Archrock, Inc.
Q2 2008 Earnings Call Transcript

Published: 25 Aug 2008

[Operator:]

Welcome the Exterran Holdings, Inc. and Exterran Partners, L.P. second quarter 2008 earnings conference call. (Operator Instructions) Earlier today Exterran Holdings and Exterran Partners released their financial results for the second quarter ended June 30, 2008. If you have not received a copy you can find the information on the company’s website at www.Exterran.com. During this call the companies will discuss some non-GAAP measures in reviewing their performances such as EBITDA as adjusted, EBITDA as further adjusted, gross margin, gross margin as adjusted and distributable cash flow. You will find a reconciliation of these measures to GAAP measures in the summary pages of their earnings release. During today’s call Exterran Holdings will be referred to as Exterran and Exterran Partners as either Exterran Partners or EXLP. Because EXLP’s financial results and positions are consolidated into Exterran the discussion of Exterran will include EXLP unless otherwise noted. I want to remind listeners that the news release issued this morning by Exterran Holdings and Exterran Partners, the company’s prepared remarks on this conference call and the related question-and-answer session include forward-looking statements. These forward-looking statements include projections and expectations of the company’s performance and represent the company’s current beliefs. Various factors could cause results to differ materially from those projected in the forward-looking statements. Information concerning the risk factors, challenges and uncertainties which could cause actual results to differ materially from those forward-looking statements can be found in the company’s press release as well as in the company’s annual report on Form 10-K for the year ended December 31, 2007 and those set forth from time to time in Exterran Holdings and Exterran Partners filings with the Securities and Exchange Commission which are currently available at www.Exterran.com. Except as required by law, the companies expressly disclaim any intention or obligation to revise or update any forward-looking statements whether a result of new information, future events or otherwise. Your host for this morning’s call is Steve Snider, President and Chief Executive Officer of Exterran Holdings and also President and Chief Executive Officer and Chairman of Exterran Partners. I would now like to turn the call over to Mr. Steve Snider. Mr. Snider please go ahead with your conference.

[Stephen A. Snider:]

I’d like to also welcome everybody to the second quarter 2008 earnings call for Exterran Holdings and Exterran Partners. Joining me today here are Michael Anderson, our Chief Financial Officer of Exterran Holdings and Daniel Schlanger, who’s the Chief Financial Officer of Exterran Partners. To begin the call I’d like to provide an overview of where we are as a company as we approach the first anniversary of the creation of Exterran which was on August 20 last year. Overall I’m really proud of the accomplishments that our great team of employees has achieved over the past year. We’ve merged two different companies and cultures together into one and this alone has given me great confidence in our company and gives us a solid foundation on which to build our future success. More specifically on things with the overall demand we’ve seen for our products and services particularly in the international market we continue to see significant opportunities for both sale and contract operations work throughout the world. Later I’ll talk more about the progress we made during the second quarter on this front. Additionally we’re seeing signs of stabilization in our North America business and we will continue to work diligently to bring this core business back to its historic levels of growth and profitability. I believe we’re doing the right things and focused on the right activities to be successful, but as always the timing of improvements remains difficult to gauge. The course the past year has not been without challenges and we are not satisfied with our overall progress to date. We will continue to evaluate our position and make changes as necessary to drive success. We announced one such change last quarter with the addition of a new management team into the North American business and we announced another this morning with the departure of Chief Operating Officer Brian Matusek. With this change I will be more directly involved in the operations of the company and the management of our profit and loss centers throughout the world. Over the past year Brian has been tremendously dedicated to the success of Exterran and I’d like to personally thank him for all of his accomplishments and hard work and wish him the best of luck in his future endeavors. Now I’d like to move on to talk about our second quarter results and recent activities that demonstrate the progress we continue to make as a company. First, during the quarter we generated sequential revenue increases in each of our international contract operations, after market services and fabrication segments. Second, we were awarded several significant new contracts for international contract operations that more than doubled our backlog in that business over a $120 million in expected annualized revenues. Third, we announced a dropdown transaction between Exterran and Exterran Partners and closed it on July 30. Fourth, we completed an acquisition of an excellent business that we believe fits very well into our North American contract operations and has growth potential in international markets. Furthermore, we made progress on driving costs down in our North America contract operations segment by $2 million over the first quarter level. Michael and I will discuss all of this in more detail as we go through the call. While all of that was good news for the quarter, we did face some unexpected disappointments. In our fabrication segment we recorded estimate costs overruns totaling $31.8 million on two international sale projects that negatively impacted second quarter results. The overruns included $17.7 million related to a Belleli gas to liquids project and $14.1 million related to a gas processing and total solution project in Kazakhstan. I’ll cover these and other operational highlights a bit later in our review. Now I’d like to summarize second quarter financial results for both Exterran and EXLP. In the second quarter for Exterran Holdings revenue was $812 million and EBITDA as adjusted was $166 million. Net income was $21.7 million or $0.33 per diluted share including merger and integration costs of $1.5 million or about $0.01 a share. The $31.8 million in losses on the two fabrication jobs equated to about $0.29 per share. We are pleased with another solid performance by Exterran Partners in the second quarter. As a reminder Exterran Holdings owns a majority interest of Exterran Partners, L.P., a master limited partnership, which