form_10k-a.htm
 
 
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K/A
 
[x] Annual Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
 
 
For the fiscal year ended December 31, 2006
  
 
[  ] Transition Report Pursuant to Section 13 of 15(d) of the Securities Exchange Act of 1934
 
For the transition period from                to_______
 
Commission File Number:                                           1-31398
NATURAL GAS SERVICES GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)

Colorado
 
75-2811855
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S.  Employer Identification No.)

2911 South County Road 1260 Midland, Texas
 
79706
(Address of Principal Executive Offices)
 
(Zip Code)
Registrant’s Telephone Number, Including Area Code:  (432) 563-3974

Securities Registered Pursuant to Section 12(b) of the Act:
Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock, $.01 par value
 
American Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act:  None.
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o                  No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o                  No þ

Indicate by check mark whether the registrant:  (1) has 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 registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ                 No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A.  [   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):
 Large Accelerated Filer    ¨                                                                Accelerated Filer  þ                                                      Non-Accelerated Filer  ¨
 
 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o                  No þ
 
The aggregate market value of voting and non-voting common equity held by non-affiliates of the Registrant as of March 12, 2007 was approximately $144,669,863, based on the closing price of the common stock on the same date.

At March 12, 2007 there were 12,067,166 shares of common stock outstanding.
 


Explanatory Note

We originally filed our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 on March 15, 2007 (the “Original Filing”).  This Amendment No. 1 on Form 10-K/A (“Form 10-K/A”) is being filed to revise certain disclosures we made under Items 6 and 7 of the Original Filing.  Generally, the Items amended relate to our presentation of gross profit (exclusive of depreciation), our cash flow from operations, our accrued liabilities, the related party nature of our subordinated notes, and our presentation of revenue from the sale of rental equipment.

In addition to the amendments described above, Item 15 of the Original Filing has also been amended to contain (1) the currently dated certifications from our Chief Executive Officer and Chief Accounting Officer required under Section 302 of the Sarbanes-Oxley Act of 2002, revised to reflect the exact wording required by Regulation S-K Item 601(b)(31), (2) the currently dated certifications from our Chief Executive Officer and Chief Accounting Officer required under Section 906 of the Sarbanes-Oxley Act of 2002, revised to identify the Form 10-K for the year ended December 31, 2006, as amended by this Amendment, as the period report covered thereby, and (3) the currently dated, consent of our independent registered public accounting firm to the use of its report on our consolidated balance sheets as of December 31, 2005 and December 31, 2006 and the related consolidated statements of income, stockholders’ equity and cash flows for the years ended December 31, 2004, 2005 and 2006 in the specified registration statements.  The updated certifications are attached to this Form 10-K/A as Exhibits 31.1, 31.2, 32.1 and 32.2, and the updated consent is attached to this Form 10-K/A as Exhibit 23.1.

As described above, this Form 10-K/A amends Items 6, 7 and 15 of the Original Filing. We did not make any revisions to Items 1, 1A, 1B, 2, 3, 4, 5, 7A, 8, 9, 9A, 9B, 10, 11 12, 13 or 14 of the Original Filing, and thus, these Items remain in effect as of the date of the Original Filing and are not included as part of this Form 10-K/A.

1

ITEM 6.                     SELECTED FINANCIAL DATA
 
In the table below, we provide you with selected historical financial data.  We have derived this information from our audited consolidated financial statements for each of the years in the five-year period ended December 31, 2006.  This information is only a summary and it is important that you read this information along with our audited consolidated financial statements and related notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Item 7 below, which discusses factors affecting the comparability of the information presented.  The selected financial information provided is not necessarily indicative of our future results of operations or financial performance.

 
 
Year Ended December 31,
 
 
 
2002
 
 
2003
 
 
2004
 
 
2005(1)
 
 
2006
 
 
 
(in thousands, except per share amounts)
 
CONSOLIDATED STATEMENTS OF INCOME AND OTHER INFORMATION:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenues                                                    
 
$
10,297
 
 
$
12,750
 
 
$
15,958
 
 
$
49,311
 
 
$
62,729
 
Costs of revenue, exclusive of depreciation shown separately below
 
 
5,572
 
 
 
6,057
 
 
 
6,951
 
 
 
31,338
 
 
 
39,308
 
Gross margin(2)                                                    
 
 
4,725
 
 
 
6,693
 
 
 
9,007
 
 
 
17,973
 
 
 
23,421
 
Depreciation and amortization                                                    
 
 
1,166
 
 
 
1,726
 
 
 
2,444
 
 
 
4,224
 
 
 
6,020
 
Other operating expenses                                                    
 
 
1,718
 
 
 
2,292
 
 
 
2,652
 
 
 
4,890
 
 
 
5,270
 
Operating income                                                    
 
 
1,841
 
 
 
2,675
 
 
 
3,911
 
 
 
8,859
 
 
 
12,131
 
Total other income (expense)(3)                                                    
 
 
(471
)
 
 
(671
)
 
 
603
 
 
 
(1,798
)
 
 
(256
)
Income before income taxes                                                    
 
 
1,370
 
 
 
2,004
 
 
 
4,514
 
 
 
7,061
 
 
 
11,875
 
Income tax expense                                                    
 
 
584
 
 
 
697
 
 
 
1,140
 
 
 
2,615
 
 
 
4,287
 
Net income                                                    
 
 
786
 
 
 
1,307
 
 
 
3,374
 
 
 
4,446
 
 
 
7,588
 
Preferred dividends                                                    
 
 
107
 
 
 
121
 
 
 
53
 
 
─
 
 
─
 
Net income available to common stockholders
 
$
679
 
 
$
1,186
 
 
$
3,321
 
 
$
4,446
 
 
$
7,588
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income per common share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic                                                
 
$
0.19
 
 
$
0.24
 
 
$
0.59
 
 
$
0.59
 
 
$
0.67
 
Diluted                                                
 
$
0.16
 
 
$
0.23
 
 
$
0.52
 
 
$
0.52
 
 
$
0.66
 
Weighted average shares of common stock outstanding:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic                                                
 
 
3,649
 
 
 
4,947
 
 
 
5,591
 
 
 
7,564
 
 
 
11,405
 
Diluted                                                
 
 
4,305
 
 
 
5,253
 
 
 
6,383
 
 
 
8,481
 
 
 
11,472
 
EBITDA(4)
 
$
3,511
 
 
$
4,397
 
 
$
7,796
 
 
$
13,282
 
 
$
19,541
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31,
 
 
 
2002
 
 
2003
 
 
2004
 
 
2005
 
 
2006
 
 
 
(in thousands)
 
BALANCE SHEET INFORMATION:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Current assets
 
$
5,084
 
 
$
3,654
 
 
$
7,295
 
 
$
24,642
 
 
$
55,170
 
Total assets
 
 
23,937
 
 
 
28,270
 
 
 
43,255
 
 
 
86,369
 
 
 
135,552
 
Long-term debt (including current portion)
 
 
8,847
 
 
 
10,724
 
 
 
15,017
 
 
 
28,205
 
 
 
18,392
 
Stockholders’ equity
 
 
13,001
 
 
 
14,425
 
 
 
22,903
 
 
 
45,690
 
 
 
101,201
 

2

(1)
The information for the periods presented may not be comparable because of our acquisition of SCS in January 2005.  For additional information regarding this acquisition, you should read the information under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 13. Certain Relationships, Related Transactions and Director Independence– Acquisition of Screw Compression Systems, Inc.” in this Annual Report on Form 10-K.
(2)
Gross margin is defined, reconciled to net income and discussed further in Part II, Item 6 (“Selected Financial Data-Non-GAAP Financial Measures”) of this report.
(3)
Total other income (expense) for the year ended December 31, 2004 includes $1.5 million in life insurance proceeds paid to us upon the death of our former Chief Executive Officer.
(4)
EBITDA, is defined, reconciled to net income and discussed further in Part II, Item 6 (“Selected Financial Data-Non-GAAP Financial Measures”) of this report.

