Hanover Compressor

(HC)

has a bad habit that it can't seem to shake.

Despite intense scrutiny from regulators and individual investors alike, Houston-based Hanover, which makes pumps to transport natural gas, has continued to use aggressive accounting techniques to hide expenses and increase its net income.

Reports of the firm's off balance sheet dealings, which kept $1.14 billion of debt off the firm's balance sheet in 2001, have been well-publicized, but Hanover has also engaged in other questionable transactions this year that haven't received as much attention.

In the first quarter, for example, the company advanced $400,000 to President and CEO Michael McGhan and $100,000 to senior vice president Robert Pierce, in return for interest-bearing unsecured notes that mature on Sept. 30, 2002.

Company officials didn't return repeated phone calls seeking comment.

Polonius

While company loans to related parties aren't uncommon, Robert Bricker, an accounting professor at the Weatherhead School of Management, said it can become a problem if loans aren't repaid in a timely manner. For the whole of 2001, Hanover advanced cash of $2.2 million to McGhan, which was still outstanding at the end of March.

Of course, that amount is a far cry from the $2.3 billion in loans extended to the founding family of

Adelphia,

which has since filed for bankruptcy. But individual investors are still being deceived, according to Bricker, because they often don't realize that big receivables have been used for investments that are potentially very risky. "Essentially, the company has become the guarantor because their money is on the line," he said.

Hanover is no stranger to controversy. In February the firm said it was under investigation by the

Securities and Exchange Commission

and announced that it would restate results for the last seven quarters after improperly recognizing revenue on its Hampton Roads joint venture as well as its acquisition of two compressors and its sale of three turbine engines and a compressor. The company also said it was hiring a new chief financial officer, but the former CFO has stayed on as vice chairman.

Hanover has fallen 25% since the revelations were first made, prompting some analysts, such as Merrill Lynch's Mike Clark, to upgrade the stock, citing a more attractive valuation.

Clark said while there are a number of unresolved issues, he believes the stock is worth $16 on the basis of conservative discounted cash-flow analysis. The stock last closed at $12.03.

"The basic compression rental business generates returns in excess of the cost of capital in our judgment," he said in a research note last month.

Although the loans to executives are an "automatic red flag," Clark said Monday that they are relatively small and would only concern him if they were not repaid by the due date in September.

In addition, he said he is comfortable with the firm's off balance sheet transactions

which add about 30 cents a year to earnings, according to his estimates, because he believes the proper disclosures have been made.

Sustenance

Still, some experts remain troubled by the firm's accounting practices, particularly after some disturbing trends were revealed in Hanover's most recent 10-Q.

One concern is that Hanover has been using noncash, non-sustainable gains to boost net income. Net income dropped to $5 million last quarter from $19.8 million a year ago and $11.8 million in December, largely because of a decline in accounts payable and accrued liabilities.

But most of the $5 million profit came from noncash gains, according to a note from the Center for Financial Research and Analysis. Specifically, the company recorded a gain from the sale of property, plant and equipment, as well as a gain from equity in income of nonconsolidated affiliates and a gain on derivative instruments. Without such gains, the company would have reported net income of just $600,000 in the quarter.

Strip out benefits that were gained from a change in the firm's depreciation policy, and net income would have declined even further. Hanover changed the useful life of certain compression equipment from 15 to 30 years last year, leading depreciation expenses to fall to about $3.3 million. That boosted net income by $2 million, or 2 cents a share.

In addition, inventory, debt levels and interest expense have been increasing sharply, and operating cash flow actually turned negative last quarter.

Those issues have led some to wonder whether Hanover will issue an earnings warning for the June quarter. Hanover is currently expected to post earnings of 17 cents a share in the second quarter and 77 cents for the year.

Clark said he wouldn't be surprised if the firm did warn or provide very cautious guidance when it reports second-quarter results, because of the wide earnings miss in the first quarter and because the company has been taking too long to renegotiate contracts in Argentina.

"There is some near-term earnings risk," he said.