provides natural gas contract operation services throughout the United States. In the second quarter’s Exterran Partners recorded revenue of $35 million EBITDA as further adjusted of $20.3 million and net income of $6.1 million. Further with the recent completion by Exterran Partners of its previously announced acquisition from Exterran Holdings we expect that EXLP’s cash distributions will increase by approximately $0.15 per unit on an annualized basis. We were very pleased with the dropdown transaction and the related financing activity which Michael will cover in his remarks. Late last month Exterran Partners announced the distribution of $0.425 per limited partner unit unchanged from the previous quarter and up 21% compared to a distribution of $0.35 per limited partner unit a year ago in second quarter 07. Our distribution coverage ratio remains very strong. As exhibited by the recently completed dropdown transaction we will strive to continue to provide attractive distribution growth for MLP Investors. Just a few days ago we announced the acquisition of EMIT Water Discharge Technology, a company that provides water management and processing services in the coal bed methane gas producing regions of the Western United States on a contract basis. We are very excited about bringing this business into our North American contract operations. The business is complementary to our compression, production and processing businesses and it fits well into our contract operations model. Although a very good acquisition for us just within its existing operating markets we are hopeful that the business can be broadened to other coal bed methane applications throughout the world. Now I’ll provide some more detail on our operational performance in the second quarter. Overall our operating horsepower was down 46,000 horsepower in the second quarter as we grew the international market but declined by 63,000 horsepower during the quarter in North America. The North American horsepower decline during the quarter was generally in line with our forecast. We did see some positive trends during the quarter as the majority of the horsepower decline occurred in April with a lesser decline sequentially in May and then in June. At June 30 we had a total North America contract compression fleet of 4.5 million horsepower and the fleet utilization for North America was 77% as compared to 79% at March 31 of this year. A quarter ago we discussed the enhancements we made to the North American management team and I remain very confident in this team and believe they are focused on the right activities to regain momentum in the business. Specifically we are increasing account coverage and sales effectiveness to increase revenues while maintaining strict focus on reducing operating costs. We believe these initiatives will lead to positive trends in our North America business. From a macro standpoint we’re optimistic that the growth trends in natural gas production in the United States as well as the continuing development of shale and other unconventional resource plays should result in growing demand for compression. Overall activity in more mature basins remains brisk while emerging plays hold great potential for future growth. On the international side of the business we’ve had a number of recent successes in new business development activity for our international contract operations. The strong demand we’ve seen throughout the international marketplace resulted in six new contract operations awards including three projects in the Eastern Hemisphere. These projects are expected to generate over $75 million of annualized revenue for Exterran and are expected to begin operations in 2009 and a few later. These awards are very significant as compared to the approximately $500 million in annual revenues we currently generate in our international contract operations segment and they reflect the strength of Exterran’s position in the robust international market. Additionally during the second quarter we started operations on projects in Oman and in Venezuela. While the commencement of these two projects reduced our backlog we were still able to more than double our international contract operations backlog during the quarter from $60 million to $121 million in expected annual revenues. I do caution that new business development activity is generally lumpy and therefore we do not expect to have this level of new projects to report every quarter. Nevertheless business activity is stronger than it has ever been for the international market and we look forward to reporting future progress in this strategic growth area. Largely as a result of the new projects we started during the quarter our international fleet utilization increased to 94% at June 30 compared to 92% at March 31, 2008 on a base of approximately 1.5 million horsepower. Exterran’s worldwide fleet totaled just under 6 million horsepower at June 30 and worldwide utilization was 81% compared to 82% at March 31. Our gross margin percentage in the international contract operations segment during the second quarter was negatively impacted by some higher than expected labor repair and maintenance costs in Latin America and was impacted by lower revenues due to the energy industry strike in Argentina. We have recovery plans in place on these issues. The strike in Argentina has been settled and we expect to see gross margins in the international contract operations segment improve during the third quarter. As I highlighted in my introduction cost overruns of $31.8 million on two projects overshadowed otherwise strong activity levels and performance in our fabrication segment. These two jobs reduced fabrication gross margin percentage in the second quarter by approximately 8 points. Due to percentage of completion accounting rules our losses for the quarter include all the expected losses of these two projects until their expected completion dates which should occur around mid-2009. We believe that several key actions that we instituted last fall in conjunction with the merger should reduce the potential for cost overruns of these types of projects in the future. We implemented a new project approval process that evaluates project risks and contingencies more closely and we enhanced our total solutions project management staffing. One result of these changes is that we generally seek to take on the higher risk portion of fabrication projects such as installations in difficult environments on a cost plus reimbursement basis rather than on a fixed price basis. Demand for our fabrication services continues to be strong as reflected by brisk inquiry of bid levels and our healthy level of fabrication backlog. Total backlog declined somewhat from $1.27 billion at March 31 to $1.15 billion at June 30 partially due to our success in converting large projects to contract operations work instead of fabrication sales. I’ll now turn the call over to Michael to review our financial performance.

