UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the transition period from             to             

Commission File Numbers:  001-15843
	333-48279

 

UNIVERSAL COMPRESSION HOLDINGS, INC.

UNIVERSAL COMPRESSION, INC.

(Exact name of registrants as specified in their charters)

(713) 335-7000

(Registrants’ telephone number, including area code)

Indicate by check mark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrants are large accelerated filers, accelerated filers, or non-accelerated filers (as defined in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer x                                Accelerated Filer o          Non-Accelerated Filer o  (Universal Compression Holdings, Inc.)

        Large Accelerated Filer o                                 Accelerated Filer o    Non-Accelerated Filer x  (Universal Compression, Inc.)

Indicate by check mark whether the registrants are a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o Nox

UNIVERSAL COMPRESSION, INC. MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM 10-Q WITH THE REDUCED DISCLOSURE FORMAT.

As of August 2, 2007 there were 30,440,190 shares of Universal Compression Holdings, Inc.’s common stock, $0.01 par value, outstanding and 4,910 shares of Universal Compression, Inc.’s common stock, $10.00 par value, outstanding.

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

UNIVERSAL COMPRESSION HOLDINGS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands)

(unaudited)

		June 30, 2007			December 31, 2006
ASSETS
Current assets:
Cash and cash equivalents		$	45,745		$	46,997
Restricted cash		3,745			4,301
Accounts receivable, net of allowance for bad debts of $5,072 and $4,686 as of June 30, 2007 and December 31, 2006, respectively		207,307			193,968
Inventories, net of reserve for obsolescence of $10,484 and $9,158 as of June 30, 2007 and December 31, 2006, respectively		208,744			175,812
Deferred income taxes		6,500			7,310
Other		33,980			21,800
Total current assets		506,021			450,188
Contract compression equipment		1,812,745			1,715,266
Other property		218,275			199,835
Accumulated depreciation and amortization		(527,588		)	(468,591		)
Net property, plant and equipment		1,503,432			1,446,510
Goodwill		435,882			412,122
Derivative financial instruments		9,713			7,269
Other assets		25,136			25,942
Total assets		$	2,480,184		$	2,342,031
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable, trade		$	105,008		$	92,063
Accrued liabilities		63,425			61,315
Unearned revenue		92,801			93,332
Accrued interest		4,511			3,583
Current portion of long-term debt and capital lease obligations		14,986			14,916
Total current liabilities		280,731			265,209
Long-term debt		858,011			815,638
Deferred income taxes		215,215			205,133
Derivative financial instruments		3,933			5,528
Other liabilities		14,910			12,013
Total liabilities		1,372,800			1,303,521
Commitments and contingencies (Note 9)
Minority interest		121,309			122,080
Stockholders’ equity:
Preferred stock		—			—
Common stock		333			331
Treasury stock		(137,914		)	(136,844		)
Additional paid-in capital		800,068			786,663
Accumulated other comprehensive income (loss)		7,102			(11,764		)
Retained earnings		316,486			278,044
Total stockholders’ equity		986,075			916,430
Total liabilities and stockholders’ equity		$	2,480,184		$	2,342,031

 

See accompanying notes to unaudited consolidated financial statements.

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UNIVERSAL COMPRESSION HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(unaudited)

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Revenue:
Domestic contract compression		$	103,596		$	101,460		$	205,630		$	195,505
International contract compression		40,014			35,010			78,548			68,303
Fabrication		134,988			38,528			189,604			94,837
Aftermarket services		55,989			43,718			100,168			89,139
Total revenue		334,587			218,716			573,950			447,784
Costs and expenses:
Cost of sales (excluding depreciation and amortization expense):
Domestic contract compression		40,543			35,792			81,599			68,706
International contract compression		10,637			8,430			20,952			16,827
Fabrication		112,602			33,797			159,839			83,902
Aftermarket services		41,262			36,359			75,698			72,166
Depreciation and amortization		35,792			30,013			70,655			59,812
Selling, general and administrative		36,802			29,461			72,543			56,042
Interest expense, net		14,063			14,605			28,102			28,662
Merger-related expenses		4,792			—			6,165			—
Foreign currency (gain) loss		(962		)	299			(1,655		)	(310		)
Minority interest		1,642			—			2,966			—
Other (income) expense, net		(518		)	(360		)	(2,249		)	(1,093		)
Total costs and expenses		296,655			188,396			514,615			384,714
Income before income taxes		37,932			30,320			59,335			63,070
Income tax expense		12,765			8,504			19,844			20,379
Net income		$	25,167		$	21,816		$	39,491		$	42,691
Weighted average common and common equivalent shares outstanding:
Basic		30,003			29,891			29,911			29,762
Diluted		31,182			31,040			31,072			30,874
Earnings per share–Basic		$	0.84		$	0.73		$	1.32		$	1.43
Earnings per share–Diluted		$	0.81		$	0.70		$	1.27		$	1.38

 

See accompanying notes to unaudited consolidated financial statements.

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UNIVERSAL COMPRESSION HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

		Six Months Ended June 30,
		2007			2006
Cash flows from operating activities:
Net income		$	39,491		$	42,691
Adjustments to reconcile net income to cash provided by operating activities, net of effect of acquisitions:
Depreciation and amortization		70,655			59,812
Minority interest		2,966			—
Gain on asset sales		(1,340		)	(346		)
Deferred income taxes		7,913			15,507
Amortization of debt issuance costs		1,185			937
Stock-based compensation expense		4,954			3,593
(Increase) decrease in other assets		6,912			(5,028		)
(Increase) decrease in receivables		(3,983		)	(46,519		)
(Increase) decrease in inventories		(31,183		)	(20,836		)
Increase (decrease) in accounts payable		4,017			22,079
Increase (decrease) in accrued liabilities		333			(1,571		)
Increase (decrease) in unearned revenue		(2,775		)	28,975
Increase (decrease) in accrued interest		932			77
Net cash provided by operating activities		100,077			99,371
Cash flows from investing activities:
Additions to property, plant and equipment		(131,579		)	(98,134		)
Proceeds from sale of property, plant and equipment		7,504			5,755
Cash paid for acquisitions, net of cash acquired		(23,320		)	(6,285		)
Decrease in restricted cash,		556			192
Net cash used in investing activities		(146,839		)	(98,472		)
Cash flows from financing activities:
Principal repayments of long-term debt		(56,006		)	(62,899		)
Borrowings under revolving credit facility		98,380			39,994
Proceeds from common stock issuance		5,545			8,685
Purchase of treasury stock		(1,070		)	(517		)
Payments on capital lease agreements		(171		)	(46		)
Distributions to non-controlling partners in the Partnership		(3,972		)	—
Net cash provided by (used in) financing activities		42,706			(14,783		)
Effect of exchange rate changes on cash and cash equivalents		2,804			(732		)
Net decrease in cash and cash equivalents		(1,252		)	(14,616		)
Cash and cash equivalents at beginning of period		46,997			39,262
Cash and cash equivalents at end of period		$	45,745		$	24,646

See accompanying notes to unaudited consolidated financial statements.

