10-Q 1 a2018q310qaroc.htm 10-Q
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File No. 001-33666
ARCHROCK, INC.
(Exact name of registrant as specified in its charter)

Delaware |  | 74-3204509
(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
9807 Katy Freeway, Suite 100 |  |
Houston, Texas |  | 77024
(Address of principal executive offices) |  | (Zip Code)

(281) 836-8000
(Registrant’s telephone number, including area code)
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 x No o
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x | Accelerated filer o
Non-accelerated filer o | Smaller reporting company o
| Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Number of shares of the common stock of the registrant outstanding as of October 25, 2018: 129,336,871 shares.

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TABLE OF CONTENTS

| Page
GLOSSARY | 3
FORWARD-LOOKING STATEMENTS | 5
PART I. FINANCIAL INFORMATION |
Item 1. Financial Statements (unaudited) | 7
Condensed Consolidated Balance Sheets | 7
Condensed Consolidated Statements of Operations | 8
Condensed Consolidated Statements of Comprehensive Income (Loss) | 9
Condensed Consolidated Statements of Equity | 10
Condensed Consolidated Statements of Cash Flows | 11
Notes to Unaudited Condensed Consolidated Financial Statements | 12
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 36
Item 3. Quantitative and Qualitative Disclosures About Market Risk | 48
Item 4. Controls and Procedures | 48
PART II. OTHER INFORMATION |
Item 1. Legal Proceedings | 49
Item 1A. Risk Factors | 49
Item 2. Unregistered Sales of Equity Securities | 49
Item 3. Defaults Upon Senior Securities | 49
Item 4. Mine Safety Disclosures | 49
Item 5. Other Information | 49
Item 6. Exhibits | 50
SIGNATURES | 51

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GLOSSARY
The following terms and abbreviations appearing in the text of this report have the meanings indicated below.

2006 Partnership LTIP | The Archrock Partners, L.P. Long Term Incentive Plan, adopted in October 2006
2007 Plan | The Archrock, Inc. 2007 Stock Incentive Plan
2013 Plan | The Archrock, Inc. 2013 Stock Incentive Plan
2017 Form 10-K | Archrock, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2017
2017 Partnership LTIP | The Archrock Partners, L.P. Long Term Incentive Plan, adopted in April 2017
Amendment No. 1 | Amendment No. 1 to Credit Agreement, dated February 23, 2018, which amended that certain Credit Agreement, dated as of March 30, 2017, which governs the Partnership Credit Facility
Archrock, our, we, us | Archrock, Inc., individually and together with its wholly-owned subsidiaries
Archrock Credit Facility | Archrock’s $350 million revolving credit facility due November 2020
ASC Topic 842 Leases | Accounting Standards Codification Topic 842 Leases as promulgated by Accounting Standards Update No. 2016-02 Leases (Topic 842) and further updated by Accounting Standards Update No. 2018-11 Leases (Topic 842): Targeted Improvements
ASU 2016-13 | Accounting Standards Update No. 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
ASU 2016-15 | Accounting Standards Update No. 2016-15 Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments
ASU 2017-12 | Accounting Standards Update No. 2017-12 Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities
ASU 2018-02 | Accounting Standards Update No. 2018-02 Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
ASU 2018-05 | Accounting Standards Update No. 2018-05 Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118
ASU 2018-13 | Accounting Standards Update No. 2018-13 Fair Value Measurement (Topic 820): Disclosure Framework — Changes to the Disclosure Requirements for Fair Value Measurement
ASU 2018-15 | Accounting Standards Update No. 2018-15 Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract
EBITDA | Earnings before interest, taxes, depreciation and amortization
EES Leasing | Archrock Services Leasing LLC, formerly known as EES Leasing LLC
Exchange Act | Securities Exchange Act of 1934, as amended
EXLP Leasing | Archrock Partners Leasing LLC, formerly known as EXLP Leasing LLC
FASB | Financial Accounting Standards Board
Financial Statements | Archrock’s Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q
Former Credit Facility | The Partnership’s former $825.0 million revolving credit facility and $150.0 million term loan, terminated in March 2017
GAAP | Accounting principles generally accepted in the U.S.
General Partner | Archrock General Partner, L.P., a wholly owned subsidiary of Archrock and the Partnership’s general partner
Heavy Equipment Statutes | Texas Tax Code §§ 23.1241, 23.1242
Merger | The transaction completed on April 26, 2018 pursuant to the Merger Agreement in which Archrock acquired all of the Partnership’s outstanding common units not already owned by Archrock
Merger Agreement | Agreement and Plan of Merger, dated as of January 1, 2018, among Archrock and the Partnership, which was amended by Amendment No. 1 to Agreement and Plan of Merger on January 11, 2018, and which was completed and effective on April 26, 2018.
OTC | Over-the-counter, as related to aftermarket services parts and components
Partnership | Archrock Partners, L.P., together with its subsidiaries

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Partnership Credit Facility | The Partnership’s $1.25 billion asset-based revolving credit facility due March 2022, as amended by Amendment No. 1
PDVSA Gas | PDVSA Gas, S.A., a subsidiary of Petroleos de Venezuela, S.A.
Revenue Recognition Update | Accounting Standards Update No. 2014-09 Revenue from Contracts with Customers (Topic 606) and additional related standards updates
ROU | Right-of-use, as related to the new lease model under ASC Topic 842 Leases
SAB 118 | SEC Staff Accounting Bulletin No. 118
SEC | U.S. Securities and Exchange Commission
SG&A | Selling, general and administrative
Spin-off | The spin-off of our international contract operations, international aftermarket services and global fabrication businesses into a standalone public company operating as Exterran Corporation, effective November 3, 2015
TCJA | Public Law No. 115-97, a comprehensive tax reform bill signed into law on December 22, 2017
U.S. | United States of America

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FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains “forward-looking statements” intended to qualify for the safe harbors from liability established by the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact contained in this Quarterly Report on Form 10-Q are forward-looking statements within the meaning of Section 21E of the Exchange Act, including, without limitation, statements regarding the effects of the Merger; our business growth strategy and projected costs; future financial position; the sufficiency of available cash flows to fund continuing operations and pay dividends; the expected amount of our capital expenditures; expenditures related to the restatement of our financial statements and related matters, including sharing a portion of costs incurred by Exterran Corporation with respect to such matters, as well as reviews, investigations or other proceedings by government authorities, stockholders or other parties; anticipated cost savings, future revenue, gross margin and other financial or operational measures related to our business; the future value of our equipment; and plans and objectives of our management for our future operations. You can identify many of these statements by looking for words such as “believe,” “expect,” “intend,” “project,” “anticipate,” “estimate,” “will continue” or similar words or the negative thereof.
Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this Quarterly Report on Form 10-Q. Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, no assurance can be given that these expectations will prove to be correct. Known material factors that could cause our actual results to differ materially from the expectations reflected in these forward-looking statements include the risk factors described in our 2017 Form 10-K and those set forth from time to time in our filings with the SEC, which are available through our website at www.archrock.com and through the SEC’s website at www.sec.gov, as well as the following risks and uncertainties:

• | the risk that cost savings, tax benefits and any other synergies from the Merger may not be fully realized or may take longer to realize than expected;

• | the impact and outcome of pending and future litigation, including litigation, if any, relating to the Merger;

• | conditions in the oil and natural gas industry, including a sustained decrease in the level of supply or demand for oil or natural gas or a sustained low price of oil or natural gas;

• | the success of our subsidiary, the Partnership, including the amount of cash distributions received from the Partnership;

• | our reduced profit margins or the loss of market share resulting from competition or the introduction of competing technologies by other companies;

• | the spin-off of our international contract operations, international aftermarket services and global fabrication businesses into an independent, publicly-traded company, Exterran Corporation;

• | changes in economic or political conditions, including terrorism and legislative changes;

• | the inherent risks associated with our operations, such as equipment defects, impairments, malfunctions and natural disasters;

• | the loss of the Partnership’s status as a partnership for U.S. federal income tax purposes;

• | the risk that counterparties will not perform their obligations under our financial instruments;

• | the financial condition of our customers;

• | our ability to timely and cost-effectively obtain components necessary to conduct our business;

• | employment and workforce factors, including our ability to hire, train and retain key employees;

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• | our ability to implement certain business and financial objectives, such as:

–winning profitable new business;
–growing our asset base and enhancing asset utilization;
–integrating acquired businesses;
–generating sufficient cash; and
–accessing the capital markets at an acceptable cost;

• | liability related to the use of our services;

• | changes in governmental safety, health, environmental or other regulations, which could require us to make significant expenditures;

•the effectiveness of our control environment, including the identification of additional control deficiencies;
•the results of reviews, investigations or other proceedings by government authorities;
•the results of any shareholder actions relating to the restatement of our financial statements that may be filed;

• | the potential additional costs related to our restatement, including cost-sharing with Exterran Corporation and the costs of addressing reviews, investigations or other proceedings by government authorities or shareholder actions; and

• | our level of indebtedness and ability to fund our business.

All forward-looking statements included in this Quarterly Report on Form 10-Q are based on information available to us on the date of this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this Quarterly Report on Form 10-Q.
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
ARCHROCK, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par value and share amounts)
(unaudited)

| September 30, 2018 |  | December 31, 2017
ASSETS |  |  |
Current assets: |  |  |
Cash and cash equivalents | $ | 3,424 |  |  | $ | 10,536 |
Accounts receivable, trade, net of allowance of $1,507 and $1,794, respectively | 141,781 |  |  | 113,416 |
Inventory | 77,497 |  |  | 90,691 |
Other current assets | 9,696 |  |  | 6,220 |
Current assets associated with discontinued operations | 300 |  |  | 300 |
Total current assets | 232,698 |  |  | 221,163 |
Property, plant and equipment, net | 2,165,845 |  |  | 2,076,927 |
Intangible assets, net | 56,289 |  |  | 68,872 |
Contract costs | 36,482 |  |  | — |
Other long-term assets | 33,655 |  |  | 27,782 |
Long-term assets associated with discontinued operations | 6,421 |  |  | 13,263 |
Total assets | $ | 2,531,390 |  |  | $ | 2,408,007 |
LIABILITIES AND EQUITY |  |  |
Current liabilities: |  |  |
Accounts payable, trade | $ | 70,950 |  |  | $ | 54,585 |
Accrued liabilities | 74,879 |  |  | 71,116 |
Deferred revenue | 12,909 |  |  | 4,858 |
Current liabilities associated with discontinued operations | 297 |  |  | 297 |
Total current liabilities | 159,035 |  |  | 130,856 |
Long-term debt | 1,515,679 |  |  | 1,417,053 |
Deferred income taxes | 2,845 |  |  | 97,943 |
Other long-term liabilities | 19,612 |  |  | 20,116 |
Long-term liabilities associated with discontinued operations | 6,421 |  |  | 6,421 |
Total liabilities | 1,703,592 |  |  | 1,672,389 |
Commitments and contingencies (Note 18) |  |  |  |  |
Equity: |  |  |  |  |
Preferred stock, $0.01 par value per share: 50,000,000 shares authorized, zero issued | — |  |  | — |
Common stock, $0.01 par value per share: 250,000,000 shares authorized, 135,572,682 and 76,880,862 shares issued, respectively | 1,356 |  |  | 769 |
Additional paid-in capital | 3,154,058 |  |  | 3,093,058 |
Accumulated other comprehensive income | 10,333 |  |  | 1,197 |
Accumulated deficit | (2,259,489 | ) |  | (2,241,243 | )
Treasury stock, 6,235,811 and 5,930,380 common shares, at cost, respectively | (78,460 | ) |  | (76,732 | )
Total Archrock stockholders’ equity | 827,798 |  |  | 777,049 |
Noncontrolling interest | — |  |  | (41,431 | )
Total equity | 827,798 |  |  | 735,618 |
Total liabilities and equity | $ | 2,531,390 |  |  | $ | 2,408,007 |

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ARCHROCK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Revenue: |  |  |  |  |  |  |
Contract operations | $ | 169,509 |  |  | $ | 153,524 |  |  | $ | 496,156 |  |  | $ | 454,622 |
Aftermarket services | 62,863 |  |  | 44,329 |  |  | 175,126 |  |  | 131,098 |
Total revenue | 232,372 |  |  | 197,853 |  |  | 671,282 |  |  | 585,720 |
Cost of sales (excluding depreciation and amortization): |  |  |  |  |  |  |
Contract operations | 69,056 |  |  | 71,951 |  |  | 201,460 |  |  | 198,291 |
Aftermarket services | 50,043 |  |  | 38,486 |  |  | 143,173 |  |  | 111,827 |
Total cost of sales (excluding depreciation and amortization) | 119,099 |  |  | 110,437 |  |  | 344,633 |  |  | 310,118 |
Selling, general and administrative | 26,298 |  |  | 29,108 |  |  | 80,455 |  |  | 81,823 |
Depreciation and amortization | 43,779 |  |  | 47,463 |  |  | 131,565 |  |  | 142,483 |
Long-lived asset impairment | 6,660 |  |  | 7,105 |  |  | 18,323 |  |  | 20,858 |
Restatement and other charges | 396 |  |  | 566 |  |  | (195 | ) |  | 3,287 |
Restructuring and other charges | — |  |  | 422 |  |  | — |  |  | 1,245 |
Interest expense | 23,518 |  |  | 22,892 |  |  | 69,402 |  |  | 66,817 |
Debt extinguishment loss | — |  |  | — |  |  | 2,450 |  |  | 291 |
Merger-related costs | 182 |  |  | — |  |  | 9,993 |  |  | — |
Other income, net | (660 | ) |  | (2,716 | ) |  | (3,449 | ) |  | (4,472 | )
Income (loss) before income taxes | 13,100 |  |  | (17,424 | ) |  | 18,105 |  |  | (36,730 | )
Provision for (benefit from) income taxes | 3,126 |  |  | (4,795 | ) |  | 1,913 |  |  | (6,052 | )
Income (loss) from continuing operations | 9,974 |  |  | (12,629 | ) |  | 16,192 |  |  | (30,678 | )
Loss from discontinued operations, net of tax | — |  |  | (54 | ) |  | — |  |  | (54 | )
Net income (loss) | 9,974 |  |  | (12,683 | ) |  | 16,192 |  |  | (30,732 | )
Less: Net (income) loss attributable to the noncontrolling interest | — |  |  | 2,448 |  |  | (8,097 | ) |  | 2,125 |
Net income (loss) attributable to Archrock stockholders | $ | 9,974 |  |  | $ | (10,235 | ) |  | $ | 8,095 |  |  | $ | (28,607 | )
Basic and diluted net income (loss) per common share: |  |  |  |  |  |  |
Net income (loss) attributable to Archrock common stockholders | $ | 0.08 |  |  | $ | (0.15 | ) |  | $ | 0.07 |  |  | $ | (0.42 | )
Weighted average common shares outstanding: |  |  |  |  |  |  |
Basic | 127,842 |  |  | 69,644 |  |  | 102,913 |  |  | 69,520 |
Diluted | 127,955 |  |  | 69,644 |  |  | 103,013 |  |  | 69,520 |
Dividends declared and paid per common share | $ | 0.132 |  |  | $ | 0.120 |  |  | $ | 0.372 |  |  | $ | 0.360 |

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ARCHROCK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(unaudited)

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Net income (loss) | $ | 9,974 |  |  | $ | (12,683 | ) |  | $ | 16,192 |  |  | $ | (30,732 | )
Other comprehensive income, net of tax: |  |  |  |  |  |  |
Interest rate swap gain, net of reclassifications to earnings | 959 |  |  | 2,076 |  |  | 7,241 |  |  | 3,890 |
Amortization of terminated interest rate swaps | — |  |  | 182 |  |  | 230 |  |  | 227 |
Merger-related adjustments | — |  |  | — |  |  | 5,670 |  |  | — |
Adjustments from other changes in ownership of Partnership | — |  |  | 32 |  |  | — |  |  | 32 |
Total other comprehensive income | 959 |  |  | 2,290 |  |  | 13,141 |  |  | 4,149 |
Comprehensive income (loss) | 10,933 |  |  | (10,393 | ) |  | 29,333 |  |  | (26,583 | )
Less: Comprehensive (income) loss attributable to the noncontrolling interest | — |  |  | 1,289 |  |  | (12,360 | ) |  | (151 | )
Comprehensive income (loss) attributable to Archrock stockholders | $ | 10,933 |  |  | $ | (9,104 | ) |  | $ | 16,973 |  |  | $ | (26,734 | )

