55 million in the March quarter, with the gross margin in the 10% range. Fabrication revenues are expected to decline sequentially in the June quarter as we will be building aggressively for the contract compression fleet, and then we expect to see fabrication revenues increase nicely during the second half of 2006.

Our after market service revenue is expected to be in the $42 million to $45 million range during the first quarter, with a gross margin in the low 20% area. We expect that we will continue to see higher SG&A levels in the March quarter, due again primarily to costs associated with ERP implementation, business development activities, and of course the Company's adoption of 123-R under which non-cash expense related to the issuance of stock options is recorded in the income statement, beginning in calendar 2006.

We also expect to see a greater than average increase in depreciation expense during the quarter, as a result of beginning depreciation on the ERP system and continued new fleet additions and overhauls.

Finally, that brings us to diluted EPS for the quarter, which is expected to be $0.58 to $0.62. That includes $0.02 to $0.03 related to 123-R. This EPS guidance would represent an increase of 29% to 37% compared to the year ago adjusted EPS.

Let's now look at the guidance for the full year ending December 31, 2006. We expect net CapEx after sales of PP&E, primarily fleet units, we expect that net CapEx will be approximately $210 million to $240 million in 2006. This compares to a number of $139 million in calendar 2005. We expect gross capital expenditures of approximately $130 million and we expect that to be split about two-thirds domestic and one-third international.

Now despite this increased level of capital spending, we still expect to generate positive free cash flow during 2006. We expect total revenues to be between $910 million and $935 million. That would represent a 13% to 16% increase over calendar 2005 results, as all four of our segments are expected to post strong year-over-year increases in revenue.

Average contract compression utilization is expected to be 92% to 93% for calendar 2006. That is fairly consistent with our current levels.

With the current energy market conditions, we are looking forward to a strong 2006 with good margins and attractive pricing. We will continue to grow our Company through additional expansion of our international infrastructure, and continued investments in people and equipment. As we look at the full year, we expect that our SG&A will remain around 10.5% to 11% of revenues, and that includes about $5 million for the year of options-related expense.

We also expect to see an uptick in depreciation expense to something around $125 million to $130 million for the full year. Some of the key increases are going to come from, again, the depreciation of our new ERP system, some accelerated depreciation on some installation work that we have been completing in the international markets, and also continued expansion of our fleet and overhaul investments.

So for the full calendar year 2006, we expect earnings per diluted share of $2.65 to $2.80 and again, that includes an expense of about $0.10 for 123-R. Now this guidance would represent a 23% to 30% increase over calendar 2005 adjusted earnings per diluted share. This type of 20% plus growth rate is consistent with our performance over the past several years, and continues to be a key target for us in moving forward. Steve.

Thank you Michael. That concludes our prepared remarks. Operator, would you please open the call to questions?

Thank you. (Operator instructions) Our first question comes from Brad Handler - Wachovia Securities.

Thanks, good morning.

Good morning.

Good morning, Brad.

Maybe I could ask you to speak to the CapEx a little bit more, start there. So if it is $2.10 to $2.40, the $130 million for growth, can you just flesh out some of the other pieces of that then? How much is ERP-related, how much is other pieces?

You bet. Of the $2.10 to $2.40 we have $1.30 in terms of growth, we have something in the $40 million to $45 million in terms of overhauls. The rest is going to be things like expansion of our facility for fabrication. We have something in the order of another I think $7 million or $8 million in terms of the ERP and then you have the normal stuff with regard to trucks, expansion of some facilities out in the field, et cetera.

Okay. Maybe more generally, just trying to get a feel for how aggressive -- how difficult it may be to actually execute on what you are hoping to do in terms of spending that much money? I guess the growth CapEx is perhaps not quite as big a jump up as the $2.10 to $2.40 suggested. But it is still a lot, I suppose, if it involves getting that bay up and running quickly and all of that. Am I on target? Does that represent a challenge for you, to spend it fast enough? To grow fast enough?

