Natural gas-compression service and rental companies have been very busy this year, muscling up through public offerings and mergers and acquisitions. As North American gas fields mature, they require some type of compression to maintain or increase their output. What better way to send more gas to market than by adding compression rather than expanding or building new pipelines? Gas demand (more so than prices or rig counts) drives demand for compression. It is essential to all phases of production and transportation of gas, notes a report by analyst Yves Siegel of First Union Securities. Currently there are two publicly traded companies in this niche, Hanover Compressor Co. (NYSE: HC) and Universal Compression Holdings (NYSE: UCO). Through several recent acquisitions, they are duking it out to see which can be named the fastest-growing, although Hanover is the largest. (See chart.) "These companies are production-oriented so they have good visibility. They are not as cyclical as the typical service company," says Lehman Brothers analyst Lisa Hackman. How big is the compression market? Tulsa consultants Spears & Associates estimate there is about 27 million horsepower of field compression in the U.S., of which about 7 million is outsourced. Lehman Brothers says there is 23 million horsepower worldwide, with 16.5 million HP in the U.S. Both agree that most of the field compression is owned by producers, with about a third outsourced. The contract compression market grew about 8% annually during the past nine years, according to Lehman (and most of the market is in North and South America). But analysts forecast about 15% annual growth in the next few years. That will be driven by strong natural gas fundamentals and operators' increased willingness to outsource compression equipment and services rather than tie up their capital. It is an often-overlooked part of the oilfield-service sector that promises to deliver earnings growth almost regardless of the gas-price cycle. It doesn't hurt a bit that North American gas drilling has soared during the past 18 months and will most likely continue. A study by Anadarko Petroleum indicates that by 2005, production could rise an incremental 1- to 2 billion cubic feet per day-which implies an average annual count of 1,000 gas rigs. The formula for success looks pretty simple: more wells, more gas, more compression. Consider too, that for companies like Burlington Resources, which produces 1.9 billion cubic feet per day, or Apache Corp., which produces about 990 million a day, gas compression is a meaningful expense. The pipeline compression market could be huge as well-and then there is the entire international arena for gas production as well. "The international market represents about 35% of the total compression fleet, yet 74% of world gas consumption," says Lehman Brothers' top service analyst, Jim Crandell. The industry is a very capital- intensive business that doesn't generate much free cash flow. Investors tend to focus on earning as the main metric when perhaps they should look at enterprise value-to-EBITDA (earnings before interest, taxes, depreciation and amortization), notes one analyst. These companies can have a high debt-to- capital ratio compared with other oilfield-service companies. To get around that, these companies use synthetic leases, an off-balance-sheet form of debt. They sell their compression assets to a trust formed by a finance institution such as a bank. They get the benefit of operating income but because the assets are in a trust and off their balance sheet, they do not have to report depreciation. This tends to inflate earnings. Still, the niche is attracting more attention. At press time, Simmons & Co. International was about to launch formal coverage of the gas-compression rental industry. Lehman Brothers launched coverage in March. "Outsourcing [gas compression rental] is a growing trend due to the benefits to the operator," notes Crandell in a recent report. "These include the reduction in capital employed by the operator; the ability to more accurately match the compressor's horsepower capacity with the changing needs of the well, pipeline or processing plant; and increased utilization and lower costs resulting from better maintenance and the use of skilled [compression] personnel," he says. "We believe the trend will broaden further internationally, given these benefits." Compression M&A No wonder compression companies are flexing their muscles. In June, market leader Hanover made investors sit up and take notice when it announced its pending acquisition of the compression and certain gas-treating assets of Schlumberger (the old Production Operators Inc. which SLB had acquired in 1998). Hanover will pay $761 million in cash and stock, by far the Houston company's largest deal yet among a string of acquisitions made since it was formed in 1990. Schlumberger will end up owning about 10% of Hanover's shares for the upside, while at the same time exiting a noncore business. In addition, Hanover will pay up to $58 million with respect to a joint venture formed with Schlumberger, which has agreed to hold its HC shares for at least three years. A senior Schlumberger executive will also join Hanover's board. Pro forma for the acquisition, Hanover's EBITDA for the 12 months ended June 30 was about $323 million. The deal is expected to add about $200 of revenues to Hanover within a year after the deal closes. "With this important acquisition and strategic alliance, Hanover has the scale, the resources and the partner with which to compete and grow in the U.S. and internationally," says