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ARCHROCK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF EQUITY
(in thousands)
(unaudited)

| Archrock Stockholders |  |  |  |
| Common Stock |  | Additional Paid-in Capital |  | Accumulated Other Comprehensive Income (Loss) |  | Treasury Stock |  | Accumulated Deficit |  | Noncontrolling Interest |  | Total
Balance at January 1, 2017 | $ | 762 |  |  | $ | 3,021,040 |  |  | $ | (1,678 | ) |  | $ | (73,944 | ) |  | $ | (2,227,214 | ) |  | $ | (34,038 | ) |  | $ | 684,928 |
Treasury stock purchased |  |  |  |  |  |  | (2,208 | ) |  |  |  |  |  | (2,208 | )
Cash dividends |  |  |  |  |  |  |  |  | (25,528 | ) |  |  |  | (25,528 | )
Shares issued in employee stock purchase plan |  |  | 195 |  |  |  |  |  |  |  |  |  |  | 195 |
Stock-based compensation, net of forfeitures | 6 |  |  | 6,003 |  |  |  |  |  |  |  |  | 598 |  |  | 6,607 |
Stock options exercised | 1 |  |  | 991 |  |  |  |  |  |  |  |  |  |  | 992 |
Contribution from Exterran Corporation |  |  | 44,709 |  |  |  |  |  |  |  |  |  |  | 44,709 |
Net proceeds from sale of Partnership units, net of tax |  |  | 17,638 |  |  |  |  |  |  |  |  | 32,088 |  |  | 49,726 |
Cash distribution to noncontrolling unitholders of the Partnership |  |  |  |  |  |  |  |  |  |  |  | (32,678 | ) |  | (32,678 | )
Impact of adoption of Accounting Standards Update 2016-09 |  |  | 209 |  |  |  |  |  |  | 1,081 |  |  |  |  | 1,290 |
Comprehensive loss |  |  |  |  |  |  |  |  |  |  |  |  |
Net loss |  |  |  |  |  |  |  |  | (28,607 | ) |  | (2,125 | ) |  | (30,732 | )
Derivative gain, net of reclassifications to earnings |  |  |  |  | 1,614 |  |  |  |  |  |  | 2,276 |  |  | 3,890 |
Amortization of terminated interest rate swaps |  |  |  |  | 227 |  |  |  |  |  |  |  |  | 227 |
Adjustment from other changes in ownership of the Partnership |  |  |  |  | 32 |  |  |  |  |  |  |  |  | 32 |
Balance at September 30, 2017 | $ | 769 |  |  | $ | 3,090,785 |  |  | $ | 195 |  |  | $ | (76,152 | ) |  | $ | (2,280,268 | ) |  | $ | (33,879 | ) |  | $ | 701,450 |
Balance at January 1, 2018 | $ | 769 |  |  | $ | 3,093,058 |  |  | $ | 1,197 |  |  | $ | (76,732 | ) |  | $ | (2,241,243 | ) |  | $ | (41,431 | ) |  | $ | 735,618 |
Treasury stock purchased |  |  |  |  |  |  | (1,728 | ) |  |  |  |  |  | (1,728 | )
Cash dividends |  |  |  |  |  |  |  |  | (41,132 | ) |  |  |  | (41,132 | )
Shares issued in employee stock purchase plan | 1 |  |  | 615 |  |  |  |  |  |  |  |  |  |  | 616 |
Stock-based compensation, net of forfeitures | 10 |  |  | 5,372 |  |  |  |  |  |  |  |  | (64 | ) |  | 5,318 |
Stock options exercised |  |  |  | 262 |  |  |  |  |  |  |  |  |  |  | 262 |
Cash distribution to noncontrolling unitholders of the Partnership |  |  |  |  |  |  |  |  |  |  | (11,766 | ) |  | (11,766 | )
Impact of adoption of Revenue Recognition Update |  |  |  |  |  |  |  |  | 14,666 |  |  |  |  | 14,666 |
Impact of adoption of ASU 2017-12 |  |  |  |  |  |  |  |  | 383 |  |  |  |  | 383 |
Impact of adoption of ASU 2018-02 |  |  |  |  | 258 |  |  |  |  | (258 | ) |  |  |  | — |
Merger-related adjustments | 576 |  |  | 54,751 |  |  |  |  |  |  |  |  | 40,901 |  |  | 96,228 |
Comprehensive income |  |  |  |  |  |  |  |  |  |  |  |  |
Net income |  |  |  |  |  |  |  |  | 8,095 |  |  | 8,097 |  |  | 16,192 |
Derivative gain, net of reclassifications to earnings |  |  |  |  | 2,978 |  |  |  |  |  |  | 4,263 |  |  | 7,241 |
Amortization of terminated interest rate swaps |  |  |  |  | 230 |  |  |  |  |  |  |  |  | 230 |
Merger-related adjustments |  |  |  |  | 5,670 |  |  |  |  |  |  |  |  | 5,670 |
Balance at September 30, 2018 | $ | 1,356 |  |  | $ | 3,154,058 |  |  | $ | 10,333 |  |  | $ | (78,460 | ) |  | $ | (2,259,489 | ) |  | $ | — |  |  | $ | 827,798 |

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ARCHROCK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

| Nine Months Ended September 30,
| 2018 |  | 2017
Cash flows from operating activities: |  |  |
Net income (loss) | $ | 16,192 |  |  | $ | (30,732 | )
Adjustments to reconcile net income (loss) to cash provided by operating activities: |  |  |
Loss from discontinued operations, net of tax | — |  |  | 54 |
Depreciation and amortization | 131,565 |  |  | 142,483 |
Long-lived asset impairment | 18,323 |  |  | 20,858 |
Inventory write-downs | 1,185 |  |  | 1,665 |
Amortization of deferred financing costs | 4,604 |  |  | 5,440 |
Amortization of debt discount | 1,049 |  |  | 986 |
Amortization of terminated interest rate swaps | 291 |  |  | 349 |
Debt extinguishment loss | 2,450 |  |  | 291 |
Interest rate swaps | 166 |  |  | 2,028 |
Stock-based compensation expense | 5,567 |  |  | 6,117 |
Non-cash restructuring charges | — |  |  | 1,245 |
Provision for doubtful accounts | 1,544 |  |  | 2,909 |
Gain on sale of property, plant and equipment | (2,894 | ) |  | (4,452 | )
Deferred income tax provision (benefit) | 1,514 |  |  | (5,611 | )
Amortization of contract costs | 10,332 |  |  | — |
Non-cash deferred revenue | (17,420 | ) |  | — |
Changes in assets and liabilities: |  |  |
Accounts receivable, trade | (21,591 | ) |  | (9,835 | )
Inventory | 3,800 |  |  | (3,254 | )
Other current assets | 1,251 |  |  | 53 |
Contract costs | (25,290 | ) |  | — |
Accounts payable and other liabilities | 16,461 |  |  | 20,458 |
Deferred revenue | 21,765 |  |  | (63 | )
Other | (159 | ) |  | 66 |
Net cash provided by operating activities | 170,705 |  |  | 151,055 |
Cash flows from investing activities: |  |  |
Capital expenditures | (241,183 | ) |  | (152,248 | )
Proceeds from sale of property, plant and equipment | 24,061 |  |  | 22,681 |
Proceeds from insurance | 252 |  |  | — |
Net cash used in investing activities | (216,870 | ) |  | (129,567 | )
Cash flows from financing activities: |  |  |
Proceeds from borrowings of long-term debt | 536,830 |  |  | 1,066,500 |
Repayments of long-term debt | (440,636 | ) |  | (1,118,000 | )
Payments for debt issuance costs | (3,332 | ) |  | (14,855 | )
Payments for settlement of interest rate swaps that include financing elements | (61 | ) |  | (1,405 | )
Net proceeds from sale of Partnership units | — |  |  | 60,291 |
Dividends to Archrock stockholders | (41,132 | ) |  | (25,528 | )
Distributions to noncontrolling partners in the Partnership | (11,766 | ) |  | (32,678 | )
Proceeds from stock options exercised | 262 |  |  | 992 |
Proceeds from stock issued under our employee stock purchase plan | 616 |  |  | 195 |
Purchases of treasury stock | (1,728 | ) |  | (2,208 | )
Contribution from Exterran Corporation | — |  |  | 44,720 |
Net cash provided by (used in) financing activities | 39,053 |  |  | (21,976 | )
Net decrease in cash and cash equivalents | (7,112 | ) |  | (488 | )
Cash and cash equivalents at beginning of period | 10,536 |  |  | 3,134 |
Cash and cash equivalents at end of period | $ | 3,424 |  |  | $ | 2,646 |
Supplemental disclosure of Non-Cash Transactions: |  |  |
Issuance of Archrock common stock pursuant to Merger, net of tax | $ | 55,327 |  |  | $ | — |

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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ARCHROCK, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Basis of Presentation
We are a pure play U.S. natural gas contract operations services business and the leading provider of natural gas compression services to customers in the oil and natural gas industry throughout the U.S. and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. We operate in two primary business segments: contract operations and aftermarket services. In our contract operations business, we use our owned fleet of natural gas compression equipment to provide operations services to our customers. In our aftermarket services business, we sell parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.
The accompanying unaudited condensed consolidated financial statements included herein have been prepared in accordance with U.S. GAAP for interim financial information and the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP are not required in these interim financial statements and have been condensed or omitted. Management believes that the information furnished includes all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly our consolidated financial position, results of operations and cash flows for the periods indicated. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements presented in our 2017 Form 10-K, which contains a more comprehensive summary of our accounting policies. The interim results reported herein are not necessarily indicative of results for a full year. Certain prior year amounts have been reclassified to conform to the current year presentation.
2. Recent Accounting Developments
Accounting Standards Updates Implemented
ASU 2018-05 was issued in March 2018 to clarify the income taxes disclosure requirements as they pertain to SAB 118, including the requirement to disclose a reasonable estimate, if determinable, of the tax effects of the TCJA in the reporting period in which the TCJA was enacted, as well as additional disclosures required in the following interim reporting periods if the measurement period approach is used. In accordance with ASU 2018-05, we disclosed a reasonable estimate of the income tax effects of the TCJA on our consolidated financial statements in our 2017 Form 10-K. We completed our analysis of the tax effects of the TCJA in the third quarter of 2018 with no material change to the amounts disclosed at December 31, 2017. See Note 14 (“Income Taxes”) for further details.
On January 1, 2018, we adopted ASU 2018-02 which allows for a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the TCJA. As a result of the TCJA’s corporate rate reduction, we had $0.3 million of stranded tax effects in accumulated other comprehensive income related to our derivative instruments and terminated interest rate swaps, which we elected to reclassify to accumulated deficit.
On January 1, 2018, we adopted ASU 2017-12 using the modified retrospective approach to existing cash flow hedge relationships as of January 1, 2018. ASU 2017-12 expands and refines hedge accounting for both financial and nonfinancial risk components, aligns the recognition and presentation of the effects of the hedging instrument and hedged item in the financial statements and eliminates the requirement to separately measure and report hedge ineffectiveness. As a result of the adoption of ASU 2017-12, we recognized a net gain of $0.4 million as a cumulative-effect adjustment to opening retained earnings and a corresponding adjustment to other comprehensive income (loss) to reverse the cumulative ineffectiveness previously recognized in interest expense.
On January 1, 2018, we adopted ASU 2016-15 on a retrospective basis. ASU 2016-15 addresses diversity in practice and simplifies several elements of cash flow classification including how certain cash receipts and cash payments are classified in the statement of cash flows. ASU 2016-15 did not have an impact on our condensed consolidated statement of cash flow for the nine months ended September 30, 2017.
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Revenue Recognition Update
On January 1, 2018, we adopted the Revenue Recognition Update using the modified retrospective method applied to those contracts which were not completed as of January 1, 2018. We recognized the cumulative effect of initially applying the Revenue Recognition Update as an adjustment to the opening balance of retained earnings. For contracts that were modified before the effective date, we identified performance obligations on the basis of the current version of the contract, which included any contract modifications since inception. The application of the practical expedient for contract modifications did not have a material effect on the adjustment to retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods.
Under previous guidance, contract operations revenue was recognized when earned, which generally occurs monthly when the service is provided under our customer contracts. Under the Revenue Recognition Update the timing of revenue recognition is impacted by contractual provisions for service availability guarantees of our compressor assets and re-billable costs associated with moving our compressor assets to a customer site. These changes are further discussed below and did not result in a material difference from previous practice for contract operations.
The Revenue Recognition Update resulted in a significant change related to our aftermarket services operations, maintenance, overhaul and reconfiguration services. Under previous guidance, revenue was recognized on a completed contract basis as products were delivered and title was transferred or services were performed for the customer. Under the Revenue Recognition Update, these services are recognized as revenue over time, using output or input methods to measure the progress toward complete satisfaction of the performance obligation based on the nature of the goods or services being provided. The adoption did not result in a material difference in the amount or timing of revenues for aftermarket services parts and components sales.
The Revenue Recognition Update provides guidance on contract costs that should be recognized as assets and amortized over the period that the related goods or services transfer to the customer. Certain costs that were previously expensed as incurred, such as sales commissions and freight charges to transport compressor assets, are deferred and amortized.
The following table summarizes the cumulative impact of the adoption of the Revenue Recognition Update on the opening balance sheet (in thousands):

| December 31, 2017 |  | Adjustments Due to the Revenue Recognition Update |  | January 1, 2018
Assets |  |  |  |  |
Accounts receivable, trade | $ | 113,416 |  |  | $ | 7,883 |  |  | $ | 121,299 |
Inventory | 90,691 |  |  | (6,917 | ) |  | 83,774 |
Contract costs | — |  |  | 21,524 |  |  | 21,524 |
Liabilities |  |  |  |  |
Accrued liabilities | $ | 71,116 |  |  | $ | 209 |  |  | $ | 71,325 |
Deferred revenue | 4,858 |  |  | 3,188 |  |  | 8,046 |
Deferred income taxes | 97,943 |  |  | 4,427 |  |  | 102,370 |
Equity |  |  |  |  |
Accumulated deficit | $ | (2,241,243 | ) |  | $ | 14,666 |  |  | $ | (2,226,577 | )

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The following tables summarize the impact of the application of the Revenue Recognition Update on our condensed consolidated balance sheet and condensed consolidated statements of operations (in thousands):

| September 30, 2018 |  |
Balance Sheet | As Reported |  | Balance Excluding the Impact of the Revenue Recognition Update |  | Effect of Change
Assets |  |  |  |  |
Accounts receivable, trade | $ | 141,781 |  |  | $ | 123,079 |  |  | $ | 18,702 |
Inventory | 77,497 |  |  | 94,528 |  |  | (17,031 | )
Contract costs | 36,482 |  |  | — |  |  | 36,482 |
Liabilities |  |  |  |  |
Accounts payable, trade | $ | 70,950 |  |  | $ | 70,875 |  |  | $ | 75 |
Accrued liabilities | 74,879 |  |  | 74,619 |  |  | 260 |
Deferred revenue | 12,909 |  |  | 8,865 |  |  | 4,044 |
Deferred income taxes | 2,845 |  |  | 2,570 |  |  | 275 |
Other long-term liabilities | 19,612 |  |  | 19,595 |  |  | 17 |
Equity |  |  |  |  |
Additional paid-in capital (1) | $ | 3,154,058 |  |  | $ | 3,144,217 |  |  | $ | 9,841 |
Accumulated deficit | (2,259,489 | ) |  | (2,283,130 | ) |  | 23,641 |

——————

(1) | Represents the impact of the Revenue Recognition Update on net income attributable to noncontrolling interest which was reclassed to additional paid-in capital pursuant to the Merger.

| Three Months Ended September 30, 2018 |  |
Statement of Operations | As Reported |  | Balance Excluding the Impact of the Revenue Recognition Update |  | Effect of Change
Revenue: |  |  |  |  |
Contract operations | $ | 169,509 |  |  | $ | 170,981 |  |  | $ | (1,472 | )
Aftermarket services | 62,863 |  |  | 59,623 |  |  | 3,240 |
Total revenue | 232,372 |  |  | 230,604 |  |  | 1,768 |
Cost of sales (excluding depreciation and amortization): |  |  |  |  |
Contract operations | 69,056 |  |  | 73,673 |  |  | (4,617 | )
Aftermarket services | 50,043 |  |  | 47,973 |  |  | 2,070 |
Total cost of sales (excluding depreciation and amortization) | 119,099 |  |  | 121,646 |  |  | (2,547 | )
Selling, general and administrative | 26,298 |  |  | 26,924 |  |  | (626 | )
Provision for income taxes | 3,126 |  |  | 2,617 |  |  | 509 |
Net income attributable to Archrock stockholders | 9,974 |  |  | 5,542 |  |  | 4,432 |