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UNIVERSAL COMPRESSION, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands)

(unaudited)

		June 30, 2007			December 31, 2006
ASSETS
Current assets:
Cash and cash equivalents		$	45,577		$	46,099
Restricted cash		3,745			4,301
Accounts receivable, net of allowance for bad debts of $5,072 and $4,686 as of June 30, 2007 and December 31, 2006, respectively		207,307			193,968
Inventories, net of reserve for obsolescence of $10,484 and $9,158 as of June 30, 2007 and December 31, 2006, respectively		208,744			175,812
Deferred income taxes		6,500			7,310
Other		33,980			21,800
Total current assets		505,853			449,290
Contract compression equipment		1,812,745			1,715,266
Other property		218,275			199,835
Accumulated depreciation and amortization		(527,588		)	(468,591		)
Net property, plant and equipment		1,503,432			1,446,510
Goodwill		435,882			412,122
Notes receivable - affiliate		68,480			78,063
Derivative financial instruments		9,713			7,269
Other assets		25,136			25,942
Total assets		$	2,548,496		$	2,419,196
LIABILITIES AND STOCKHOLDER’S EQUITY
Current liabilities:
Accounts payable, trade		$	105,008		$	92,063
Accrued liabilities		63,425			61,315
Unearned revenue		92,801			93,332
Accrued interest		4,409			3,472
Current portion of long-term debt and capital lease obligations		14,986			14,916
Total current liabilities		280,629			265,098
Long–term debt		821,011			778,638
Deferred income taxes		218,097			207,254
Derivative financial instruments		3,933			5,528
Other liabilities		14,910			12,013
Total liabilities		1,338,580			1,268,531
Commitments and contingencies (Note 9)
Minority interest		121,309			122,080
Stockholder’s equity:
Common stock		49			49
Additional paid-in capital		750,955			750,838
Accumulated other comprehensive income (loss)		7,102			(11,764		)
Retained earnings		330,501			289,462
Total stockholder’s equity		1,088,607			1,028,585
Total liabilities and stockholder’s equity		$	2,548,496		$	2,419,196

 

See accompanying notes to unaudited consolidated financial statements.

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UNIVERSAL COMPRESSION, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands)

(unaudited)

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Revenue:
Domestic contract compression		$	103,596		$	101,460		$	205,630		$	195,505
International contract compression		40,014			35,010			78,548			68,303
Fabrication		134,988			38,528			189,604			94,837
Aftermarket services		55,989			43,718			100,168			89,139
Total revenue		334,587			218,716			573,950			447,784
Costs and expenses:
Cost of sales (excluding depreciation and amortization expense):
Domestic contract compression		40,543			35,792			81,599			68,706
International contract compression		10,637			8,430			20,952			16,827
Fabrication		112,602			33,797			159,839			83,902
Aftermarket services		41,262			36,359			75,698			72,166
Depreciation and amortization		35,792			30,013			70,655			59,812
Selling, general and administrative		36,802			29,461			72,543			56,042
Interest expense, net		13,470			14,605			26,920			28,662
Interest income from affiliate		(1,031		)	(1,543		)	(2,177		)	(2,990		)
Merger-related expenses		4,792			—			6,165			—
Foreign currency (gain) loss		(962		)	299			(1,655		)	(310		)
Minority interest		1,642			—			2,966			—
Other (income) expense, net		(518		)	(360		)	(2,249		)	(1,093		)
Total costs and expenses		295,031			186,853			511,256			381,724
Income before income taxes		39,556			31,863			62,694			66,060
Income tax expense		13,126			9,044			20,606			21,444
Net income		$	26,430		$	22,819		$	42,088		$	44,616

 

See accompanying notes to unaudited consolidated financial statements.

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UNIVERSAL COMPRESSION, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

		Six Months Ended June 30,
		2007			2006
Cash flows from operating activities:
Net income		$	42,088		$	44,616
Adjustments to reconcile net income to cash provided by operating activities, net of effect of acquisitions:
Depreciation and amortization		70,655			59,812
Minority interest		2,966			—
Gain on asset sales		(1,340		)	(346		)
Deferred income taxes		8,675			16,572
Amortization of debt issuance costs		1,185			937
Stock-based compensation expense		4,954			3,593
(Increase) decrease in other assets		6,912			(5,028		)
(Increase) decrease in receivables		(3,983		)	(46,519		)
(Increase) decrease in inventories		(31,183		)	(20,836		)
Increase (decrease) in accounts payable		4,017			22,079
Increase (decrease) in accrued liabilities		333			(1,571		)
Increase (decrease) in unearned revenue		(2,775		)	28,975
Increase (decrease) in accrued interest		932			77
Net cash provided by operating activities		103,436			102,361
Cash flows from investing activities:
Additions to property, plant and equipment		(131,579		)	(98,134		)
Proceeds from sale of property, plant and equipment		7,504			5,755
Cash paid for acquisitions, net of cash acquired		(23,320		)	(6,285		)
Payment from affiliate on note receivable		1,846			5,178
Decrease in restricted cash		556			192
Net cash used in investing activities		(144,993		)	(93,294		)
Cash flows from financing activities:
Principal repayments of long-term debt		(56,006		)	(62,899		)
Borrowings under revolving credit facility		98,380			39,994
Payments on capital lease agreements		(171		)	(46		)
Distributions to non-controlling partners in the Partnership		(3,972		)	—
Net cash provided by (used in) financing activities		38,231			(22,951		)
Effect of exchange rate changes on cash and cash equivalents		2,804			(732		)
Net decrease in cash and cash equivalents		(522		)	(14,616		)
Cash and cash equivalents at beginning of period		46,099			39,262
Cash and cash equivalents at end of period		$	45,577		$	24,646

 

See accompanying notes to unaudited consolidated financial statements.

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UNIVERSAL COMPRESSION HOLDINGS, INC.

UNIVERSAL COMPRESSION, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2007

1.     Basis of Presentation

These notes apply to the unaudited consolidated financial statements of both Universal Compression Holdings, Inc. (“Holdings”) and Universal Compression, Inc. (“Universal”) and their subsidiaries. The term “Company” will be used if a statement is applicable to both Holdings and Universal.  These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements presented in the Company’s Annual Report on Form 10-K for the twelve months ended December 31, 2006. That report contains a more comprehensive summary of the Company’s major accounting policies. In the opinion of management, the accompanying unaudited consolidated financial statements contain all appropriate adjustments, all of which are normally recurring adjustments unless otherwise noted, considered necessary to present fairly the financial position of the Company and its consolidated subsidiaries and the results of operations and cash flows for the respective periods. Operating results for the three-month and six-month periods ended June 30, 2007 are not necessarily indicative of the results that may be expected for the twelve months ending December 31, 2007.

Earnings per Share

Net income per share, basic and diluted, is calculated for Holdings in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share.”

The only potentially dilutive securities issued by Holdings are stock options and unvested restricted stock grants, neither of which would impact the calculation of net income for dilutive earnings per share purposes.

The dilutive effect of stock options and unvested restricted stock grants outstanding for the three months and six months ended June 30, 2007 was 1,179,000 shares and 1,161,000 shares, respectively.  The dilutive effect of stock options and unvested restricted stock grants outstanding for the three months and six months ended June 30, 2006 was 1,149,000 shares and 1,112,000 shares, respectively.  For the three months and six months ended June 30, 2007, outstanding stock options of 106,054 and 107,584 shares, respectively, were excluded from the computation of diluted earnings per share as the options’ exercise price was greater than the average market price of the common stock for such periods.  For the three months and six months ended  June 30, 2006, outstanding stock options of zero and 16,000 shares, respectively, were excluded from the computation of diluted earnings per share as the options’ exercise price was greater than the average market price of the common stock for such periods.

Goodwill

               Goodwill and intangible assets acquired in connection with business combinations represent the excess of consideration over the fair value of tangible net assets acquired.  Certain assumptions and estimates are employed in determining the fair value of assets acquired and liabilities assumed, as well as in determining the allocation of goodwill to the appropriate reporting unit.

                The Company performs an impairment test for goodwill assets annually, or more often, if indicators of potential impairment exist. The Company’s goodwill impairment test involves a comparison of the fair value of each of its reporting units with their carrying value. The fair value is determined using discounted cash flows and other market-related valuation models. Certain estimates and judgments are required in the application of the fair value models. As of February 2007, the Company performed its annual impairment analysis in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” and determined that no impairment had occurred.  If for any reason the fair value of the Company’s goodwill or that of any of its reporting units declines below the carrying value in the future, the Company may incur charges for the impairment.