[J. Michael Anderson:]

I’m sure that you’ve had a chance to look at our press release that we issued earlier this morning. During my discussion I will review the second quarter financial performance for both Exterran Holdings and Exterran Partners and also discuss our earnings outlook for the third quarter. Due to the August 2007 merger of course our year-over-year comparisons are still not especially meaningful and so therefore most of the comparisons that I’ll have will be against the first quarter as well as the guidance that was provided during our last earnings conference call. So if we look at our North America contract operations business revenue was $195 million in the second quarter. It was down somewhat on a sequential basis from the first quarter but it was in line with our expectations. We are pleased that costs in the segment declined from $88 million in the first quarter to $86 million in the second quarter. Gross margin percentage was flat at 56% but we do expect gross margins to gradually improve throughout the remainder of the year. Our international contract operations revenue increased on a sequential basis to $126 million in the second quarter. That was in line with our guidance range as working horsepower increased by about 17,000. International contract operations gross margin was about 62% in the quarter and that’s below the 67% gross margin we had in the first quarter and it’s also a little bit below our mid-60s guidance range but as covered earlier by Steve we do expect margin performance to improve in the third quarter. If we move over to fabrication we generated revenues of $394 million. That was above the first quarter levels which were $337 million. It was also above our guidance which was $340 million to $360 million. Revenue was higher than expected due to better sales of standard compressor packages and production equipment which is typically sold on a shorter lead time basis. Gross margin was approximately 10% and of course that was below our guidance of the mid to high teens as a result of the cost overruns in the two projects discussed by Steve. Compressors represented about 40% of fabrication revenue for the quarter, Belleli was about 25% and other production and processing equipment made up most of the remaining 35% of revenues for the quarter. If we move to after market services second quarter revenue was $98 million. That was above both our guidance of $90 million to $95 million as well as above the first quarter revenue of $84 million. All this was driven by increases in North America and also Eastern Hemisphere. Gross margin percentage came in at 22% and that was in line with guidance in the low 20s. SG&A expenses were $95 million in the second quarter. That was on track with our expectations. The sequential increase in SG&A over the prior quarter was driven by costs associated with the expansion of our international operations and also the initiation of non-cash amortization expenses associated with Exterran’s long term incentive plan. We generated $166 million in second quarter EBITDA and that of course excludes the $1.5 million that we had of merger costs. Interest expense was $30 million in the second quarter. That was also in line with our expectations and guidance. We had $7 million in equity income from joint venture investments in the second quarter and also had $8.6 million of other income primarily related to currency translations and a settlement gain. I would like to caution that continued strengthening of the dollar could reduce our quarterly other income line item going forward. The effective tax rate in the quarter was 41%. It’s a little bit higher than what we had in the first quarter which came in at 37%. The tax rate was higher than expected due largely to losses on the Belleli job which it is now unlikely that we will not be able to utilize a prior period tax losses as we believed before they expire at the end of the year. We do continue to expect a corporate tax rate in the mid-30% range going forward. So we reported diluted net income per share of $0.33 in the second quarter, merger costs would increase EPS by about $0.01 per share. Capital expenditures, net cap ex for the second quarter was $130 million. Total cap ex included about $99 million in growth capital and $33 million in fleet maintenance capital. If we look at the balance sheet total debt declined by about $53 million during the quarter from operating cash flow and debt stood at $2.3 billion on June 30. Debt to capitalization was 41%. Now although we believe we are under levered on a consolidated debt basis we did not repurchase any of our stock under our previously announced $200 million share repurchase program during the second quarter. The recently completed dropdown transaction enhanced liquidity at Exterran Holdings and given the current price level of our stock we will look more aggressively at share repurchases during the third quarter. To that end we still have $100 million remaining under our share repurchase program. During May Exterran Partners added $117.5 million of a term facility which was undrawn at June 30 and this was added to the existing senior secured agreement and that expanded the total amount of that facility from $315 million to $433 million and that was all done in conjunction with the plan dropdown from Exterran. At June 30 if we look at the Exterran Holdings revolving credit facility it had $312 million drawn on it, available debt capacity for Exterran Holdings was $412 million and that includes capacity under the ABS facility. Since the end of the quarter we had a couple of transactions that closed. Of course we funded about $108 million from the Exterran revolver for our acquisition of the EMIT Water business and then we also reduced the Exterran revolver by about $176 million in conjunction with the EXLP dropdown. So that net change from those two transactions resulted in a reduction of about $68 million. In connection with the dropdown transaction EXLP borrowed about $176 million in new debt and of course that included debt under that new term loan and issued to Exterran about $2.4 million common units and 49,000 general partner units. Though pro forma for this transaction EXLP has about $40 million of unused and available debt capacity under its existing debt agreements. Also with the transaction, EXLP now owns a compressor fleet of about 984,000 horsepower and that’s about 22% of the combined Exterran Holdings and Exterran Partners contract operations business in the US. I think you all know that in connection with the dropdown the Omnibus Agreement between Holdings and EXLP was amended to reflect adjustments in the caps for both SG&A and operating costs. The SG&A cap was increased from $4.75 million per quarter to $6 million a quarter and the cap and operating cost was increased from $18 per horsepower per quarter to $21.75 per horsepower per quarter. The termination date for the caps has now been extended by one year and the termination date is currently December 31, 2009. As Steve previously mentioned of course the transaction is expected to be accretive to Exterran Partners’ cash distribution per unit by about $0.15 per year. I’d like to now talk a little bit about our guidance for the third quarter. Let’s start with North America contract operations we expect average working horsepower to be relatively flat for the third quarter as compared to second quarter results. We expect that sequential revenue will grow largely due to the contribution of the EMIT acquisition and we expect margins to be flat to modestly higher than the second quarter levels. For the third quarter in international contract operations we expect revenue growth there with the revenues slated to come in at $129 million to $132 million and margins back again in the mid-60s. We continue to expect our international contract operations business for the year to do well with revenues of just over $500 million from 2008 and that would represent growth of about 20% year-over-year compared to the 2007 combined international contract operations revenues for the business. If you look at after market service we expect to generate third quarter revenues of about $90 million to $95 million, margins again in the low 20s and for fabrication for the third quarter we expect fab revenues of $370 million to $390 million and margins in the mid to high teens. When we look at fabrications again for the full year 2008 we do think that we’ll still be within the $1.5 billion to $1.6 billion guidance range that we earlier had expressed but will likely be towards the lower end of that. We expect that net capital expenditures for the full year will be $450 million to $500 million and that is in the upper end of our earlier guidance range due to expenditures for our new international projects that we added this quarter. We continue to expect fleet maintenance capital of about $110 million to $120 million and when we look back at that growth capital we expect that about 60% of it in fact will be coming from international. I want to look at Exterran partners now for a minute. Although operating costs have been higher at Exterran Partners as well the Omnibus Agreement capped EXLP’s operating costs at that $18 per horsepower per quarter and during the second quarter the SG&A cap was not exceeded. The operating cost cap was exceeded by about $3.5 million and as I noted earlier of course the caps on both were increased on conjunction with the dropdown. With the benefit of the cost caps that we had for the second quarter EXLP generated EBITDA of $20.3 million and distributable cash flow of $14 million. This distributable cash flow was sufficient to cover the $0.425 per unit distribution by about 1.7 times. Even without the benefit of the cost caps distributable cash flow covered the distribution by 1.3 times. It’s important to note that the coverage ratios for this quarter include the payment of distributions on the new units that were issued to Exterran Holdings in connection with closing the dropdown transaction since those units were basically issued on July 30 which was prior to the record date for EXLP’s second quarter distribution. When we look at EXLP in comparison to the first quarter with the cost caps EBITDA for EXLP in the first quarter was $19.2 million, distributable cash flow was steady at that $14 million level and coverage was 1.9 times. In the second quarter Exterran Partners’ fleet average operating horsepower was 652,000 and that compares to 659,000 in the first quarter. At June 30 EXLP had total available horsepower of 742,000. That equates to a spot utilization rate of 88%. I think it’s important to note that we made very good progress in converting contracts during the quarter as we added about 350,000 converted horsepower in the second quarter so now we have over 1.6 million horsepower of Exterran Holdings and EXLP’s combined contract fleet now covered by contracts converted to service agreements and that compares to 1.3 million horsepower that we had at March 31. If you look at the total horsepower that’s been converted it now represents about 37% of the combined US contract operations horsepower. Lastly we do expect to file both 10-Qs for Exterran Holdings and Exterran Partners within the next couple of days. At this point let’s turn the call over for questions.