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| Nine Months Ended September 30, 2018 |  |
Statement of Operations | As Reported |  | Balance Excluding the Impact of the Revenue Recognition Update |  | Effect of Change
Revenue: |  |  |  |  |
Contract operations | $ | 496,156 |  |  | $ | 500,306 |  |  | $ | (4,150 | )
Aftermarket services | 175,126 |  |  | 161,065 |  |  | 14,061 |
Total revenue | 671,282 |  |  | 661,371 |  |  | 9,911 |
Cost of sales (excluding depreciation and amortization): |  |  |  |  |
Contract operations | 201,460 |  |  | 214,823 |  |  | (13,363 | )
Aftermarket services | 143,173 |  |  | 132,984 |  |  | 10,189 |
Total cost of sales (excluding depreciation and amortization) | 344,633 |  |  | 347,807 |  |  | (3,174 | )
Selling, general and administrative | 80,455 |  |  | 82,051 |  |  | (1,596 | )
Provision for income taxes | 1,913 |  |  | (1,837 | ) |  | 3,750 |
Less: Net income attributable to the noncontrolling interest | (8,097 | ) |  | (6,141 | ) |  | (1,956 | )
Net income (loss) attributable to Archrock stockholders | 8,095 |  |  | (880 | ) |  | 8,975 |

Accounting Standards Updates Not Yet Implemented
In August 2018, the FASB issued ASU 2018-15 which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). For public entities, ASU 2018-15 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. We are currently evaluating the impact of ASU 2018-15 on our consolidated financial statements and footnote disclosures and anticipate adopting this guidance on a prospective basis in the fourth quarter of 2018.
In August 2018, the FASB issued ASU 2018-13 which amends the required fair value measurements disclosures related to valuation techniques and inputs used, uncertainty in measurement, and changes in measurements applied. These amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. We are currently evaluating the impact of ASU 2018-13 on our consolidated financial statements and footnote disclosures.
In June 2016, the FASB issued ASU 2016-13 that changes the impairment model for most financial assets and certain other instruments, including trade and other receivables, held-to-maturity debt securities and loans, and requires entities to use a new forward-looking expected loss model that will result in the earlier recognition of allowance for losses. For public entities that meet the definition of an SEC filer, ASU 2016-13 is effective for fiscal years beginning after December 15, 2019 and early adoption is permitted. Entities will apply ASU 2016-13 provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We are currently evaluating the impact of ASU 2016-13 on our consolidated financial statements and footnote disclosures.
Leases
ASC Topic 842 Leases establishes a ROU model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. Under the new guidance, lessor accounting is largely unchanged. ASC Topic 842 Leases is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach that involves recasting the comparative periods in the year of initial application is required for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain transition practical expedients available. In July 2018 the FASB provided an optional transition method that would allow adoption of the standard as of the effective date without restating prior periods. We intend to adopt ASC Topic 842 Leases on January 1, 2019 using the optional transition method and are currently assessing the transition practical expedients. Upon adoption, we will recognize the cumulative effect of adoption as an adjustment to the opening balance of our retained earnings. Comparative information will continue to be reported under the accounting standards in effect for those periods.
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Additionally, the July 2018 amendment provided lessors with a practical expedient to not separate nonlease components from the associated lease component and, instead, to account for those components as a single component if the nonlease components otherwise would be accounted for under the Revenue Recognition Update and certain conditions are met. The amendment also provided clarification on whether ASC Topic 842 or the Revenue Recognition Update is applicable to the combined component based on determination of the predominant component. An entity that elects the lessor practical expedient also should provide certain disclosures. We are evaluating the impact of the July 2018 amendment on our contract operations services agreements and have tentatively concluded that the services nonlease component is predominant, which would result in the ongoing recognition following the Revenue Recognition Update guidance.
Our evaluation of the impact of adopting ASC Topic 842 Leases is ongoing. We have established a cross-functional implementation team to identify our lease population and are assessing changes to our internal control structure, business processes, systems and accounting policies that are necessary to implement the standard. We do not believe the standard will materially affect our consolidated statements of operations or cash flows. At September 30, 2018, adoption of ASC Topic 842 Leases would have resulted in recognition of a ROU asset of less than $25 million and a lease liability of a similar amount in our consolidated balance sheet. The amount of the ROU asset and the lease liability we ultimately recognize will depend on our lease portfolio as of the adoption date.
3. Revenue from Contracts with Customers
Revenue Recognition
Revenue is recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we are entitled to receive in exchange for those goods or services. Sales and usage-based taxes that are collected from the customer are excluded from revenue.
The following table presents our revenue from contracts with customers disaggregated by revenue source (in thousands):

| Three Months Ended September 30, 2018 |  | Nine Months Ended September 30, 2018
Contract Operations (1): |  |  |  |
0 - 1000 horsepower per unit | $ | 60,725 |  |  | $ | 179,917 |
1,001 - 1,500 horsepower per unit | 69,663 |  |  | 204,841 |
Over 1,500 horsepower per unit | 38,053 |  |  | 108,367 |
Other (2) | 1,068 |  |  | 3,031 |
Total contract operations (3) | 169,509 |  |  | 496,156 |
Aftermarket Services (1): |  |  |
Services | 38,863 |  |  | 107,776 |
OTC parts and components sales | 24,000 |  |  | 67,350 |
Total aftermarket services (4) | 62,863 |  |  | 175,126 |
Total revenue (5) | $ | 232,372 |  |  | $ | 671,282 |

——————

(1) | We operate in two segments: contract operations and aftermarket services. See Note 20 (“Segments”) for further details regarding our segments.

(2) | Primarily relates to fees associated with Archrock-owned non-compressor equipment.

(3) | Includes $1.6 million and $4.3 million for the three and nine months ended September 30, 2018, respectively, related to billable maintenance on Archrock-owned units that was recognized at a point in time. All other revenue within contract operations is recognized over time.

(4) | All service revenue within aftermarket services is recognized over time. All OTC parts and components sales revenue is recognized at a point in time.

Contract Operations
We provide comprehensive contract operations services including the personnel, equipment, tools, materials and supplies to meet our customers’ natural gas compression needs. Based on the operating specifications at the customer location and each customer's unique needs, these services include designing, sourcing, owning, installing, operating, servicing, repairing and maintaining equipment to provide natural gas compression services to our customers.
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Natural gas compression services are generally satisfied over time, as the customer simultaneously receives and consumes the benefits provided by these services. Our performance obligation is a series in which the unit of service is one month, as the customer receives substantially the same benefit each month from the services regardless of the type of service activity performed, which may vary. If the transaction price is based on a fixed fee, revenue is recognized monthly on a straight-line basis over the period that we are providing services to the customer. Amounts invoiced to customers for costs associated with moving our compressor assets to a customer site are also included in the transaction price and are amortized over the initial contract term.
Variable consideration exists if customers are billed at a lesser standby rate when a unit is not running. We have elected to apply the invoicing practical expedient to recognize revenue for such variable consideration, as the invoice corresponds directly to the value transferred to the customer based on our performance completed to date. The rate for standby service is lower to reflect the decrease in costs and effort required to provide standby service when a unit is not running.
We also perform billable maintenance service on our natural gas compression equipment at the customer’s request on an as-needed basis. The performance obligation is satisfied, and revenue is recognized at the agreed-upon transaction price, at the point in time when service is complete and the customer has accepted the work performed and can obtain the remaining benefits of the service that the unit will provide.
As of September 30, 2018, we had $267.3 million of remaining performance obligations related to our contract operations segment. We have elected to apply the practical expedient to not consider the effects of the time value of money, as the expected time between the transfer of services and payment for such services is less than one year. The remaining performance obligations will be recognized through 2022 as follows (in thousands):

| 2018 |  | 2019 |  | 2020 |  | 2021 |  | 2022 |  | Total
Contract operations remaining performance obligations | $ | 93,227 |  |  | $ | 118,368 |  |  | $ | 46,404 |  |  | $ | 8,276 |  |  | $ | 1,073 |  |  | $ | 267,348 |

Aftermarket Services
We provide a full range of services to support the compression needs of customers. We sell OTC parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.
We sell OTC parts and components needed for the maintenance or repair of customer-owned compression equipment. The performance obligation is generally satisfied at the point in time when delivery takes place and the customer obtains control of the part or component. The transaction price is the fixed sales price for the part stated in the contract. Revenue is recognized upon delivery, as we have a present right to payment and the customer has legal title.
Our aftermarket service activities include operations, maintenance, overhaul and reconfiguration services on customer-owned compression equipment on an as-needed basis or as part of a monthly maintenance schedule. The service activities performance obligation is satisfied over time, as the work performed enhances the customer-controlled asset and another entity would not have to substantially re-perform the work we completed if they were to fulfill the remaining performance obligation. The transaction price may be a fixed monthly service fee, a fixed quoted fee or entirely variable, calculated on a time and materials basis.
For service provided based on a fixed monthly fee, the performance obligation is a series in which the unit of service is one month. The customer receives substantially the same benefit each month from the service, regardless of the type of service activity performed, which may vary. As the progress towards satisfaction of the performance obligation is measured based on the passage of time, revenue is recognized monthly based on the fixed fee provided for in the contract.
For service provided based on a quoted fixed fee, progress towards satisfaction of the performance obligation is measured using an input method based on the actual amount of labor and material costs incurred. The amount of the transaction price recognized as revenue each reporting period is determined by multiplying the transaction price by the ratio of actual costs incurred to date to total estimated costs expected for the service. Significant judgment is involved in the estimation of the progress to completion. Any adjustments to the measure of the progress to completion will be accounted for on a prospective basis. Changes to the scope of service is recognized as an adjustment to the transaction price in the period in which the change occurs.
Service provided based on time and materials are generally short-term in nature and labor rates and parts pricing is agreed upon prior to commencing the service. We have elected to use the right-to-invoice practical expedient using an estimated gross margin percentage applied to actual costs incurred. The estimated gross margin percentage is fixed based on historical time and materials-based service. We evaluate the estimated gross margin percentage at the end of each reporting period and adjust the transaction price as appropriate.
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We believe these fee- and cost-based inputs fairly depict our efforts to provide aftermarket services and the amount of revenue recognized is representative of the transfer of service and value that the customer will have received as of the reporting date. As of September 30, 2018 we have elected to apply the practical expedient to not disclose the aggregate transaction price for the remaining performance obligations for aftermarket services, as there are no contracts with customers with an original contract term that is greater than one year.
Contract Balances
Contract operations services are generally billed monthly at the beginning of the month in which service is being provided. For aftermarket services, billings will typically occur when parts are delivered or when service is complete; however, milestone billings may be used in longer-term projects. We recognize a contract asset when we have the right to consideration in exchange for goods or services transferred to a customer when the right is conditioned on something other than the passage of time. We recognize a contract liability when we have an obligation to transfer goods or services to a customer for which we have already received consideration. Freight billings to transport compressor assets and milestone billings on aftermarket services often result in a contract liability.
As of September 30, and January 1, 2018, our receivables from contracts with customers, net of allowance for doubtful accounts were $136.8 million and $115.6 million, respectively. As of September 30, and January 1, 2018, our contract liabilities were $13.3 million and $9.0 million, respectively, which are included in deferred revenue and other long-term liabilities in our condensed consolidated balance sheets. The increase in the contract liability balance during the nine months ended September 30, 2018 was due to the deferral of $21.8 million primarily related to freight billings and aftermarket services, partially offset by $17.4 million recognized as revenue during the period primarily related to freight billings and aftermarket services.
4. Discontinued Operations
Spin-off of Exterran Corporation
In 2015 we completed the Spin-off. In order to effect the Spin-off and govern our relationship with Exterran Corporation after the Spin-off, we entered into several agreements with Exterran Corporation, which include but are not limited to the separation and distribution agreement, the tax matters agreement and the supply agreement. Certain terms of these agreements are described as follows:

• | The separation and distribution agreement specifies our right to promptly receive payments from a subsidiary of Exterran Corporation based on a notional amount corresponding to payments received by Exterran Corporation’s subsidiaries from PDVSA Gas, in respect of the sale of Exterran Corporation’s subsidiaries’ and joint ventures’ previously nationalized assets after such amounts are collected by Exterran Corporation’s subsidiaries. During the nine months ended September 30, 2017, we rece ived $19.7 million from Exterran Corporation pursuant to this term of the separation and distribution agreement. Exterran Corporation was due to receive the remaining principal amount as of September 30, 2018 of approximately $20.9 million. The separation and distribution agreement also specifies our right to receive a $25.0 million cash payment from a subsidiary of Exterran Corporation promptly following the occurrence of a qualified capital raise as defined in the Exterran Corporation credit agreement. Such a qualified capital raise occurred on April 4, 2017 and we received a cash payment of $25.0 million on April 11, 2017.

Generally, the separation and distribution agreement provides for cross-indemnities principally designed to place financial responsibility for the obligations and liabilities of our business with us and financial responsibility for the obligations and liabilities of Exterran Corporation’s business with Exterran Corporation. Pursuant to the separation and distribution agreement, we and Exterran Corporation generally release the other party from all claims arising prior to the Spin-off that relate to the other party’s business.
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• | The tax matters agreement governs the respective rights, responsibilities and obligations of Exterran Corporation and us with respect to tax liabilities and benefits, tax attributes, the preparation and filing of tax returns, the control of audits and other tax proceedings and certain other matters regarding taxes. Subject to the provisions of this agreement Exterran Corporation and we agreed to indemnify the primary obligor of any return for tax periods beginning before and ending before or after the Spin-off (including any ongoing or future amendments and audits for these returns) for the portion of the tax liability (including interest and penalties) that relates to their respective operations reported in the filing. As of September 30, 2018, we classified $6.4 million of unrecognized tax benefits (including interest and penalties) as long-term liability associated with discontinued operations since it relates to operations of Exterran Corporation prior to the Spin-off. We have also recorded an offsetting $6.4 million indemnification asset related to this reserve as long-term assets associated with discontinued operations.

• | The supply agreement, which expired November 2017, set forth the terms under which Exterran Corporation provided manufactured equipment, including the design, engineering, manufacturing and sale of natural gas compression equipment, on an exclusive basis to us and the Partnership, subject to certain exceptions. For the nine months ended September 30, 2017, we purchased $115.3 million of newly-manufactured compression equipment from Exterran Corporation.

Other Discontinued Operations Activity
In December 2013, we abandoned our contract water treatment business as part of our continued emphasis on simplification and focus on our core businesses. The abandonment of this business meets the criteria established for recognition as discontinued operations under GAAP. Therefore certain deferred tax assets related to our contract water treatment business have been reported as discontinued operations in our condensed consolidated balance sheets. This business was previously included in our contract operations segment.
The following table summarizes the balance sheet data for discontinued operations (in thousands):

| September 30, 2018 |  | December 31, 2017
| Exterran Corporation |  | Exterran Corporation |  | Contract Water Treatment Business |  | Total
Other current assets | $ | 300 |  |  | $ | 300 |  |  | $ | — |  |  | $ | 300 |
Total current assets associated with discontinued operations | 300 |  |  | 300 |  |  | — |  |  | 300 |
Other assets, net | 6,421 |  |  | 6,421 |  |  | — |  |  | 6,421 |
Deferred income taxes (1) | — |  |  | — |  |  | 6,842 |  |  | 6,842 |
Total assets associated with discontinued operations | $ | 6,721 |  |  | $ | 6,721 |  |  | $ | 6,842 |  |  | $ | 13,563 |
Other current liabilities | $ | 297 |  |  | $ | 297 |  |  | $ | — |  |  | $ | 297 |
Total current liabilities associated with discontinued operations | 297 |  |  | 297 |  |  | — |  |  | 297 |
Deferred income taxes | 6,421 |  |  | 6,421 |  |  | — |  |  | 6,421 |
Total liabilities associated with discontinued operations | $ | 6,718 |  |  | $ | 6,718 |  |  | $ | — |  |  | $ | 6,718 |

——————

(1) | Reduced by $0.9 million for current period tax amortization and $5.9 million for a valuation allowance recorded as a result of the Merger, whereby we assessed the available positive and negative evidence and concluded, based on the weight of the evidence, that a valuation allowance was required on our resulting net deferred tax asset position, with an offsetting increase to additional paid-in capital in our condensed consolidated balance sheet as of September 30, 2018. See Note 17 (“Equity”) for further details of the Merger.

