| NATURAL GAS SERVICES GROUP INC ITEM 1A RISK FACTORS You should carefully consider the following risks before you decide to buy our common stock |
| If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer |
| If this occurs, the trading price of our common stock could decline, and you could lose all or part of the money you paid to buy our common stock |
| Although the risks described below are the risks that we believe are material, they are not the only risks relating to our industry, our business and our common stock |
| Additional risks and uncertainties, including those that are not yet identified or that we currently believe are immaterial, may also adversely affect our business, financial condition or results of operations |
| Risks Associated With Our Industry Decreased oil and natural gas prices and oil and gas industry expenditure levels would adversely affect our revenue |
| Our revenue is derived from expenditures in the oil and natural gas industry which, in turn, are based on budgets to explore for, develop and produce oil and natural gas |
| If these expenditures decline, our revenue will suffer |
| The industry’s willingness to explore for, develop and produce oil and natural gas depends largely upon the prevailing view of future oil and natural gas prices |
| Prices for oil and gas historically have been, and are likely to continue to be, highly volatile |
| Many factors affect the supply and demand for oil and natural gas and, therefore, influence oil and natural gas prices, including: • the level of oil and natural gas production; • the level of oil and natural gas inventories; • domestic and worldwide demand for oil and natural gas; • the expected cost of developing new reserves; • the cost of producing oil and natural gas; • the level of drilling and producing activity; • inclement weather; • domestic and worldwide economic activity; • regulatory and other federal and state requirements in the United States; • the ability of the Organization of Petroleum Exporting Countries to set and maintain production levels and prices for oil; • political conditions in or affecting oil and natural gas producing countries; • terrorist activities in the United States and elsewhere; • the cost of developing alternate energy sources; • environmental regulation; and • tax policies |
| If the demand for oil and natural gas decreases, then demand for our compressors likely will decrease |
| 8 _________________________________________________________________ [60]Table of Contents Depending on the market prices of oil and natural gas, companies exploring for oil and natural gas may cancel or curtail their drilling programs, thereby reducing demand for our equipment and services |
| Our rental contracts are generally short-term, and oil and natural gas companies tend to respond quickly to upward or downward changes in prices |
| Any reduction in drilling and production activities may materially erode both pricing and utilization rates for our equipment and services and adversely affects our financial results |
| As a result, we may suffer losses, be unable to make necessary capital expenditures and be unable to meet our financial obligations |
| The intense competition in our industry could result in reduced profitability and loss of market share for us |
| In our business segments, we compete with the oil and natural gas industry’s largest equipment and service providers who have greater name recognition than we do |
| These companies also have substantially greater financial resources, larger operations and greater budgets for marketing, research and development than we do |
| They may be better able to compete because of their broader geographic dispersion, the greater number of compressors in their fleet or their product and service diversity |
| As a result, we could lose customers and market share to those competitors |
| These companies may also be better positioned than us to successfully endure downturns in the oil and natural gas industry |
| Our operations may be adversely affected if our current competitors or new market entrants introduce new products or services with better prices, features, performance or other competitive characteristics than our products and services |
| Competitive pressures or other factors also may result in significant price competition that could harm our revenue and our business |
| Additionally, we may face competition in our efforts to acquire other businesses |
| Our industry is highly cyclical, and our results of operations may be volatile |
| Our industry is highly cyclical, with periods of high demand and high pricing followed by periods of low demand and low pricing |
| Periods of low demand intensify the competition in the industry and often result in rental equipment being idle for long periods of time |
| We may be required to enter into lower rate rental contracts in response to market conditions in the future, and our sales may decrease as a result of such conditions |
| Due to the short-term nature of most of our rental contracts, changes in market conditions can quickly affect our business |
| As a result of the cyclicality of our industry, our results of operations may be volatile in the future |
| We are subject to extensive environmental laws and regulations that could require us to take costly compliance actions that could harm our financial condition |
| Our fabrication and maintenance operations are significantly affected by stringent and complex federal, state and local laws and regulations governing the discharge of substances into the environment or otherwise relating to environmental protection |
| In these operations, we generate and manage hazardous wastes such as solvents, thinner, waste paint, waste oil, washdown wastes, and sandblast material |
| We attempt to use generally accepted operating and disposal practices and, with respect to acquisitions, will attempt to identify and assess whether there is any environmental risk before completing an acquisition |
| Based on the nature of the industry, however, hydrocarbons or other wastes may have been disposed of or released on or under properties owned or leased by us or on or under other locations where such wastes have been taken for disposal |