[Operator:]

(Operator Instructions) We’ll take our first question from Michael Urban – Deutsche Bank Securities.

[Michael Urban:]

In the North American business you’ve guided to roughly flat utilization to flat horsepower employed, what would you attribute the decline that you’ve seen? Is it continued share losses you’ve alluded to before or are you seeing any change in customer preferences as a lot of these larger guys and centralized gathering systems gain favor? What are the trends you’re seeing up there at the leading edge?

[Stephen A. Snider:]

I don’t think the trend is any different, Mike, than it was in last quarter. I think that the difference is that we’ve seen a diminish over the duration of the last quarter as I said in my comments that was very heavily front end loaded and it appeared to be the residual of some of the market share loss we had earlier but we’re stemming the tide pretty aggressively. I haven’t seen a change in the buying habits necessarily. I think the market for contract compression remains real strong in North America certainly with all the gas work that’s going on. We just again need to get back in the game with our market share. A lot of effort with customers, a lot of work around the sales side of the business and a lot of work on execution and operations and I think it’s paying off.

[Michael Urban:]

So to be clear, as we sit here today at the leading edge, you don’t feel like the share losses are continuing to be just stabilizing?

[Stephen A. Snider:]

We hope that we’ve stabilized it, yes and we’re hoping that the third quarter shows much more stable numbers like Michael has guided to. We’ll see at the end of the quarter how it turns out.

[Michael Urban:]

On the international side you spoke to some of the issues that drove the margin there but you also mentioned that you are having some success in converting folks over from fabrication type projects on an operate, do you feel like there’s any impact on the margin there going forward? Are those inherently lower margin businesses or are you trying to entice people to do that by perhaps offering a lower margin than what the traditional contract business has been international?

[Stephen A. Snider:]

No, not all. The margins on those projects will be just fine and be in alignment with the international margins we’ve had on other projects. I think the difference is simply that we’re aggressively pursuing them in the Eastern Hemisphere now where in the past you would have automatically defaulted to a sale, now we’re taking some of those customers over to the contract side and it’s being accepted very readily and hence the success in this quarter with landing three Eastern Hemisphere total solutions projects.

[Michael Urban:]

Finally you mentioned that you’re going to hopefully be a little more aggressive this quarter on the buy back given the greater liquidity at the EXH level. Where the stock is now you’re almost at a level where per horsepower basis and with what some of the pieces are valued at from a per horsepower basis you’re trading at or maybe below what you can build at, and $100 million is where you’re at now, in theory shouldn’t you be buying every dollar of capital you can come up with should go into the buy back in theory. What’s the deal on that?

[J. Michael Anderson:]

I think we’ll just reiterate the fact that we’ve got $100 million left on the buy back program and we are going to be looking more aggressively at analyzing this over the course of the quarter and can’t really disagree with anyone that you said, Mike.

[Michael Urban:]

Is there anything magical about the $100 million other than that’s what the Board authorized? Would there be anything liquidity wise that would preclude you from going higher than that?

[J. Michael Anderson:]

We mentioned on the details of the call that the Exterran Holdings credit availability is a little bit more than $400 million. The magic of the $100 million is that we have a $200 million share buy back program and we already bought $100 million already in previous quarters.

[Michael Urban:]

If you are able to finish that there’s no reason why you couldn’t go back to the Board and re-up?

[J. Michael Anderson:]

That’s correct.

[Operator:]

We’ll take our next question from Robert Christensen – Buckingham Research Group.

[Robert Christensen:]

I want to be clear on this, the overruns on the two projects, will they have any kind of tail? Will they be ongoing? Your guidance suggests that they won’t. Take me through the percentage completion type of accounting. Your comment there.

[J. Michael Anderson:]

Bob, just real quick on that. Both these are lost contracts so percentage of completion accounting says you will take all the loss that you had for the rest of the project in this current quarter. Basically the forecast for the rest of these two projects is a 0% margin in coming quarters. From a percentage completion standpoint the Belleli job was probably in the order of 75% complete from a revenue recognition standpoint and the other job is about 50% complete from a revenue standpoint.

[Robert Christensen:]

The fact that it was in Belleli, it appears to me that this is the second disappointment from Belleli, I know those two reactors were set back and had to be reworked, that cost you. Previously I think the company has mentioned that Belleli you just enjoy the future and the robust period for their product lines and no need to even contemplate a divestiture because the business might not fit. Does this motivate you to reconsider?

[Stephen A. Snider:]

No think this is outside of that consideration and the facts here are these are products that we have elected to build in our Dubai facility and normally would have been built in Italy. It is the first time this type of equipment has been attempted in our Dubai facility. I think we’re paying the price for the learning curve in Dubai and the project that we had the first time that you’re referring to on the reactor vessel is this same project and it is the same one that’s being built in Dubai. I think if we built it in Mantova, Italy where this build this type of equipment all the time we might have had different results but that water has passed the dam by this point. This doesn’t do anything to change the capabilities of Belleli, it was more of a startup cost issue in a new facility.

[Robert Christensen:]

How about the Kazakhstan, a little more color there. It sounds like the installation was the problem area. Could you spend a little time on that for us?

[Stephen A. Snider:]

Yes, the installation was the biggest part of the issue there and that’s a job that we probably went a little bit too aggressively to get into a new market area and took a job that we probably hadn’t done enough homework on with all of the issues in doing business in Kazakhstan. We had some surprises early on and they manifested themselves over the last quarter and when we got to this point which we also believe is a full summation of the cost of this project going forward. This one is definitely a learning curve on a sale project in Kazakhstan, new market, new customer and the installation bit us badly.

[Robert Christensen:]

One more if I may and then I’ll get back in line. The departure of the Chief Operating Officer, was he under any kind of contract? Did it have more term on it and does he have a non-compete clause?

[Stephen A. Snider:]

No, nobody is under contract at Exterran and I’m looking at somebody for the non-compete clause. We’ve got a change of control agreement at the merger and as part of that he’s gotten a non-compete agreement for a while.

[Operator:]

We’ll go next to Geoff Kieburtz – Weeden & Co.

