Warning Signs Were Flashing for Hanover Compressor

Hanover Compressor's(HC Quote) investors have learned to live with controversy, bidding up the stock since the company disclosed an earnings restatement and Securities and Exchange Commission probe last month.

Indeed, the shares have climbed 22% since Feb. 25, the day before the news was released, as investors evidently concluded the worst was over. But concerns remain about the company's Hampton Roads partnership, the former off balance sheet entity that led Hanover to downwardly restate revenue by $16 million in 2000 and $3.6 million in 2001.

Hanover, whose primary business is selling pumps to the natural gas industry, formed Hampton Roads Shipping in September 2000 in order to build and operate barge-mounted gas compression and gas processing facilities to be stationed off the coast of Nigeria. Hanover invested $1.25 million for a 25% stake in the joint venture and intended to lease the barges to Houston energy company Global Energy to fulfill a contract that Global had with Shell(RD Quote), according to filings. An independent investor owned the other 75% of the venture.

Norton Street

Hanover started recognizing construction revenue from Hampton Roads in 2000 and booked about $19 million over two years. It used an accounting procedure that allowed it to book revenue proportionate to the progress it was making building the barges, so if the barges were 50% finished, the company would book 50% of the revenue. Hanover ran into trouble when it became apparent it had overestimated the value of the contract and its completion date.

In its most recent 8-K filing, Hanover says the equipment had a sale price of $51 million, but that the "scope of the project was reduced to $43 million" in the first quarter of 2001. It was at this time that Hanover learned the equipment wouldn't be used until September 2003, according to the filing. The company had previously expected the project to be operational as of Sept. 30, 2001.

Still, documents from Global Energy suggest there was reason to believe the deal would change long before then.

Exactly when Hanover knew the project had been pushed out and reduced in scope is important because it goes to the issue of whether the company should have known the revenue it recorded might not stand up. If the company knew early on that the project had been delayed, there would have been no need to build the barges until sometime in 2002 and therefore no good reason to book revenue.

Pistol Hot

Mark Roberts, an analyst at Off Wall Street Consulting, said a statement issued by Global Energy "may be considered a smoking gun on the question of what Hanover knew and when it knew it."

In October 2000, Global released an interim report to shareholders saying that Global and its subsidiaries "have debated tirelessly with Shell during this year" and that "Shell has agreed to provide Global with a reduced amount of gas." Global also mentioned that Hanover has been "a stalwart supporter throughout our deliberations with Shell." Indeed, Hanover acquired a 10% interest in Global.

The report states that Hanover was to provide "some $42 million worth of compression and gas processing facilities to Global in the Cawthorne Channel Field." In fact, Global said as early as July 1999 that the deal "had an approximate value of $42 million," not $51 million as claimed by Hanover when it first estimated the deal's value.

Hampton Roads investor Spyro Contogouris said he learned in January 2001 that problems existed with the deal's scope. At a meeting in Nigeria, he allegedly was told that Shell could not provide enough natural gas to support the facility until 2004 and that in fact, this had always been the completion date.

"Hanover bought into (Global) so they clearly knew the contract (with Shell) was in dispute," Contogouris said. "If they knew that, there was no way they could not have known how long it would take to put the facilities in place in Nigeria."

"They had to know they couldn't perform and if they knew that, then they must have had other motives for proceeding with the sale of the barge and guaranteeing a 2001 startup date to the partnership," he added.

In The Timing

Investors in Hanover have filed numerous lawsuits against the company alleging that the firm was anxious to record revenue in late 2000 because of a $170 million convertible bond offering planned for the first quarter of 2001. The company also announced a secondary offering, in which insiders sold 7.5 million shares while the company sold 2.5 million shares. The company declines to comment on the suits.

According to Contogouris, Hanover offered to pay him an additional $1 million commission if the partnership was formed promptly, suggesting the company was eager to start booking revenues.

John Jackson, Hanover's new chief financial officer, said in an interview Wednesday that the company was informed in October 2000 that Shell had requested an extension of the project. He added that Global "had assured us it had an enforceable contract with Shell for $51 million."

Global's chief executive Kenneth Yellowe said the equipment had always been worth $42 million, and he acknowledged to The Wall Street Journal that there had been talks of delaying the project as early as the summer of 2000, although nothing was finalized at that time. Of course, no matter what Hanover thought in the first quarter of 2001, it still doesn't explain why the firm continued to book revenue from the project for the first nine months of 2001.

In a conference call on Feb 26, Hanover blamed "back office" problems for the restatement of its financial results and said the necessary papers did not reach the right people within the organization. Jackson said in an interview that a couple of documents "didn't make it into the hands of accountants" because the company is "growing so quickly."

But Off Wall Street's Roberts contends that the company didn't simply make a clerical error and that Hanover knew the project would be pushed out and reduced in scope, perhaps even before it entered into the partnership.

Roberts and Contogouris are also asking questions about the "new independent investment group" that replaced Contogouris last year until Hanover purchased the remaining 75% of Hampton Roads in February 2002.

Hanover said Friday that the SEC has requested information relating to the "other matters" involved in the company's previously announced restatement of results.

The Feb. 26 revision, which comprised the Hampton Roads restatement and other matters, cut earnings for the first nine months of 2001 by 2 cents to 86 cents a share. In disclosing the restatement, Hanover cut its earnings estimate for its yet-to-be-reported fourth quarter to a range of 16 cents to 21 cents a share from a consensus 39 cents.