Michael J. McGhan, president and chief executive. Hanover has grown its horsepower at a compound annual rate of 40%, and cash flow by 44%, since inception, says analyst Siegel. It's done this by consolidating many of the regional mom-and-pop compression-rental firms, then branching out internationally. It operates in eight countries with Venezuela, Canada and Argentina the most active. The recent deal vaulted it into new markets in the Middle East, Asia and Africa. It remains the largest company to focus on renting and selling equipment for natural gas compression, dominating the U.S. market with about a 60% share. Lehman has a Buy on Hanover, expecting it to deliver steadily increasing earnings, rising from about $1.35 per share this year to $1.75 next year and$2.25 in 2003. The company is increasingly oriented toward higher-horsepower units that command longer-term contracts and higher margins. First Union has a Strong Buy. "We believe it can sustain 25% to 30% earnings-per-share growth during the next several years," Siegel says. Future growth also should come from a fledgling business unit that manufactures and rents gas separation or treating equipment for the well site. This is used to separate the oil, gas, water and contaminates before the gas enters the gathering system or pipeline. Currently this makes up about 10% of Hanover's revenues, but it generates much higher margins of up to 75%, Crandell notes. The company plans to spend about 10% to 15% of its budget this year on standardizing the gas-treating equipment, much as it has standardized its compression equipment. In July, Houston-based Universal Compression also made headlines by closing two deals. It acquired KCI Inc., a Tulsa fabricator of large-horsepower compressors, for $26.3 million in cash and 694,927 shares of UCO common, plus absorbing $51 million of debt. The deal added a manufacturing facility in Tulsa, which augments its Houston and Calgary facilities, and another 125,000 horsepower. It also paid $25.7 million in cash for Louisiana Compressor Maintenance Co. With these two deals, UCO expands into the pipeline-compression market. In February it acquired Weatherford Global Compression Services, a unit of Weatherford International, to boost its No. 2 spot in the compression-rental marketplace by adding 950,00 horsepower. At the same time, the company raised $114 million by issuing 4 million shares of common stock at $28.50 per share. Lehman Brothers initiated coverage of UCO in March, saying it believes in "strong, steady growth" for the company. Since the $149-million IPO in May 2000, the company has made six large acquisitions. Its compound annual growth rate for revenue since 1998 is 56%, pro forma its July acquisitions. With these deals, UCO now offers an integrated line of products through sales and rentals, operations, fabrication, and maintenance for compression in gas fields and for gas pipelines. Annual rental revenues are about $330 million, fabrication and sales revenues are $200 million and parts and service yield about $120 million, pro forma all the recent acquisitions. "Given the company's high potential growth rates, coupled with its partial insulation to downturns (resulting from steady cash flows) we believe Universal Compression can trade at a premium to its peers even during the early stages of a recovery. We expect its total market share (measured by horsepower), will grow to 37% in fiscal 2003 from the current 33% level," says Lehman's Crandell. UCO intends to grow in three ways, said president and chief executive Stephen A. Snider in the firm's annual report earlier this year. First, it will build compressors and second, continue the common industry practice of buying compression fleets from E&P companies and then leasing them back. Third, it will continue to consider potential company acquisitions. Currently, UCO builds about 350,00 horsepower per year of new units. "With our substantial backlog of units to be built and shipped for rental or sales, we have a pretty good idea of our earnings and cash flow visibility for the next two or three quarters," says Snider. "The demand for our services is fairly predictable and does not fluctuate wildly [with the price of gas or storage levels]. Our customers are very bullish on their need for compression-they've got to get that gas to market." USA Compression Also growing at a rapid rate is USA Compression, a private Dallas firm started in July 1998 by C. William Pollock, chairman, who founded the predecessor to Hanover in 1984, and Eric D. Long, president and CEO. USA Compression has more than $100 million in assets, 13 sales offices and 160,000 horsepower of compression. The company differentiates between leasing, which may be a shorter term of 12 months, for example, versus outsourcing, which may be much longer-term. The company has developed CompresSmart, which continuously monitors up to 80 separate bits of information about a customer's compression equipment via on-skid control panels. These transmit data via satellite from remote locations to the Internet or a pager. "We're seeing a 20% or 30% enhancement of productivity, prevention of catastrophic system failures and big savings for customers," says Long. The company plans to keep growing by acquiring new equipment (not companies) and via new-build compression, and hopes to possibly merge or go public one day. "We think there are still a lot of efficiencies to be achieved," says Pollock. "Compression tends to be overlooked, yet it is really the heart of the natural gas infrastructure-gas cannot move without it. If a unit goes down, just think of the lost revenue."