[Geoff Kieburtz:]

I also wanted to ask about the fabrication cost overruns just to clarify here as to whether the charge is taken because of performance deterioration during the quarter or whether any part of this was related to the post-merger review of projects already in house?

[Stephen A. Snider:]

No, this is all related to realization in this quarter that we had cost overruns on these projects in Dubai that I already talked about and as we began to go into execution on the Kazakhstan project it became apparent we were having cost overruns there too and it all occurred in the last quarter. No, it’s nothing that has to do with a project review. One of the projects, the Belleli project, was on the books at the time of the merger, the other project for Kazakhstan was actually booked since the merger.

[Geoff Kieburtz:]

I think Steve you mentioned in your comments that you’ve instituted procedures and policies that will reduce the risk of these kinds of problems recurring and I wondered two things, could you clarify are those substitution projects relative to fabrication sales projects and can you give us a little bit of sense as to what the nature of those new policies and procedures are?

[Stephen A. Snider:]

Yes, they’re common to both because when you bid a job like that it’s immaterial to us whether it’s a sale or a contract operation from the risk assessment and project management side and we have significantly increased the rigor around project analysis, risk analysis, certainty around costs, contingency control, margins that we’re willing to take and have put, I can’t explain how much more discipline we have in the process now than we probably had nine months ago when some of these jobs were first coming through the system. I have a high degree of confidence that jobs post this Kazakhstan job and these new ones we just booked will be executed at the kind of margins that we’ll be proud of and we’ll be reporting those when they occur.

[Geoff Kieburtz:]

Would you say the problems on these two projects were more at the up front contract? You mentioned not doing enough homework and so on, or were they really operational because you had mentioned Dubai being kind of a first timer in this type of project?

[Stephen A. Snider:]

Yes, they’re each different answers. On the Belleli project, that’s operations, we just didn’t execute because we didn’t have the people with the experience to build it the way we needed to build it in Dubai and we’re paying the price for that. We had manufacturing issues there which ate up man hours and ate up material. In the Kazakhstan project, that was up front for estimating of the real cost of that job and running into the real cost later on when we come in pretty aggressively to capture a new project. So I think it was risk assessment and cost analysis and certainty of costs before we went in.

[Geoff Kieburtz:]

Quickly a question on the North American market, I do appreciate your comment about the difficulty and precisely forecasting when margins can get back to an acceptable level but can you share with us at least an approximation?

[Stephen A. Snider:]

An approximation, you think I just gave you a forecast that I told you I just can’t give you. What we’ve said is and it would be consistent with us and I’m still believing it that over 2008 we’re going to continue to improve North America and we have I think guarded the last two quarters with don’t expect things to change a lot over 2008. By the end of the year hopefully we’re seeing some small gains in margins in North America, but or focus right now is on the revenue side, stopping horsepower loss and making certain that we’re beginning to participate in our share of the market. The cost improvements will help us toward the margin goal but it’s too soon to tell you if we’re going to be able to get there in third quarter, fourth quarter, second quarter of next year. We’ll just have to take it a quarter at a time.

[Operator:]

We’ll take our next question from Sharon Lui – Wachovia Securities.

[Sharon Lui:]

This question is for the MLP, when you guys are setting the distribution for the third quarter would you consider raising the distribution above the $0.15 accretion given your high coverage ratio right now?

[J. Michael Anderson:]

Sharon, I think we’re just going to have to look at that as we get to third quarter and we see the performance. We think that the transaction is going to $0.15 accretive. We have also said that to date we have generally relied upon the dropdowns to provide distribution for us but we do certainly have high coverage ratios but we will just have to take a look at that quarter from now.

[Sharon Lui:]

Looking also to third quarter you mentioned that you expect the margins for North America to remain relatively flat. Is that the same type of forecast for the MLP?

[J. Michael Anderson:]

Yes.

[Operator:]

We’ll take our next question from [Christopher Gillespie – Simmons & Company International].

[[Christopher Gillespie:]

My question pertains to North America and going back to the margin question, last quarter we had talked about a lot of issues with the rising costs in labor, lube oil and diesel. I was just wondering what are you we seeing now and is that going to, with North American costs down $2 million quarter-over-quarter can we expect that it’s being mitigated by the synergies or what can we expect there?

[Stephen A. Snider:]

I think the costs are still increasing. There hasn’t been any letup on labor cost increases. Certainly lube oil, etc. is still in the high end of the range so I can’t say that that has reduced itself. I would say that all the gains we made in the second quarter were just streamlining the operation, getting more efficient at what we do and basic execution of locking and tackling, scheduling people better, taking care of units better. I’m optimistic that that beginning change, the little blip we’ve seen in the second quarter is representative of what we’re going to continue to see.

[Operator:]

We’ll go next to Glenn J. Primack – Broad View.

[Glenn J. Primack:]

What are the return on capital assumptions for the recent international project?

[J. Michael Anderson:]

They’re very much in line with what we’ve historically talked about. In international we typically are looking at returns on capital on an unlevered after-tax basis in the high teens and getting into the low 20s. They’re in line with that.

[Glenn J. Primack:]

In North America I guess over time do you think you can earn your cost of capital there?

[J. Michael Anderson:]

Absolutely. We do very well in terms of incremental fleet investment, what kind of returns in revenues and margins that we get on new fleet investment.

[Glenn J. Primack:]

Current lead times, if I was going to order a 1,000 horsepower unit and I had to call up CAT and I had to call [Aerial] what would that take to get delivery from them and put the skid and stuff together?

[Stephen A. Snider:]

If we’re building a unit where we had to go back to the manufacturers and get the engines and compressors we’d be looking at six months to deliver that compressor to you at this point in time but a lot of the fabricators have engines and compressors coming through that we’re fabricating along the way so we’re generally quoting shorter lead times to customers now because we have inventory coming in that we can apply it to. It might be two or three months to get a compressor to you instead of six.

[Glenn J. Primack:]

And if was competing against you would it take me longer to get something that was higher horsepower versus when you can receive it?

[Stephen A. Snider:]

Generally it’s going to depend upon who has inventory and shop space but since we have such a large allocation we have a pretty good advantage on delivery most of the time. I would say that we’d be as competitive as anybody on delivery.

[Glenn J. Primack:]

Going back to Mike Urban’s comment not would only your stock be trading under liquidation but for someone to put together the whole plate it would take them a long time anyway on top of that?