Before Steve answers, let me say I forgot one other important item. We have got about $30 million that we are going to have in terms of quasi-growth capital, it is not included in that $130 million, but that is related to installation projects, primarily in the international arena.

Okay.

Brad, on the basic ability to spend that amount of CapEx. In a perverse kind of way, the long delivery of major components is helping us there, because our customers are committing earlier to delivery slots. So we are probably more confident in that CapEx number than most CapEx we have been able to put out, because our visibility is way out there through 2006.

Okay. I guess that makes sense. When do you expect that third bay to be finished, or is it finished?

It will be done next month, at the end of next month so it will be in the second quarter production schedule.

And can I ask you just to comment a little bit on, I guess we are moving on to another topic and then I will probably hop off. The margin adjustments in the quarter domestically, I just wasn't sure I heard that or understood it.

For the December quarter?

Yes.

We had a couple of positive adjustments that I wanted to highlight, because we don't necessarily think that those are going to be recurring as we go forward. In the domestic market, as we got to the year end we had some positive kind of reversals of some benefit costs. So those came out and boosted margins, about 1.5 points.

On the international side, we had some adjustments again on the positive side related to inventory accruals and things like that that probably added 2 or 3 points on the international side. So when you look at the business on a going-forward basis, you need to adjust for that and that is therefore consistent with the guidance that we provided going forward.

Okay, fair enough. All right guys, thanks. I will turn it back.

Thank you. Our next question comes from Mike Irving with Deutsche Bank.

Thanks, good morning.

Good morning.

Good morning.

On the acquisition in Africa, you said small. Roughly what kind of dollars are we talking about?

That was about a $10 million acquisition purchase price.

Would you, as you have done in the past, use that as a kind of a foothold to expand your business there? And along those lines, if that is the case, do you have specific opportunities in mind or in discussion with customers in that market for compression pricing?

Actually we do. There are some of our customers, our good customers that operate in that part of the world have been encouraging us to participate there. We kept that in mind during the time of the acquisition, so it just gives us that foothold and a local presence in a new market for us.

Roughly what kind of period of time would we expect to see some business start going up there?

Well you see, their business continues, the distribution business that they are in.

Sure, the new Universal-related business.

Yes, that will probably roll out over the year, and I wouldn't look for huge accelerations. We are basically doing some service work, that is what the market would be for us in that part of the world at first. It is going to show up in our International after-market work, and it won't be real big numbers, at least to begin with.

Is that based in Nigeria, is that where?

Yes.

Have you run into any issues with some of the disruptions that have gone on over there? Are you comfortable with the risks there?

Well we are. There are always risks when you branch out into more and more global locations. We're actually I think better balanced on our risk now, with the bigger profile around the world. It's a risky area, but the Company has been operating there for 10 years and has been able to survive fairly well in that tough environment. They are good partners.

Good. Then last question is on the fabrication side. A nice big jump in the backlog there. Do you have cost escalation clauses built into those contracts?

On most of them we have the price of the major components are known, and we have a pretty good handle on our other component pricing, so no. Those are bid, but the price make-up is anticipatory of what our cost will be at the time we fabricate it, so we put that in our pricing estimate to begin with.

So in other words, if you continue to see labor costs going up, you've anticipated that and that is reflected in the price?

We have.

Great, that is all for me. Thank you.

Thank you. Our next question comes from Jim Wickland with Banc of America Securities.

Good morning, guys.

Good morning.

Good morning, Jim.

Following up on Brad's question, your backlog, you are booked basically through the end of the year. Can you compare that margin to what the market has been? I know we can run it out through our earnings. I am just wondering how strong, if everybody is ordering in advance, how much price improvement can you or are you going to see in that backlog?

On the fabrication side?

Yes.

We have seen some price improvement throughout, and we have seen a price improvement from when we took our time out a year ago now and rethought the business. Having said that, it is still a business that pretty well keeps itself in the 10% to 15% range for margin. As the year progresses, we get closer and closer to the higher end of that as we have more business that we book out towards the end of it.

Right now, it's whoever has the components and can have a delivery slot and secure the order, and that has allowed us to move those margins up somewhat. But there is a trading point there when other competitors can come in. They can elect to wait a little longer and take a lower margin.