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5. Inventory
Inventory consisted of the following amounts (in thousands):

| September 30, 2018 |  | December 31, 2017
Parts and supplies | $ | 65,393 |  |  | $ | 72,528 |
Work in progress | 12,104 |  |  | 18,163 |
Inventory | $ | 77,497 |  |  | $ | 90,691 |

6. Property, Plant and Equipment, Net
Property, plant and equipment, net, consisted of the following (in thousands):

| September 30, 2018 |  | December 31, 2017
Compression equipment, facilities and other fleet assets | $ | 3,314,995 |  |  | $ | 3,192,363 |
Land and buildings | 46,993 |  |  | 45,754 |
Transportation and shop equipment | 101,868 |  |  | 100,133 |
Computer hardware and software | 92,301 |  |  | 90,296 |
Other | 12,867 |  |  | 12,419 |
Property, plant and equipment | 3,569,024 |  |  | 3,440,965 |
Accumulated depreciation | (1,403,179 | ) |  | (1,364,038 | )
Property, plant and equipment, net | $ | 2,165,845 |  |  | $ | 2,076,927 |

7. Contract Costs
We capitalize incremental costs to obtain a contract with a customer if we expect to recover those costs. Capitalized costs include commissions paid to our sales force to obtain contract operations contracts. We have applied the practical expedient to expense commissions paid for sales of service contracts and OTC parts and components within our aftermarket services segment as the amortization period is less than one year. As of September 30, and January 1, 2018, we recorded contract costs of $3.9 million and $2.3 million, respectively, associated with sales commissions.
We capitalize costs incurred to fulfill a contract if those costs relate directly to a contract, enhance resources that we will use in satisfying performance obligations and if we expect to recover those costs. Capitalized costs incurred to fulfill our customer contracts include freight charges to transport compressor assets before transferring services to the customer and mobilization activities associated with our contract operations services. As of September 30, and January 1, 2018, we recorded contract costs of $32.6 million and $19.2 million, respectively, associated with freight and mobilization.
Contract operations costs are amortized based on the transfer of service to which the assets relate, which is estimated to be 36 months based on average contract term, including anticipated renewals. We assess periodically whether the 36-month estimate fairly represents the average contract term and adjust as appropriate. Aftermarket services fulfillment costs are recognized based on the percentage-of-completion method applicable to the customer contract. Contract costs associated with commissions are amortized to SG&A. Contract costs associated with freight and mobilization are amortized to cost of sales (excluding depreciation and amortization). During the three and nine months ended September 30, 2018, we amortized $0.4 million and $1.1 million, respectively, related to commissions and $3.6 million and $9.2 million, respectively, related to freight and mobilization. During the three and nine months ended September 30, 2018, there was no impairment loss recorded in relation to the costs capitalized.
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8. Long-Term Debt
Long-term debt consisted of the following (in thousands):

| September 30, 2018 |  | December 31, 2017
Credit Facility | $ | — |  |  | $ | 56,000 |
Partnership Credit Facility | 826,500 |  |  | 674,306 |
Partnership’s 6% senior notes due April 2021 | 350,000 |  |  | 350,000 |
Less: Debt discount, net of amortization | (1,977 | ) |  | (2,523 | )
Less: Deferred financing costs, net of amortization | (2,568 | ) |  | (3,338 | )
| 345,455 |  |  | 344,139 |
Partnership’s 6% senior notes due October 2022 | 350,000 |  |  | 350,000 |
Less: Debt discount, net of amortization | (2,938 | ) |  | (3,441 | )
Less: Deferred financing costs, net of amortization | (3,338 | ) |  | (3,951 | )
| 343,724 |  |  | 342,608 |
Long-term debt | $ | 1,515,679 |  |  | $ | 1,417,053 |

Credit Facility
On April 26, 2018, in connection with the Merger and Amendment No. 1, the Archrock Credit Facility was terminated. Upon termination, we repaid $63.2 million in borrowings and accrued and unpaid interest and fees outstanding. All commitments under the Archrock Credit Facility were terminated and the $15.4 million of letters of credit outstanding under the Archrock Credit Facility as of the Merger were converted to letters of credit under the Partnership Credit Facility. As a result of the termination, we recorded a debt extinguishment loss of $2.5 million.
At December 31, 2017, the weighted average annual interest rate, excluding the effect of interest rate swaps, on the outstanding balance under the Archrock Credit Facility was 3.3%. During the three and nine months ended September 30, 2017, we incurred $0.2 million and $0.5 million, respectively, in commitment fees on the daily unused amount of the Archrock Credit Facility. We incurred $0.2 million in commitment fees in 2018 prior to the facility’s termination and were in compliance with all covenants under the Archrock Credit Facility through its closing.
Partnership Credit Facility
The Partnership Credit Facility is a five-year, $1.25 billion asset-based revolving credit facility that will mature on March 30, 2022 except that if any portion of the Partnership’s 6% senior notes due April 2021 are outstanding as of December 2, 2020, then maturity will instead be on December 2, 2020. In March 2017, the Partnership incurred $14.9 million in transaction costs related to the formation of the Partnership Credit Facility. Concurrent with entering into the Partnership Credit Facility, the Partnership expensed $0.6 million of unamortized deferred financing costs and recorded a debt extinguishment loss of $0.3 million related to the termination of its Former Credit Facility.
On February 23, 2018, the Partnership amended the Partnership Credit Facility to, among other things:

• | increase the maximum Total Debt to EBITDA ratios, as defined in the Partnership Credit Facility agreement (see below for the revised ratios), effective as of the execution of Amendment No. 1 on February 23, 2018; and

• | effective upon completion of the Merger on April 26, 2018:

– | increase the aggregate revolving commitment from $1.1 billion to $1.25 billion;

– | increase the amount available for the issuance of letters of credit from $25.0 million to $50.0 million;

– | increase the basket sizes under certain covenants including covenants limiting our ability to make investments, incur debt, make restricted payments, incur liens and make asset dispositions;

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– | name Archrock Services, L.P., one of our subsidiaries, as a borrower under the Partnership Credit Facility and certain of our other subsidiaries as loan guarantors; and

– | amend the definition of “Borrowing Base” to include certain assets of ours and our subsidiaries.

The Partnership incurred $3.3 million in transaction costs related to Amendment No. 1 which were included in other long-term assets in our condensed consolidated balance sheet and are being amortized over the term of the Partnership Credit Facility.
As of September 30, 2018, the Partnership had $15.4 million outstanding letters of credit under the Partnership Credit Facility and the applicable margin on amounts outstanding under the Credit Facility was 3.2%. The weighted average annual interest rate on the outstanding balance under the Partnership Credit Facility, excluding the effect of interest rate swaps, was 5.5% and 4.8% at September 30, 2018 and December 31, 2017, respectively. The Partnership incurred $0.6 million in commitment fees on the daily unused amount of the Partnership Credit Facility and the Former Credit Facility during each of the three months ended September 30, 2018 and 2017, and $1.7 million and $1.5 million during the nine months ended September 30, 2018 and 2017, respectively.
The Partnership must maintain the following consolidated financial ratios, as defined in the Partnership Credit Facility agreement:

EBITDA to Interest Expense | 2.5 to 1.0
Senior Secured Debt to EBITDA | 3.5 to 1.0
Total Debt to EBITDA |
Through fiscal year 2018 | 5.95 to 1.0
Through fiscal year 2019 | 5.75 to 1.0
Through second quarter of 2020 | 5.50 to 1.0
Thereafter (1) | 5.25 to 1.0

——————

(1) | Subject to a temporary increase to 5.5 to 1.0 for any quarter during which an acquisition satisfying certain thresholds is completed and for the two quarters immediately following such quarter.

As of September 30, 2018, the Partnership had undrawn capacity of $408.1 million under the Partnership Credit Facility. As a result of the ratio requirements above, $324.0 million of the $408.1 million of undrawn capacity was available for additional borrowings as of September 30, 2018. As of September 30, 2018, the Partnership was in compliance with all covenants under the Partnership Credit Facility agreement.
9. Derivatives
We are exposed to market risks associated with changes in the variable interest rate of the Partnership Credit Facility. We use derivative instruments to manage our exposure to fluctuations in this variable interest rate and thereby minimize the risks and costs associated with financial activities. We do not use derivative instruments for trading or other speculative purposes.
At September 30, 2018, the Partnership was a party to the following interest rate swaps, which were entered into to offset changes in expected cash flows due to fluctuations in the associated variable interest rates (in millions):

Expiration Date |  | Notional Value
May 2019 |  | $ | 100.0 |
May 2020 |  | 100.0 |
March 2022 |  | 300.0 |
|  | $ | 500.0 |

The counterparties to the derivative agreements are major financial institutions. We monitor the credit quality of these financial institutions and do not expect non-performance by any counterparty, although such non-performance could have a material adverse effect on us. The Partnership has no specific collateral posted for its derivative instruments.
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We have designated these interest rate swaps as cash flow hedging instruments and so any change in their fair value is recognized as a component of other comprehensive income (loss) until the hedged transaction affects earnings. At that time, amounts are reclassified into earnings to interest expense, the same statement of operations line item to which the earnings effect of the hedged item is recorded. Cash flows from derivatives designated as hedges are classified in our condensed consolidated statements of cash flows under the same category as the cash flows from the underlying assets, liabilities or anticipated transactions, unless the derivative contract contains a significant financing element; in this case, the cash settlements for these derivatives are classified as cash flows from financing activities.
We expect the hedging relationship to be highly effective as the swap terms substantially coincide with the hedged item and are expected to offset changes in expected cash flows due to fluctuations in the variable rate. Prior to adoption of ASU 2017-12, we performed quarterly calculations to determine whether the swap agreements continued to be highly effective at achieving offsetting changes in cash flows attributable to the hedged risk. Upon adoption of ASU 2017-12, we perform quarterly qualitative prospective and retrospective hedge effectiveness assessments unless facts and circumstances related to the hedging relationships change such that we can no longer assert qualitatively that the cash flow hedge relationships were and continue to be highly effective. We estimate that $3.6 million of the deferred pre-tax gain attributable to interest rate swaps included in accumulated other comprehensive income (loss) at September 30, 2018 will be reclassified into earnings as interest income at then-current values during the next twelve months as the underlying hedged transactions occur.
In August 2017, the Partnership amended the terms of $300.0 million of its interest rate swap agreements to adjust the fixed interest rate and extend the maturity dates to March 2022. These amendments effectively created new derivative contracts and terminated the old derivative contracts. As a result, as of the amendment date, we discontinued the original cash flow hedge relationships on a prospective basis and designated the amended interest rate swaps under new cash flow hedge relationships based on the amended terms. The fair value of the interest rate swaps immediately prior to the execution of the amendments was a liability of $0.7 million. The associated amount in accumulated other comprehensive income (loss) was amortized into interest expense over the original terms of the interest rate swaps through May 2018.
As of September 30, 2018, the weighted average effective fixed interest rate on the interest rate swaps was 1.8%.
The following tables present the effect of the derivative instruments designated as cash flow hedging instruments on our condensed consolidated balance sheets (in thousands):

| Fair Value Asset (Liability)
| September 30, 2018 |  | December 31, 2017
Other current assets | $ | 3,592 |  |  | $ | 186 |
Other long-term assets | 9,487 |  |  | 4,490 |
Accrued liabilities | — |  |  | (134 | )
| $ | 13,079 |  |  | $ | 4,542 |

The following tables present the effect of the derivative instruments designated as cash flow hedging instruments on our condensed consolidated statements of operations (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Pre-tax gain recognized in other comprehensive income (loss) | $ | 1,642 |  |  | $ | 1,919 |  |  | $ | 8,583 |  |  | $ | 2,282 |
Pre-tax gain (loss) reclassified from accumulated other comprehensive income (loss) into interest expense | 429 |  |  | (678 | ) |  | (83 | ) |  | (2,521 | )

| Three Months Ended September 30, 2018 |  | Nine Months Ended September 30, 2018
Total amount of interest expense in which the effects of cash flow hedges are recorded | $ | 23,518 |  |  | $ | 69,402 |
Amount of gain reclassified from accumulated other comprehensive income (loss) into interest expense | 429 |  |  | 582 |

See Note 18 (“Accumulated Other Comprehensive Income”) for further details on the derivative instruments.
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10. Fair Value Measurements
The accounting standard for fair value measurements and disclosures establishes a fair value hierarchy that prioritizes the inputs of valuation techniques used to measure fair value into the following three categories:

• | Level 1 — Quoted unadjusted prices for identical instruments in active markets to which we have access at the date of measurement.

• | Level 2 — Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Level 2 inputs are those in markets for which there are few transactions, the prices are not current, little public information exists or prices vary substantially over time or among brokered market makers.

• | Level 3 — Model-derived valuations in which one or more significant inputs or significant value drivers are unobservable. Unobservable inputs are those inputs that reflect our own assumptions regarding how market participants would price the asset or liability based on the best available information.

Assets and Liabilities Measured at Fair Value on a Recurring Basis
On a quarterly basis, our interest rate swaps are valued based on the income approach (discounted cash flow) using market observable inputs, including London Interbank Offered Rate forward curves. These fair value measurements are classified as Level 2.
The following table presents our interest rate swaps asset and liability measured at fair value on a recurring basis with pricing levels as of the date of valuation (in thousands):

| September 30, 2018 |  | December 31, 2017
Interest rate swaps asset | $ | 13,079 |  |  | $ | 4,676 |
Interest rate swaps liability | — |  |  | (134 | )

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
During the nine months ended September 30, 2018, we recorded non-recurring fair value measurements related to our idle and previously-culled compressor units. Our estimate of the compressor units’ fair value was primarily based on the expected net sale proceeds compared to other fleet units we recently sold and/or a review of other units recently offered for sale by third parties, or the estimated component value of the equipment we plan to use. We discounted the expected proceeds, net of selling and other carrying costs, using a weighted average disposal period of four years. These fair value measurements are classified as Level 3. The fair value of our impaired compressor units was $1.5 million and $2.6 million at September 30, 2018 and December 31, 2017, respectively. See Note 11 (“Long-Lived Asset Impairment”) for further details.
Other Financial Instruments
The carrying amounts of our cash, receivables and payables approximate fair value due to the short-term nature of those instruments.
The carrying amount of borrowings outstanding under the Partnership Credit Facility approximates fair value due to its variable interest rate. The fair value of these outstanding borrowings was estimated using a discounted cash flow analysis based on interest rates offered on loans with similar terms to borrowers of similar credit quality, which are Level 3 inputs.
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The fair value of our fixed rate debt was estimated based on quoted prices in inactive markets and is considered a Level 2 measurement. The following table summarizes the carrying amount and fair value of our fixed rate debt (in thousands):

| September 30, 2018 |  | December 31, 2017
Carrying amount of fixed rate debt (1) | $ | 689,179 |  |  | $ | 686,747 |
Fair value of fixed rate debt | 706,000 |  |  | 702,000 |

——————

(1) | Carrying amounts are shown net of unamortized debt discounts and unamortized deferred financing costs. See Note 8 (“Long-Term Debt”) for further details.

11. Long-Lived Asset Impairment
We review long-lived assets, including property, plant and equipment and identifiable intangibles that are being amortized, for impairment whenever events or changes in circumstances, including the removal of compressor units from our active fleet, indicate that the carrying amount of an asset may not be recoverable.
We periodically review the future deployment of our idle compression assets for units that are not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. Based on these reviews, we determine that certain idle compressor units should be retired from the active fleet. The retirement of these units from the active fleet triggers a review of these assets for impairment and as a result of our review, we may record an asset impairment to reduce the book value of each unit to its estimated fair value. The fair value of each unit is estimated based on the expected net sale proceeds compared to other fleet units we recently sold, a review of other units recently offered for sale by third parties or the estimated component value of the equipment we plan to use.
In connection with our review of our idle compression assets, we evaluate for impairment idle units that were culled from our fleet in prior years and are available for sale. Based on that review, we may reduce the expected proceeds from disposition and record additional impairment to reduce the book value of each unit to its estimated fair value.
The following table presents the results of our impairment review as recorded in our contract operations segment (dollars in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Idle compressor units retired from the active fleet | 60 |  |  | 50 |  |  | 225 |  |  | 190 |
Horsepower of idle compressor units retired from the active fleet | 23,000 |  |  | 20,000 |  |  | 73,000 |  |  | 71,000 |
Impairment recorded on idle compressor units retired from the active fleet | $ | 6,660 |  |  | $ | 5,934 |  |  | $ | 18,323 |  |  | $ | 19,686 |

In addition to the impairment discussed above, during the three and nine months ended September 30, 2017, $0.8 million of leasehold improvements and furniture and fixtures were impaired in conjunction with the relocation of our corporate office during the third quarter of 2017. See Note 13 (“Corporate Office Relocation”) for further details.
12. Restructuring and Other Charges
As discussed in Note 4 (“Discontinued Operations”), we completed the Spin-off in 2015. During the three and nine months ended September 30, 2017, we incurred $0.4 million and $1.2 million, respectively, of costs for retention benefits associated with the Spin-off that were directly attributable to Archrock. The restructuring charges associated with the Spin-off are not directly attributable to our reportable segments because they primarily represent costs incurred within the corporate function. No such costs were incurred subsequent to December 31, 2017.
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13. Corporate Office Relocation
During the three and nine months ended September 30, 2017, we recorded $2.1 million in charges associated with the relocation of our corporate headquarters during the third quarter 2017. These charges were reflected in SG&A and included accelerated expense associated with the contractual lease payments of our former corporate office, which were made through the end of the lease term in the first quarter of 2018, and relocation costs to move our corporate office. Additionally, leasehold improvements and furniture and fixtures were impaired in the third quarter of 2017 and are reflected in long-lived asset impairment in our condensed consolidated income statements (see Note 11 (“Long-Lived Asset Impairment”)). We did not incur additional costs as a result of the relocation subsequent to September 30, 2017.
The following table summarizes the changes to our accrued liability balance related to our corporate office relocation for the nine months ended September 30, 2018 and 2017 (in thousands):

| Nine Months Ended September 30,
| 2018 |  | 2017
Beginning balance | $ | 583 |  |  | $ | — |
Additions for costs expensed | — |  |  | 2,113 |
Less non-cash expense (1) | — |  |  | (613 | )
Reductions for payments | (583 | ) |  | (72 | )
Ending balance | $ | — |  |  | $ | 1,428 |

——————

(1) | Represents non-cash write-off of leasehold improvements, furniture and fixtures and the net liability associated with the straight-line expense associated with the lease of our former corporate office.