Stock-Based Compensation

Effective January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” which requires that compensation cost relating to share-based payment transactions be recognized in the financial statements.  That cost will be measured based on the fair value of the equity or liability instruments issued.

2.  Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.”  FIN 48 was issued to clarify the accounting for

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uncertainty in income taxes recognized in an entity’s financial statements by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The Company adopted the provisions of FIN 48 on January 1, 2007. See Note 10 for the impact that the adoption of FIN 48 had on the Company’s financial statements.

In June 2006, the FASB’s Emerging Issues Task Force (“EITF”) reached a consensus on Issue 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation),” that concludes that the presentation of taxes within EITF 06-3’s scope is an accounting policy decision that should be disclosed. If the taxes are reported on a gross basis, companies are required to disclose the amounts of those taxes if such amounts are deemed significant. This pronouncement is effective for interim and annual reporting periods beginning after December 15, 2006.  The Company presents the taxes within the scope of EITF 06-3 on a net basis.  The adoption of EITF 06-3 did not impact the Company’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact that the adoption of SFAS No. 157 will have on its consolidated financial statements.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. The adoption of SAB 108 did not have a material impact on the Company’s consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value.  SFAS No. 159 will be effective for the Company on January 1, 2008.  The Company is currently evaluating the impact that the adoption of SFAS No. 159 will have on its consolidated financial statements.

3.  Inventories, Net

Inventories, net consisted of the following (in thousands):

		June 30, 2007			December 31, 2006
Raw materials		$	113,671		$	83,688
Work-in-progress		103,005			100,866
Finished goods.		2,552			416
Total inventories		219,228			184,970
Reserve for obsolescence.		(10,484		)	(9,158		)
Inventories, net		$	208,744		$	175,812

 

4.  Long-Term Debt

    As of June 30, 2007, the Company had approximately $872.6 million in outstanding debt, consisting of $179.4 million outstanding under the asset-backed securitization facility (“ABS facility”), $401.1 million outstanding under the $500 million revolving credit facility, $171.1 million outstanding under the 7 1/4 % senior notes and $121.0 million outstanding under Universal Compression Partners, L.P.’s (the “Partnership”) revolving credit facility (See Note 13).  Covenants in the credit facilities require that the Company maintain various financial ratios.  As of June 30, 2007, the Company was in compliance with all financial covenants.

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5.  Stock-Based Compensation

The following table presents the stock-based compensation expense included in the Company’s results of operations (in thousands):

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Stock options, unit options and phantom options		$	1,001		$	1,133		$	2,328		$	2,246
Restricted stock		830			628			1,507			1,097
Unit appreciation rights		680			—			906			—
Employee Stock Purchase Plan		100			150			213			250
Total stock-based compensation expense		2,611			1,911			4,954			3,593
Income tax benefit		(875		)	(624		)	(1,653		)	(1,138		)
Total after-tax stock-based compensation expense		$	1,736		$	1,287		$	3,301		$	2,455

 

There was no stock-based compensation cost capitalized during the three months and six months ended June 30, 2007 and 2006.

Stock Options

The Incentive Stock Option Plan (the “ISO Plan”) authorizes the Company to grant stock options to its employees, consultants and directors.  The Company utilizes stock options under the ISO Plan in order to motivate and retain key employees.  In July 2004, an amendment to the ISO Plan was approved, increasing the number of shares of common stock available for grant under the ISO Plan from 5,012,421 shares to 6,012,421 shares to allow the continuation of this long-term incentive program.  Options generally vest over the following time period:

Year 1		331¤3	%
Year 2		331¤3	%
Year 3		331¤3	%

 

Under the ISO Plan, options to purchase common stock may be granted until 2011. Options are granted at fair market value at the date of grant, are exercisable in installments beginning one year from the date of grant, and expire ten years after the date of grant.

The weighted average fair values at date of grant for options granted during the six months ended June 30, 2007 and 2006 were $31.09 and $18.22, respectively and were estimated using the Black-Scholes option valuation model with the following weighted average assumptions:

		Six Months Ended June 30,
		2007		2006
Expected life in years		6.0		6.0
Risk-free interest rate		5.16	%	4.72	%
Volatility		33.39	%	33.15	%
Dividend yield		0.00	%	0.00	%

 

The expected life represents the period of time the stock options are expected to be outstanding prior to exercise and is based on the simplified model.  The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant for a period commensurate with the estimated expected life of the stock options.  Expected volatility is based on the historical volatility of the Company’s stock over the most recent period commensurate with the expected life of the stock options and other factors.  The Company has not historically paid a dividend and does not expect to pay a dividend during the expected life of the stock options.  Under SFAS No. 123R, the Company is required to record compensation cost from stock-based compensation utilizing an estimated forfeiture rate.  Historical data related to forfeitures experienced by the Company was used to estimate forfeiture rates.

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The following table presents stock option activity for the six months ended June 30, 2007 (remaining life in years, intrinsic value in thousands):

		Stock Options		Weighted Average Exercise Price			Weighted Average Remaining Life		Aggregate Intrinsic Value
Options outstanding, December 31, 2006		1,894,286		$	29.85
Granted		117,584		73.34
Exercised		(205,005	)	25.49
Cancelled		(8,904	)	34.36
Options outstanding, June 30, 2007		1,797,961		$	33.17		6.2		$	70,665
Options exercisable at June 30, 2007		1,462,967		$	28.60		5.5		$	64,180

 

Intrinsic value is the difference between the market value of the Company’s stock and exercise price of each option multiplied by the number of options outstanding.  The total intrinsic value of stock options exercised during the six months ended June 30, 2007 and 2006 was $8.9 million and $10.7 million, respectively.  The total grant date fair value of stock options that vested during the six months ended June 30, 2007 and 2006 was $2.5 million and $4.5 million, respectively.  As of June 30, 2007, $7.1 million of unrecognized compensation cost related to non-vested stock options is expected to be recognized over the weighted-average period of 2.1 years.

Cash received from stock option exercises during the six months ended June 30, 2007 and 2006 was $5.2 million and $7.8 million, respectively.

Restricted Stock

The Company utilizes grants of restricted stock as long-term compensation for designated employees. The Company’s restricted stock plan provides for the award of up to 1,350,000 shares of the Company’s common stock to certain officers and designated employees. Generally, common stock subject to restricted stock grants that were granted prior to June 2007 vest 0% upon the first anniversary of the grant and 25% on each anniversary thereafter through the fifth anniversary.  Common stock subject to restricted stock grants that were granted in June 2007 vest 33 1/3% on each of the first three anniversaries of the grant date.

Under APB 25, prior to January 1, 2006, deferred compensation was charged for the market value of restricted shares granted. Upon adoption of SFAS No. 123R, the deferred compensation balance at January 1, 2006 was reversed and recorded to additional paid-in capital.  Under both APB 25 and SFAS No. 123R, the market value of the restricted shares granted is amortized ratably over the restricted period.

Prior to January 1, 2006, under APB 25, the Company recorded the effect of forfeitures on compensation expense related to restricted stock as it actually occurred.  Effective January 1, 2006, under SFAS No. 123R, the Company is required to record compensation cost from stock-based compensation utilizing an estimated forfeiture rate.  Historical data related to forfeitures experienced by the Company was used to estimate forfeiture rates.

The following table presents restricted stock activity for the six months ended June 30, 2007:

		Shares		Weighted Average Grant-Date Fair Value
Non-vested restricted stock, December 31, 2006		339,362		$	38.38
Granted		95,359		74.90
Vested		(55,285	)	32.80
Cancelled		(11,475	)	41.09
Non-vested restricted stock, June 30, 2007		367,961		$	48.58

 

The total grant date fair value of restricted stock that vested during the six months ended June 30, 2007 and 2006 was $1.8 million and $1.0 million, respectively.  As of June 30, 2007, $14.1 million of unrecognized compensation cost related to non-vested restricted stock is expected to be recognized over the weighted-average period of 3.1 years.