| The waste on these properties may be subject to federal or state environmental laws that could require us to remove the wastes or remediate sites where they have been released |
| We could be exposed to liability for cleanup costs, natural resource and other damages as a result of our conduct or the conduct of, or conditions caused by, prior owners, lessees or other third parties |
| Environmental laws and regulations have changed in the past, and they are likely to change in the future |
| If existing regulatory requirements or enforcement policies change, we may be required to make significant unanticipated capital and operating expenditures |
| Any failure by us to comply with applicable environmental laws and regulations may result in governmental authorities taking actions against our business that could harm our operations and financial condition, including the: • issuance of administrative, civil and criminal penalties; • denial or revocation of permits or other authorizations; • reduction or cessation in operations; and 9 _________________________________________________________________ [61]Table of Contents • performance of site investigatory, remedial or other corrective actions |
| Risks Associated With Our Company We might be unable to employ adequate technical personnel, which could hamper our plans for expansion or increase our costs |
| Many of the compressors that we sell or rent are mechanically complex and often must perform in harsh conditions |
| We believe that our success depends upon our ability to employ and retain a sufficient number of technical personnel who have the ability to design, utilize, enhance and maintain these compressors |
| Our ability to expand our operations depends in part on our ability to increase our skilled labor force |
| The demand for skilled workers is high and supply is limited |
| A significant increase in the wages paid by competing employers could result in a reduction of our skilled labor force or cause an increase in the wage rates that we must pay or both |
| If either of these events were to occur, our cost structure could increase and our operations and growth potential could be impaired |
| We could be subject to substantial liability claims that could harm our financial condition |
| Our products are used in hazardous drilling and production applications where an accident or a failure of a product can cause personal injury, loss of life, damage to property, equipment or the environment, or suspension of operations |
| While we maintain insurance coverage, we face the following risks under our insurance coverage: • we may not be able to continue to obtain insurance on commercially reasonable terms; • we may be faced with types of liabilities that will not be covered by our insurance, such as damages from significant product liabilities and from environmental contamination; • the dollar amount of any liabilities may exceed our policy limits; and • we do not maintain coverage against the risk of interruption of our business |
| Any claims made under our policy will likely cause our premiums to increase |
| Any future damages caused by our products or services that are not covered by insurance, are in excess of policy limits or are subject to substantial deductibles, would reduce our earnings and our cash available for operations |
| We will require a substantial amount of capital to expand our compressor rental fleet and grow our business |
| During 2006, we plan to spend approximately dlra25dtta0 million to dlra30dtta0 million in capital expenditures to expand our rental fleet |
| The amount and timing of these capital expenditures may vary depending on a variety of factors, including the level of activity in the oil and natural gas exploration and production industry and the presence of alternative uses for our capital, including any acquisitions that we may pursue |
| Historically, we have funded our capital expenditures through internally generated funds, borrowings under bank credit facilities and the proceeds of equity financings |
| Although we believe that the proceeds from our recently completed public offering, cash flows from our operations and borrowings under our existing bank credit facility will provide us with sufficient cash to fund our planned capital expenditures for 2006, we cannot assure you that these sources will be sufficient |
| We may require additional capital to fund any unanticipated capital expenditures, including any acquisitions, and to fund our growth beyond 2006, and necessary capital may not be available to us when we need it or on acceptable terms |
| Our ability to raise additional capital will depend on the results of our operations and the status of various capital and industry markets at the time we seek such capital |
| Failure to generate sufficient cash flow, together with the absence of alternative sources of capital, could have a material adverse effect on our business, consolidated financial condition, results of operations or cash flows |
| 10 _________________________________________________________________ [62]Table of Contents Our current debt level is high and may negatively impact our current and future financial stability |
| As of December 31, 2005, we had an aggregate of approximately dlra28dtta2 million of outstanding indebtedness, not including outstanding letters of credit in the aggregate face amount of dlra2dtta0 million, and accounts payable and accrued expenses of approximately dlra5dtta1 million |
| As a result of our significant indebtedness, we might not have the ability to incur any substantial additional indebtedness |
| The level of our indebtedness could have several important effects on our future operations, including: • our ability to obtain additional financing for working capital, acquisitions, capital expenditures and other purposes may be limited; • a significant portion of our cash flow from operations may be dedicated to the payment of principal and interest on our debt, thereby reducing funds available for other purposes; and • our significant leverage could make us more vulnerable to economic downturns |
| If we are unable to service our debt, we will likely be forced to take remedial steps that are contrary to our business plan |