[J. Michael Anderson:]

Absolutely.

[Glenn J. Primack:]

At what percent are you starting to book business in the US for 09?

[Stephen A. Snider:]

Yes, there’s some business coming in, definitely in the fabrication side, we’re booking a lot of 09 business with longer lead times and on contract units, some of it will be starting in 08 or 09.

[Glenn J. Primack:]

Those customers that buy direct, they just come through your fabrication side or do they go back through your supplier base and put a unit together themselves?

[Stephen A. Snider:]

No, the supplier base has just been referring to us or one of the other fabricators that distributes for the supplier so either CAT or Aerial would send them back to us. They don’t sell engines and compressors direct to third party users.

[Glenn J. Primack:]

Any preexisting contracts at all from the Universal and Hanover, that’s been all converted into Exterran contracts?

[Stephen A. Snider:]

Yes.

[Glenn J. Primack:]

Yes there are preexisting or yes everything has been converted?

[Stephen A. Snider:]

Everything has been converted over to Exterran at this point in time.

[Operator:]

We’ll take our next question from Paul Carpenter – Semaphore Management.

[Paul Carpenter:]

A few questions, the first one not to beat a dead horse too much on the value of the company relative to the cost of reproducing the whole fleet but I would just like a little more detail on your capital allocation mindset. You’ve gone out and made this acquisition of these assets recently, the new purchase of EMIT whereas it could have been an opportune time to go back and buy back the stock instead. As you mentioned you did buy back $100 million of stock post the merger since the formation of Exterran at if I believe correctly much higher prices than what it’s trading at today. So my question for you is how do you balance that kind of capital allocation decision between making that acquisition and buying back the stock? Is there a way you can dial down the growth cap ex? I understand that for a custom job you can’t just take the equipment that might be idle elsewhere but is there way to get the growth cap ex down maybe to move some of the idle equipment in North America internationally as you see it with some other oil field service companies?

[Stephen A. Snider:]

We’re actually doing that. If you listened to the comments the international utilization went up because they reapplied some existing equipment into their market and in the North American market the first place we went for equipment is to the idle fleet and to that end over the last I’d say three months or so, four months maybe, we have become much more aggressive on refurbishing existing units and putting them on a ready line so we can get them to a customer very quickly and it’s all about keeping existing assets utilized. The only place we’re building new assets in the horsepower category where we’re essentially fully utilized and the market is still absorbing more and that’s in the 1,000 to 1,300 horsepower range. The new investments are going there where the returns are just outstanding and we don’t have assets to cover the market as it sits. On the allocation of capital between stock buy backs and acquisitions and what not, we do continually look for acquisitions that fit our long term gain plan for the company and yes we do internally balance our available cash and make conscientious decisions as to where we’re going to spend it. The EMIT Water Technology we’ve been talking to for a while and they are at the very beginning of coal bed methane gas production and their customers are largely the same customers we do business with later in the compressor side and to get the gas out of coal bed operations, to get the methane to flow, we’ve got to take the water off and these folks have developed a wonderful technology to do that and they do it on a contract basis, not on a sale basis so it fits our contract operations, gives us earlier entry into coal bed methane projects and over the long term should help us around the world with other opportunities in produced water from coal. So we thought it was a strategic fit and made sense and that’s how that acquisition came about. Michael, I’ll let you comment if you want.

[J. Michael Anderson:]

I think with regard to capital allocation I think we have typically said that we like the returns in our business, we would like to reinvest those into things that make a lot of sense. We think EMIT it makes a lot of sense, we think international contract operations these new jobs make a lot of sense as does continued selective investments in the US market. That being said, it’s a business that in this last quarter basically generated $53 million of free cash flow that we used to pay down debt despite some of the growth opportunities that we had. So there’s probably some opportunity to do both.

[Paul Carpenter:]

Another question if I could, with utilization in the US it’s my understanding having followed at least the universal side of the business since the transaction that created it which I think was about 10 years ago, the North American utilization now is in frankly the very low end of the range and in a price environment for natural gas which compared to the last 10 years is a much favorable price environment. Anecdotally I’ve heard stores about customers who have been leaving you frankly because they just can’t get the sales person to return their call because of problem with integration or such from the merger and that is surprising to me given that it’s now been something like a year since the merger. So what can you do to address this? What can you do besides putting a new COO in charge of the North American business?

[Stephen A. Snider:]

Yes, a new COO in charge of that is not going to change that dynamic. We’ve been aware of that as well over recent months and the answer to that was encrypted in my comments in that one of the major things we’ve done in the last 90 days in North America is aggressively reassess our sales effort and we have put additional incremental sales talent in place, we have gone through an intensive training of every sales person in North America and we have added a substantial amount of new sales management talent into the organization to stop exactly those kind of issues that you are bringing up because they are very painful. When you hear a customer that’s not getting calls returned from a salesman you can’t stay in business very long. This isn’t a complicated business. It’s pretty straightforward. You go call on the customers, you have the equipment, you execute your operations and you do a good job and you get more business. We are at the low end of our utilization, competitors have taken market share from us in a robust and growing market, there’s nothing I can do but agree with that. All I can tell you is that the higher effort of our North American group is around changing that and I think we made some significant progress, we got our costs reduced in the second quarter and we also began to trail down on releases in the second quarter. That’s a long answer, more than you asked but hopefully it’s fulsome for you.

[Paul Carpenter:]

The point at which I was trying to get to is it’s been a year since the merger and Wall Street is your worst friend at the worst of times, they love you when you’re doing well and they want you to push you to buy back your stock at any time, but now you’re in an environment where you haven’t been doing well, the stock trades at a discount when it looks like the value to replace the company disregarding what people may have urged you to do back when you were buying back the stock a year ago post merger. Now I guess I just don’t understand why there’s not more urgency either to push to fix the business more aggressively in North America or to push for a big dropdown to the MLP because if there was ever a time to give up a bit on the financing rate there on the cost for the dropdown to buy back the stock, it sounds to me that that would be a very accretive investment for all your shareholders and you wouldn’t have to take the risk of Belleli not being able to execute on a project or buying a business which you think is good but don’t really know, you’re buying your own assets. You should know them better than any other assets and to me it seems like a low risk play and I guess I don’t understand why there’s not more enthusiasm or urgency about that from the management team.