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Unit Appreciation Rights

There were no grants, exercises or cancellations of unit appreciation rights during the six months ended June 30, 2007.

Partnership Long-Term Incentive Plan

Under the Partnership’s Long-Term Incentive Plan, there were no grants, exercises or cancellations of unit options or phantom units during the six months ended June 30, 2007.

6.  Accounting for Interest Rate Swaps

In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, all derivative instruments must be recognized on the balance sheet at fair value, and changes in such fair values are recognized in earnings unless specific hedging criteria are met. Changes in the values of derivatives that meet these hedging criteria will ultimately offset related earnings effects of the hedged item pending recognition in earnings.

As of June 30, 2007, the Company had interest rate swap agreements with a notional amount of $161.5 million related to the $179.4 million outstanding under the ABS facility. The swaps amortize ratably through 2019 and have a weighted average fixed rate of 4.94%.  The Company’s balance sheet at June 30, 2007 included a $4.3 million derivative asset related to these interest rate swap agreements.

As of June 30, 2007, the Company had interest rate swap agreements with a notional amount of $275.0 million related to the Company’s floating rate debt, excluding the interest rate swap agreements related to the ABS facility discussed above and the Partnership’s floating rate debt discussed below. The swaps amortize ratably from June 2007 through March 2010 and have a weighted average fixed rate of 4.02%.  The Company’s balance sheet at June 30, 2007 included a $5.0 million derivative asset related to these interest rate swap agreements.

As of June 30, 2007, the Partnership had an interest rate swap agreement with a notional amount of $125.0 million related to the Partnership’s floating rate debt. The swap terminates in December 2011 and has a fixed rate of 5.28%.  The Company’s balance sheet at June 30, 2007 included a derivative asset of approximately $0.4 million related to this interest rate swap agreement.

These swaps, except for the swap agreement related to the Partnership’s $121.0 million of floating rate debt, which the Company has designated as cash flow hedging instruments, meet the specific hedge criteria of SFAS No. 133, so that any changes in their fair values were recognized as a component of comprehensive income or loss and are included in accumulated other comprehensive income or loss. Because the terms of the hedged items and the swaps substantially coincide, the hedges are expected to offset changes in expected cash flows due to fluctuations in the variable rate and, therefore, the Company currently does not expect any ineffectiveness.  For the swap agreement related to the Partnership’s $121.0 million of floating rate debt, the Company performs calculations to determine if the swap agreement is still effective and to calculate any ineffectiveness due to the terms of the hedged item and the swap not substantially coinciding.  For the three months and six months ended June 30, 2007, the Partnership recorded approximately $36,000 of ineffectiveness related to this swap.

As of June 30, 2007, the Company had interest rate swap agreements with a notional amount of $100.0 million related to the $171.1 million outstanding under its 7 1/4% senior notes. The swaps are used to hedge the change in fair value of the debt and, in effect, convert the fixed interest payment to a variable interest payment based on six-month LIBOR in arrears.  The Company’s balance sheet at June 30, 2007 included a $3.9 million derivative liability related to these interest rate swap agreements. The change in the debt’s fair value for the hedged portion is recorded as an adjustment to the carrying value of debt, with the offset being recorded to interest expense.  The swaps, which the Company has designated as fair value hedging instruments, meet the specific hedge criteria and any changes in their fair values were recognized in interest expense.  For the three months and six months ended June 30, 2007, the change in the debt’s fair value and the change in the swaps’ fair value offset and did not impact net income. Because the terms of the hedged item and the swaps substantially coincide, the hedge is expected to offset changes in fair values due to fluctuations in the variable rate and, therefore, the Company currently does not expect any ineffectiveness.

The counterparties to the Company’s interest rate swap agreements are major international financial institutions. The Company monitors the credit quality of these financial institutions and does not expect non-performance by them.

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7.  Comprehensive Income

Comprehensive income consisted of the following (in thousands):

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Net income.		$	25,167		$	21,816		$	39,491		$	42,691
Other comprehensive income, net of tax:
Interest rate swap gain...		4,709			2,738			3,006			6,970
Cumulative translation adjustment		14,229			5,276			15,860			5,888
Comprehensive income.		$	44,105		$	29,830		$	58,357		$	55,549

 

Amounts for the three months and six months ended June 30, 2007 were identical for both Holdings and Universal with the following exceptions:  Universal had net income of $26.4 million and $42.1 million, respectively, and total comprehensive income of $45.4 million and $61.0 million, respectively.  Amounts for the three months and six months ended June 30, 2006 were identical for both Holdings and Universal with the following exceptions:  Universal had net income of $22.8 million and $44.6 million, respectively, and total comprehensive income of $30.8 million and $57.5 million, respectively.

8.  Industry Segments

The Company has four principal business segments: domestic contract compression, international contract compression, fabrication and aftermarket services. The domestic contract compression segment provides natural gas compression services to customers in the United States. The international contract compression segment provides natural gas compression services to international customers, including those in Canada. The fabrication segment provides services related to the design, engineering and assembly of natural gas compressors for sale to third parties in addition to those that the Company uses in its contract compression fleet.  This segment also fabricates marine and offshore equipment, including pressure vessels, floating production, storage and offloading process modules, terminal buoys and turrets. The aftermarket services segment sells parts and components and provides maintenance, operations and repair services to customers who own compression equipment and customers who use equipment provided by other companies. Fabrication and aftermarket services revenue presented in the table below include only sales to third parties.

The Company’s reportable segments are strategic business units that offer distinct products and services. They are managed separately since each business segment requires different marketing strategies due to customer specifications. The Company evaluates the performance of its reportable segments based on segment gross margin. Gross margin is defined as total revenue less cost of sales, excluding depreciation and amortization expense. The segment gross margin measure used by management for evaluation purposes excludes inter-segment transactions and, accordingly, there is no inter-segment revenue reported.

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The following table presents unaudited revenue and gross margin by business segment (in thousands):

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Revenue:
Domestic contract compression		$	103,596		$	101,460		$	205,630		$	195,505
International contract compression		40,014			35,010			78,548			68,303
Fabrication		134,988			38,528			189,604			94,837
Aftermarket services		55,989			43,718			100,168			89,139
Total		$	334,587		$	218,716		$	573,950		$	447,784
Gross Margin (1):
Domestic contract compression		$	63,053		$	65,668		$	124,031		$	126,799
International contract compression		29,377			26,580			57,596			51,476
Fabrication		22,386			4,731			29,765			10,935
Aftermarket services		14,727			7,359			24,470			16,973
Total		$	129,543		$	104,338		$	235,862		$	206,183

 

(1)   Gross margin, a non-GAAP financial measure, is reconciled to net income below.

 No one customer accounted for more than 10% of total revenue for any of the periods presented.

The following table presents unaudited revenue and gross margin by geographic location (in thousands).  The basis of attributing revenue and gross margin to specific geographic locations is primarily based upon the geographic location of the sale or service or where the assets are utilized.

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Revenue:
United States		$	253,878		$	152,742		$	419,410		$	308,944
Canada		20,661			27,287			42,401			57,716
Argentina		18,861			16,711			38,483			34,363
Other International		41,187			21,976			73,656			46,761
Total		$	334,587		$	218,716		$	573,950		$	447,784
Gross Margin (1):
United States		$	90,240		$	72,157		$	162,352		$	143,389
Canada		8,658			7,648			14,666			14,572
Argentina		12,921			11,097			25,331			22,875
Other International		17,724			13,436			33,513			25,347
Total		$	129,543		$	104,338		$	235,862		$	206,183

 

(1)    Gross margin, a non-GAAP financial measure, is reconciled to net income below.