| As of December 31, 2005, our principal payments for our debt service requirements were approximately dlra473cmam000 on a monthly basis; dlra1dtta4 million on a quarterly basis; and dlra5dtta7 million on an annual basis |
| It is possible that our business will not generate sufficient cash flow from operations to meet our debt service requirements and the payment of principal when due |
| If this were to occur, we may be forced to: • sell assets at disadvantageous prices; • obtain additional financing; or • refinance all or a portion of our indebtedness on terms that may be less favorable to us |
| Our current bank loan agreement contains covenants that limit our operating and financial flexibility and, if breached, could expose us to severe remedial provisions |
| Under the terms of our loan agreement, we must: • comply with a minimum current ratio; • maintain minimum levels of tangible net worth; • not exceed specified levels of debt; • comply with a debt service coverage ratio; and • comply with a debt to tangible net worth ratio |
| Our ability to meet the financial ratios and tests under our bank loan agreement can be affected by events beyond our control, and we may not be able to satisfy those ratios and tests |
| A breach of any one of these covenants could permit the bank to accelerate the debt so that it is immediately due and payable |
| If a breach occurred, no further borrowings would be available under our loan agreement |
| If we were unable to repay the debt, the bank could proceed against and foreclose on our assets |
| If we fail to acquire or successfully integrate additional businesses, our growth may be limited and our results of operations may suffer |
| As part of our business strategy, we intend to evaluate potential acquisitions of other businesses or assets |
| However, there can be no assurance that we will be successful in consummating any such acquisitions |
| Successful acquisition of businesses or assets will depend on various factors, including, but not limited to, our ability to obtain financing and the competitive environment for acquisitions |
| In addition, we may not be able to successfully integrate 11 _________________________________________________________________ [63]Table of Contents any businesses or assets that we acquire in the future |
| The integration of acquired businesses is likely to be complex and time consuming and place a significant strain on management and may disrupt our business |
| We also may be adversely impacted by any unknown liabilities of acquired businesses, including environmental liabilities |
| We may encounter substantial difficulties, costs and delays involved in integrating common accounting, information and communication systems, operating procedures, internal controls and human resources practices, including incompatibility of business cultures and the loss of key employees and customers |
| These difficulties may reduce our ability to gain customers or retain existing customers, and may increase operating expenses, resulting in reduced revenues and income and a failure to realize the anticipated benefits of acquisitions |
| As of December 31, 2005, a significant majority of our compressor rentals were for terms of six months or less which, if terminated or not renewed, would adversely impact our revenue and our ability to recover our initial equipment costs |
| The length of our compressor rental agreements with our customers varies based on customer needs, equipment configurations and geographic area |
| In most cases, under currently prevailing rental rates, the initial rental periods are not long enough to enable us to fully recoup the average cost of acquiring or fabricating the equipment |
| We cannot be sure that a substantial number of our customers will continue to renew their rental agreements or that we will be able to re-rent the equipment to new customers or that any renewals or re-rentals will be at comparable rental rates |
| The inability to timely renew or re-rent a substantial portion of our compressor rental fleet would have a material adverse effect upon our business, consolidated financial condition, results of operations and cash flows |
| The loss of one or more of our current customers could adversely affect our results of operations |
| It is likely that we will not continue to receive the same level of revenues we have received in the past from one of our customers |
| Our business is dependent not only on securing new customers but also on maintaining current customers |
| In connection with our acquisition in March 2001 of the compression related assets of Dominion Michigan Petroleum Services, Inc, an affiliate of Dominion Michigan, Dominion Exploration & Production, Inc, committed to purchase compressors from us or enter into five year rental contracts with us for compression totaling five-thousand horsepower |
| This obligation expired December 31, 2005 |
| In August 2005, we and competing third parties were invited to submit bids for providing continued rental and maintenance services to Dominion |
| In October 2005, we were advised that we will retain Dominion’s screw compressor rental business and the associated maintenance and service business, but that an unaffiliated third party will maintain and service Dominion’s reciprocating compressors |
| We estimate that the screw compressor rental, maintenance and service business we have retained from Dominion Exploration represented approximately 78prca and 86prca of our revenues from Dominion Exploration in the years ended December 31, 2004 and 2005, respectively |
| accounted for approximately 21prca of our consolidated revenue for the year ended December 31, 2004, and approximately 9prca of our consolidated revenue for the year ended December 31, 2005 |
| XTO Energy, Inc |
| accounted for approximately 36prca of our consolidated revenue for the year ended December 31, 2005 |
| Unless we are able to retain our existing customers, or secure new customers if we lose one or more of our significant customers, our revenue and results of operations would be adversely affected |
| Loss of key members of our management could adversely affect our business |