Non-GAAP Financial Measures

Our definition and use of  EBITDA

“EBITDA” is a non-GAAP financial measure of earnings (net income) from continuing operations before interest, taxes, depreciation, and amortization.  This term, as used and defined by us, may not be comparable to similarly titled measures employed by other companies and is not a measure of performance calculated in accordance with GAAP.  EBITDA should not be considered in isolation or as a substitute for operating income, net income or loss, cash flows provided by operating, investing and financing activities, or other income or cash flow statement data prepared in accordance with GAAP.  However, management believes EBITDA is useful to an investor in evaluating our operating performance because:
 
 
 
·
it is widely used by investors in the energy industry to measure a company’s operating performance without regard to items excluded from the calculation of EBITDA, which can vary substantially from company to company depending upon accounting methods and book value of assets, capital structure and the method by which assets were acquired, among other factors;

 
·
it helps investors to more meaningfully evaluate and compare the results of our operations from period to period by removing the impact of our capital structure and asset base from our operating structure; and

 
·
it is used by our management for various purposes, including as a measure of operating performance, in presentations to our Board of Directors, as a basis for strategic planning and forecasting, and as a component for setting incentive compensation.

There are material limitations to using EBITDA as a measure of performance, including the inability to analyze the impact of certain recurring items that materially affect our net income or loss, and the lack of comparability of results of operations of different companies.

Our definition and use of gross margin

We define 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 our management as it represents the results of revenue and cost of sales (excluding depreciation and amortization expense), which are key components of our operations.  Gross margin differs from gross profit which includes depreciation expense.  We believe gross margin is important because it focuses on the current operating performance of our operations and excludes the impact of the prior historical costs of the assets acquired or constructed that are utilized in those operations, the indirect costs associated with our selling, general and administrative activities, the impact of our financing methods and income taxes.  Depreciation expense may not accurately reflect the costs required to maintain and replenish the operational usage of our assets and therefore may not portray the costs from current operating activity.  Rather, depreciation expense reflects the systematic allocation of historical fixed asset values over the estimated useful lives.

Gross margin has certain material limitations associated with its use as compared to net income.  These limitations are primarily due to the exclusion of certain expenses.  Each of these excluded expenses is material to our consolidated results of operations.  Because we use capital assets, depreciation expense is a necessary element of our costs and our ability to generate revenue and selling, general and administrative expense is a necessary cost to support our operations and required corporate activities.  In order to compensate for these limitations, management uses this non-GAAP measure as a supplemental measure to other GAAP results to provide a more complete understanding of our performance.


3

As an indicator of our operating performance, gross margin should not be considered an alternative to, or more meaningful than, net income as determined in accordance with GAAP.  Our 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.
 
Reconciliation

The following table reconciles net income to EBITDA and gross margin, the most directly comparable GAAP financial measure:

 
 
Year Ended December 31,
 
 
 
2002
 
 
2003
 
 
2004
 
 
2005
 
 
2006
 
 
 
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
786
 
 
$
1,307
 
 
$
3,374
 
 
$
4,446
 
 
$
7,588
 
  Interest expense, net
 
 
975
 
 
 
667
 
 
 
838
 
 
 
1,997
 
 
 
1,646
 
  Income taxes
 
 
584
 
 
 
697
 
 
 
1,140
 
 
 
2,615
 
 
 
4,287
 
  Depreciation and amortization
 
 
1,166
 
 
 
1,726
 
 
 
2,444
 
 
 
4,224
 
 
 
6,020
 
EBITDA
 
$
3,511
 
 
$
4,397
 
 
$
7,796
 
 
$
13,282
 
 
$
19,541
 
  Other operating expenses
 
 
1,718
 
 
 
2,292
 
 
 
2,652
 
 
 
4,890
 
 
 
5,270
 
  Other income (expense)
 
 
(504
)
 
 
4
 
 
 
(1,441
)
 
 
(199
)
 
 
(1,390
)
Gross Margin
 
$
4,725
 
 
$
6,693
 
 
$
9,007
 
 
$
17,973
 
 
$
23,421
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ITEM 7.                     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion is intended to assist you in understanding our financial position and results of operations for each year in the three-year period ended December 31, 2006.  You should read the following discussion and analysis in conjunction with our audited consolidated financial statements and the related notes.

The following discussion contains forward-looking statements.  For a description of limitations inherent in forward-looking statements, see “Special Note Regarding Forward-Looking Statements” on page (ii).

Overview

We fabricate, manufacture, rent and sell natural gas compressors and related equipment.  Our primary focus is on the rental of natural gas compressors.  Our rental contracts generally provide for initial terms of six to 24 months.  After the initial term of our rental contracts, most of our customers have continued to rent our compressors on a month-to-month basis.  Rental amounts are paid monthly in advance and include maintenance of the rented compressors.  As of December 31, 2006, we had 974 natural gas compressors totaling approximately 112,718 horsepower rented to 84 third parties, compared to 820 natural gas compressors totaling approximately 90,486 horsepower rented to 75 third parties at December 31, 2005.

We also fabricate natural gas compressors for sale to our customers, designing compressors to meet unique specifications dictated by well pressures, production characteristics and particular applications for which compression is sought.  Fabrication of compressors involves the purchase by us of engines, compressors, coolers and other components, and then assembling these components on skids for delivery to customer locations.  These major components of our compressors are acquired through periodic purchase orders placed with third-party suppliers on an “as needed” basis, which presently requires a three to four month lead time with delivery dates scheduled to coincide with our estimated production schedules.  Although we do not have formal continuing supply contracts with any major supplier, we believe we have adequate alternative sources available.  In the past, we have not experienced any sudden and dramatic increases in the prices of the major components for our compressors.  However, the occurrence of such an event could have a material adverse effect on the results of our operations and financial condition, particularly if we were unable to increase our rental rates and sales prices proportionate to any such component price increases.


4

We also manufacture a proprietary line of compressor frames, cylinders and parts, known as our CiP (Cylinder-in-Plane) product line.  We use finished CiP component products in the fabrication of compressor units for sale or rental by us or sell the finished component products to other compressor fabricators.  We also design, fabricate, sell, install and service flare stacks and related ignition and control devices for onshore and offshore incineration of gas compounds such as hydrogen sulfide, carbon dioxide, natural gas and liquefied petroleum gases.  To provide customer support for our compressor and flare sales businesses, we stock varying levels of replacement parts at our Midland, Texas facility and at field service locations.  We also provide an exchange and rebuild program for screw compressors and maintain an inventory of new and used compressors to facilitate this business.

We provide service and maintenance to our customers under written maintenance contracts or on an as required basis in the absence of a service contract.  Maintenance agreements typically have terms of six months to one year and require payment of a monthly fee.

The following table sets forth our revenues from each of our three business segments for the periods presented:

 
 
Year Ended December 31,
 
 
2002
 
 
2003
 
 
2004
 
 
2005
 
 
2006
 
 
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sales
 
$
4,336
 
 
$
3,865
 
 
$
3,593
 
 
$
30,278
 
 
$
38,214
Service and maintenance
 
 
1,563
 
 
 
1,773
 
 
 
1,874
 
 
 
2,424
 
 
 
979
Rental
 
 
4,398
 
 
 
7,112
 
 
 
10,491
 
 
 
16,609
 
 
 
23,536
Total
 
$
10,297
 
 
$
12,750
 
 
$
15,958
 
 
$
49,311
 
 
$
62,729

On January 3, 2005, we completed the acquisition of Screw Compression Systems, Inc., or “SCS,” for consideration consisting of $8.0 million in cash, subordinated promissory notes payable by us to the former stockholders of SCS in the aggregate principal amount of $3.0 million, and approximately 610 thousand shares of our common stock.  As a result of this acquisition, our results of operations for periods before and after the completion of the acquisition may not be comparable.