The Company defines gross margin as total revenue less cost of sales (excluding depreciation and amortization expense).  Gross margin is included as a supplemental disclosure because it is a primary measure used by the Company’s management as it represents the results of revenue and cost of sales (excluding depreciation and amortization expense), which are key components of the Company’s operations.  As an indicator of the Company’s operating performance, gross margin should not be considered an alternative to, or more meaningful than, net income as determined in accordance with GAAP.  The Company’s gross margin may not be comparable to a similarly titled measure of another company because other entities may not calculate gross margin in the same manner.

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The following table reconciles net income to gross margin (in thousands):

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
Net income		$	25,167		$	21,816		$	39,491		$	42,691
Depreciation and amortization		35,792			30,013			70,655			59,812
Selling, general and administrative		36,802			29,461			72,543			56,042
Interest expense, net		14,063			14,605			28,102			28,662
Merger-related expenses		4,792			—			6,165			—
Foreign currency (gain) loss		(962		)	299			(1,655		)	(310		)
Minority interest		1,642			—			2,966			—
Other (income) expense, net		(518		)	(360		)	(2,249		)	(1,093		)
Income tax expense		12,765			8,504			19,844			20,379
Gross margin		$	129,543		$	104,338		$	235,862		$	206,183

 

Amounts for the three months ended June 30, 2007 are identical for both Holdings and Universal with the following exceptions:  Universal had interest expense, net of $13.5 million, interest income from an affiliate of $1.0 million, income tax expense of $13.1 million and net income of $26.4 million.  Amounts for the three months ended June 30, 2006 are identical for both Holdings and Universal with the following exceptions:  Universal had interest income from an affiliate of $1.5 million, income tax expense of $9.0 million and net income of $22.8 million.

Amounts for the six months ended June 30, 2007 are identical for both Holdings and Universal with the following exceptions:  Universal had interest expense, net of $26.9 million, interest income from an affiliate of $2.2 million, income tax expense of $20.6 million and net income of $42.1 million.  Amounts for the six months ended June 30, 2006 are identical for both Holdings and Universal with the following exceptions:  Universal had interest income from an affiliate of $3.0 million, income tax expense of $21.4 million and net income of $44.6 million.

9.  Commitments and Contingencies

In the ordinary course of business, the Company is involved in various pending or threatened legal actions. In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a material adverse effect on the Company’s financial position, results of operations or cash flows; however, because of the inherent uncertainty of litigation, the Company cannot provide assurance that the resolution of any particular claim or proceeding to which it is a party will not have a material adverse effect on the Company’s financial position, results of operations or cash flows for the period in which that resolution occurs.

10.  Income Taxes

The Company adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, the Company recognized a $1.0 million liability for unrecognized tax benefits, which was accounted for as a decrease to the January 1, 2007 balance of retained earnings.  All of the $1.0 million of unrecognized tax benefits, if recognized, would impact the Company’s effective tax rate.

The Company and its subsidiaries file consolidated and separate income tax returns in the U.S. federal jurisdiction and in numerous state and foreign jurisdictions. The Company is subject to U.S. federal income tax examinations for all tax years beginning with its initial tax year ended March 31, 1998. The Internal Revenue Service has yet to commence an examination of any of the Company’s U.S. federal income tax returns.

State income tax returns are generally subject to examination for a period of three to five years after filing of the respective returns.  In addition, the state impact of any U.S. federal changes remains subject to examination by various states for a period of up to one year after formal notification to the states.  The Company and its subsidiaries do not have any state audits currently underway that would have a material impact on the Company’s financial position or results of operations.

The Company is subject to examination by taxing authorities throughout the world, including such major foreign jurisdictions as Argentina, Brazil, Canada, Mexico and Thailand. With few exceptions, the Company and its subsidiaries are no longer subject to foreign income tax examinations for tax years before 2001. With respect to ongoing audits, the Canadian federal and provincial tax authorities commenced audits of certain Canadian income tax returns for tax years ending within the calendar years 2001 through

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2005. The audits were initiated in the fourth quarter of 2005, the third quarter of 2006 and the first quarter of 2007. At the end of 2006, the Brazilian tax authorities commenced an audit of certain Brazilian income tax returns for the tax years 2001 through 2006.  To date, no adjustments have been proposed as a result of these audits.  There are no other foreign audits underway that would have a material impact on the Company’s financial position or results of operations.

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in interest expense and income tax expense, respectively.  In conjunction with the adoption of FIN 48, the Company recognized approximately $0.2 million for the accrual of interest and penalties at January 1, 2007 which is included as a component of the $1.0 million of unrecognized tax benefits. During the three months and six months ended June 30, 2007, the Company recognized an immaterial amount of potential interest expense and income tax expense associated with uncertain tax positions. To the extent interest and penalties are not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as reductions in interest expense and income tax expense, respectively.

The Company does not anticipate that total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of statute of limitations prior to June 30, 2008.  However, due to the uncertain and complex application of tax regulations, it is possible that the ultimate resolution of these matters may result in liabilities which could be materially different from these estimates.

11.  Business Acquisition

In January 2007, the Company acquired B.T.I. Holdings Pte Ltd (“B.T.I.”) and its wholly owned subsidiary B.T. Engineering Pte Ltd, a Singapore-based fabricator of oil and gas, petrochemical, marine and offshore equipment, including pressure vessels, floating, production, storage and offloading process modules, terminal buoys, turrets, natural gas compression units and related equipment, for $17.6 million in cash, net of cash acquired, plus certain other working capital adjustments.  In April 2007, the Company paid $5.7 million for the working capital adjustment.  Total consideration will also include a contingent obligation of up to $20 million based on the earnings of B.T.I. over the two years ending March 31, 2009.  Pro forma results of operations have not been presented because the effect of the acquisition is not considered to be significant.  As of June 30, 2007, the purchase price allocation is still preliminary due to the ongoing evaluation of the assets acquired and liabilities assumed.

12.  Proposed Merger with Hanover Compressor Company

In February 2007, the Company and Hanover Compressor Company (“Hanover”) entered into a merger agreement. Upon consummation of the transactions set forth in the merger agreement, each common share of Hanover will be converted into 0.325 shares of common stock of a newly created holding company, Exterran Holdings, Inc. (“Exterran”) and each common share of Holdings will be converted into one share of Exterran.  Hanover will be treated as the acquirer for accounting purposes.

The merger agreement has been unanimously approved by both companies’ boards of directors. Completion of the merger is subject to a number of conditions, including the approval of the stockholders of both companies and customary regulatory approvals, including the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“Hart-Scott-Rodino Act”).  On July 3, 2007, the Company and Hanover each received notice that the waiting period required by the Hart-Scott-Rodino Act with respect to the merger had been terminated.  On July 10, 2007, the SEC declared effective the registration statement for the proposed merger.  Each company has scheduled its annual meeting of stockholders, at which the proposed merger will be considered, for August 16, 2007.  The Company and Hanover expect the merger to close on or about August 20, 2007, but no assurances can be given as to the timing of the satisfaction of all closing conditions or that all required approvals will be received.

In April 2007, the Company’s board of directors approved the adoption of a retention bonus plan for selected employees, including executive officers, to provide the plan participants with an incentive to continue employment with the Company or an affiliate of the Company in light of the Company’s proposed merger with Hanover.  Payments will be made to these plan participants on specified dates which will typically occur after the consummation of the merger.  Plan participants whose employment is terminated involuntarily without cause or due to death or disability prior to the specified dates will receive any unpaid portion of the retention bonus.  The retention bonus plan provides for an aggregate payment of approximately $7.2 million.