The following table summarizes our corporate office relocation costs by category during the three and nine months ended September 30, 2017 (in thousands):

Remaining lease costs | $ | 1,258 |
Impairment of leasehold improvements and furniture and fixtures | 795 |
Relocation costs | 60 |
Total corporate relocation costs | $ | 2,113 |

14. Income Taxes
Unrecognized Tax Benefits
As of September 30, 2018, we believe $0.9 million of our unrecognized tax benefits will be reduced prior to September 30, 2019 due to the settlement of audits or the expiration of statutes of limitations or both. However, due to the uncertain and complex application of the tax regulations, it is possible that the ultimate resolution of these matters may result in liabilities which could materially differ from this estimate.
Impact of the TCJA
At December 31, 2017, a provisional amount for the effects of the TCJA was recorded and resulted in a $53.4 million tax benefit to our provision for income taxes in our consolidated statement of operations. This amount consisted of a $57.7 million tax benefit due to reducing our continuing operations net deferred tax liability, a $4.6 million tax detriment due to reducing our discontinued operations deferred tax asset and a $0.3 million tax benefit due to reducing our other comprehensive income net deferred tax liability. As of September 30, 2018, our analysis of the impact of the TCJA was complete and there were no material changes to the provisional amount recorded at December 31, 2017.
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15. Stock-Based Compensation
Stock Incentive Plan
In April 2013, we adopted the 2013 Plan to provide for the granting of stock options, restricted stock, restricted stock units, stock appreciation rights, performance units, other stock-based awards and dividend equivalent rights to employees, directors and consultants of Archrock. The 2013 Plan is administered by the compensation committee of our board of directors. Under the 2013 Plan, the maximum number of shares of common stock available for issuance pursuant to awards is 10,100,000. Each option and stock appreciation right granted counts as one share against the aggregate share limit, and any share subject to a stock settled award other than a stock option, stock appreciation right or other award for which the recipient pays intrinsic value counts as 1.75 shares against the aggregate share limit. Shares subject to awards granted under the 2013 Plan that are subsequently canceled, terminated, settled in cash or forfeited (excluding shares withheld to satisfy tax withholding obligations or to pay the exercise price of an option) are, to the extent of such cancellation, termination, settlement or forfeiture, available for future grant under the 2013 Plan. Cash-settled awards are not counted against the aggregate share limit. No additional grants have been or may be made under the 2007 Plan following the adoption of the 2013 Plan. Previous grants made under the 2007 Plan will continue to be governed by that plan and the applicable award agreements.
The compensation committee of our board of directors generally establishes its schedule for making annual long-term incentive awards, consisting of a combination of restricted shares and performance units vesting over multiple years, to our named executive officers several months in advance and does not make such awards based on knowledge of material nonpublic information. Although the compensation committee of our board of directors has historically granted awards on a regular, predictable cycle — after earnings information has been disseminated to the marketplace — such awards may be granted at other times during the year, as determined in the sole discretion of the compensation committee.
Stock Options
Stock options are granted at fair market value at the grant date, are exercisable according to the vesting schedule established by the compensation committee of our board of directors in its sole discretion and expire no later than seven years after the grant date. Stock options generally vest one-third per year on each of the first three anniversaries of the grant date, subject to continued service through the applicable vesting date.
The following table presents stock option activity during the nine months ended September 30, 2018:

| Stock Options (in thousands) |  | Weighted Average Exercise Price Per Share |  | Weighted Average Remaining Life (in years) |  | Aggregate Intrinsic Value (in thousands)
Options outstanding, January 1, 2018 | 489 |  |  | $ | 12.28 |  |  |  |  |
Exercised | (30 | ) |  | 8.79 |  |  |  |  |  |
Canceled | (53 | ) |  | 13.96 |  |  |  |  |
Options outstanding and exercisable, September 30, 2018 | 406 |  |  | 12.31 |  |  | 0.8 |  | $ | 1,305 |

Intrinsic value is the difference between the market value of our stock and the exercise price of each stock option multiplied by the number of stock options outstanding for those stock options where the market value exceeds their exercise price. The total intrinsic value of stock options exercised during nine months ended September 30, 2018 was $0.1 million.
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Restricted Stock, Stock-Settled Restricted Stock Units, Performance Units, Cash-Settled Restricted Stock Units and Cash Settled Performance Units
For grants of restricted stock, restricted stock units and performance units, we recognize compensation expense over the vesting period equal to the fair value of our common stock at the grant date. Our restricted stock, restricted stock units, and performance units include rights to receive dividends or dividend equivalents. We remeasure the fair value of cash-settled restricted stock units and cash-settled performance units and record a cumulative adjustment of the expense previously recognized. Our obligation related to the cash-settled restricted stock units and cash settled performance units is reflected as a liability in our condensed consolidated balance sheets. Restricted stock, stock-settled restricted stock units, cash-settled restricted stock units and cash-settled performance units generally vest one-third per year on dates as specified in the applicable award agreement, subject to continued service through the applicable vesting date. Stock-settled performance units cliff vest at the end of the performance period as specified in the terms of the applicable award agreement, subject to continued service through the applicable vesting date.
The following table presents restricted stock, restricted stock unit, performance unit, cash-settled restricted stock unit and cash- settled performance unit activity during the nine months ended September 30, 2018:

| Shares (in thousands) |  | Weighted Average Grant Date Fair Value Per Share
Non-vested awards, January 1, 2018 | 1,440 |  |  | $ | 10.39 |
Granted | 1,148 |  |  | 9.66 |
Converted (1) | 140 |  |  | 7.03 |
Vested | (747 | ) |  | 10.46 |
Canceled | (219 | ) |  | 9.79 |
Non-vested awards, September 30, 2018 (2) | 1,762 |  |  | 9.69 |

——————

(1) | Reflects conversion of Partnership phantom units into Archrock restricted stock units pursuant to the Merger See “Partnership Long-Term Incentive Plan” section below for detail regarding the conversion of awards.

(2) | Non-vested awards as of September 30, 2018 are comprised of 216,000 cash-settled restricted stock units and cash-settled performance units and 1,546,000 restricted shares and stock-settled performance units.

As of September 30, 2018, we expect $13.2 million of unrecognized compensation cost related to unvested restricted stock, stock-settled restricted stock units, performance units, cash-settled restricted stock units and cash-settled performance units to be recognized over the weighted-average period of 2.3 years.
Partnership Long-Term Incentive Plan
In April 2017, the Partnership adopted the 2017 Partnership LTIP to provide for the benefit of employees, directors and consultants of the Partnership, us and our respective affiliates. The 2017 Partnership LTIP provided for the issuance of unit options, unit appreciation rights, restricted units, phantom units, performance awards, bonus awards, distribution equivalent rights, cash awards and other unit based awards. Previous grants made under the 2006 Partnership LTIP continued to be governed by the 2006 Partnership LTIP and the applicable award agreements. We recognized compensation expense over the vesting period equal to the fair value of the Partnership’s common units at the grant date. Phantom units granted under the 2017 and 2006 LTIP may include nonforfeitable tandem distribution equivalent rights to receive cash distributions on unvested phantom units in the quarter in which distributions are paid on common units. Phantom units generally vested one-third per year on dates as specified in the applicable award agreements subject to continued service through the applicable vesting date. During the nine months ended September 30, 2018, 53,091 phantom units vested with a weighted average grant date fair value per unit of $11.24.
Pursuant to the Merger, all outstanding phantom units previously granted under the 2017 and 2006 Partnership LTIP were converted into comparable awards based on Archrock’s common shares. As such, all outstanding phantom units were converted, effective as of the closing of the Merger, into Archrock restricted stock units. See Note 17 (“Equity”) for further details regarding the Merger. Each Archrock restricted stock unit will be subject to the same vesting, forfeiture and other terms and conditions applicable to the converted Partnership phantom units. Under Accounting Standards Codification Topic 718, Compensation - Stock Compensation, we determined that there was no additional compensation cost to record as the conversion of awards did not result in incremental fair value.
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16. Earnings per Share
Basic income (loss) attributable to Archrock common stockholders per common share is computed using the two-class method, which is an earnings allocation formula that determines net income (loss) per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Under the two-class method, basic income (loss) attributable to Archrock common stockholders per common share is determined by dividing income (loss) attributable to Archrock common stockholders after deducting amounts allocated to participating securities, by the weighted average number of common shares outstanding for the period. Participating securities include unvested restricted stock and stock settled restricted stock units that have nonforfeitable rights to receive dividends or dividend equivalents, whether paid or unpaid. During periods of net loss, no effect is given to participating securities because they do not have a contractual obligation to participate in our losses.
Diluted income (loss) attributable to Archrock common stockholders per common share is computed using the weighted average number of shares outstanding adjusted for the incremental common stock equivalents attributed to outstanding options and stock to be issued pursuant to our employee stock purchase plan unless their effect would be anti-dilutive.
The following table summarizes net income (loss) attributable to Archrock common stockholders used in the calculation of basic and diluted loss per common share (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Income (loss) from continuing operations attributable to Archrock stockholders | $ | 9,974 |  |  | $ | (10,181 | ) |  | $ | 8,095 |  |  | $ | (28,553 | )
Loss from discontinued operations, net of tax | — |  |  | (54 | ) |  | — |  |  | (54 | )
Net income (loss) attributable to Archrock stockholders | 9,974 |  |  | (10,235 | ) |  | 8,095 |  |  | (28,607 | )
Less: Net income attributable to participating securities | (241 | ) |  | (179 | ) |  | (554 | ) |  | (513 | )
Net income (loss) attributable to Archrock common stockholders | $ | 9,733 |  |  | $ | (10,414 | ) |  | $ | 7,541 |  |  | $ | (29,120 | )

The following table shows the potential shares of common stock that were included in computing diluted income (loss) attributable to Archrock common stockholders per common share (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Weighted average common shares outstanding including participating securities | 129,486 |  |  | 70,952 |  |  | 104,489 |  |  | 70,847 |
Less: Weighted average participating securities outstanding | (1,644 | ) |  | (1,308 | ) |  | (1,576 | ) |  | (1,327 | )
Weighted average common shares outstanding — used in basic income (loss) per common share | 127,842 |  |  | 69,644 |  |  | 102,913 |  |  | 69,520 |
Net dilutive potential common shares issuable: |  |  |  |  |  |  |
On exercise of options | 111 |  |  | * |  |  | 96 |  |  | * |
On the settlement of employee stock purchase plan shares | 2 |  |  | * |  |  | 4 |  |  | * |
Weighted average common shares outstanding — used in diluted income (loss) per common share | 127,955 |  |  | 69,644 |  |  | 103,013 |  |  | 69,520 |

——————

* | Excluded from diluted income (loss) per common share as their inclusion would have been anti-dilutive.

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The following table shows the potential shares of common stock issuable that were excluded from computing diluted income (loss) attributable to Archrock common stockholders per common share as their inclusion would have been anti-dilutive (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Net dilutive potential common shares issuable: |  |  |  |  |  |  |
On exercise of options where exercise price is greater than average market value for the period | 187 |  |  | 240 |  |  | 199 |  |  | 278 |
On exercise of options | — |  |  | 100 |  |  | — |  |  | 116 |
Net dilutive potential common shares issuable | 187 |  |  | 340 |  |  | 199 |  |  | 394 |

17. Equity
Merger Transaction
On January 1, 2018, we entered into the Merger Agreement pursuant to which we agreed to merge the Partnership with and into our indirect wholly-owned subsidiary. On April 26, 2018, the Merger was completed and we issued 57.6 million shares of our common stock to acquire the 41.2 million common units of the Partnership not owned by us prior to the Merger at a fixed exchange ratio of 1.40 shares of our common stock for each Partnership common unit for total implied consideration of $625.3 million. Additionally, the incentive distribution rights in the Partnership, all of which we owned indirectly prior to the Merger, were canceled and ceased to exist. As a result of the Merger, the Partnership’s common units are no longer publicly traded. The Partnership’s 6% senior notes due April 2021 and October 2022 were not impacted by the Merger and remain outstanding.
As we controlled the Partnership prior to the Merger and continue to control the Partnership after the Merger, we accounted for the change in our ownership interest in the Partnership as an equity transaction which was reflected as a reduction of the noncontrolling interest with corresponding increases to common stock, additional paid-in capital and accumulated other comprehensive income. No gain or loss was recognized in our condensed consolidated statements of operations as a result of the Merger.
The following table presents the effects of changes in our ownership interest in the Partnership on the equity attributable to Archrock stockholders:

| Nine Months Ended September 30,
| 2018 |  | 2017
Net income (loss) attributable to Archrock stockholders | $ | 8,095 |  |  | $ | (28,607 | )
Increase in Archrock stockholders’ additional paid-in capital for purchase of Partnership common units | 54,751 |  |  | 17,638 |
Change from net income (loss) attributable to Archrock stockholders and transfers from noncontrolling interest | $ | 62,846 |  |  | $ | (10,969 | )

Prior to the Merger, public unitholders held an approximate 57% ownership interest in the Partnership and we owned the remaining equity interest. The equity interests in the Partnership that were owned by the public prior to April 26, 2018 are reflected within noncontrolling interest in our condensed consolidated balance sheet as of December 31, 2017. The earnings of the Partnership that were attributed to its common units held by the public prior to April 26, 2018 are reflected in net income (loss) attributable to the noncontrolling interest in our condensed consolidated statement of operations.
The tax effects of the Merger were reported as adjustments to other long-term assets, long-term assets associated with discontinued operations, deferred income taxes, additional paid-in capital and other comprehensive income. Due to the change in ownership and tax step up from the consideration given in the Merger, we recorded a $156.5 million deferred tax asset which resulted in an overall $55.0 million net deferred tax asset. We evaluated the realizability of our resulting net deferred tax asset position by assessing the available positive and negative evidence and concluded, based on the weight of the evidence, that a $53.4 million valuation allowance was required. The $103.1 million net tax impact of the change in deferred tax asset and the valuation allowance was recorded as an offsetting increase to additional paid-in capital.
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We incurred $0.2 million and $10.0 million of transaction costs directly attributable to the Merger during the three and nine months ended September 30, 2018, respectively, including financial advisory, legal service and other professional fees, which were recorded to merger-related costs on our condensed consolidated statements of operations.
Partnership Capital Offering
In August 2017, the Partnership sold, pursuant to a public underwritten offering, 4,600,000 common units, including 600,000 common units pursuant to an over-allotment option. The Partnership received net proceeds of $60.3 million after deducting underwriting discounts, commissions and offering expenses, which it used to repay borrowings outstanding under the Partnership Credit Facility. In connection with this sale and as permitted under its partnership agreement, the Partnership sold 93,163 general partner units to its General Partner for a contribution of $1.3 million to maintain the General Partner’s approximate 2% general partner interest in the Partnership.
Cash Dividends
The following table summarizes our dividends per common share:

Declaration Date |  | Payment Date |  | Dividends per Common Share |  | Total Dividends (in thousands)
January 19, 2017 |  | February 15, 2017 |  | $ | 0.120 |  |  | $ | 8,458 |
April 26, 2017 |  | May 16, 2017 |  | 0.120 |  |  | 8,534 |
July 26, 2017 |  | August 15, 2017 |  | 0.120 |  |  | 8,536 |
October 20, 2017 |  | November 15, 2017 |  | 0.120 |  |  | 8,536 |
January 18, 2018 |  | February 14, 2018 |  | 0.120 |  |  | 8,532 |
April 25, 2018 |  | May 15, 2018 |  | 0.120 |  |  | 15,486 |
July 25, 2018 |  | August 14, 2018 |  | 0.132 |  |  | 17,114 |

On October 24, 2018, our board of directors declared a quarterly dividend of $0.132 per share of common stock to be paid on November 14, 2018 to stockholders of record at the close of business on November 7, 2018.
18. Accumulated Other Comprehensive Income
Components of comprehensive income (loss) are net income (loss) and all changes in equity during a period except those resulting from transactions with owners. Our accumulated other comprehensive income (loss) consists of changes in the fair value of derivative instruments, net of tax, that are designated as cash flow hedges, amortization of terminated interest rate swaps and adjustments related to changes in our ownership of the Partnership.
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The following table presents the changes in accumulated other comprehensive income (loss) of our derivative cash flow hedges, net of tax and excluding noncontrolling interest, during the three and nine months ended September 30, 2018 and 2017 (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Beginning accumulated other comprehensive income (loss) | $ | 9,374 |  |  | $ | (936 | ) |  | $ | 1,197 |  |  | $ | (1,678 | )
Gain recognized in other comprehensive income, net of tax provision of $345, $247, $1,234 and $290, respectively | 1,298 |  |  | 931 |  |  | 3,349 |  |  | 1,104 |
(Gain) loss reclassified from accumulated other comprehensive loss to interest expense, net of tax provision (benefit) of $90, $(108), $37 and $(414), respectively (1) | (339 | ) |  | 200 |  |  | 117 |  |  | 769 |
Merger-related adjustments (2) | — |  |  | — |  |  | 5,670 |  |  | — |
Other comprehensive income attributable to Archrock stockholders | 959 |  |  | 1,131 |  |  | 9,136 |  |  | 1,873 |
Ending accumulated other comprehensive income | $ | 10,333 |  |  | $ | 195 |  |  | $ | 10,333 |  |  | $ | 195 |

——————

(1) | Included stranded tax effects resulting from the TCJA of $0.3 million reclassified to accumulated deficit during the nine months ended September 30, 2018. See Note 2 (“Recent Accounting Developments”) for further details.