Historically, the majority of our revenues and income from operations has come from our compressor rental business.  The acquisition of SCS, which is engaged primarily in the business of custom fabrication of compressors for sale to third parties, significantly altered the mix of our revenues, with compressor sales now contributing the largest percentage of our revenues.  Margins for our rental business have recently averaged 60% to 65%, while margins for the compressor sales business have recently averaged approximately 18% to 20%.  Our strategy for growth is focused on our compressor rental business, and we intend to use the additional fabrication capacity now available through SCS to expand our rental fleet while continuing SCS’s core custom fabrication business.  As our rental business grows and contributes a larger percentage of our total revenues, we expect our overall margins to improve from those experienced in 2006.

The oil and gas equipment rental and services industry is cyclical in nature.  The most critical factor in assessing the outlook for the industry is the worldwide supply and demand for natural gas and the corresponding changes in commodity prices.  As demand and prices increase, oil and gas producers increase their capital expenditures for drilling, development and production activities.  Generally, the increased capital expenditures ultimately result in greater revenues and profits for services and equipment companies.

In general, we expect our overall business activity and revenues to track the level of activity in the natural gas industry, with changes in domestic natural gas production and consumption levels and prices more significantly affecting our business than changes in crude oil and condensate production and consumption levels and prices.  We also believe that demand for compression services and products is driven by declining reservoir pressure in maturing natural gas producing fields and, more recently, by increased focus by producers on non-conventional natural gas production, such as coalbed methane, gas shales and tight gas, which typically requires more compression than production from conventional natural gas reservoirs.

Demand for our products and services have been strong throughout 2005 and 2006.  We believe demand will remain strong throughout 2007 due to high oil and natural gas prices and increased demand for natural gas.  Because of these market fundamentals for natural gas, we believe the long-term trend of activity in our markets is favorable.  However, these factors could be more than offset by other developments affecting the worldwide supply and demand for natural gas.  Additionally, activity created by recent increases in the price of natural gas may make it difficult to meet the demands of our markets.


5

For fiscal year 2007, our forecasted capital expenditures are approximately $27 to $32 million, primarily for additions to our compressor rental fleet.  We believe that the proceeds from our public offering of common stock we completed in March 2006, together with funds available to us under our bank credit facility and cash flows from operations will be sufficient to satisfy our capital and liquidity requirements through 2007.  We may further require additional capital to fund any unanticipated expenditures, including any acquisitions of other businesses.  Additional capital may not be available to us when we need it or on acceptable terms.

Results of Operations

Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005

The table below shows our revenues, percentage of total revenues, gross margin, exclusive of depreciation, and gross margin percentage of each of our segments for the years ended December 31, 2006 and December 31, 2005.  Gross margin is the difference between revenue and cost of sales, exclusive of depreciation.

            
 
Revenue
 
 
Gross Margin, Exclusive of Depreciation(1)
 
 
Year Ended December 31,
 
 
Year Ended December 31,
 
 
2005
 
 
2006
 
 
2005
 
 
2006
 
 
(dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sales
$
30,278
 
 
 
61
%
 
$
38,214
 
 
 
61
%
 
$
6,947
 
 
 
23
%
 
$
8,585
 
 
 
23
%
Service and Maintenance
 
2,424
 
 
 
5
%
 
 
979
 
 
 
1
%
 
 
945
 
 
 
39
%
 
 
244
 
 
 
25
%
Rental
 
16,609
 
 
 
34
%
 
 
23,536
 
 
 
38
%
 
 
10,081
 
 
 
61
%
 
 
14,592
 
 
 
62
%
Total
$
49,311
 
 
 
 
 
 
$
62,729
 
 
 
 
 
 
$
17,973
 
 
 
36
%
 
$
23,421
 
 
 
37
%
                        (1)      For a reconciliation of gross margin to its most directly comparable financial measure calculated and presented in accordance with GAAP, please
                               read Part II, Item 6 ("Selected Financial Data-Non-GAAP Financial Measures") of this report.
 
       Total revenues for the year ended December 31, 2006 increased 27.2% to $62.7 million, as compared to $49.3 million for the year ended December 31, 2005.  The increase in revenue reflects the increase in our rental revenue and unit sales to third parties offset by the decline in service revenue.

Sales revenue increased from $30.3 million to $38.2 million, or 26.2%, for the year ended December 31, 2006, compared to the year ended December 31, 2005. This increase was mainly the result of $4.1 million in sales of rental equipment to an existing rental customer and additional sales of compressor units from our Tulsa, Oklahoma location.  Sales to third parties included (1) compressor unit sales (including used rental equipment), (2) flare sales, (3) parts sales, (4) compressor rebuilds and (5) sale of rental units.

Service and maintenance revenue decreased from $2.4 million to $979 thousand, or 59.6%, for the year ended December 31, 2006, compared to the year ended December 31, 2005. This decrease was mainly the result of the change in our maintenance contract with Dominion Exploration & Production, Inc. beginning January 1, 2006.  Our five-year rental and maintenance agreement with Dominion Exploration expired on December 31, 2005.  In August 2005, we were advised by Dominion Exploration that it would seek competing proposals from us as well as other third parties to continue the rental and maintenance services required for its northern Michigan operations.  We submitted a bid to rent screw compressors to Dominion Exploration and to provide maintenance and service on certain screw compressors owned by Dominion Exploration.  We also submitted a proposal to continue service and maintenance of reciprocating compressors owned by Dominion Exploration.  In October 2005, we were advised by Dominion Exploration that we would retain the screw compressor rental, maintenance and service businesses, but that a third party was successful in bidding for the maintenance and service of Dominion Exploration’s reciprocating compressors.

Rental revenue increased from $16.6 million to $23.5 million, or 41.7%, for the year ended December 31, 2006, compared to the year ended December 31, 2005.  The increase is mainly the result of units added to our rental fleet and rented to third parties.  At December 31, 2006, we had 1,111 compressor packages in our rental fleet, up from 865 units at December 31, 2005.  The average monthly rental rate per unit at December 31, 2006 was $2.3 thousand, as compared to $2.1 thousand at December 31, 2005.  This increase resulted from normal price increases throughout the year and the addition of larger units to our rental fleet which command higher rental rates.


6

The overall gross margin percentage, exclusive of depreciation, increased to 37.3% for the year ended December 31, 2006, as compared to 36.4% for the year ended December 31, 2005.  This increase resulted mainly from the relative increase in compressor rental revenue as a percentage of the total revenue.  Our rental fleet carried a gross margin averaging 62.0% for 2006, and compressor and parts sales margins averaged 22.5%.

Selling expense increased from $1.0 million to $1.3 million, or 23.1%, for the year ended December 31, 2006, as compared to the year ended December 31, 2005. This increase is mainly the result of increased commissions paid to salesmen for the increase in rental activity.

General and administrative expenses remained relatively flat at $4.0 million for the year ended December 31, 2006, as compared to $3.9 million for the year ended December 31, 2005. While there was an increase in the expense to comply with SOX 404, this was offset by a decrease in officer salary and bonus expenses due to the departure of personnel.

Depreciation and amortization expense increased 42.5% from $4.2 million to $6.0 million for the year ended December 31, 2006, compared to the year ended December 31, 2005.  There was a net increase of 246 natural gas compressor units to our rental fleet between December 31, 2005 and 2006, thus increasing our depreciable base.

Other income increased approximately $1.2 million for the year ended December 31, 2006, compared to the same period in 2005. This increase was mainly the result of additional interest income from our short-term investment account as a result of increased cash balances from our March 2006 public offering.