Okay. In terms of business concentration, if I look at the Rockies, the Barnett Shale and the other shale plays, and then everything else, can you just give us some ballpark numbers of where your U.S. market is concentrated.

Well we were just talking about that this morning, in the U.S. market. Where a year ago I would have answered that question with the bulk of our new horsepower is going to Barnett Shale and the Rocky Mountains, I guess it is balanced out more now than it has been for several years. I think we are seeing growth across the board, everywhere from the Rocky Mountains across to the Appalachians. Growth in Texas, Louisiana, Oklahoma, in the shale plays, in the coal bed methane plays. There is plenty of activity. It really is almost evenly dispersed.

Which I would think you consider a positive thing in normalizing out and not putting too many eggs in one basket?

Yes, and for a company our size that is operating in all of those markets, it gives us nice balance. We don't have labor issues in any one market that are overwhelming, and we can kind of deal with the growth that is more spread out.

Clearly a positive. Last question. On your CapEx, your growth CapEx, how soon after you spend the dollars in the U.S. do you start to see cash flow? And compare that to international, how soon after you spend money do you start to see the cash flow.

Well in the U.S., when we build the unit we get the components in probably a month before the unit is completed. Give it a month to go to the field and be installed, so probably 90 days from when you spend the money to when you start seeing some cash flow on the domestic side; sometimes a little longer than that, but on average maybe 90-120 days.

On international, most of those projects have a life that takes them out a year or so from the time the order is placed. Embedded in that we have to build the equipment, then we have to ship it there, build a compressor station and install it. So it has got a longer tail. It is probably six months from the time the equipment investment is made, to when it starts generating revenue. Of course the installation, we have some costs for that that occur along the way. It is quite often paid for, or at least a significant amount of it is paid for at the time we start the package.

Gentlemen, very helpful. The detail is very helpful. Best of luck. Thank you.

Your next question is from Thiru Ramakrishnan; Simmons.

Good morning, gentlemen.

Good morning.

Good morning.

Looking at your 2006 guidance, what pricing assumptions are you assuming on the domestic contract rental side?

Well what we have done is we have taken that December/January price increase that just went into effect and we have told our customers they should expect a mid-year price increase, and we have not really given them a range for that increase. But we told them they should expect another domestic increase somewhere around mid-year.

What about one at the end of the year?

Well if it does, it won't affect this year very much and we will be thinking about that after we see how the mid-year one goes. That is a long way from now to the end of the year.

Okay, on the expected downtick on the international gross margins. How much of that can be -- can you quantify how much of that can be attributed to the labor issues in Argentina?

It is a really minimal amount. We may be able to recover almost all of our costs after a time delay, but when you recover 100% of your costs your margins, over time, erode a little bit just due to the math.

So the Argentine labor issue is temporary?

I wouldn't say it is temporary, I think it is probably permanent for the foreseeable future, but every time we have a labor increase issue there and go back to our customers, they reimburse us for the increase in that labor cost.

Switching gears here on the fabrication side. What percentage of your space is committed to third-party work versus your own book, your own work?

On a space basis, it is probably 60-40, I would guess, to sold units versus our own book of business.

And kind of a general question. Given the lead times you are seeing for new compression units, your backlog, the fact that your space is essentially fully utilized; the fact that your rental fleet is almost fully utilized, can we expect gross margins in this business to exit the year north of 15%?

Gross margins in the fabrication business?

Yes sir.

I don't think you will see them exit north of 15%, but you will get them closer to 15% as the year progresses.

Great, thanks. That is all I had.

Thank you. Our next question comes from Marty Malloy with Hibernia Southcoast.

Good morning.

Good morning.

Good morning.

On the mid-year price increase that potentially could happen, is that in your guidance for the year?

Yes.

And then in terms of the horsepower that you are adding to the domestic market, I assume that this is the higher end horsepower that is more in demand. How should we think about where your gross profit margins can go to on the domestic contract compression front?