(2) | Pursuant to the Merger, we reclassified a gain of $5.7 million from noncontrolling interest to accumulated other comprehensive income (loss) related to the fair value of our derivative instruments that was previously attributed to public ownership of the Partnership.

See Note 9 (“Derivatives”) for further details on the derivative instruments.
19. Commitments and Contingencies
Performance Bonds
In the normal course of business we have issued performance bonds to various state authorities that ensure payment of certain obligations. We have also issued a bond to protect our 401(k) retirement plan against losses caused by acts of fraud or dishonesty. The bonds have expiration dates in 2018 through the first quarter of 2020 and maximum potential future payments of $2.3 million. As of September 30, 2018, we were in compliance with all obligations to which the performance bonds pertain.
Tax Matters
We are subject to a number of state and local taxes that are not income-based. As many of these taxes are subject to audit by the taxing authorities, it is possible that an audit could result in additional taxes due. We accrue for such additional taxes when we determine that it is probable that we have incurred a liability and we can reasonably estimate the amount of the liability. As of September 30, 2018 and December 31, 2017, we accrued $3.2 million and $1.7 million, respectively, for the outcomes of non-income based tax audits. We do not expect that the ultimate resolutions of these audits will result in a material variance from the amounts accrued. We do not accrue for unasserted claims for tax audits unless we believe the assertion of a claim is probable, it is probable that it will be determined that the claim is owed and we can reasonably estimate the claim or range of the claim. We believe the likelihood is remote that the impact of potential unasserted claims from non-income based tax audits could be material to our consolidated financial position, but it is possible that the resolution of future audits could be material to our consolidated results of operations or cash flows.
Subject to the provisions of the tax matters agreement between Exterran Corporation and us, both parties agreed to indemnify the primary obligor of any return for tax periods beginning before and ending before or after the Spin-off (including any ongoing or future amendments and audits for these returns) for the portion of the tax liability (including interest and penalties) that relates to their respective operations reported in the filing. The tax contingencies mentioned above relate to tax matters for which we are responsible in managing the audit. As of both September 30, 2018 and December 31, 2017, we recorded an indemnification liability (including penalties and interest), in addition to the tax contingency above, of $1.6 million for our share of non-income based tax contingencies related to audits being managed by Exterran Corporation.
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Insurance Matters
Our business can be hazardous, involving unforeseen circumstances such as uncontrollable flows of natural gas or well fluids and fires or explosions. As is customary in our industry, we review our safety equipment and procedures and carry insurance against some, but not all, risks of our business. Our insurance coverage includes property damage, general liability and commercial automobile liability and other coverage we believe is appropriate. In addition, we have a minimal amount of insurance on our offshore assets. We believe that our insurance coverage is customary for the industry and adequate for our business; however, losses and liabilities not covered by insurance would increase our costs.
Additionally, we are substantially self-insured for workers’ compensation and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses up to the deductible amounts are estimated and accrued based upon known facts, historical trends and industry averages.
Indemnification Obligations
In connection with the Spin-off, we entered into a separation and distribution agreement which provides for cross-indemnities between Exterran Corporation’s operating subsidiary and us and established procedures for handling claims subject to indemnification and related matters. Generally, the separation and distribution agreement provides for cross-indemnities principally designed to place financial responsibility for the obligations and liabilities of our business with us and financial responsibility for the obligations and liabilities of Exterran Corporation’s business with Exterran Corporation. Pursuant to the separation and distribution agreement, we and Exterran Corporation will generally release the other party from all claims arising prior to the Spin-off that relate to the other party’s business.
Litigation and Claims
In the ordinary course of business, we are involved in various pending or threatened legal actions. While management is unable to predict the ultimate outcome of these actions, it believes that any ultimate liability arising from any of these actions will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends. However, because of the inherent uncertainty of litigation and arbitration proceedings, we cannot provide assurance that the resolution of any particular claim or proceeding to which we are a party will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends.
Heavy Equipment
In 2011, the Texas Legislature enacted changes that affected the appraisal of natural gas compressors for ad valorem tax purposes by expanding the special valuation methodology for “Heavy Equipment Inventory” to include inventory held for lease effective from the beginning of 2012. Under the Heavy Equipment Statutes, we are a “Heavy Equipment Dealer” and our natural gas compressors are Heavy Equipment Inventory. As such, we began filing our ad valorem taxes under this methodology starting in the 2012 tax year. Our natural gas compressors are taxable under the Heavy Equipment Statutes in the counties where we maintain a business location and store our inventory of natural gas compressors as opposed to where the compressors may be located on January 1 of a tax year. Although a few appraisal review boards accepted our position, many denied it. As a result, our wholly-owned subsidiary, Archrock Services Leasing LLC, formerly known as EES Leasing, and the Partnership’s wholly-owned subsidiary, Archrock Partners Leasing LLC, formerly known as EXLP Leasing, filed numerous petitions for review in the appropriate district courts with respect to the 2012-2017 tax years.
To date, three cases have been decided by trial courts, with two of the decisions having been rendered by the same presiding judge. All three of those decisions were appealed, and all three of the appeals have been decided on by intermediate appellate courts. On March 2, 2018, the Texas Supreme Court ruled in one of the cases, EXLP Leasing LLC & EES Leasing LLC v. Galveston Central Appraisal District, on two of the three issues related to the Heavy Equipment Statutes: constitutionality and situs. The third issue — the district court’s ruling that the Heavy Equipment Statutes apply to the compressors — was not appealed in this case. The Texas Supreme Court ruled in our favor on all accounts, holding that the Heavy Equipment Statutes are constitutional and that our natural gas compressors are taxable only in the counties where we maintain a business location that manages our inventory of natural gas compressors. On September 28, 2018, the Texas Supreme Court denied Galveston Central Appraisal District’s motion for rehearing, thus concluding the litigation in this case.
Two cases, EXLP Leasing LLC & EES Leasing LLC v. Loving County Appraisal District and EES Leasing LLC & EXLP Leasing LLC v. Ward County Appraisal District, remain pending for review by the Texas Supreme Court. We expect the pending cases to be disposed of in a manner consistent with the Galveston case.
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As a result of the rulings on the Heavy Equipment litigation thus far, all counties in which we filed petitions for review have removed our compressors from their 2018 property rolls except for Galveston County, which has agreed to do so promptly. As of September 30, 2018, many of the petitions that we filed for tax years 2012-2017 have been closed and the remaining pending petitions are in the process of being closed. We believe that the likelihood of an unfavorable outcome or further litigation on this issue is remote.
Other
The SEC has been conducting an investigation in connection with certain previously disclosed errors and possible irregularities at one of our former international operations. We and Exterran Corporation are cooperating with the SEC in the investigation of this matter. The SEC’s investigation related to the circumstances giving rise to the restatement of prior period consolidated and combined financial statements is continuing, and we are presently unable to predict the duration, scope or results or whether the SEC will commence any legal action.
20. Segments
We manage our business segments primarily based upon the type of product or service provided. We have two segments which we operate within the U.S.: contract operations and aftermarket services. The contract operations segment primarily provides natural gas compression services to meet specific customer requirements. The aftermarket services segment provides a full range of services to support the compression needs of customers, from part sales and normal maintenance services to full operation of a customer’s owned assets.
We evaluate the performance of our segments based on gross margin for each segment. Revenue includes only sales to external customers.
The following table presents revenue and gross margin by segment during the three and nine months ended September 30, 2018 and 2017 (in thousands):

| Contract Operations |  | Aftermarket Services |  | Total
Three months ended September 30, 2018 |  |  |  |  |
Revenue | $ | 169,509 |  |  | $ | 62,863 |  |  | $ | 232,372 |
Gross margin | 100,453 |  |  | 12,820 |  |  | 113,273 |
Three months ended September 30, 2017 |  |  |  |  |
Revenue | $ | 153,524 |  |  | $ | 44,329 |  |  | $ | 197,853 |
Gross margin | 81,573 |  |  | 5,843 |  |  | 87,416 |
Nine months ended September 30, 2018 |  |  |  |  |
Revenue | $ | 496,156 |  |  | $ | 175,126 |  |  | $ | 671,282 |
Gross margin | 294,696 |  |  | 31,953 |  |  | 326,649 |
Nine months ended September 30, 2017 |  |  |  |  |
Revenue | $ | 454,622 |  |  | $ | 131,098 |  |  | $ | 585,720 |
Gross margin | 256,331 |  |  | 19,271 |  |  | 275,602 |

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The following table reconciles total gross margin to income (loss) before income taxes (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Total gross margin | $ | 113,273 |  |  | $ | 87,416 |  |  | $ | 326,649 |  |  | $ | 275,602 |
Less: |  |  |  |  |  |  |
Selling, general and administrative | 26,298 |  |  | 29,108 |  |  | 80,455 |  |  | 81,823 |
Depreciation and amortization | 43,779 |  |  | 47,463 |  |  | 131,565 |  |  | 142,483 |
Long-lived asset impairment | 6,660 |  |  | 7,105 |  |  | 18,323 |  |  | 20,858 |
Restatement and other charges | 396 |  |  | 566 |  |  | (195 | ) |  | 3,287 |
Restructuring and other charges | — |  |  | 422 |  |  | — |  |  | 1,245 |
Interest expense | 23,518 |  |  | 22,892 |  |  | 69,402 |  |  | 66,817 |
Debt extinguishment loss | — |  |  | — |  |  | 2,450 |  |  | 291 |
Merger-related costs | 182 |  |  | — |  |  | 9,993 |  |  | — |
Other income, net | (660 | ) |  | (2,716 | ) |  | (3,449 | ) |  | (4,472 | )
Income (loss) before income taxes | $ | 13,100 |  |  | $ | (17,424 | ) |  | $ | 18,105 |  |  | $ | (36,730 | )

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited financial statements and the notes thereto included in the Financial Statements of this Quarterly Report on Form 10-Q and in conjunction with our 2017 Form 10-K.
Overview
We are a pure play U.S. natural gas contract operations services business and the leading provider of natural gas compression services to customers in the oil and natural gas industry throughout the U.S. and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. We operate in two primary business segments: contract operations and aftermarket services. In our contract operations business, we use our owned fleet of natural gas compression equipment to provide operations services to our customers. In our aftermarket services business, we sell parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.
Recent Business Developments
Merger Transaction
On April 26, 2018, we completed the acquisition of all of the outstanding common units of the Partnership and the Partnership became our indirect wholly-owned subsidiary. In connection with the closing of the Merger, we issued 57.6 million shares of our common stock to acquire the 41.2 million common units of the Partnership not owned by us prior to the Merger at a fixed exchange ratio of 1.40 shares of our common stock for each Partnership common unit, for total implied consideration of $625.3 million. Additionally, the incentive distribution rights in the Partnership, which were previously owned indirectly by us, were canceled and ceased to exist. As a result of the Merger, common units of the Partnership are no longer publicly traded. See Note 17 (“Equity”) to our Financial Statements for further details of the Merger.
Amendment to the Partnership Credit Facility and Termination of the Archrock Credit Facility
On February 23, 2018, the Partnership amended the Partnership Credit Facility to, among other things, increase the maximum Total Debt to EBITDA ratio. In addition, on April 26, 2018, concurrent with the Merger and certain terms within Amendment No. 1, the Partnership increased the aggregate revolving commitment under the Partnership Credit Facility to $1.25 billion and we terminated the Archrock Credit Facility and all commitments under that facility. See “Liquidity and Capital Resources - Financial Resources” below and Note 8 (“Long-Term Debt”) to the Financial Statements for further details of Amendment No. 1 and the termination of the Archrock Credit Facility.
Operating Highlights
The following table summarizes our available and operating horsepower and horsepower utilization (in thousands, except percentages):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Total available horsepower (at period end)(1) | 3,937 |  |  | 3,866 |  |  | 3,937 |  |  | 3,866 |
Total operating horsepower (at period end)(2) | 3,465 |  |  | 3,204 |  |  | 3,465 |  |  | 3,204 |
Average operating horsepower | 3,406 |  |  | 3,166 |  |  | 3,348 |  |  | 3,125 |
Horsepower utilization: |  |  |  |  |  |  |  |  |
Spot (at period end) | 88 | % |  | 83 | % |  | 88 | % |  | 83 | %
Average | 87 | % |  | 82 | % |  | 86 | % |  | 82 | %

——————

(1) | Defined as idle and operating horsepower. New compressor units completed by a third party manufacturer that have been delivered to us are included in the fleet.

(2) | Defined as horsepower that is operating under contract and horsepower that is idle but under contract and generating revenue such as standby revenue.

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Non-GAAP Financial Measures
Management uses a variety of financial and operating metrics to analyze our performance. These metrics are significant factors in assessing our operating results and profitability and include the non-GAAP financial measure of gross margin.
We define gross margin as total revenue less cost of sales (excluding depreciation and amortization). Gross margin is included as a supplemental disclosure because it is a primary measure used by our management to evaluate the results of revenue and cost of sales (excluding depreciation and amortization), which are key components of our operations. 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 SG&A activities, the impact of our financing methods and income taxes. In addition, depreciation and amortization may not accurately reflect the costs required to maintain and replenish the operational usage of our assets and therefore may not portray the costs of current operating activity. As an indicator of our operating performance, gross margin should not be considered an alternative to, or more meaningful than, net income (loss) 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.
Gross margin has certain material limitations associated with its use as compared to net income (loss). These limitations are primarily due to the exclusion of interest expense, depreciation and amortization, SG&A, impairments, restatement and other charges, restructuring and other charges, debt extinguishment costs, Merger-related costs, provision for (benefit from) income taxes and other (income) loss, net. Because we intend to finance a portion of our operations through borrowings, interest expense is a necessary element of our costs and our ability to generate revenue. Additionally, because we use capital assets, depreciation expense is a necessary element of our costs and our ability to generate revenue and SG&A is necessary to support our operations and required corporate activities. 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.
The following table reconciles net income (loss) to gross margin (in thousands):

| Three Months Ended September 30, |  | Nine Months Ended September 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Net income (loss) | $ | 9,974 |  |  | $ | (12,683 | ) |  | $ | 16,192 |  |  | $ | (30,732 | )
Selling, general and administrative | 26,298 |  |  | 29,108 |  |  | 80,455 |  |  | 81,823 |
Depreciation and amortization | 43,779 |  |  | 47,463 |  |  | 131,565 |  |  | 142,483 |
Long-lived asset impairment | 6,660 |  |  | 7,105 |  |  | 18,323 |  |  | 20,858 |
Restatement and other charges | 396 |  |  | 566 |  |  | (195 | ) |  | 3,287 |
Restructuring and other charges | — |  |  | 422 |  |  | — |  |  | 1,245 |
Interest expense | 23,518 |  |  | 22,892 |  |  | 69,402 |  |  | 66,817 |
Debt extinguishment loss | — |  |  | — |  |  | 2,450 |  |  | 291 |
Merger-related costs | 182 |  |  | — |  |  | 9,993 |  |  | — |
Other income, net | (660 | ) |  | (2,716 | ) |  | (3,449 | ) |  | (4,472 | )
Provision for (benefit from) income taxes | 3,126 |  |  | (4,795 | ) |  | 1,913 |  |  | (6,052 | )
Loss from discontinued operations, net of tax | — |  |  | 54 |  |  | — |  |  | 54 |
Gross margin | $ | 113,273 |  |  | $ | 87,416 |  |  | $ | 326,649 |  |  | $ | 275,602 |

Financial Results of Operations
Summary of Results
Revenue. Revenue was $232.4 million and $197.9 million during the three months ended September 30, 2018 and 2017, respectively, and $671.3 million and $585.7 million during the nine months ended September 30, 2018 and 2017, respectively. The increases in revenue during the three and nine months ended September 30, 2018 compared to the three and nine months ended September 30, 2017 were due to increases in revenue from our contract operations and aftermarket services businesses. See “Contract Operations” and “Aftermarket Services” below for further details.
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Net income (loss) attributable to Archrock stockholders. Net income attributable to Archrock stockholders was $10.0 million and net loss attributable to Archrock stockholders was $10.2 million during the three months ended September 30, 2018 and 2017, respectively. Net income attributable to Archrock stockholders was $8.1 million and net loss attributable to Archrock stockholders was $28.6 million during the nine months ended September 30, 2018 and 2017, respectively.
The change from net loss to net income attributable to Archrock stockholders during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily driven by the increase in gross margin from our contract operations and aftermarket services businesses and decreases in depreciation and amortization and SG&A, partially offset by the change in provision for (benefit from) income taxes and decreases in net loss attributable to the noncontrolling interest and other income, net.
The change from net loss to net income attributable to Archrock stockholders during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily driven by the increase in gross margin from our contract operations and aftermarket services businesses and decreases in depreciation and amortization, restatement and other charges and long-lived asset impairment, partially offset by the change in net income (loss) attributable to the noncontrolling interest, Merger-related costs, the change in provision for (benefit from) income taxes and increases in interest expense and debt extinguishment loss.
Three Months Ended September 30, 2018 Compared to Three Months Ended September 30, 2017
Contract Operations
(dollars in thousands)

| Three Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Revenue | $ | 169,509 |  |  | $ | 153,524 |  |  | 10 | %
Cost of sales (excluding depreciation and amortization expense) | 69,056 |  |  | 71,951 |  |  | (4 | )%
Gross margin | $ | 100,453 |  |  | $ | 81,573 |  |  | 23 | %
Gross margin percentage (1) | 59 | % |  | 53 | % |  | 6 | %

——————

(1) | Defined as gross margin divided by revenue.