Interest expense decreased by $351 thousand, or 17.6%, for the year ended December 31, 2006, compared to the year ended December 31, 2005, mainly due to decreases in our loan balances.  In March 2006, we reduced our bank debt by $5.0 million with proceeds from our March 2006 public offering of common stock and continued our normal amortization of the remaining debt.

Provision for income tax increased by $1.7 million, or 64.0%, and is the result of the increase in taxable income.

Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004

The table below shows our revenues, percentage of total revenues, gross margin, exclusive of depreciation, and gross margin percentage of each of our segments for the years ended December 31, 2005 and December 31, 2004.  Gross margin is the difference between revenue and cost of sales, exclusive of depreciation

 
 
Revenue
 
 
Gross Margin, Exclusive of Depreciation(1)
 
  
 
 
Year Ended December 31,
 
 
Year Ended December 31,
 
  
 
 
2004
 
 
2005
 
 
2004
 
 
2005
 
  
 
 
(dollars in thousands)
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
 Sales
$
3,593
 
 
 
23
%
 
$
30,278
 
 
 
61
%
 
$
1,037
 
 
 
29
%
 
$
6,947
 
 
 
23
%
  
 
 Service and Maintenance
 
1,874
 
 
 
11
%
 
 
2,424
 
 
 
5
%
 
 
517
 
 
 
28
%
 
 
945
 
 
 
39
%
  
 
 Rental
 
10,491
 
 
 
66
%
 
 
16,609
 
 
 
34
%
 
 
7,453
 
 
 
71
%
 
 
10,081
 
 
 
61
%
  
 
 Total
$
15,958
 
 
 
 
 
 
$
49,311
 
 
 
 
 
 
$
9,007
 
 
 
56
%
 
$
17,973
 
 
 
36
%
  
              (1)     For a reconciliation of gross margin to its most directly comparable financial measure calculated and presented in accordance with GAAP, please
                                    read Part II, Item 6 ("Selected Financial Data-Non-GAAP Financial Measures") of this report.
        Total revenues for the year ended December 31, 2005 increased 209.0% to $49.3 million, as compared to $16.0 million for the year ended December 31, 2004.  The increase in revenue reflects the increase in our rental revenue and the addition of revenue from our acquisition of SCS.

Sales revenue increased from $3.6 million to $30.3 million, or 742.7%, for the year ended December 31, 2005, compared to the year ended December 31, 2004.  The increase was mainly the result of the sale of compressor units to outside third parties by SCS.

Service and maintenance revenue increased from $1.9 million to $2.4 million, or 29.3%, for the year ended December 31, 2005, compared to the year ended December 31, 2004.  The increase was mainly the result of additional third party labor sales in our New Mexico area and Michigan branches.


7

Rental revenue increased from $10.5 million to $16.6 million, or 58.3%, for the year ended December 31, 2005, compared to the year ended December 31, 2004.  The increase was mainly the result of units added to our rental fleet and rented to third parties.  At December 31, 2005, we had 865 compressor packages in our rental fleet, up from 586 units at December 31, 2004.  The average monthly rental rate per unit at December 31, 2005 was $2.1 thousand, as compared to $2.0 thousand at December 31, 2004.

The overall gross margin percentage, exclusive of depreciation, decreased to 36.4% for the year ended December 31, 2005, as compared to 56.4% for the year ended December 31, 2004.  This decrease resulted mainly from the relative increase in compressor sales revenue as a percentage of the total revenue.  Our rental fleet carried a gross margin averaging 60.7% for 2005, and compressor and parts sales margins averaged 23.0%.

Selling, general and administrative expense increased from $2.7 million to $4.9 million, or 84.4%, for the year ended December 31, 2005, as compared to the year ended December 31, 2004.  This was mainly the result of the increased expenses attributed to our acquisition of SCS.  SCS accounted for approximately $1.5 million of the total selling, general and administrative expenses for the year ended December 31, 2005.

Depreciation and amortization expense increased 72.8% from $2.4 million to $4.2 million for the year ended December 31, 2005, compared to the year ended December 31, 2004.  This increase was the result of 279 new gas compressor rental units being added to rental equipment from December 31, 2004 to December 31, 2005, thus increasing the depreciable base.

Other income decreased approximately $1.2 million for the year ended December 31, 2005, compared to the same period in 2004.  This decrease was due mainly to the $1.5 million that was received in the year ended December 31, 2004 as life insurance proceeds from the death of our former Chief Executive Officer, offset by additional interest income from our money market accounts in 2005.

Interest expense increased by $1.2 million, or 138%, for the year ended December 31, 2005, compared to the same period ended December 31, 2004, mainly due to increased debt incurred to finance rental equipment additions, debt related to our acquisition of SCS and increased interest rates.
 
Provision for income tax increased by $1.5 million, or 129.4%, because taxable income increased after giving effect to the non-taxable life insurance proceeds received in 2004.

Critical Accounting Policies and Practices

We have identified the policies below as critical to our business operations and the understanding of our results of operations.  In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States.  Actual results could differ significantly from those estimates under different assumptions and conditions.  We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Our critical accounting policies are as follows:

 
·
revenue recognition;

 
·
estimating the allowance for doubtful accounts;

 
·
accounting for income taxes;

 
·
valuation of long-lived and intangible assets and goodwill; and

 
·
valuation of inventory


8

Revenue Recognition

Revenue from the sales of custom and fabricated compressors, and flare systems is recognized upon shipment of the equipment to customers.  Revenue from sale of rental units is included in sales revenue when equipment is shipped or title is transferred to the customer.  Exchange and rebuild compressor revenue is recognized when both the replacement compressor has been delivered and the rebuild assessment has been completed.  Revenue from compressor services is recognized upon providing services to the customer.  Maintenance agreement revenue is recognized as services are rendered.  Rental revenue is recognized over the terms of the respective rental agreements based upon the classification of the rental agreement.  Deferred income represents payments received before a product is shipped.

Allowance for Doubtful Accounts Receivable

We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer’s current credit worthiness, as determined by our review of their current credit information.  We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified.  While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.  At December 31, 2006 and December 31, 2005, XTO Energy, Inc. accounted for approximately 54% and 44%, respectively, of our accounts receivable.  A significant change in the liquidity or financial position of this customer could have a material adverse impact on the collectibility of our accounts receivables and our future operating results.

Accounting for Income Taxes

As part of the process of preparing our consolidated financial statements we are required to estimate our federal income taxes as well as income taxes in each of the states in which we operate.  This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes.  These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet.  We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not probable, we must establish a valuation allowance.  To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense in the tax provision in the statement of operations.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets.

Valuation of Long-Lived and Intangible Assets and Goodwill

We assess the impairment of identifiable intangibles, long-lived assets and related goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable.  Factors we consider important which could trigger an impairment review include the following:

 
·
significant underperformance relative to expected historical or projected future operating results;

 
·
significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and

 
·
significant negative industry or economic trends.

When we determine that the carrying value of intangibles, long-lived assets and related goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.


9

We adopted FAS 142 as of January 1, 2002.  Based on an independent valuation in June 2006 and an internal evaluation in December 2004 and June 2005 of our reporting units with goodwill, adoption of FAS 142 did not have a material adverse effect on us in 2004, 2005 or 2006.  In the future, it could result in impairments of our intangible assets or goodwill.  We expect to continue to amortize our intangible assets with finite lives over the same time periods as previously used, and we will test our intangible assets with indefinite lives for impairment at least once each year.  In addition, we are required to assess the consumptive life, or longevity, of our intangible assets with finite lives and adjust their amortization periods accordingly.  Our net intangible assets, including goodwill, were recorded on our balance sheet at approximately $14.0 million as of December 31, 2005, and at December 31, 2006, the carrying value of net intangible assets, including goodwill, decreased to approximately $13.7 million.  Our intangibles are amortized at a rate of $299 thousand per year.  Any impairment in future periods of those assets, or a reduction in their consumptive lives, could materially and adversely affect our consolidated statements of income and financial position.