Well you are right, it is large horsepower that we are adding into the U.S. fleet as well as international, as we have been for the last three or four years now. Gross margins have been hitting around that 64% mark. As we have increased prices our costs have come up a bit. But we think we are going to stay at that 64%, 65%, 66% range. 65% is where we designed the business to operate. We would like to get it higher, but we will have to see what happens in costs.

On the other side, the gross profit dollars have come up significantly.

Thank you.

We have a follow-up question from Brad Handler.

Thanks. I guess I was curious about your entry into the gas treatment business. Maybe you could talk to us about that a little bit, and opportunities that you might already be looking at on that side of it. What it takes to do that part of it well, relative to where you are today. What investments you might need to make.

Well that represents a return for our Company to a business we were in 20 years ago, doing some gas processing. It is not rocket science to process gas, and it is quite often in conjunction with gas compression packages.

We saw an opportunity, jumped in, were successful and are pleased with the results we have seen on that project. We did it as kind of a test case to see if we were comfortable with it, and if the numbers all work. And they do. So we are now interested in pursuing more of those opportunities and have begun to talk to various international customers about going down that path with them in this fiscal year and next fiscal year, depending when the projects come up. So it is of interest to us, no doubt. Like I said, it is something that we have done in the past many years ago and we are just resurrecting those skills.

I was under the impression that you might have been bidding for that type of work, be partnering with someone to do the gas treatment side. I guess that is right over the last 10 -- sounds like even longer -- years. Is it just simply a question that you can perhaps gain a little bit more margin, or a little bit more profitability dollars by doing it yourself?

Well we hadn't really -- I guess on one or two occasions we co-bid a job with a processing company, and I don't think there is room in there for two companies to work together on these projects.

So we took it under one prime responsibility and acquired the processing plant and ran out our own numbers and just decided we would supply it all. And that's what we would do again. We would identify the process as to what processing equipment purchases, put it with the compression, bundle it together and use our in-country expertise to bid the job.

If I have this right, and please correct me if I don't -- often your main competitor has sort of touted that as a competitive advantage, at least in securing some jobs in some other parts of the world where you haven't been -- maybe in Africa, Middle East, for example. Do you see that that way? Do you see some of the initial opportunities in those countries? Is it a means for you to enter into those regions more aggressively?

It certainly broadens our product offering as we expand globally, and one could draw the conclusion that as we get into new markets that we will be talking about this service as well. I think immediately the opportunities are in our existing markets where we have great customer relations and we can offer them a little broader venue of services. Almost everybody around the world is going to use some form of gas processing.

Okay.

Does that answer your question?

Yes, I need to chew on that. Thanks, that is fine.

Our next question comes from Eric Kalamaras with Wachovia Securities.

Good morning.

Good morning.

Good morning.

A question regarding the E&P CapEx budgets. I am looking at those and wondering how much inflation is there that Universal can realistically push through in '06 and potentially into early '07?

I am sorry, that was on the CapEx budget?

No, it is really inflation. I am looking at the E&P CapEx budgets and they are up significantly. I was wondering how much cost increases can be pushed through? That you can push through into '06 and into '07?

Well we have been accelerating our aggressiveness on price increases on our contract compression fleet over the last year-and-a-half or two years or so, and the December/January increase was the stoutest increase we have put through. Right at the moment, our customers are growing their production quickly and compressors are in short supply, so we do have opportunities for bigger price increases. We are going to monitor that as we go, though.

Our ability to lever those prices is relatively small compared to some of the other service companies in the industry, however, unlike drillers and some others that can force through some huge rate increases. These are normally long-term customers. Compressors go out and stay out for a long period of time, and we do want to be a little cautious in the market as to how aggressive we are in pricing.

If the cycle were to last into, let's say '08, do you think we are in the middle stages of rate increases?

Yes, definitely and it is also going to depend on our cost increases, of course. But if this cycle continues then deliveries will continue to be long, prices will go up because compressors will be in scarce supply and everybody will be highly utilized.

Okay, thanks.

Our next question comes from Joe Agular with Johnson Rice.