The increase in revenue during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to an 8% increase in average operating horsepower and an increase in rates resulting from an increase in customer demand driven by improved market conditions. The increase in revenue was partially offset by the deferral of rebillable freight revenue as a result of the adoption of the Revenue Recognition Update.
Gross margin increased during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 due to the increase in revenue mentioned above and the decrease in cost of sales. The decrease in cost of sales was primarily driven by the capitalization of freight and mobilization costs incurred to fulfill contracts prior to the transfer of service as a result of the adoption of the Revenue Recognition Update, decreases in costs associated with the mobilization of compressor units and other operating costs of providing our contract operations services and a one-time adjustment to lube oil expense in the third quarter of 2017. The decrease in cost of sales was partially offset by increases in maintenance expense, lube oil expense and freight expense associated with the increase in average operating horsepower.
Gross margin percentage increased during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 primarily due to the increase in rates, the capitalization of costs incurred to fulfill contracts prior to the transfer of service as a result of the adoption of the Revenue Recognition Update, the one-time adjustment to lube oil expense in the third quarter of 2017 and the decrease in costs associated with the mobilization of compressor units.
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Aftermarket Services
(dollars in thousands)

| Three Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Revenue | $ | 62,863 |  |  | $ | 44,329 |  |  | 42 | %
Cost of sales (excluding depreciation and amortization expense) | 50,043 |  |  | 38,486 |  |  | 30 | %
Gross margin | $ | 12,820 |  |  | $ | 5,843 |  |  | 119 | %
Gross margin percentage | 20 | % |  | 13 | % |  | 7 | %

The increase in revenue during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to increases in service activities and part sales resulting from increased customer demand driven by improved market conditions, as well as the change to recognize revenue for service activities over time as a result of the adoption of the Revenue Recognition Update.
Gross margin increased during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 due to the increase in revenue mentioned above, partially offset by the increase in cost of sales. The increase in cost of sales was primarily driven by the increase in service activities and part sales as well as the change to recognize costs associated with service activities over time as a result of the adoption of the Revenue Recognition Update.
Gross margin percentage increased during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 primarily due to higher billable labor utilization as a result of the increase in activity mentioned above.
Costs and Expenses
(dollars in thousands)

| Three Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Selling, general and administrative | $ | 26,298 |  |  | $ | 29,108 |  |  | (10 | )%
Depreciation and amortization | 43,779 |  |  | 47,463 |  |  | (8 | )%
Long-lived asset impairment | 6,660 |  |  | 7,105 |  |  | (6 | )%
Restatement and other charges | 396 |  |  | 566 |  |  | (30 | )%
Restructuring and other charges | — |  |  | 422 |  |  | (100 | )%
Interest expense | 23,518 |  |  | 22,892 |  |  | 3 | %
Merger-related costs | 182 |  |  | — |  |  | n/a |
Other income, net | (660 | ) |  | (2,716 | ) |  | (76 | )%

Selling, general and administrative. The decrease in SG&A during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to a $1.3 million decrease in corporate office relocation costs (see Note 13 (“Corporate Office Relocation”) to our Financial Statements), a $1.0 million decrease in bad debt expense and a $0.8 million decrease in facility rent expense.
Depreciation and amortization. The decrease in depreciation and amortization expense during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to a decrease in depreciation expense resulting from certain assets reaching the end of their depreciable lives as well as the impact of asset impairments during 2017 and 2018, partially offset by an increase in depreciation expense associated with fixed asset additions.
Long-lived asset impairment. During the three months ended September 30, 2018 and 2017, we reviewed the future deployment of our idle compression assets for units that were not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. In addition, we evaluated for impairment idle units that had been culled from our fleet in prior years and were available for sale. See Note 11 (“Long-Lived Asset Impairment”) to our Financial Statements for further details.
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The following table presents the results of our impairment review (dollars in thousands):

| Three Months Ended September 30,
| 2018 |  | 2017
Idle compressor units retired from the active fleet | 60 |  |  | 50 |
Horsepower of idle compressor units retired from the active fleet | 23,000 |  |  | 20,000 |
Impairment recorded on idle compressor units retired from the active fleet | $ | 6,660 |  |  | $ | 5,934 |

In addition to the impairment discussed above, during the three months ended September 30, 2017, $0.8 million of leasehold improvements and furniture and fixtures were impaired in conjunction with the relocation of our corporate office during the third quarter of 2017. See Note 13 (“Corporate Office Relocation”) to our Financial Statements for further details.
Restatement and other charges. During the three months ended September 30, 2018 and 2017, we recorded $0.4 million and $0.6 million, respectively, of restatement and other charges for our share of professional and legal fees related to the restatement of prior period financial statements and disclosures and the related matters described in Note 19 (“Commitments and Contingencies”) to our Financial Statements.
Restructuring and other charges. As discussed in Note 4 (“Discontinued Operations”) to our Financial Statements, we completed the Spin-off in 2015. During the three months ended September 30, 2017, we incurred $0.4 million of costs associated with the Spin-off which were directly attributable to Archrock. No such costs were incurred subsequent to December 31, 2017.
Interest expense. The increase in interest expense during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to an increase in the average outstanding balance of long-term debt partially offset by a decrease in the weighted average effective interest rate.
Other income, net. The decrease in other income, net during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to a $1.9 million decrease in the gain on sale of property, plant and equipment.
Income Taxes
(dollars in thousands)

| Three Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Provision for (benefit from) income taxes | $ | 3,126 |  |  | $ | (4,795 | ) |  | (165 | )%
Effective tax rate | 24 | % |  | 28 | % |  | (4 | )%

The change in provision for (benefit from) income taxes during the three months ended September 30, 2018 compared to the three months ended September 30, 2017 was primarily due to an increase in book income tax effected at the lower corporate income tax rate in 2018 as the result of the TCJA.
Net Income Attributable to the Noncontrolling Interest
(dollars in thousands)

| Three Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Net loss attributable to the noncontrolling interest | $ | — |  |  | $ | 2,448 |  |  | (100 | )%

The noncontrolling interest comprises the portion of the Partnership’s earnings that are applicable to the Partnership’s publicly-held common unitholder interest through the completion of the Merger. See Note 17 (“Equity”) to our Financial Statements for further details on the Merger. The decrease in net loss attributable to the noncontrolling interest during three months ended September 30, 2018 compared to the three months ended September 30, 2017 was due to Archrock’s acquisition of all of the outstanding common units of the Partnership in conjunction with the Merger on April 26, 2018.
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Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017
Contract Operations
(dollars in thousands)

| Nine Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Revenue | $ | 496,156 |  |  | $ | 454,622 |  |  | 9 | %
Cost of sales (excluding depreciation and amortization) | 201,460 |  |  | 198,291 |  |  | 2 | %
Gross margin | $ | 294,696 |  |  | $ | 256,331 |  |  | 15 | %
Gross margin percentage (1) | 59 | % |  | 56 | % |  | 3 | %

——————

(1) | Defined as gross margin divided by revenue.

The increase in revenue during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to a 7% increase in average operating horsepower and an increase in rates resulting from an increase in customer demand driven by improved market conditions. The increase in revenue was partially offset by the deferral of rebillable freight revenue as a result of the adoption of the Revenue Recognition Update.
Gross margin increased during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 due to the increase in revenue mentioned above partially offset by the increase in cost of sales. The increase in cost of sales was primarily driven by increases in maintenance expense, freight expense, lube oil expense and the mobilization of compressor units associated with the increase in average operating horsepower. The increase in cost of sales was partially offset by the capitalization of freight and mobilization costs incurred to fulfill contracts prior to the transfer of service as a result of the adoption of the Revenue Recognition Update and a decrease in other operating costs of providing our contract operations services.
Gross margin percentage increased during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 primarily due to the capitalization of costs incurred to fulfill contracts prior to the transfer of service as a result of the adoption of the Revenue Recognition Update and the increase in rates.
Aftermarket Services
(dollars in thousands)

| Nine Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Revenue | $ | 175,126 |  |  | $ | 131,098 |  |  | 34 | %
Cost of sales (excluding depreciation and amortization) | 143,173 |  |  | 111,827 |  |  | 28 | %
Gross margin | $ | 31,953 |  |  | $ | 19,271 |  |  | 66 | %
Gross margin percentage | 18 | % |  | 15 | % |  | 3 | %

The increase in revenue during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to increases in service activities and part sales resulting from increased customer demand driven by improved market conditions, as well as the change to recognize revenue for service activities over time as a result of the adoption of the Revenue Recognition Update.
Gross margin increased during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 due to the increase in revenue mentioned above partially offset by the increase in cost of sales. The increase in cost of sales was primarily driven by the increase in service activities and part sales as well as the change to recognize costs associated with service activities over time as a result of the adoption of the Revenue Recognition Update.
Gross margin percentage increased during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 primarily due to higher billable labor utilization as a result of the increase in activity mentioned above.
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Costs and Expenses
(dollars in thousands)

| Nine Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Selling, general and administrative | $ | 80,455 |  |  | $ | 81,823 |  |  | (2 | )%
Depreciation and amortization | 131,565 |  |  | 142,483 |  |  | (8 | )%
Long-lived asset impairment | 18,323 |  |  | 20,858 |  |  | (12 | )%
Restatement and other charges | (195 | ) |  | 3,287 |  |  | (106 | )%
Restructuring and other charges | — |  |  | 1,245 |  |  | (100 | )%
Interest expense | 69,402 |  |  | 66,817 |  |  | 4 | %
Debt extinguishment loss | 2,450 |  |  | 291 |  |  | 742 | %
Merger-related costs | 9,993 |  |  | — |  |  | n/a |
Other income, net | (3,449 | ) |  | (4,472 | ) |  | (23 | )%

Selling, general and administrative. The decrease in SG&A during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to a $1.6 million decrease in facility rent expense, a $1.4 million decrease in bad debt expense and a $1.3 million decrease in corporate office relocation costs (see Note 13 (“Corporate Office Relocation”) to our Financial Statements), partially offset by a $1.5 million increase in professional expenses and a $1.2 million increase in compensation and benefits.
Depreciation and amortization. The decrease in depreciation and amortization expense during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to a decrease in depreciation expense resulting from certain assets reaching the end of their depreciable lives as well as the impact of asset impairments during 2017 and 2018, partially offset by an increase in depreciation expense associated with fixed asset additions.
Long-lived asset impairment. During the nine months ended September 30, 2018 and 2017, we reviewed the future deployment of our idle compression assets for units that were not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. In addition, we evaluated for impairment idle units that had been culled from our fleet in prior years and were available for sale. See Note 11 (“Long-Lived Asset Impairment”) to our Financial Statements for further details.
The following table presents the results of our impairment review (dollars in thousands):

| Nine Months Ended September 30,
| 2018 |  | 2017
Idle compressor units retired from the active fleet | 225 |  |  | 190 |
Horsepower of idle compressor units retired from the active fleet | 73,000 |  |  | 71,000 |
Impairment recorded on idle compressor units retired from the active fleet | $ | 18,323 |  |  | $ | 19,686 |

In addition to the impairment discussed above, during the nine months ended September 30, 2017, $0.8 million of leasehold improvements and furniture and fixtures were impaired in conjunction with the relocation of our corporate office during the third quarter of 2017. See Note 13 (“Corporate Office Relocation”) to our Financial Statements for further details.
Restatement and other charges. During the nine months ended September 30, 2018 we recorded $1.8 million for the expected recovery of shared professional and legal fees incurred related to the restatement of prior period financial statements and disclosures and the related matters described in Note 19 (“Commitments and Contingencies”) to our Financial Statements. We were billed $1.6 million and $3.3 million for our share of these fees during the nine months ended September 30, 2018 and 2017, respectively.
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Restructuring and other charges. As discussed in Note 4 (“Discontinued Operations”) to our Financial Statements, we completed the Spin-off in 2015. During the nine months ended September 30, 2017 we incurred $1.2 million of costs associated with the Spin-off which were directly attributable to Archrock. No such costs were incurred subsequent to December 31, 2017.
Interest expense. The increase in interest expense during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to increases in the average outstanding balance of long-term debt and the weighted average effective interest rate partially offset by a $0.6 million write-off of deferred financing costs associated with the termination of the Former Credit Facility in the nine months ended September 30, 2017.
Debt extinguishment loss. We recorded a debt extinguishment loss of $2.5 million during the nine months ended September 30, 2018 as a result of the termination of the Archrock Credit Facility. We recorded a debt extinguishment loss of $0.3 million during the nine months ended September 30, 2017 as a result of the termination of the Former Credit Facility. See Note 8 (“Long-Term Debt”) to our Financial Statements for further details.
Merger-related costs. We incurred $10.0 million of Merger-related costs consisting of financial advisory, legal and other professional fees during the nine months ended September 30, 2018.
Other income, net. The decrease in other income, net during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to a $1.5 million decrease in the gain on sale of property, plant and equipment partially offset by a $0.5 million increase in indemnification income received pursuant to our tax matters agreement with Exterran Corporation and a $0.4 million decrease in indemnification expense remitted pursuant to the same agreement.
Income Taxes
(dollars in thousands)

| Nine Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Provision for (benefit from) income taxes | $ | 1,913 |  |  | $ | (6,052 | ) |  | (132 | )%
Effective tax rate | 11 | % |  | 16 | % |  | (5 | )%

The change in provision for (benefit from) income taxes during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to an increase in book income tax effected at the lower corporate income tax rate in 2018 as the result of the TCJA, partially offset by a lower unrecognized tax benefit recorded in 2018 compared to 2017 and a benefit recorded in 2018 for the settlement of a tax audit.
Net Income (Loss) Attributable to the Noncontrolling Interest
(dollars in thousands)

| Nine Months Ended September 30, |  | Increase
| 2018 |  | 2017 |  | (Decrease)
Net (income) loss attributable to the noncontrolling interest | $ | (8,097 | ) |  | $ | 2,125 |  |  | (481 | )%

The noncontrolling interest comprises the portion of the Partnership’s earnings that were applicable to the Partnership’s publicly-held common unitholder interest through the completion of the Merger. Immediately prior to the Merger and as of September 30, 2017, public unitholders held a 57% and 55% ownership interest in the Partnership, respectively. See Note 17 (“Equity”) to our Financial Statements for further details on the Merger. The change from net loss to net income attributable to the noncontrolling interest during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to the change from net loss to net income of the Partnership partially offset by Archrock’s acquisition of all of the outstanding common units of the Partnership in conjunction with the Merger on April 26, 2018. The change from net loss to net income of the Partnership was primarily due to the increase in revenue and decreases in depreciation and amortization, long-lived asset impairment and provision for income taxes, partially offset by increases in cost of sales (excluding depreciation and amortization), interest expense, net and Merger-related costs and a decrease in other income, net.
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Liquidity and Capital Resources
Overview
Our ability to fund operations, finance capital expenditures and pay dividends depends on the levels of our operating cash flows and access to the capital and credit markets. Our primary sources of liquidity are cash flows generated from our operations and our borrowing availability under the Partnership Credit Facility. On April 26, 2018, in connection with the closing of the Merger and Amendment No. 1, the aggregate revolving commitment of the Partnership Credit Facility was increased from $1.1 billion to $1.25 billion and the Archrock Credit Facility was terminated. See “Financial Resources” below and Notes 8 (“Long-Term Debt”) and 17 (“Equity”) to the Financial Statements for further details of the Merger and the changes to the credit facilities.
Our cash flow is affected by numerous factors including prices and demand for our services, volatility in commodity prices and their effect on oil and natural gas exploration and production spending, conditions in the financial markets and other factors. New orders for compression services were strong in 2017 and we have continued to book new orders at elevated rates into 2018. We believe that our operating cash flows and borrowings under the Partnership Credit Facility will be sufficient to meet our liquidity needs through at least September 30, 2019.
We may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.
Capital Requirements
The natural gas compression business is capital intensive, requiring significant investment to maintain and upgrade existing operations. Our capital spending is dependent on the demand for our contract operations services and the availability of the type of compression equipment required for us to render those contract operations services to our customers. Our capital requirements have consisted primarily of, and we anticipate will continue to consist of, the following:

• | growth capital expenditures, which are made to expand or replace partially or fully depreciated assets or to expand the operating capacity or revenue generating capabilities of existing or new assets, whether through construction, acquisition or modification; and

• | maintenance capital expenditures, which are made to maintain the existing operating capacity of our assets and related cash flows, further extending the useful lives of the assets.