Inventories

We value our inventory at the lower of the actual cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory.  We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements.

Recently Issued Accounting Pronouncements

On December 16, 2004, the FASB published FASB Statement No.  123 (revised 2004), Share-Based Payment (“Statement 123R”), requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements.  That cost will be measured based on the fair value of the equity or liability instruments issued.  We were required to apply Statement 123R as of January 1, 2006.  Statement 123R replaces FASB Statement No.  123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No.  25, Accounting for Stock Issued to Employees.  Statement 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees.  However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used.

The Company has adopted Statement 123(R) effective January 1, 2006 using the modified prospective method.  The Company recognized $376 thousand in expense in 2006 as a result of stock options vesting during 2006.

In November 2004, the FASB issued SFAS No 151, Inventory Costs — an Amendment of ARB No. 43, Chapter 4 (“SFAS 151”).  This standard provides clarification that abnormal amounts of idle facility expense, freight, handling costs, and spoilage should be recognized as current-period charges.  Additionally, this standard requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities.  The provisions of this standard are effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  The adoption of the new standard did not have a material effect on our consolidated results of operations, cash flows or financial position in 2006.

In July 2006 the FASB issued FASB Interpretation ("FIN") No.  48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 109.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No.  109, Accounting for Income Taxes.  FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  If there are changes in net assets as a result of application of FIN 48 these will be accounted for as an adjustment to retained earnings.  We adopted FIN 48 on January 1, 2007 and have determined its adoption will not have a material impact on our consolidated financial position and results of operations.
 
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on how to evaluate prior period financial statement misstatements for purposes of assessing their materiality in the current period.  If the prior period effect is material to the current period, then the prior period is required to be corrected.  Correcting prior year financial statements would not require an amendment of prior year financial statements, but such corrections would be made the next time the company files the prior year financial statements.  Upon adoption, SAB 108 allows a one-time transitional cumulative effect adjustment to retained earnings for corrections of prior period misstatements required under this statement.  SAB 108 is effective for fiscal year ending December 31, 2006.


10

Environmental Regulations

Various federal, state and local laws and regulations covering the discharge of materials into the environment, or otherwise relating to protection of human safety and health and the environment, affect our operations and costs.  Compliance with these laws and regulations could cause us to incur remediation or other corrective action costs or result in the assessment of administrative, civil and criminal penalties and the issuance of injunctions delaying or prohibiting operations.  In addition, we have acquired certain properties and plant facilities from third parties whose actions with respect to the management and disposal or release of hydrocarbons or other wastes were not under our control.  Under environmental laws and regulations, we could be required to remove or remediate wastes disposed of or released by prior owners.  In addition, we could be responsible under environmental laws and regulations for properties and plant facilities we lease, but do not own.  Compliance with such laws and regulations increases our overall cost of business, but has not had a material adverse effect on our operations or financial condition.  It is not anticipated, based on current laws and regulations, that we will be required in the near future to expend amounts that are material in relation to our total expenditure budget in order to comply with environmental laws and regulations but, such laws and regulations are frequently changed and we are unable to predict the ultimate cost of compliance.  We also could incur costs related to the clean up of sites to which we send equipment and for damages to natural resources or other claims related to releases of regulated substances at such sites.

Liquidity and Capital Resources

The following represents the Company’s working capital position as of December 31,2005 and 2006

 
 
December 31, 2005
 
 
December 31, 2006
 
Current Assets:
 
 
 
 
 
 
   Cash & cash equivalents
 
$
3,271
 
 
$
4,391
 
   Short-term investments
 
─
 
 
 
25,052
 
   Trade accounts receivable, net
 
 
6,192
 
 
 
8,463
 
   Inventory, net
 
 
14,723
 
 
 
16,943
 
   Prepaid expenses and other
 
 
456
 
 
 
321
 
              Total current assets
 
 
24,642
 
 
 
55,170
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Current Liabilities:
 
 
 
 
 
 
 
 
   Current portion of long-term debt and subordinated notes
 
 
5,680
 
 
 
4,442
 
   Line of credit
 
 
300
 
 
─
 
   Accounts payable
 
 
3,180
 
 
 
2,837
 
   Accrued liabilities
 
 
1,737
 
 
 
2,077
 
   Current portion of tax liability
 
 
207
 
 
 
1,056
 
   Deferred income
 
 
103
 
 
 
225
 
              Total current liabilities
 
 
11,207
 
 
 
10,637
 
 
 
 
 
 
 
 
 
 
Total working capital
 
$
13,435
 
 
$
44,533
 

Historically, we have funded our operations through public and private offerings of our equity securities, subordinated debt, bank borrowings and cash flow from operations.  Proceeds of financings have been primarily used to repay debt, to fund the manufacture and fabrication of additional units for our rental fleet of natural gas compressors and for acquisitions.

For the year ended December 31, 2006, we invested approximately $27.7 million in equipment for our rental fleet and in service vehicles.  We financed this activity with the proceeds from our March 2006 public offering of common stock and funds from operations.  We borrowed approximately $1.4 million from our bank in 2006.  We also repaid approximately $11.3 million of our existing debt during 2006.


11

Cash flows

At December 31, 2005, we had cash and cash equivalents of approximately $3.3 million, working capital of $13.4 million and total debt of $28.2 million, of which approximately $6.0 million was classified as current.  At that same date, we also had letters of credit outstanding in the aggregate face amount of $2.0 million which secured payment of our subordinated debt in the amount of $3.0 million.  We had positive net cash flow from operating activities of approximately $3.8 million during 2005.  This was primarily from net income of $4.4 million, plus depreciation and amortization of $4.2 million, an increase in deferred taxes of $2.4 million, an increase in accounts payable and accrued liabilities of $0.4 million, offset by an increase in trade accounts receivable of $1.4 million, deferred income of $0.9 million, and an increase in inventory of $5.7 million.

At December 31, 2006, we had cash and cash equivalents of approximately $4.4 million, working capital of $44.5 million and total debt of $18.4 million, of which approximately $4.4 million was classified as current.  At that same date, we also had letters of credit outstanding in the aggregate face amount of $2.0 million.  We had positive net cash flow from operating activities of approximately $16.1 million during 2006.  This was primarily from net income of $7.6 million, plus depreciation and amortization of $6.0 million, an increase in deferred taxes of $2.5 million and offset by an increase in trade accounts receivable of $2.3 million.
 
Short term investments increased to $25.1 million from December 31, 2005 to December 31, 2006.  This  increase is the remaining  proceeds from our March 2006 secondary public offering. The initial net proceeds from the offering were $47.1 million, from this we paid down $5.0 million of debt and the remainder was used for capital expenditures to build additional units for our compressor rental fleet.

Trade accounts receivable increased $2.3 million to $8.5 million at December 31, 2006 as compared to $6.2 million at December 31, 2005, largely reflecting the impact of higher sales.

Inventory increased $2.2 million to $16.9 million as of the end of 2006 as compared to $14.7 million as of the end of 2005. This increase is mainly a reflection of increased sales activity. Inventory turnover was 7.97 at December 31, 2005 and 7.41 at December 31, 2006.
 
Long term debt decreased $9.8 million to $18.4 million at December 31, 2006 compared to $28.2 million at December 31, 2005. The current portion of long term debt decreased $1.5 million to $4.4 million at December 31, 2006 compared to $6.0 million at December 31, 2005, mainly the result of normal amortization of debt and a one time payment of $5 million  from offering proceeds.
 