The merger agreement requires the Company and Hanover to continue to operate their businesses in the ordinary course of business and to obtain the other party’s consent prior to engaging in certain specified activities, such as issuing or repurchasing securities, acquiring or disposing of businesses above specified thresholds, incurring new debt other than below specified thresholds and or for specified purposes, paying dividends or granting awards with respect to the Company’s common stock (other than under employee compensation arrangements).  These agreements are subject to specified exceptions, including those (1) permitting the Company to repurchase up to an additional $75 million of its common stock in accordance with its previously announced open-market stock repurchase program, (2) permitting the Partnership to make cash distributions in accordance with its partnership agreement, (3)

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permitting the Company to make contributions of its domestic compression assets to the Partnership, subject to certain limitations and (4) permitting the Company to redeem its 7 1/4% Senior Notes due 2010, as discussed below.

13.  Subsequent Events

Contract Compression Acquisition by the Partnership

In July 2007, the Partnership acquired from Holdings contract compression customer service agreements with eight customers and a fleet of 722 compressor units, comprising 281,992 horsepower, or 13% (by available horsepower) of the combined domestic contract compression business of Holdings and the Partnership. These compressor units serve the compression service needs of the eight customers that became customers of the Partnership upon the closing of the transaction.  In connection with the acquisition, the Partnership assumed $159.6 million in debt from Holdings and issued to Holdings approximately 2.0 million common units and approximately 82,000 general partnership units.  Additionally, the Partnership issued approximately 2.0 million common units for proceeds of $69.1 million, (net of private placement fees of $0.9 million) to institutional investors in a private placement.  The Partnership used the proceeds from the private placement to repay a portion of the debt assumed from Holdings.

Additionally, in connection with this acquisition, the Partnership expanded its revolving credit facility from $225 million to $315 million and borrowed an additional $90 million under that facility, which it used, along with available cash, to repay the remainder of the debt assumed from Holdings in conjunction with this acquisition.

In July 2007, the Partnership entered into two interest rate swap agreements related to its floating rate debt.  Each swap agreement has a notional amount of $40 million.   These swap agreements both terminate in October 2011 and have a weighted average fixed rate of 5.33%.

Also, in connection with the closing of the acquisition, the Partnership entered into an amendment (the “First Amendment”) to its existing Omnibus Agreement with the Company.  The First Amendment, among other things, increased the cap on selling, general and administrative costs allocable from the Company to the Partnership based on such costs incurred by Holdings on behalf of the Partnership from $2.5 million per quarter to $4.75 million per quarter (after taking into account any such costs the Partnership incurs and pays directly) and increased the cap on cost of sales from $16.95 per horsepower per quarter to $18.00 per horsepower (after taking into account any such costs the Partnership incurs and pays directly) per quarter.  These caps are scheduled to terminate on December 31, 2008, as previously agreed.

Debt Refinancing

In July 2007, the Company announced that it will redeem all $175 million face value of its outstanding 7 1/4% senior notes due 2010.  The indenture governing the notes permits the unconditional redemption of all of the notes at a redemption price of 103.625% plus accrued and unpaid interest up to and including the date fixed for redemption.  The expected date of redemption is August 13, 2007.  The redemption of the 7 1/4% senior notes is part of the refinancing plan of the Company and Hanover being implemented in anticipation of the closing of the pending merger.

Exterran, which will be the publicly traded holding company following the completion of the merger, has engaged Wachovia Capital Markets, LLC and J. P. Morgan Securities Inc. to arrange and syndicate a senior secured credit facility, consisting of a revolving credit facility and a term loan, and has engaged Wachovia to provide a new asset-backed securitization facility to Exterran. The primary purpose of these new facilities will be to fund the redemption or repurchase of substantially all of Hanover’s and the Company’s outstanding debt other than Hanover’s convertible debt securities and the credit facility of the Partnership. The new facilities will replace Hanover’s and the Company’s existing bank lines and the Company’s existing ABS facility. The closing of the new facilities is subject to, among other things, the receipt of sufficient commitments from participating lenders and the execution of mutually satisfactory documentation.  The Company can provide no assurance that the proposed merger between the Company and Hanover will close or that the Company will be successful in refinancing its and Hanover’s existing debt.

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ITEM 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The terms “our,” “Company,” “we” and “us” when used in this report refer to Universal Compression Holdings, Inc. (“Holdings”) and Universal Compression, Inc. (“Universal”) and their subsidiaries, except where otherwise indicated.  The following discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited consolidated financial statements, and the notes thereto, appearing elsewhere in this report, as well as the consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations presented in our Annual Report on Form 10-K for the twelve months ended December 31, 2006.

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

This report contains “forward-looking statements” intended to qualify for the safe harbors from liability established by the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact contained in this report are forward-looking statements within the meaning of section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements regarding future financial position, business strategy, proposed acquisitions, budgets, litigation, projected costs and plans and objectives of management for future operations, and are intended to come within the safe harbor protection provided by that section. You can identify many of these statements by looking for words such as “believes,” “expects,” “will,” “intends,” “projects,” “anticipates,” “estimates” or similar words or the negative thereof.

Such forward-looking statements in this report include, without limitation, statements regarding:

·              our business growth strategy and projected costs;

·              our future financial position;

·              the sufficiency of available cash flows to fund continuing operations;

·              the expected amount of our capital expenditures;

·              anticipated cost savings, future revenue, gross margin and other financial or operational measures related to our business and our primary business segments;

·              the future value of our equipment;

·              plans and objectives of our management for our future operations; and

·              our anticipated merger with Hanover Compressor Company (“Hanover”).

Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this report. Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, no assurance can be given that these expectations will prove to be correct.  These forward-looking statements are also affected by the risk factors and forward-looking statements described in our Annual Report on Form 10-K for the twelve months ended December 31, 2006 and those set forth from time to time in our filings with the Securities and Exchange Commission (“SEC”), which are available through our website and through the SEC’s Electronic Data Gathering and Retrieval System (“EDGAR”) at www.sec.gov.  Important factors that could cause our actual results to differ materially from the expectations reflected in these forward-looking statements include, among other things:

·              conditions in the oil and gas industry, including a sustained decrease in the level of supply or demand for natural gas and the impact on the price of natural gas;

·              competition among the various providers of natural gas compression services;

·              the success of our subsidiary, Universal Compression Partners, L.P. (the “Partnership”);

·              our ability to obtain necessary approvals for our proposed merger with Hanover and the success of the merger if approved and consummated;

·              employment workforce factors, including our ability to hire, train and retain key employees;

·              our ability to timely and cost-effectively obtain components necessary to conduct our business;

·              our ability to timely and cost-effectively implement our enterprise resource planning (“ERP”) system;

·              changes in safety and environmental regulations pertaining to the production and transportation of natural gas;

·              changes in political or economic conditions in key operating markets, including international markets;

·              acts of war or terrorism or governmental or military responses thereto;

·              introduction of competing technologies by other companies;

·              our ability to retain and grow our customer base;

·              our level of indebtedness and ability to fund our business;

·              currency exchange rate fluctuations; and

·              liability claims related to the use of our products and services.

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All forward-looking statements included in this report are based on information available to us on the date of this report. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this report.

Recent Developments

Business Acquisition

In January 2007, we acquired B.T.I. Holdings Pte Ltd (“B.T.I.”) and its wholly owned subsidiary B.T. Engineering Pte Ltd, a Singapore based fabricator of oil and gas, petrochemical, marine and offshore equipment, including pressure vessels; floating, production, storage and offloading process modules; terminal buoys; turrets; natural gas compression units and related equipment, for $17.6 million in cash, net of cash acquired, plus certain other working capital adjustments.  In April 2007, we paid $5.7 million for the working capital adjustment.  Total consideration will also include a contingent obligation of up to $20 million which is based on earnings of B.T.I. over the two years ending March 31, 2009.