[Stephen A. Snider:]

I want to take the first one off the table and you made an indication that maybe there wasn’t enough urgency around the situation in North America and I would invite you to come talk to some of the North America people about the sense of urgency we have around that issue. It’s not that we’re ignoring it, not taking action. I think the plans have been well thought out, they’re being implemented and we’re making progress. On the second point we just completed a dropdown which was only a week and a half ago so I think what you’ve suggested is worth us considering. We’ve had several suggestions on how we can be more aggressive on stock buy backs. There is no one more upset about the value of our stock than we are but I would also challenge you that the comment was made that we’re not executing very well and I agree with that in North America, at the beginning of this merger what we said was we were going to use North America cash flow, dropdowns into the MLP to fund some extensive international growth and that would be a big catalyst for us and I would suggest that we’re executing extremely well in that regard with finding new projects, moving to contract operations and getting new project on the books. I think in some areas we’re doing fine and some areas that we need to have some improvements.

[Operator:]

We’ll go next to [Rick Johnson – Thai Capital].

[[Rick Johnson:]

I assume it’s the Kazakhstan project that is 50% complete, is that correct?

[Stephen A. Snider:]

Correct.

[[Rick Johnson:]

Now your visibility on estimating those costs at 50% complete in that area of the world, how do you feel about that? Because I’ve seen lots of these types of situations where the costs continue to escalate, the estimates continue to get worse and the charges don’t stop.

[Stephen A. Snider:]

We’ve been through that contract and when you’re 50% into one of these turnkey contracts like that you’ve got your hard costs hammered out and now we have the firm prices on installation, we have the firm prices on transportation, we have all of those add on costs that we didn’t have it nailed down as well as we should have at the bid time. We know what it’s going to cost and that’s how we got to these numbers today and I think we’ve scrubbed it about as well as you can scrub a project.

[[Rick Johnson:]

So you think you have the installation costs set?

[Stephen A. Snider:]

I think we have the installation costs for what we have proposed to build at this point is set, yes. Now there is always risk, we’re in a new country, there are unexpected things that happen, you never know what’s going to end up. You were correct about that, but from what we know and where we are today we took everything that we thought we needed to take to make this come whole for that particular job.

[Operator:]

We’ll take our next question from Hamlin Thompson – Westfield Capital.

[Hamlin Thompson:]

Just a quick question on what competitors are doing in pricing on the North American contracting market understanding that they are also facing cost pressures? Are you seeing any of them raising prices and do you expect to follow that any time in the near future?

[Stephen A. Snider:]

The only place we’ve seen price increases that we’re able to document is a competitor that’s in the small horsepower segment and who indicated they are going to raise their price a few percentage points. I can’t say that we’ve seen a tremendous of pricing improvement in North America market nor have we seen pricing erosion. We seem to be sitting on these prices right now and I suspect there’s a couple of reasons. I think that our competitors are enjoying taking market share from us right now and with that market share erosion we’re in a weakened position t go out and try to increase price and drive the market. So we’re kind of in a balance right now where the market seems to be sitting tight with where it is.

[Hamlin Thompson:]

Just remind me, historically what’s pricing been in this business? Is it inflationary year in, year out?

[Stephen A. Snider:]

Yes.

[Hamlin Thompson:]

So would you expect to, and I assume pricing hasn’t moved at all this year, would you expect t go back towards that inflationary pricing next year?

[Stephen A. Snider:]

If we were in a more normal market and not suffering the erosion that we’d suffer we’d be going to our customers now and asking them for cost increase adjustments to cover our labor costs and lube oil costs. We just don’t feel strong enough to do that right now. We need to execute better first.

[Operator:]

We’ll take a follow up question from Robert Christensen – Buckingham Research Group.

[Robert Christensen:]

Many of the E&P companies are citing the over pressured nature of the Haynesville Shale and so no immediate need for compression. What are your thoughts there?

[Stephen A. Snider:]

We’ve had some success in the Haynesville Shale so it can’t all be over pressured. I’m going to have to claim ignorance on that detail at this point in time. I have not paid close attention to that play.

[Robert Christensen:]

Where is most of your new horsepower going then? I’m trying to track you around and find you in the Fayetteville Shale and I don’t find much entry there. So where is most of the growth coming from for Exterran domestically?

[Stephen A. Snider:]

Some of it’s coming out of the existing basins that we have served for a long time and we’re seeing a nice uptick in both the Northeastern US and we’re beginning to see a nice uptick in the Northern Rockies as well. Basically the Rocky Mountain area is out in the West and up to the East areas where we’ve always been strong and we’re seeing some nice growth there.

[Robert Christensen:]

The backlog that you provide us in the press release, what was the amount related to Belleli?

[J. Michael Anderson:]

It was about $600 million.

[Robert Christensen:]

And if I look to the total backlog of the company, compressor fab and production and processing, how would those break out between domestic and international?

[J. Michael Anderson:]

I think it’s probably about a 50/50 mix when we look at those two segments for that which is not much of change that we’ve talked about historically.

[Robert Christensen:]

If I might maybe I’m a little confused when you cite that you have $120 million of annual revenues in your backlog related to international, how does that tie to the backlog that you have published? I guess that’s what you’re going to build and then is what you’re going to be seeing in the way of future revenues related to the rental of equipment? I’m just not totally clear. If you could just help me on that.

[J. Michael Anderson:]

Bob, I’m glad you asked that question if you were confused about it because we don’t want anybody being confused. The backlog numbers that we put out in the press release are fabrication backlog so that’s the number that today is $1.1 billion and up until this point you and I have been talking about that. $600 million of that is Belleli and the split international and domestic on compressor fabrication and production processing. Completely separate from that is a number that we talked about in our call specifically the international contract operations backlog. That number today is a little bit North of $120 million of annualized revenue is how we measure that. So today we talked about 2008 international contract operations being about a $500 million revenue business. We have another $120 million of annualized revenue that we will be adding to that that is in firm backlog for us today.

[Stephen A. Snider:]

Bob, on the fabrication side all that fabrication is sold to third parties. That does not include anything we build for ourselves.