Contractual Obligations and Commitments

We have contractual obligations and commitments that affect our consolidated results of operations, financial condition and liquidity.  The following table is a summary of our significant cash contractual obligations:

 
 
Obligation Due in Period
 
 
 
 
 
Cash Contractual Obligations
 
2007
 
 
2008
 
 
2009
 
 
2010
 
 
2011
 
 
Thereafter
 
 
Total
 
 
 
(in thousands)
 
Credit facility (secured)
 
$
3,442
 
 
$
3,378
 
 
$
3,378
 
 
$
3,378
 
 
$
2,816
 
 
$ ─
 
 
$
16,392
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest on credit facility
 
 
1,160
 
 
 
865
 
 
 
591
 
 
 
338
 
 
 
211
 
 
─
 
 
 
3,165
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subordinated debt
 
 
1,000
 
 
 
1,000
 
 
─
 
 
─
 
 
─
 
 
─
 
 
 
2,000
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Facilities and office leases
 
 
129
 
 
 
62
 
 
 
29
 
 
 
29
 
 
 
30
 
 
 
76
 
 
 
355
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Purchase obligations
 
─
 
 
─
 
 
─
 
 
─
 
 
─
 
 
─
 
 
─
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
5,731
 
 
$
5,305
 
 
$
3,998
 
 
$
3,745
 
 
$
3,057
 
 
$
76
 
 
$
21,912
 


12

Senior Bank Borrowings

On October 15, 2006, we entered into a Seventh Amended and Restated Loan Agreement, or “Loan Agreement,” with Western National Bank, Midland, Texas.  This Loan Agreement (1) consolidated our previously existing advancing line of credit and term loan facilities into one term loan facility, and (2) extended, renewed and increased our revolving line of credit facility.  Our revolving line of credit and multiple advance term loan facilities are described below.

Revolving Line of Credit Facility.  Our revolving line of credit facility allows us to borrow, repay and reborrow funds drawn under this facility.  After entering into the Seventh Amended and Restated Loan Agreement, the total amount that we could borrow and have outstanding at any one time is the lesser of $40.0 million or the amount available for advances under a “borrowing base” calculation established by the bank.  As of December 31, 2006, the amount available for revolving line of credit advances under our borrowing base was $40.0 million, and there was no principal amount outstanding under the revolving line of credit at that same date.  The amount of the borrowing base is based primarily upon our receivables, equipment and inventory.  The borrowing base is redetermined by the bank on a monthly basis.  If, as a result of the redetermination of the borrowing base, the aggregate outstanding principal amount of the notes payable to the bank under the Loan Agreement exceeds the borrowing base, we must prepay the principal of the revolving line of credit note in an amount equal to such excess.  Interest only on borrowings under our revolving line of credit facility is payable monthly on the first day of each month.  All outstanding principal and unpaid interest is due on October 1, 2008.  As of December 31, 2006, our interest rate on the revolving line of credit was 7.5%.

$16.9 Million Multiple Advance Term Loan Facility.  This multiple advance term loan facility represents the consolidation of our previously existing advancing line of credit and term loan facilities.  Reborrowings are not permitted under this facility.  Principal under this credit facility is due and payable in 59 monthly installments of $282 thousand each, commencing November 1, 2006 and continuing through September 1, 2011.  The interest rate is fixed at 7.5% for this loan facility.  Interest on the unpaid principal balance is due and payable on the same dates as principal payments.  All outstanding principal and unpaid interest is due on October 1, 2011.  As of December 31, 2006 this term loan facility had a principal balance of $16.4 million.

During the year ended December 31, 2006, we made principal payments in the aggregate amount of approximately $8.5 million on our term loan facilities.

SCS has guaranteed payment of our loans.

Our obligations under the Loan Agreement are secured by substantially all of our properties and assets, including our equipment, trade accounts receivable and other personal property, the stock we own in SCS, and by the real estate and related plant facilities owned by SCS.

The maturity dates of the loan facilities may be accelerated by the bank upon the occurrence of an event of default under the Loan Agreement.

The Loan Agreement contains various restrictive covenants and compliance requirements.  These requirements provide that we must have:

 
·
at the end of each month, a consolidated current ratio (as defined in the Loan Agreement) of at least 1.4 to 1.0;

 
·
at the end of each month, consolidated tangible net worth (as defined in the Loan Agreement) of at least $70.0 million;

 
·
at the end of each fiscal quarter, a debt service coverage ratio (as defined in the Loan Agreement) of at least 1.50 to 1.00; and

 
·
at the end of each month, a ratio of consolidated debt to consolidated tangible net worth (as such terms are defined in the Loan Agreement) of less than 2.0 to 1.0.

The Loan Agreement also contains restrictions on incurring additional debt and paying dividends.

As of December 31, 2006, we were in compliance with all material covenants in our Loan Agreement.  A default under our bank credit facility could trigger the acceleration of our bank debt so that it is immediately due and payable.  Such default would have a material adverse effect on our liquidity, financial position and operations.

13

Subordinated Debt and Related Letters of Credit

The principal amounts of the promissory notes issued to the three stockholders of SCS in the SCS acquisition are payable in three equal annual installments, commencing on January 3, 2006.  Accrued and unpaid interest on the unpaid principal balance of the notes is payable on the same dates as, and in addition to, the installments of principal.  Subject to the consent of the holder of each respective note, principal payments may be made by us in shares of our common stock valued at the average daily closing prices of the common stock on the American Stock Exchange for the twenty consecutive trading days commencing thirty trading days before the due date of the principal payment, or by combination of cash and shares of common stock.  Under the terms of our Loan Agreement with our bank lender, we are prohibited from making payments on these notes if at the time of any such payment we are then in default under the Loan Agreement or if any such payment would cause or result in a default under the Loan Agreement.

To secure payment of these notes, our bank lender issued for our account three separate letters of credit for the benefit of the holders of the notes in the initial aggregate face amount of $2.0 million.  The letters of credit expire February 3, 2008.  Drafts for payment under the letters of credit may be made by the beneficiaries only upon our default in payment of the notes.  On February 3, 2007, the face amount of the letters of credit automatically reduced to $1.0 million.

Components of Our Principal Capital Expenditures

The table below sets out components of our principal capital expenditures for the three years ended December 31,  2006, along with the total budgeted for 2007, excluding acquisitions:

 
 
Actual
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Budgeted 2007
 
Expenditure Category
 
2004
 
 
2005
 
 
2006
 
 
(excluding acquisitions)
 
 
 
(in thousands)
 
Rental equipment, vehicles and shop equipment
 
$
11,596
 
 
$
17,708
 
 
$
27,684
 
 
$
30,000 to $35,000
 

The level of our expenditures will vary in future periods depending on energy market conditions and other related economic factors.  Based upon existing economic and market conditions, we believe that the proceeds from our March 2006 public offering of common stock, our operating cash flow and available bank borrowings will be sufficient to fully fund our net investing cash requirements for 2007.  We also believe we have significant flexibility with respect to our financing alternatives and adjustment of our expenditure plans if circumstances warrant.  When considered in relation to our total financial capacity, we do not have any material continuing commitments associated with expenditure plans related to our current operations.

Off-Balance Sheet Arrangements

From time-to-time, we enter into off-balance sheet arrangements and transactions that can give rise to off-balance sheet obligations.  As of December 31, 2006, the off-balance sheet arrangements and transactions that we have entered into include an undrawn letter of credit and operating lease agreements.  The Company does not believe that these arrangements are reasonably likely to materially affect its liquidity or availability of, or requirements for, capital resources.

14

PART IV
 
ITEM 15.                   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
The following documents are filed as part of this Annual Report on Form 10-K/A:
 
(a)(1) and (a)(2) Financial Statement and Financial Statement Schedules
 
For a list of Consolidated Financial Statements and Schedules, see “Index to Financial Statements”
on page F-1, and incorporated herein by reference.

(a)(3) Exhibits

See Item 15(b) below.