Thank you. Steve, I wanted to ask a question, a general question, but going back a few years there was, as you remember, a lot of questions from some analysts out there who were wondering whether or not this model was actually a high return on investment model. I think the last years have shown obviously that you guys have had -- it is a good business model, and your CapEx was rather disciplined and now you are getting into a little bit more of a growth phase.

But I was wondering if you could give us an update as to where you all think your returns on new investments are today versus where they were a year ago or so? At today's pricing level, if you will.

I will help you with that. Joe, you are right. Three or four years ago the knock on the industry was really one of somewhat meager returns and continued borrowing to fund the growth of the business. I think we have killed that over the last three or four years with some significant cash flows and debt reduction, and more discipline in our CapEx.

Now what we did, we have talked about it in some prior calls, is we put in some floors for capital investment of an IRR criteria for international and domestic of 15% for international, unlevered after tax IRR and 17% for international, and then we risk-weight those and raise them for certain markets and certain opportunities.

Now the problem with telling you where we are and what we can get in today's market is that typically those are the ways that we in the industry price our projects and if I tell you our IRR threshold that we are using today, I would be disclosing a little bit too much about the competitive side. But we are able to get above our floor rate in both international and domestic, very comfortably right at this point in time, if that helps you any.

Well it does. Maybe -- how long have you been that way, I guess? I mean it has been a while, hasn't it?

We have been above the floor for a couple of years now, and increasingly moving that up as compression gets in shorter and shorter supply. It is another way of answering the other gentleman's question about pricing. There are multiple ways to increase pricing, and one is to announce a price increase on what's out there, and one is to just keep raising prices every time someone calls and asks you a question about additional compression.

And the second one is pretty easy. We can just keep raising prices while we have scarce commodity.

Right, it just seems like there is sort of a calculation or an analysis that you have to go through in deciding whether it is -- I guess from a return standpoint, you are achieving significant returns right now. Pricing obviously helps that. I don't want to say, you don't want to invite too much competition, but there has got to be some sort of an analysis there between what is the right mix, or how much to push for, I guess.

Yes, there is and we are always mindful that the customers always have the opportunity to go out and purchase their own equipment and operate for themselves, that is why we are testing the pricing model and see where the pressure points are.

That is what I meant. They always have the option of buying it themselves and working it themselves. Well congratulations. Thank you all very much.

Thank you. You have a follow up question from Karen Green.

Yes, good morning, gentlemen. I just had a question with regard to the contract terms now versus, let's say a year, year-and-a-half ago. Are you still offering the option for the customers to buy out their equipment?

Almost never. We have eliminated purchase options from our domestic pricing with very few exceptions about a year ago, and international sometimes by the bid spec you have to give them an option at the end, but they rarely exercise it, notwithstanding the fact they are going to exercise one this year. But we are eliminating that wherever we can. Absolutely in the domestic business.

Did I hear you correctly, that about 25,000 horsepower is going to be coming out of 2Q?

We just said later in '06. And that is international.

And going back to the gas treatment facility, could you just give us an idea in terms of what kind of revenue and margin contribution that facility had?

Well it is really bundled in with a compressor package, so if we look at those same criteria that we set for returns, the 17% IRR for international, and we look at each project as a bundle of installation, compression and ancillary equipment, and that just goes in the ancillary equipment. So we would be 17% unlevered IRR or north of that as we risk weight it for where locations are and the market is and the risk that we see.

And can you just refresh my memory on the timing of the entrance with regard to the 200,000 horsepower that you are adding this year, how much is international and domestic?

That is going to be about, I think 60% domestic, 40% international roughly. Maybe two-thirds/one-third, something like that.

And the timing with regard to when that is going to be coming into the market?

That is going to be spread out. It is a fairly steady flow. There are some holes in the schedule here and there, but it is pretty steady over the year as we are able to produce it in the facility and get the components in.

Great, thanks a lot. That is all I have.

You have a follow-up question from Thiru Ramakrishnan; Simmons.