[Robert Christensen:]

You hired a lot more management for the domestic business, that was a big part of your first quarter conference call and here you are saying you’ve hired more people. Who are these people? Where did they come from, other companies that they had worked for in the compression business? Who are these people? How many? What’s the cost of this management I guess initiative towards the domestic?

[Stephen A. Snider:]

Bob I think actually what we said at the end of the first quarter when we went into the second quarter was that we had reassigned a group of talent from Exterran into North America and the changes we made in North America at that time were all internal people who got reassigned from one other position over to a position to help out the North America effort. In sales and sales management in the field we are always hiring, losing people, adding, subtracting. What we have done is we’ve tried to increase the number of sales people and improve the level of sales management that we have holding those people accountable. I don’t know that we need to go into how many salesmen we have and how many we hired and where they came from. Some have come from the industry, some have come from outside the industry. I think the issue here is that we are aggressively finding ways to get in front of our customers, communicate better and we’re trying to do everything we can in our brief experience of only 50 years in this business to drive this market forward. That’s where we are.

[Robert Christensen:]

If I may, certainly appreciate the hands on nature of the investor relations effort and the ability to reach out and talk to you and get information but it seems to me that there’s a void between our conference calls. Nice to be greeted and be updated every 90 days but there’s very little information flow as to what is happening in the way of international business or domestic business mid-quarter. Is there any way your company could provide more interim updates or information? Do you see a necessity for that? Because I feel it.

[Stephen A. Snider:]

I feel the opposite. I think that the shareholders are better served if this management team keeps their head down and keeps moving the ball ahead and report on a quarterly basis what we’ve done, the business doesn’t change in a monthly basis that anything major and I think that we need all hands on deck making this business perform properly. You obviously know I’m not in favor of your suggestion at this point in time. I appreciate the idea and I wish you could communicate better with everybody and tell our story on a regular basis but it’s more complicated than that right now.

[Operator:]

We’ll take a follow up question from Geoff Kieburtz – Weeden & Co.

[Geoff Kieburtz:]

This will be a lot easier. The sales of PP&E in the quarter jumped up. Can you tell us anything about that?

[J. Michael Anderson:]

We just had some customer purchases of some equipment and actually a portion of those were in the MLP, nothing really out of the norm. That happens from time to time, this one was a little bit bigger than some other quarters but we’re always moving things in and out of the fleet.

[Geoff Kieburtz:]

Was that principally domestic?

[J. Michael Anderson:]

Yes.

[Operator:]

At this time we have time for one additional question. We’ll go to Glenn J. Primack – Broad View.

[Glenn J. Primack:]

Given the robust demand internationally and the orders that you’ve booked that start to flow through next year and more it seems like in 2010 your gross profit dollars from international rentals business should at some point I’d guess eclipse domestic as we move out of 09 into 2010. Is that a fair assumption?

[Stephen A. Snider:]

I think that’s too soon, I don’t think we can eclipse the North America contract operations with international by then but it certainly is on a track to get there at some point in time. If we’re able to add most of that $120 million by say the middle of 2010, we’ll have as Michael said significantly increased where we are in contract revenue but I don’t think it’s going to equal North America unless North America goes down but that’s not the game plan. Does that answer your question?

[Glenn J. Primack:]

If I flatten out North America and I put in a $120 million with the given margins where they’re at today, the international gets a lot closer towards your domestic, doesn’t eclipse it, but I’m thinking maybe 2010 could be a timeframe where the international gross profit dollars are ahead of the domestic.

[Stephen A. Snider:]

That’s what we suggested at the time of the merger would be outcome of this new combined company and the successes are getting eclipsed by some of the other issues that we faced as well they should but the international execution and the demand that we’re seeing and the way we’re able to respond to it, I think is just outstanding and it’s making us move right toward that vision that we had when we started.

[Glenn J. Primack:]

Lastly in the US do you have a different pricing schedule for rental versus if someone wants to purchase so that potentially you capture a little more maybe on a purchase versus as a way to entice someone to rent more or does that really not happen?

[Stephen A. Snider:]

We do but remember they can buy compressors almost anywhere in the US, there’s lots of fabricators that build compressors so you have only so much leverage to be able to raise a price to push them over to the other side. We do try to balance that though and our first effort is always to contract equipment and we sell only as a second choice.

[Glenn J. Primack:]

And how about global alliances? Do you have anything like that in place with the larger customers?

[Stephen A. Snider:]

Yes, both companies have had global alliances and regional alliances and country alliances with different customers. Probably our biggest is with Chevron, it’s a worldwide alliance with them and we do work with them all over the world.

[Glenn J. Primack:]

The reason I ask is if I go back to that original conference call when you guys announced the merger and that last question came from a customer who made it sound like potentially you guys had a velvet hammer post integration and everything and it may be not until you get some of your share back and execute or maybe not at all domestically.

[Stephen A. Snider:]

I always find it interesting when Royal Dutch Shell is concerned that Exterran is going to take advantage of Shell Oil Company. I’m glad they’re thinking like that but somehow I just don’t think that’s going to pan out correctly for them.

[Operator:]

That will complete our question-and-answer session.

[Stephen A. Snider:]

Just a couple of comments. One is that I’ve been informed that I made an error that I need to correct so we don’t have to issue any paperwork after this meeting and that is that Brian Matusek does not have a non-compete with Exterran so I take back what I said before that we might have him under change of control and the actual correct answer is that he does not have a non-compete. I think other than that I’d just like to reiterate a couple of things here that I think is important for everybody on the phone to understand. This is not a complicated business that we run. We’re a business where we take assets and put them to work and we run them very well. It is all about execution, it’s all about customer communications, doing what you say you’re going to do, charging a fair price for it and getting it done. We have been doing it in the legacy companies to Exterran for 30 years, 40 years, 50 years and many of you have been around the legacy companies that we came from and have talked to them over the years and they’ve executed well. We’re going to get this right, we have enough management in place with a deep amount of experience as to how this business works and what we’re going through right now is clutter. We will get it cleaned up, we will get it performing properly and I think we have the right team focused on taking it there. With that I’m going to conclude for this quarter and in 90 days we’ll get back together and hopefully we have a much more pleasant conversation. Thanks everybody for joining us today. I really do appreciate your interest in Exterran.