(b)           Exhibits:

A list of exhibits to this Annual Report on Form 10-K/A is set forth below:

Exhibit No.                                                                           Description

3.1
Articles of Incorporation, as amended (Incorporated by reference to Exhibit 3.1 of the 10QSB filed and dated November 10, 2004)

3.2
Bylaws (Incorporated by reference to Exhibit 3.4 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

4.1
Form of warrant certificate (Incorporated by reference to Exhibit 4.1 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

4.2
Form of warrant agent agreement (Incorporated by reference to Exhibit 4.2 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

4.3
Form of representative's option for the purchase of common stock (Incorporated by reference to Exhibit 4.4 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

4.4
Form of representative's option for the purchase of warrants (Incorporated by reference to Exhibit 4.5 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

4.5
Stockholders Agreement, dated January 3, 2005 among Paul D. Hensley, Tony Vohjesus, Jim Hazlett and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 4.3 of the Registrant's From 8-K Report, dated January 3, 2005, as filed with the Securities and Exchange Commission on January 7, 2005)

 
Executive Compensation Plans and Arrangements (Exhibits 10.1, 10.14, 10.15, 10.16, 10.23, 10.24, 10.26 and 10.27)

10.1
1998 Stock Option Plan, as amended (Incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K Report dated June 20, 2006 on file with the SEC June 26, 2006)

10.2
Form of Series A 10% Subordinated Notes due December 31, 2006 (Incorporated by reference to Exhibit 10.8 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

10.3
Form of Five-Year Warrants to Purchase Common Stock (Incorporated by reference to Exhibit 10.9 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

10.4
Warrants issued to Berry-Shino Securities, Inc.  (Incorporated by reference to Exhibit 10.10 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

E-1


Exhibit No.
Description

10.5
Warrants issued to Neidiger, Tucker, Bruner, Inc.  (Incorporated by reference to Exhibit 10.11 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

10.6
Form of warrant issued in March 2001 for guaranteeing debt (Incorporated by reference to Exhibit 10.12 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

10.7
Form of warrant issued in April 2002 for guaranteeing debt (Incorporated by reference to Exhibit10.13 of the Registrant's Registration Statement on Form SB-2, No.  333-88314)

10.8
First Amended and Restated Loan Agreement between the Registrant and Western National Bank (Incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K, dated March 27, 2003 and filed with the Securities and Exchange Commission on April 14, 2003)

10.9
Lease Agreement, dated March 1, 2004, between the Registrant and the City of Midland, Texas (Incorporated by reference to Exhibit 10.19 of the Registrant's Form 10-QSB for the fiscal quarter ended June 30, 2004)

10.10
Second Amended and Restated Loan Agreement, dated November 3, 2003, between the Registrant and Western National Bank (Incorporated by reference to Exhibit 10.20 of the Registrant's Form 10-QSB for the fiscal quarter ended June 30, 2004)

10.11
Securities Purchase Agreement, dated July 20, 2004, between the Registrant and CBarney Investments, Ltd.  (Incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K dated July 20, 2004 and filed with the Securities and Exchange Commission on July 27, 2004)

10.12
Stock Purchase Agreement, dated October 18, 2004, by and among the Registrant, Screw Compression Systems, Inc., Paul D. Hensley, Jim Hazlett and Tony Vohjesus (Incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K dated October 18, 2004 and filed with the Securities and Exchange Commission on October 21, 2004)

10.13
Third Amended and Restated Loan Agreement, dated as of January 3, 2005, among Natural Gas Services Group, Inc., Screw Compression Systems, Inc.  and Western National Bank (Incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K, dated January 3, 2005, and filed with the Securities and Exchange Commission on January 7, 2005)

10.14
Employment Agreement between Paul D. Hensley and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 10.1 of the Registrants Form 8-K Report, dated January 3, 2005, as filed with the Securities and Exchange Commission on January 7, 2005)

10.15
Employment Agreement between William R. Larkin and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 10.25 of the Registrant's Form 10-KSB for the fiscal year ended December 31, 2004, and filed with the Securities and Exchange Commission on March 30, 2005)

10.16
Promissory Note, dated January 3, 2005, in the original principal amount of $2.1 million made by Natural Gas Services Group, Inc.  payable to Paul D. Hensley (Incorporated by reference to Exhibit 10.26 of the Registrant's Form 10-KSB for the fiscal year ended December 31, 2004, and filed with the Securities and Exchange Commission on March 30, 2005)

10.17
Fourth Amended and Restated Loan Agreement (Incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K, dated March 14, 2005, and filed with the Securities and Exchange Commission on March 18, 2005)

10.18
Modification Agreement, dated as of  January 3, 2005, by and between Natural Gas Services Group, Inc.  and Western National Bank  (Incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 8-K, dated January 3, 2005, and filed with the Securities and Exchange Commission on January 7, 2005)

E-2

Exhibit No.
Description

10.19
Guaranty Agreement, dated as of January 3, 2005, made by Natural Gas Service Group, Inc., for the benefit of Western National Bank (Incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K, dated January 3, 2005, and filed with the Securities and Exchange Commission on January 7, 2005)

10.20
Guaranty Agreement, dated as of January 3, 2005, made by Screw Compression Systems, Inc., for the benefit of Western National Bank (Incorporated by reference to Exhibit 10.4 of the Registrant’s Current Report on Form 8-K, dated January 3, 2005, and filed with the Securities and Exchange Commission on January 7, 2005)

10.21
Fifth Amended and Restated Loan Agreement (Incorporated by reference to Exhibit 10.2 of the Registrant’s Form 8-K dated January 3, 2006 and filed with the Securities and Exchange Commission January 6, 2006)

10.22
First Modification to Fourth Amended and Restated Loan Agreement (Incorporated by reference Exhibit 10.1 of the Registrant’s Form 8-K dated May 1, 2005 and filed with Securities and Exchange Commission May 13, 2005)

10.23
Employment Agreement between Stephen C. Taylor and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K Report, dated August 24, 2005, and filed with the Securities and Exchange Commission on August 30, 2005)

10.24
Employment Agreement between James R. Hazlett and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K Report, dated June 14, 2005, and filed with the Securities and Exchange Commission on November 14, 2005)

10.25
Stockholders Agreement, dated January 3, 2005 among Paul D. Hensley, Tony Vohjesus, Jim Hazlett and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 4.3 of the Registrant’s Form 8-K Report, dated January 3, 2005, and filed with the Securities and Exchange Commission on January 7, 2005)

10.26
Promissory Note, dated January 3, 2005, in the original principal amount of $300 thousand made by Natural Gas Services Group, Inc.  payable to Jim Hazlett (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 8-K Report, dated June 14, 2005, and filed with the Securities and Exchange Commission on November 14, 2005)

10.27
Retirement Agreement, dated December 14, 2005, between Wallace C. Sparkman and Natural Gas Services Group, Inc.  (Incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K Report, dated December 14, 2005, and filed with the Securities and Exchange Commission on December 15, 2005)

10.28
Sixth Amended and Restated Loan Agreement, dated as of January 3, 2006 (Incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K, dated January 3, 2006, and filed with the Securities and Exchange Commission on January 6, 2006)

10.29
Guaranty Agreement, dated as of January 3, 2006, and made by Screw Compression Systems, Inc.  for the benefit of Western National Bank (Incorporated by reference to Exhibit 10.4 of the Registrant’s Current Report on Form 8-K, dated January 3, 2006, and filed with the Securities and Exchange Commission on January 6, 2006)

10.30
Seventh Amended and Restated Loan Agreement (Incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K dated October 26, 2006 and filed with the Securities and Exchange Commission on November 1, 2006

14.0
Code of Ethics (Incorporated by reference to Exhibit 14.0 of the Registrant's Form 10-KSB for the fiscal year ended December 31, 2004, and filed with the Securities and Exchange Commission on March 30, 2005)

21.0
Subsidiaries (Incorporated by reference to Exhibit 21.0 of the Registrant's Form 10-KSB for the fiscal year ended December 31, 2004, and filed with the Securities and Exchange Commission on March 30, 2005)


E-3


Exhibit No.
Description

*23.1
Consent of Hein & Associates LLP

*31.1
Certifications

*31.2
Certifications

*32.1
Certification required by Section 906 of the Sarbanes-Oxley Act of 2002

*32.2
Certification required by Section 906 of the Sarbanes-Oxley Act of 2002


             * Filed herewith.