| We depend on the continued employment and performance of Stephen C Taylor, our Chairman of the Board of Directors, President and Chief Executive Officer, and other key members of our management |
| If any of our key managers resigns or becomes unable to continue in his present role and is not adequately replaced, our business operations could be materially adversely affected |
| Failure to effectively manage our growth and expansion could adversely affect our business and operating results and our internal controls |
| We have rapidly and significantly expanded our operations in recent years and anticipate that our growth will continue if we are able to execute our strategy |
| Our rapid growth has placed significant strain on our management and other resources which, given our expected future growth rate, is likely to continue |
| To manage our future growth, we must, among other things: • accurately assess the number of additional officers and employees we will require and the areas in which they will be required; 12 _________________________________________________________________ [64]Table of Contents • attract, hire and retain additional highly skilled and motivated officers and employees; • train and manage our work force in a timely and effective manner; • upgrade and expand our office infrastructure so that it is appropriate for our level of activity; and • improve our financial and management controls, reporting systems and procedures |
| Liability to customers under warranties may materially and adversely affect our earnings |
| We provide warranties as to the proper operation and conformance to specifications of the equipment we manufacture |
| Our equipment is complex and often deployed in harsh environments |
| Failure of this equipment to operate properly or to meet specifications may increase our costs by requiring additional engineering resources and services, replacement of parts and equipment or monetary reimbursement to a customer |
| To the extent that we incur substantial warranty claims in any period, our reputation, our ability to obtain future business and our earnings could be materially and adversely affected |
| Failure to maintain effective internal controls could have a material adverse effect on our operations |
| We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal control over financial reporting and a report by our independent auditors addressing these assessments |
| During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by SEC rules under the Sarbanes-Oxley Act for compliance with the requirements of Section 404 |
| In addition, if we fail to achieve and maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act |
| Moreover, effective internal controls are necessary for us to produce reliable financial reports and to help prevent financial fraud |
| If, as a result of deficiencies in our internal controls, we cannot provide reliable financial reports or prevent fraud, our business decision process may be adversely affected, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the price of our stock could decrease as a result |
| We must evaluate our intangible assets annually for impairment |
| Our intangible assets are recorded at cost less accumulated amortization and consist of goodwill and patent costs and other identifiable intangibles acquired as part of the SCS acquisition |
| Through December 31, 2001, goodwill was amortized using the straight-line method over 15 years and patent costs were amortized over 13 to 15 years |
| In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards Nodtta 142, “Goodwill and Other Intangible Assets |
| ” FAS 142 provides that: (1) goodwill and intangible assets with indefinite lives will no longer be amortized; (2) goodwill and intangible assets with indefinite lives must be tested for impairment at least annually; and (3) the amortization period for intangible assets with finite lives will no longer be limited to 40 years |
| If we determine that our intangible assets with indefinite lives have been impaired, we must record a write-down of those assets on our consolidated statements of income during the period of impairment |
| Our determination of impairment will be based on various factors, including any of the following factors, if they materialize: • 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; • significant negative industry or economic trends; • significant decline in our stock price for a sustained period; and • our market capitalization relative to net book value |
| Based on an independent valuation in July 2002 and June 2003 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 2003, 2004 or 2005 |
| 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 were recorded on our balance sheet at approximately dlra2dtta7 million as of December 31, 2004, and at December 31, 2005, the carrying value of net intangible assets had increased to approximately dlra14dtta0 million with the acquisition of Screw Compression Systems, Inc |
| 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 |
| Risks Associated With Our Common Stock The price of our common stock may fluctuate which may cause our common stock to trade at a substantially lower price than the price which you paid for our common stock |
| The trading price of our common stock and the price at which we may sell securities in the future is subject to substantial fluctuations in response to various factors, including our ability to successfully accomplish our business strategy, the trading volume of our stock, changes in governmental regulations, actual or anticipated variations in our quarterly or annual financial results, our involvement in litigation, general market conditions, the prices of oil and natural gas, announcements by us and our competitors, our liquidity, our ability to raise additional funds, and other events |
| Future sales of our common stock could adversely affect our stock price |
| Substantial sales of our common stock in the public market, or the perception by the market that those sales could occur, may lower our stock price or make it difficult for us to raise additional equity capital in the future |
| These potential sales could include sales of shares of our common stock by our Directors and officers, who beneficially owned approximately 12dtta34prca of the outstanding shares of our common stock as of March 30, 2006 |