Pending Merger With Hanover

In February 2007, we and Hanover entered into a merger agreement. Upon consummation of the transactions set forth in the merger agreement, each common share of Hanover will be converted into 0.325 shares of common stock of a newly created holding company, Exterran Holdings, Inc. (“Exterran”) and each of our common shares will be converted into one share of Exterran.  Hanover will be treated as the acquirer for accounting purposes.

The merger agreement has been unanimously approved by both companies’ boards of directors. Completion of the merger is subject to a number of conditions, including the approval of the stockholders of both companies and customary regulatory approvals, including the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“Hart-Scott-Rodino Act”).  On July 3, 2007, we and Hanover each received notice that the waiting period required by the Hart-Scott-Rodino Act with respect to the merger had been terminated.  On July 10, 2007, the SEC declared effective the registration statement for the proposed merger.  Each company has scheduled its annual meeting of stockholders, at which the proposed merger will be considered, for August 16, 2007.  The Company and Hanover expect the merger to close on or about August 20, 2007, but no assurances can be given as to the timing of the satisfaction of all closing conditions or that all required approvals will be received.

In April 2007, our board of directors approved the adoption of a retention bonus plan for selected employees, including executive officers, to provide the plan participants with an incentive to continue employment with us in light of our proposed merger with Hanover.  Payments will be made to these plan participants on specified dates which will typically occur after the consummation of the merger.  Plan participants whose employment is terminated involuntarily without cause or due to death or disability prior to the specified dates will receive any unpaid portion of the retention bonus.  The retention bonus plan provides for an aggregate payment of approximately $7.2 million.

The merger agreement requires us and Hanover to continue to operate our businesses in the ordinary course of business and to obtain the other party’s consent prior to engaging in certain specified activities, such as issuing or repurchasing securities, acquiring or disposing of businesses above specified thresholds, incurring new debt other than below specified thresholds and or for specified purposes, paying dividends or granting awards with respect to our common stock (other than under employee compensation arrangements).  These agreements are subject to specified exceptions, including those (1) permitting us to repurchase up to an additional $75 million of our common stock in accordance with our previously announced open-market stock repurchase program, (2) permitting the Partnership to make cash distributions in accordance with its partnership agreement, (3) permitting us to make contributions of our domestic compression assets to the Partnership, subject to certain limitations and (4) permitting us to redeem our 7 1/4% Senior Notes due 2010, as discussed below.

In July 2007, we announced that we will redeem all $175 million face value our outstanding 7 1/4% senior notes due 2010.  The indenture governing the notes permits the unconditional redemption of all of the notes at a redemption price of 103.625% plus accrued and unpaid interest up to and including the date fixed for redemption.  The expected date of redemption is August 13, 2007.  The redemption of the 7 1/4% senior notes is part of the refinancing plan of us and Hanover being implemented in anticipation of the closing of the pending merger.

As part of the refinancing plan, Exterran, which will be the publicly traded holding company following the completion of the merger, has engaged Wachovia Capital Markets, LLC and J. P. Morgan Securities Inc. to arrange and syndicate a senior secured credit facility, consisting of a revolving credit facility and a term loan, and has engaged Wachovia to provide a new asset-backed

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securitization facility to Exterran. The primary purpose of these new facilities will be to fund the redemption or repurchase of substantially all of Hanover’s and our outstanding debt other than the Hanover’s convertible debt securities and the credit facility of the Partnership. The new facilities will replace Hanover’s and our existing bank lines and our existing ABS facility. The closing of the new facilities is subject to, among other things, the receipt of sufficient commitments from participating lenders and the execution of mutually satisfactory documentation.  We can provide no assurance that the proposed merger between us and Hanover will close or that we will be successful in refinancing our and Hanover’s existing debt.

Contract Compression Acquisition by the Partnership

In July 2007, the Partnership acquired from us contract compression customer service agreements with eight customers and a fleet of 722 compressor units comprising 281,992 horsepower, or 13% (by available horsepower) of the combined domestic contract compression business of us and the Partnership. These compressor units serve the compression service needs of the eight customers that became customers of the Partnership upon the closing of the acquisition.  In connection with the acquisition, the Partnership assumed $159.6 million in debt from us and issued to us approximately 2.0 million common units and approximately 82,000 general partnership units.  Additionally, the Partnership issued approximately 2.0 million common units for proceeds of $69.1 million, (net of private placement fees of $0.9 million) to institutional investors in a private placement.  The Partnership used the proceeds from the private placement to repay a portion of the debt assumed from us.

Additionally, in connection with this acquisition, the Partnership expanded its revolving credit facility from $225 million to $315 million and borrowed an additional $90 million under that facility, which it used, along with available cash, to repay the remainder of the debt assumed from us.

In July 2007, the Partnership entered into two interest rate swap agreements related to its floating rate debt.  Each swap agreement has a notional amount of $40 million.   These swap agreements both terminate in October 2011 and have a weighted average fixed rate of 5.33%.

Also, in connection with the closing of the acquisition, the Partnership entered into an amendment (the “First Amendment”) to its existing Omnibus Agreement with us.  The First Amendment, among other things, increased the cap on selling, general and administrative costs allocable from us to the Partnership based on such costs incurred by us on behalf of the Partnership from $2.5 million per quarter to $4.75 million per quarter (after taking into account any such costs the Partnership incurs and pays directly) and increases the cap on cost of sales from $16.95 per horsepower per quarter to $18.00 per horsepower (after taking into account any such costs the Partnership incurs and pays directly) per quarter.  These caps are scheduled to terminate on December 31, 2008, as previously agreed.

Financial Highlights

Some of the more significant financial items for the three months and six months ended June 30, 2007, as compared to the prior year period, which are discussed below in “Financial Results of Operations,” were as follows:

·                  Net Income.  Net income for the three months ended June 30, 2007 increased by $3.4 million, or 15.4%, and decreased by $3.2 million, or 7.5%, for the six months ended June 30, 2007.

·                  Revenue and Gross Margin. Revenue was higher for the three months and six months ended June 30, 2007 by $115.9 million and $126.2 million, respectively, or 53.0% and 28.2%, respectively.  Gross margin was higher for the three months and six months ended June 30, 2007 by $25.2 million and $29.7 million, respectively, or 24.2% and 14.4%, respectively.

·                  Depreciation and Amortization Expense.  Depreciation and amortization expense increased for the three months ended June 30, 2007 by $5.8 million, or 19.3%, and by $10.8 million, or 18.1%, for the six months ended June 30, 2007.

·                  Selling, General and Administrative Expense.  Selling, general and administrative (“SG&A”) expense increased for the three months ended June 30, 2007 by $7.3 million, or 24.9%, and by $16.5 million, or 29.4%, for the six months ended June 30, 2007.

·                  Merger-Related Expense.  During the three months and six months ended June 30, 2007, we incurred merger-related expenses of $4.8 million and $6.2 million, respectively.

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Operating Highlights

The following table summarizes total available horsepower, average operating horsepower, horsepower utilization percentages and compressor fabrication backlog.

		Three Months Ended						Six Months Ended
		June 30, 2007		December 31,2006		June 30, 2006		June 30, 2007		June 30, 2006
		(Horsepower in thousands)						(Horsepower in thousands)
Total Available Horsepower (at period end):
Domestic contract compression		2,147		2,069		1,989		2,147		1,989
International contract compression		614		607		595		614		595
Total		2,761		2,676		2,584		2,761		2,584
Average Operating Horsepower:
Domestic contract compression		1,825		1,816		1,794		1,824		1,797
International contract compression		556		541		549		554		548
Total		2,381		2,357		2,343		2,378		2,345
Horsepower Utilization:
Spot (at period end)		87.1	%	88.9	%	90.2	%	87.1	%	90.2	%
Average		87.3	%	89.4	%	91.1	%	87.8	%	91.5	%

 

		June 30, 2007			December 31, 2006			June 30, 2006
		(In millions)
Compressor Fabrication Backlog		$	222.5		$	289.3		$	275.0

 

The increase in domestic available horsepower as of June 30, 2007 compared to June 30, 2006 was primarily attributable to large horsepower units added to our fleet to meet the incremental demand for these units by our customers.  The increase in available international horsepower during the same period was primarily attributable to horsepower that was added in Latin America in response to new projects.