E-4

 
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
Natural Gas Service Group, Inc.
 
 
 
 
 
Date:  June 8, 2007
By:
/s/ Stephen C. Taylor
 
 
 
Stephen C. Taylor
 
 
 
Chairman of the Board of Directors, Chief Executive Officer and
President (Principal Executive Officer)
 
 
 
 
 

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
 
Signature
 
Title
 
Date
 
 
 
 
 
/s/ Stephen C. Taylor
 
Chairman of the Board of Directors, Chief Executive Officer and President
 
June 8, 2007
Stephen C. Taylor
 
(Principal Executive Officer)
 
 
 
 
 
 
 
/s/ Earl R. Wait
 
Vice President – Accounting
 
June 8, 2007
Earl R. Wait
 
(Principal Financial Officer)
 
 
 
 
 
 
 
 
 


 
INDEX TO FINANCIAL STATEMENTS


 
 
 Page
 
 
 
 Report of Independent Registered Public Accounting Firm
 
 F-2
 
 
 
 Consolidated Balance Sheets as of December 31, 2005 and 2006
 
 F-3
 
 
 
 Consolidated Statements of Income for the Years Ended December 31, 2004, 2005 and 2006
 
 F-4
 
 
 
 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2004, 2005, and 2006
 
 F-5
 
 
 
 Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2005 and 2006
 
 F-6
 
 
 
 Notes to Consolidated Financial Statements
 
 F-7

 
                   


F-1

                                                                                                                                     
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors
Natural Gas Services Group, Inc.


We have audited the consolidated balance sheets of Natural Gas Services Group, Inc. and Subsidiaries (the “Company”) as of December 31, 2005 and 2006, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2006, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Natural Gas Services Group, Inc. and Subsidiaries internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 12, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.


/s/HEIN& ASSOCIATES LLP
Dallas, Texas
March 12, 2007


F-2

NATURAL GAS SERVICES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except per share data)

 
 
December 31,
 
 
 
2005
 
 
2006
 
ASSETS
 
 
 
 
 
 
Current Assets:
 
 
 
 
 
 
  Cash and cash equivalents
 
$
3,271
 
 
$
4,391
 
  Short-term investments
 
 
—
 
 
 
25,052
 
  Trade accounts receivable, net of doubtful accounts of $75 and $110, respectively
 
 
6,192
 
 
 
8,463
 
  Inventory, net of allowance for obsolescence of $361 and $347, respectively
 
 
14,723
 
 
 
16,943
 
  Prepaid expenses and other
 
 
456
 
 
 
321
 
     Total current assets
 
 
24,642
 
 
 
55,170
 
 
 
 
 
 
 
 
 
 
Rental equipment, net of accumulated depreciation of $7,598 and $11,320, respectively
 
 
41,201
 
 
 
59,866
 
Property and equipment, net of accumulated depreciation of $2,458 and $3,679, respectively
 
 
6,424
 
 
 
6,714
 
Goodwill, net of accumulated amortization of $325
 
 
10,039
 
 
 
10,039
 
Intangibles, net of accumulated amortization of $492 and $819, respectively
 
 
3,978
 
 
 
3,650
 
Other assets
 
 
85
 
 
 
113
 
     Total assets
 
$
86,369
 
 
$
135,552
 
 
 
 
 
 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Current Liabilities:
 
 
 
 
 
 
 
 
  Current portion of long-term debt and subordinated notes
 
$
5,680
 
 
$
4,442
 
  Line of credit
 
 
300
 
 
 
—
 
  Accounts payable
 
 
3,180
 
 
 
2,837
 
  Accrued liabilities
 
 
1,737
 
 
 
2,077
 
  Current income tax liability
 
 
207
 
 
 
1,056
 
  Deferred income
 
 
103
 
 
 
225
 
     Total current liabilities
 
 
11,207
 
 
 
10,637
 
 
 
 
 
 
 
 
 
 
Long term debt, less current portion
 
 
20,225
 
 
 
12,950
 
Subordinated notes-related parties, less current portion
 
 
2,000
 
 
 
1,000
 
Deferred income tax payable
 
 
7,247
 
 
 
9,764
 
Commitments (Note 11)
 
 
 
 
 
 
 
 
Stockholders’ equity:
 
 
 
 
 
 
 
 
  Common stock, 30,000 shares authorized, par value $0.01; 9,022 and 12,046 shares issued and outstanding, respectively
 
 
90
 
 
 
120
 
  Additional paid-in capital
 
 
34,667
 
 
 
82,560
 
  Retained earnings
 
 
10,933
 
 
 
18,521
 
     Total stockholders’ equity
 
 
45,690
 
 
 
101,201
 
     Total liabilities and stockholders’ equity
 
$
86,369
 
 
$
135,552
 
 
 
 
 
 
 
 
 
 

See accompanying notes to these consolidated financial statements.


F-3

NATURAL GAS SERVICES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(amounts in thousands, except per share data)

 
 
For the Years Ended December 31,
 
 
 
2004
 
 
2005
 
 
2006
 
Revenue:
 
 
 
 
 
 
 
 
 
  Sales, net
 
$
3,593
 
 
$
30,278
 
 
$
38,214
 
  Service and maintenance income
 
 
1,874
 
 
 
2,424
 
 
 
979
 
  Rental income
 
 
10,491
 
 
 
16,609
 
 
 
23,536
 
     Total revenue
 
 
15,958
 
 
 
49,311
 
 
 
62,729
 
Operating costs and expenses:
 
 
 
 
 
 
 
 
 
 
 
 
  Cost of sales, exclusive of depreciation stated separately below
 
 
2,556
 
 
 
23,331
 
 
 
29,629
 
  Cost of service, exclusive of depreciation stated separately below
 
 
1,357
 
 
 
1,479
 
 
 
735
 
  Cost of rental, exclusive of depreciation stated separately below
 
 
3,038
 
 
 
6,528
 
 
 
8,944
 
  Selling expenses
 
 
875
 
 
 
1,034
 
 
 
1,273
 
  General and administrative
 
 
1,777
 
 
 
3,856
 
 
 
3,997
 
  Depreciation and amortization
 
 
2,444
 
 
 
4,224
 
 
 
6,020
 
     Total operating costs and expenses
 
 
12,047
 
 
 
40,452
 
 
 
50,598
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating income
 
 
3,911
 
 
 
8,859
 
 
 
12,131
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other income (expense):
 
 
 
 
 
 
 
 
 
 
 
 
  Interest expense
 
 
(838
)
 
 
(1,997
)
 
 
(1,646
)
  Other income
 
 
1,441
 
 
 
199
 
 
 
1,390
 
     Total other income (expense)
 
 
603
 
 
 
(1,798
)
 
 
(256
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Income before provision for income taxes
 
 
4,514
 
 
 
7,061
 
 
 
11,875
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  Provision for income taxes:
 
 
 
 
 
 
 
 
 
 
 
 
    Current
 
 
20
 
 
 
207
 
 
 
1,743
 
    Deferred
 
 
1,120
 
 
 
2,408
 
 
 
2,544
 
       Total income tax expense
 
 
1,140
 
 
 
2,615
 
 
 
4,287
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
3,374
 
 
 
4,446
 
 
 
7,588
 
  Preferred dividends
 
 
53
 
 
 
—
 
 
 
—