| We have filed registration statements with the Securities and Exchange Commission registering the resale of approximately 649cmam574 shares of our currently outstanding common stock and approximately 289cmam696 shares of common stock that may be issued upon exercise of outstanding stock options and warrants |
| In January 2005, we issued a total of 609cmam756 shares of our common stock to the former stockholders of SCS in partial payment of the total purchase price for SCS When originally issued, all of these shares were “restricted” securities within the meaning of Rule 144 under the Securities Act of 1933, as amended |
| As of March 29, 2006, a total of 477cmam756 of these shares remain “restricted” securities under Rule 144 |
| Under Rule 144, shares of our common stock that have been held for at least one year may generally be sold in brokers transaction if the amount of shares sold by any stockholder (and the stockholder’s transferees under certain circumstances) in any three-month period does not exceed the greater of 1prca of the outstanding stock (currently approximately 119cmam279 shares) or the four-week average weekly trading volume of the common stock |
| The 609cmam756 shares of common stock we issued to the former stockholders of SCS became eligible for sale under Rule 144 on January 3, 2006, and a total of 132cmam000 of these shares were sold in our public offering that we completed on March 8, 2006 |
| Substantially all other outstanding shares of common stock held by non-affiliates are freely tradable |
| If securities analysts downgrade our stock or cease coverage of us, the price of our stock could decline |
| The trading market for our common stock relies in part on the research and reports that industry or financial analysts publish about us or our business |
| Furthermore, there are many large, well-established, publicly traded companies active in our industry and market, which may mean that it is less likely that we will receive widespread analysts coverage |
| If one or more of the analysts who do cover us downgrade our stock, our stock price would likely decline rapidly |
| If one or more of these analysts cease coverage of our company, we could lose visibility in the market, which in turn could cause our stock price to decline |
| 14 _________________________________________________________________ [66]Table of Contents If we issue debt or equity securities, you may lose certain rights and be diluted |
| If we raise funds in the future through the issuance of debt or equity securities, the securities issued may have rights and preferences and privileges senior to those of holders of our common stock, and the terms of the securities may impose restrictions on our operations or dilute your ownership in Natural Gas Services Group, Inc |
| We do not intend to pay, and have restrictions upon our ability to pay, dividends on our common stock |
| We have not paid cash dividends in the past and do not intend to pay dividends on our common stock in the foreseeable future |
| Net income from our operations, if any, will be used for the development of our business, including capital expenditures, and to retire debt |
| In addition, our bank loan agreement contains restrictions on our ability to pay cash dividends on our common stock |
| We have a comparatively low number of shares of common stock outstanding and, therefore, our common stock may suffer from limited liquidity and its prices will likely be volatile and its value may be adversely affected |
| Because of our relatively low number of outstanding shares of common stock, the trading price of our common stock will likely be subject to significant price fluctuations and limited liquidity |
| This may adversely affect the value of your investment |
| In addition, our common stock price could be subject to fluctuations in response to variations in quarterly operating results, changes in management, future announcements concerning us, general trends in the industry and other events or factors as well as those described above |
| Provisions contained in our governing documents could hinder a change in control of us |
| Our articles of incorporation and bylaws contain provisions that may discourage acquisition bids and may limit the price investors are willing to pay for our common stock |
| Our articles of incorporation and bylaws provide that: • directors will be elected for three-year terms, with approximately one-third of the board of directors standing for election each year; • cumulative voting is not allowed, which limits the ability of minority shareholders to elect any directors; • the unanimous vote of the board of directors or the affirmative vote of the holders of not less than 80prca of the votes entitled to be cast by the holders of all shares entitled to vote in the election of directors is required to change the size of the board of directors; and • directors may be removed only for cause and only by the holders of not less than 80prca of the votes entitled to be cast on the matter |
| Our Board of Directors has the authority to issue up to five million shares of preferred stock |
| The Board of Directors can fix the terms of the preferred stock without any action on the part of our stockholders |
| The issuance of shares of preferred stock may delay or prevent a change in control transaction |
| In addition, preferred tock could be used in connection with the Board of Directors’ adoption of a shareholders’ rights plan (also known as a poison pill), which would make it much more difficult to elect a change in control of our company through acquiring or controlling blocks of stock |
| Also, after completion of this offering, our Directors and officers as a group will continue to beneficially own stock |
| Although this is not a majority of our stock, it confers substantial voting power in the election of Directors and management of our company |
| This would make it difficult for other minority stockholders, such as the investors in this offering, to effect a change in control or otherwise extend any significant control over the management of our company |
| This may adversely affect the market price and interfere with the voting and other rights of our common stock |