The majority of our growth capital expenditures are related to the acquisition cost of new compressor units that we add to our fleet. In addition, growth capital expenditures can also include the upgrading of major components on an existing compressor unit where the current configuration of the compressor unit is no longer in demand and the compressor is not likely to return to an operating status without the capital expenditures. These latter expenditures substantially modify the operating parameters of the compressor unit such that it can be used in applications for which it previously was not suited. Maintenance capital expenditures are related to major overhauls of significant components of a compressor unit such as the engine, compressor and cooler, which return the components to a like-new condition but do not modify the applications for which the compressor unit was designed.
We generally invest funds necessary to purchase fleet additions when our idle equipment cannot be reconfigured to economically fulfill a project’s requirements and the new equipment expenditure is expected to generate economic returns over its expected useful life that exceed our targeted return on capital. We currently plan to spend approximately $320 million in capital expenditures during 2018, primarily consisting of approximately $250 million for growth capital expenditures and approximately $50 million for maintenance capital expenditures.
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Financial Resources
Revolving Credit Facilities
The following tables present the weighted average annual interest rate and average daily debt balance of our revolving credit facilities (dollars in thousands):

| September 30, 2018 |  | December 31, 2017
Weighted average annual interest rate (1) |  |  |
Archrock Credit Facility | n/a |  |  | 3.3 | %
Partnership Credit Facility | 5.5 | % |  | 4.8 | %

——————

(1) | Excludes the effect of interest rate swaps.

| Nine Months Ended September 30,
| 2018 |  | 2017
Average daily debt balance |  |  |
Archrock Credit Facility (1) | $ | 51,720 |  |  | $ | 70,270 |
Partnership Credit Facility (2) | 741,496 |  |  | 616,564 |

——————

(1) | The amount for the nine months ended September 30, 2018 is the average daily debt balance through the close of the facility on April 26, 2018.

(2) | The amount for the nine months ended September 30, 2018 pertains to the Partnership Credit Facility. The amount for the nine months ended September 30, 2017 pertains to a mix of the Partnership Credit Facility and the Partnership’s Former Credit Facility.

Archrock Credit Facility. On April 26, 2018, in connection with the Merger and Amendment No. 1, we terminated the Archrock Credit Facility and borrowed on the Partnership Credit Facility to repay $63.2 million in borrowings and accrued and unpaid interest and fees outstanding. All commitments under the Archrock Credit Facility were terminated and the $15.4 million of letters of credit outstanding under the Archrock Credit Facility as of the Merger were converted to letters of credit under the Partnership Credit Facility.
Prior to its termination, the Archrock Credit Facility required us to maintain the following consolidated financial ratios, as defined in the Archrock Credit Facility agreement:

EBITDA to Total Interest Expense | 2.25 to 1.0
Total Debt to EBITDA (1) | 4.25 to 1.0

——————

(1) | Subject to a temporary increase to 4.75 to 1.0 for any quarter during which an acquisition satisfying certain thresholds is completed and for the two quarters immediately following such quarter.

The Archrock Credit Facility contained various additional covenants with which we were required to comply, including, but not limited to, limitations on the incurrence of indebtedness, investments, liens on assets, repurchasing equity and making distributions, transactions with affiliates, mergers, consolidations, dispositions of assets and other provisions customary in similar types of agreements. We were in compliance with all covenants under the Archrock Credit Facility through its closing.
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Partnership Credit Facility. On February 23, 2018, the Partnership amended the Partnership Credit Facility to, among other things:

• | increase the maximum Total Debt to EBITDA ratios, as defined in the Partnership Credit Facility agreement (see below for the revised ratios), effective as of the execution of Amendment No. 1 on February 23, 2018; and

• | effective upon completion of the Merger on April 26, 2018:

– | increase the aggregate revolving commitment from $1.1 billion to $1.25 billion;

– | increase the amount available for the issuance of letters of credit from $25.0 million to $50.0 million;

– | increase the basket sizes under certain covenants including covenants limiting our ability to make investments, incur debt, make restricted payments, incur liens and make asset dispositions;

– | name Archrock Services, L.P., one of our subsidiaries, as a borrower under the Partnership Credit Facility and certain of our other subsidiaries as loan guarantors; and

– | amend the definition of “Borrowing Base” to include certain assets of ours and our subsidiaries.

The Partnership Credit Facility matures on March 30, 2022, except that if any portion of the Partnership’s 6% senior notes due April 2021 are outstanding as of December 2, 2020, then maturity will instead be on December 2, 2020. Portions of the Partnership Credit Facility up to $50.0 million are available for the issuance of swing line loans. The Partnership Credit Facility borrowing base consists of eligible accounts receivable, inventory and compressor units.
The Partnership must maintain the following consolidated financial ratios, as defined in the Partnership Credit Facility agreement:

EBITDA to Interest Expense | 2.5 to 1.0
Senior Secured Debt to EBITDA | 3.5 to 1.0
Total Debt to EBITDA |
Through fiscal year 2018 | 5.95 to 1.0
Through fiscal year 2019 | 5.75 to 1.0
Through second quarter of 2020 | 5.50 to 1.0
Thereafter (1) | 5.25 to 1.0

——————

(1) | Subject to a temporary increase to 5.50 to 1.0 for any quarter during which an acquisition satisfying certain thresholds is completed and for the two quarters immediately following such quarter.

As a result of the ratio requirements above, $324.0 million of the $408.1 million of undrawn capacity under the Partnership Credit Facility was available for additional borrowings as of September 30, 2018.
The Partnership Credit Facility agreement contains various additional covenants including, but not limited to, mandatory prepayments from the net cash proceeds of certain asset transfers, restrictions on the use of proceeds from borrowings and limitations on the Partnership’s ability to incur additional indebtedness, engage in transactions with affiliates, merge or consolidate, sell assets, make certain investments and acquisitions, make loans, grant liens, repurchase equity and pay distributions. In addition, if as of any date the Partnership has cash and cash equivalents (other than proceeds from a debt or equity issuance received in the 30 days prior to such date reasonably expected to be used to fund an acquisition permitted under the Partnership Credit Facility agreement) in excess of $50.0 million, then such excess amount will be used to pay down outstanding borrowings of a corresponding amount under the Partnership Credit Facility. As of September 30, 2018, the Partnership was in compliance with all covenants under the Partnership Credit Facility.
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Partnership Capital Offering
In August 2017, the Partnership sold, pursuant to a public underwritten offering, 4,600,000 common units, including 600,000 common units pursuant to an over-allotment option. The Partnership received net proceeds of $60.3 million after deducting underwriting discounts, commissions and offering expenses, which it used to repay borrowings outstanding under the Partnership Credit Facility. In connection with this sale and as permitted under its partnership agreement, the Partnership sold 93,163 general partner units to its General Partner for a contribution of $1.3 million to maintain the General Partner’s approximate 2% general partner interest in the Partnership.
Other
In connection with the Spin-off, we entered into a separation and distribution agreement with Exterran Corporation pursuant to which we have the right to receive payments from a subsidiary of Exterran Corporation based on a notional amount corresponding to payments received by Exterran Corporation’s subsidiaries from PDVSA Gas in respect of the sale of Exterran Corporation’s subsidiaries’ and joint ventures’ previously nationalized assets. As of September 30, 2018, Exterran Corporation was due to receive the remaining principal amount of $20.9 million from PDVSA Gas.
Cash Flows
Our cash flows from operating, investing and financing activities, as reflected in the condensed consolidated statements of cash flows, are summarized in the table below (in thousands):

| Nine Months Ended September 30,
| 2018 |  | 2017
Net cash provided by (used in) continuing operations: |  |  |
Operating activities | $ | 170,705 |  |  | $ | 151,055 |
Investing activities | (216,870 | ) |  | (129,567 | )
Financing activities | 39,053 |  |  | (21,976 | )
Net change in cash and cash equivalents | $ | (7,112 | ) |  | $ | (488 | )

Operating Activities. The increase in net cash provided by operating activities from continuing operations during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to an increase in revenue in our contract operations and aftermarket services segments primarily driven by improved market conditions and a decrease in inventory. These activities were partially offset by an increase in cost of sales, including freight and mobilization costs incurred to fulfill contracts prior to the transfer of service, an increase in Merger-related costs and an increase in accounts receivable as a result of the timing of payments received from our customers.
Investing Activities. The increase in net cash used in investing activities from continuing operations during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to an $88.9 million increase in capital expenditures, partially offset by a $1.4 million increase in proceeds from sale of property, plant and equipment.
Financing Activities. The change in net cash provided by (used in) financing activities from continuing operations during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to $96.2 million of net borrowings of long-term debt during the nine months ended September 30, 2018 compared to $51.5 million in net repayments of long-term debt during the nine months ended September 30, 2017, a $20.9 million decrease in distributions to noncontrolling partners in the Partnership and an $11.5 million decrease in payments for debt issuance costs. These changes were partially offset by $60.3 million of proceeds received from a public offering by the Partnership of its common units during the nine months ended September 30, 2017, a $44.7 million decrease in contributions from Exterran Corporation and a $15.6 million increase in dividends to Archrock stockholders.
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Dividends
On October 24, 2018, our board of directors declared a quarterly dividend of $0.132 per share of common stock to be paid on November 14, 2018 to stockholders of record at the close of business on November 7, 2018. Any future determinations to pay cash dividends to our stockholders will be at the discretion of our board of directors and will be dependent upon our financial condition and results of operations, credit and loan agreements in effect at that time and other factors deemed relevant by our board of directors.
Off-Balance Sheet Arrangements
For information on our obligations with respect to performance bonds and letters of credit see Note 19 (“Commitments and Contingencies”) and Note 8 (“Long-Term Debt”), respectively, to our Financial Statements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk primarily associated with changes in the variable interest rate of the Partnership Credit Facility. We use derivative instruments to manage our exposure to fluctuations in this variable interest rate and thereby minimize the risks and costs associated with financing activities. We do not use derivative instruments for trading or other speculative purposes.
As of September 30, 2018, after taking into consideration interest rate swaps, we had $326.5 million of outstanding indebtedness that was effectively subject to variable interest rates. A 1% increase in the effective interest rate on our outstanding debt subject to variable interest rates at September 30, 2018 would result in an annual increase in our interest expense of $3.3 million.
See Note 9 (“Derivatives”) to our Financial Statements for further information regarding our use of interest rate swaps in managing our exposure to interest rate fluctuations.
Item 4. Controls and Procedures
This Item 4 includes information concerning the controls and controls evaluation referred to in the certifications of our Chief Executive Officer and Chief Financial Officer required by Rule 13a-14 of the Exchange Act included in this Quarterly Report as Exhibits 31.1 and 31.2.
Management’s Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management to allow timely decisions regarding required disclosures.
As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act), which are designed to provide reasonable assurance that we are able to record, process, summarize and report the information required to be disclosed in our reports under the Exchange Act within the time periods specified in the rules and forms of the SEC. Based on the evaluation, as of September 30, 2018 our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to management, and made known to our principal executive officer and principal financial officer, on a timely basis to ensure that it is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the last fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
See Note 19 (“Commitments and Contingencies”) to our Financial Statements for a discussion of litigation related to the Heavy Equipment Statutes, which is incorporated by reference into this Item 1.
In the ordinary course of business, we are also involved in various other pending or threatened legal actions. While management is unable to predict the ultimate outcome of these actions, it believes that any ultimate liability arising from any of these other actions will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends. However, because of the inherent uncertainty of litigation and arbitration proceedings, we cannot provide assurance that the resolution of any particular claim or proceeding to which we are a party will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends.
The SEC has been conducting an investigation in connection with certain previously disclosed errors and possible irregularities at one of our former international operations. We and Exterran Corporation are cooperating with the SEC in the investigation of this matter. The SEC’s investigation related to the circumstances giving rise to the restatement of prior period consolidated and combined financial statements is continuing, and we are presently unable to predict the duration, scope or results or whether the SEC will commence any legal action.
Item 1A. Risk Factors
There have been no material changes or updates to our risk factors that were previously disclosed in our 2017 Form 10-K.
Item 2. Unregistered Sales of Equity Securities
The following table summarizes our repurchases of equity securities during the three months ended September 30, 2018:

Period |  | Total Number of Shares Repurchased (1) |  | Average Price Paid per Share |  | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs |  | Maximum Number of Shares yet to be Purchased Under the Publicly Announced Plans or Programs
July 1, 2018 - July 31, 2018 |  | 108 |  |  | $ | 12.00 |  |  | N/A |  | N/A
August 1, 2018 - August 31, 2018 |  | 54,736 |  |  | 12.55 |  |  | N/A |  | N/A
September 1, 2018 - September 30, 2018 |  | — |  |  | — |  |  | N/A |  | N/A
Total |  | 54,844 |  |  | $ | 12.55 |  |  | N/A |  | N/A

——————
(1) Represents shares withheld to satisfy employees’ tax withholding obligations in connection with vesting of restricted stock awards during the period.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
None.
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Item 6. Exhibits

Exhibit No. |  | Description
2.1 |  | Agreement and Plan of Merger, dated as of January 1, 2018, by and among Archrock, Inc., Archrock GP LLC, Archrock General Partner, L.P. and Archrock Partners, L.P., incorporated by reference to Exhibit 2.1 of Archrock’s Current Report on Form 8-K filed on January 2, 2018
2.2 |  | Amendment No. 1 to Agreement and Plan of Merger, dated as of January 11, 2018, by and among Archrock, Inc., Archrock GP LLC, Archrock General Partner, L.P., Archrock Partners, L.P. and Amethyst Merger Sub LLC, incorporated by reference to Exhibit 2.2 of Archrock’s Current Report on Form 8-K filed on January 16, 2018
3.1 |  | Restated Certificate of Incorporation of Exterran Holdings, Inc. (now Archrock, Inc.), incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K filed on August 20, 2007
3.2 |  | Certificate of Amendment of Certificate of Incorporation of Exterran Holdings, Inc. (now Archrock, Inc.), incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K filed on November 5, 2015
3.3 |  | Composite Certificate of Incorporation of Archrock, Inc. (as amended as of November 3,2015), incorporated by reference to Exhibit 3.3 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2015
3.4 |  | Third Amended and Restated Bylaws of Exterran Holdings, Inc. (now Archrock, Inc.), incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K filed on March 20, 2013
10.1 |  | Form of Employment Letter applicable to Mr. Douglas S. Aron, incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on July 12, 2018
10.2 |  | Form of Change of Control Agreement applicable to Mr. Douglas S. Aron, incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed on July 12, 2018
31.1* |  | Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2* |  | Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1** |  | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2** |  | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.1* |  | Interactive data files pursuant to Rule 405 of Regulation S-T

* | Filed herewith.

** | Furnished, not filed.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

|  | ARCHROCK, INC.
|  | By: | /s/ DOUGLAS S. ARON
|  |  | Douglas S. Aron
|  |  | Senior Vice President and Chief Financial Officer
|  |  | (Principal Financial Officer)
|  | By: | /s/ DONNA A. HENDERSON
|  |  | Donna A. Henderson
|  |  | Vice President and Chief Accounting Officer
|  |  | (Principal Accounting Officer)
|  |  | November 1, 2018

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