On the domestic side, what percentage of -- domestic rental side -- what percentage of your rental fleet is on alliance/longer-term versus spot market?

There is probably about one-third, 25% to one-third that is on alliance contract, and then the rest is either in or out of its primary term, depending on how long it has been out.

So it ends up being about half of the contracts are outside of the initial term. We know that in part because that is the part of the business that got affected by the January price increase, the December/January price increase.

Right, so that other half, on average, when does that start to -- when do those contracts expire and when can we expect to get pricing on that other half?

Well on the alliance partners, they have annual price adjustments built into the contracts. They are usually based on indexes. And those just occur throughout the year, depending on who the customer is, so those are continual but they are more modest price increases, they more cover cost changes and small improvements there.

On the remainder of it, when they come out of their primary term, we track that, they come out of primary term and we then make an evaluation as to where they are versus market and determine whether we go back to them individually, we aggregate them and wait for a large price increase, or exactly what we should do about them. But those are continually monitored by our fleet management team.

Lastly, Steve, I just heard you say that the customer always has the option to go out and buy it or build it, in terms of looking at it from returns. But do they really? Given that space is full, that lead times are going to be over a year to get a new unit, that you are probably not going to sell a unit from your existing fleet anymore. I am just trying to understand the dynamics.

In the year that we face, in the next 12-15 months, you are absolutely right. But I don't want to force customers to begin to rethink the model and feel that they should control their own assets for the long period, not just the short. I don't want to, in short, get into the situation as I referenced the drillers are in, where prices go way up when business is good and come way down and utilization falls when it is bad. I think I would be on the production side of this business, we have long-term relationships with these customers and we want to share the wealth and keep within a model that works for both of us.

Thanks.

Our next question comes from Bob Christiansen with Buckingham Resource Group.

It is Bob Christiansen with Buckingham Resource. Sorry, I am out of pocket here on a cell phone. A question about the Fayetteville Shale in Arkansas -- it happens to be where I am at right now at a conference on this. Have you guys pursued the customers here aggressively? And if so, why not? This could be the second coming of the Barnett Shale and we think that would stack up very well for your future.

Yes, as that play develops they will require compression. We've talked to all of the customers over there. We have been in every shale and coal bed play in the U.S. and we will be in the Fayetteville Shale also. To this point, there are the beginnings of horsepower and the beginnings of production. It has all of the earmarks of being a tremendous play and we will do our best to be in the middle of it.

When will we know if you are in the middle of it? When I look at the potential for thousands of wells, I just wonder, when will we hear more?

Well what has to happen here is the potential for thousands of wells has actually got to become hundreds of wells, and then when they are in and gas is ready to be produced, we will be in there bidding with the rest of the providers. It is not an area that we are ignoring. Several of our good customers are there. Most of the competitors are there as well, but until it is drilled and producing it is hard to project what kind of business levels we are going to see from there. If it is like the Barnett Shale, it will take thousands of horsepower.

Okay. Well I expect hundreds of wells this year from one company, and then next year multiple hundreds of wells. So I am just --

If you are talking about Southeastern Energy, yes. They will be the biggest holder there and will drill lots of wells. We have put out some compressors for Southwestern and our competitors have put out some compressors there. There will be enough business for everybody.

Is that one play on the margin sufficient to keep the compression business tight for the foreseeable future? If it is the second coming of the Barnett, I would think that it would be, by itself on the margin, capable of keeping the U.S. compression tight for an extended period.

Well it will help, but let's not make the assumption that the Barnett Shale has kept the compressor industry tight. There has been a lot of Rocky Mountain activity, a lot of coal bed activity, a lot of South Texas activity, Appalachian activity that is all tied in to keeping the market tight. It will certainly be incremental and will help.

Okay, well thank you.

At this time I show no further questions. I will turn the conference back over to Mr. Steve Snider, for any closing comments.

Well as I see, we have taken a full hour this morning, so thanks for all of the good questions. It has been a good quarter. Here's to another good quarter coming up soon and we will talk to you in 90 days or so.

That concludes today's teleconference. Have a great day. You may disconnect.