Domestic and international average operating horsepower increased by 1.7% and 1.3%, respectively, for the three months ended June 30, 2007 as compared to the prior year periods.  Domestic and international average operating horsepower increased by 1.5% and 1.1%, respectively, for the six months ended June 30, 2007 as compared to the prior year periods.  Average horsepower utilization decreased in the three months and six months ended June 30, 2007 as compared to the prior year periods as the number of units returned by customers of small and medium horsepower units partially offset the new fleet additions of larger horsepower units that were put to work during the period.

Compressor fabrication backlog fluctuates quarter to quarter due to the timing of receipt of orders placed by customers and the timing of recognition of revenue.  The compressor fabrication backlog at August 2, 2007 was approximately $265.6 million.  A majority of the backlog is expected to be completed within a 270-day period.

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Financial Results of Operations

     Three months ended June 30, 2007 compared to three months ended June 30, 2006

     The following table summarizes revenue, gross margin, gross margin percentage, expenses and net income:

		Three Months Ended June 30,
		2007 (1)			2006 (1)
		(Dollars in thousands)
Revenue:
Domestic contract compression		$	103,596		$	101,460
% of revenue		31.0		%	46.4		%
International contract compression		$	40,014		$	35,010
% of revenue		12.0		%	16.0		%
Fabrication		$	134,988		$	38,528
% of revenue		40.3		%	17.6		%
Aftermarket services		$	55,989		$	43,718
% of revenue		16.7		%	20.0		%
Total Revenue		$	334,587		$	218,716
Gross margin (2):
Domestic contract compression		$	63,053		$	65,668
International contract compression		29,377			26,580
Fabrication		22,386			4,731
Aftermarket services		14,727			7,359
Total Gross Margin		$	129,543		$	104,338
Gross margin percentage:
Domestic contract compression		60.9		%	64.7		%
International contract compression		73.4		%	75.9		%
Fabrication		16.6		%	12.3		%
Aftermarket services		26.3		%	16.8		%
Total Gross Margin Percentage		38.7		%	47.7		%
Expenses:
Depreciation and amortization		$	35,792		$	30,013
Selling, general and administrative		36,802			29,461
Interest expense, net		14,063			14,605
Merger-related expenses		4,792			—
Foreign currency (gain) loss		(962		)	299
Minority interest		1,642			—
Other (income) expense, net		(518		)	(360		)
Income tax expense		12,765			8,504
Net income		$	25,167		$	21,816

 

(1)         Amounts for the three months ended June 30, 2007 are identical for both Holdings and Universal with the following exceptions:  Universal had interest expense, net of $13.5 million, interest income from an affiliate of $1.0 million, income tax expense of $13.1 million and net income of $26.4 million.  Amounts for the three months ended June 30, 2006 are identical for both Holdings and Universal with the following exceptions:  Universal had interest income from an affiliate of $1.5 million, income tax expense of $9.0 million and net income of $22.8 million.

(2)         For a reconciliation of gross margin to its most directly comparable financial measure calculated and presented in accordance with GAAP, please read Part I, Item 2 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations – Non-GAAP Financial Measures”) of this report.

Revenue.  Domestic contract compression revenue increased for the three months ended June 30, 2007 compared to the prior year period primarily due to higher operating horsepower and average contract prices in the current period.  Domestic average operating horsepower increased to approximately 1,825,000 horsepower in the three months ended June 30, 2007 as compared to approximately 1,794,000 horsepower in the prior year period.  Domestic contract compression revenue per average monthly operating horsepower

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increased to $18.92 in the three months ended June 30, 2007.    This was a slight increase from the prior year period amount of $18.86.  International contract compression revenue increased for the three months ended June 30, 2007 compared to the prior year period primarily as a result of additional business in Argentina and Mexico of $3.0 million and $1.6 million, respectively.  Fabrication revenue increased by $96.5 million, or 250%, compared to the prior year period primarily as a result of an installation project in the United States that accounted for $32.9 million of the increase, increased shipments of fabricated units in the United States and the Asia Pacific region and our Singapore acquisition.  Aftermarket services revenue increased for the three months ended June 30, 2007 compared to the prior year period primarily due to increased pricing to customers and increased activity in the United States.

Gross Margin.  The decrease in domestic contract compression gross margin (defined as total revenue less cost of sales, excluding depreciation and amortization expense) for the three months ended June 30, 2007 compared to the prior year period was primarily attributable to higher expenses in the current year period including labor and benefits cost, parts cost and lubricant cost, partially offset by revenue increases in the current year period discussed above. International contract compression gross margin was higher for the three months ended June 30, 2007 compared to the prior year period due primarily to the increased business in Argentina and Brazil, discussed above.   The increase in fabrication gross margin for the three months ended June 30, 2007 compared to the prior year period was attributable primarily to the increased shipments, as described above, increased pricing to customers, the installation project discussed above, which generated higher margins than our typical fabrication projects, and the implementation of process improvements.  Aftermarket services gross margin increased for the three months ended June 30, 2007 compared to the prior year period primarily due to increased pricing to customers and increased activity, as discussed above.  Gross margin is reconciled to net income within Part I, Item 2 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations – Non-GAAP Financial Measures”) of this report.

Gross Margin Percentage.  Domestic contract compression gross margin percentage decreased for the three months ended June 30, 2007 compared to the prior year period primarily due to higher expenses in the current year period, partially offset by higher average operating horsepower and contract prices, each as discussed above.  International contract compression gross margin percentage decreased for the three months ended June 30, 2007 compared to the prior year period due primarily to higher expenses in the current year period, primarily from parts cost.  Aftermarket services gross margin percentage increased for the three months ended June 30, 2007 compared to the prior year period primarily due to increased pricing to customers.  The higher fabrication gross margin percentage for the three months ended June 30, 2007 compared to the prior year period was attributable primarily to increased pricing to customers, the higher margin installation project and the implementation of process improvements, each as discussed above.

Depreciation and Amortization Expense.  The increase in depreciation and amortization expense for the three months ended June 30, 2007 compared to the prior year period was primarily the result of on-going capital expenditures, consisting primarily of additions to our contract compression fleet and compressor overhauls.

SG&A Expenses. The increase in SG&A expenses for the three months ended June 30, 2007 compared to the prior year period was due primarily to increased expenses related to our acquisition in Singapore, the on-going implementation of our ERP system, increased consulting and professional services fees and increased stock-based compensation expense.  SG&A expenses represented 11.0% and 13.5% of revenues for the three months ended June 30, 2007 and 2006, respectively.

Merger-Related Expenses.  Merger-related expenses include costs, such as legal and other professional fees and accruals for retention bonuses, associated with the proposed merger between us and Hanover.

Minority Interest.  Minority interest reflects the portion of the Partnership’s earnings applicable to the 49% limited partnership interest not owned by us.

Income Tax Expense.  The increase in income tax expense for the three months ended June 30, 2007 compared to the prior year period relates primarily to increased income before taxes in the current year period and the impact of tax law changes that occurred in the prior year period that lowered the effective tax rate in that period.  The decrease in the prior year period effective tax rate was impacted by the passage of the State of Texas Margin Tax, a reduction in Subpart F income from applying a new look-through rule included in the Tax Increase Prevention and Reconciliation Act of 2005 and the enactment of reductions in Alberta, Canada and Canadian federal income tax rates.

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