##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended June 30, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from              to

Commission file number 1-15603



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NATCO Group Inc.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 22-2906892                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|2950 North Loop West 7th Floor Houston, Texas                  |  | 77092                               
|(Address of principal executive offices)                       |  | (Zip Code)                          

713-683-9292

(Registrants telephone number, including area code)



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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 ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of
accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):



|                         |  |                      |  |                       
|------------------------ |  | -------------------- |  | ----------------------
|Large accelerated filer ̈ |  | Accelerated filer  x |  | Non-accelerated filer ̈

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).    Yes ̈No  x

As of July 31, 2006, the issuer had outstanding 17,240,465 shares of common stock, par value $0.01 per share.



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##### Table of Contents

NATCO GROUP INC.

FORM 10-Q

For the Quarter Ended June 30, 2006

TABLE OF CONTENTS



|           |  |                                                                                                             |  |         
|---------- |  | ----------------------------------------------------------------------------------------------------------- |  | --------
|           |  |                                                                                                             |  | Page No.
|PART I     |  | FINANCIAL INFORMATION                                                                                       |  |         
|           |  |                                                                                                            
|Item 1.    |  | Financial Statements                                                                                        |  |         
|           |  |                                                                                                            
|           |  | Condensed Consolidated Balance SheetsJune 30, 2006 (unaudited) and December 31, 2005                       |  | 2       
|           |  |                                                                                                            
|           |  | Unaudited Condensed Consolidated Statements of OperationsThree and Six Months Ended June 30, 2006 and 2005 |  | 3       
|           |  |                                                                                                            
|           |  | Unaudited Condensed Consolidated Statements of Cash FlowsSix Months Ended June 30, 2006 and 2005           |  | 4       
|           |  |                                                                                                            
|           |  | Notes to Unaudited Condensed Consolidated Financial Statements                                              |  | 5       
|           |  |                                                                                                            
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                       |  | 25      
|           |  |                                                                                                            
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                                  |  | 42      
|           |  |                                                                                                            
|Item 4.    |  | Controls and Procedures                                                                                     |  | 43      
|           |  |                                                                                                            
|PART II    |  | OTHER INFORMATION                                                                                           |  |         
|           |  |                                                                                                            
|Item 2.    |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                 |  | 44      
|           |  |                                                                                                            
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                         |  | 44      
|           |  |                                                                                                            
|Item 5.    |  | Other Events                                                                                                |  | 45      
|           |  |                                                                                                            
|Item 6.    |  | Exhibits                                                                                                    |  | 45      
|           | 
|Signatures |  | 46                                                                                                         



1



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##### Table of Contents

PART IFINANCIAL INFORMATION

Item 1.Financial Statements

NATCO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and par value data)



|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | ----------------- | - | ------- | -
|                                                                                                                                                                                                                  |  | June 30, 2006 |         | December 31, 2005 |  
|                                                                                                                                                                                                                  |  | (unaudited)   |         |                   |  
|ASSETS                                                                                                                                                                                                            |  |               |         |                   |   |         |  
|Current assets:                                                                                                                                                                                                   |  |               |         |                   |   |         |  
|Cash and cash equivalents                                                                                                                                                                                         |  | $             | 9,195   |                   | $ | 9,198   |  
|Trade accounts receivable, less allowance for doubtful accounts of $1,796 and $1,123 as of June 30, 2006 and December 31, 2005
respectively                                                                       |  |               | 123,824 |                   |   | 111,770 |  
|Inventories                                                                                                                                                                                                       |  |               | 47,279  |                   |   | 37,194  |  
|Deferred income tax assets, net                                                                                                                                                                                   |  |               | 3,698   |                   |   | 3,465   |  
|Prepaid expenses and other current assets                                                                                                                                                                         |  |               | 4,263   |                   |   | 3,612   |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Total current assets                                                                                                                                                                                              |  |               | 188,259 |                   |   | 165,239 |  
|Property, plant and equipment, net                                                                                                                                                                                |  |               | 33,175  |                   |   | 33,263  |  
|Goodwill, net                                                                                                                                                                                                     |  |               | 81,200  |                   |   | 80,891  |  
|Deferred income tax assets, net                                                                                                                                                                                   |  |               | 3,247   |                   |   | 3,329   |  
|Other assets, net                                                                                                                                                                                                 |  |               | 1,330   |                   |   | 1,021   |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Total assets                                                                                                                                                                                                      |  | $             | 307,211 |                   | $ | 283,743 |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY                                                                                                                                      |  |               |         |                   |   |         |  
|Current liabilities:                                                                                                                                                                                              |  |               |         |                   |   |         |  
|Trade accounts payable and other                                                                                                                                                                                  |  | $             | 37,257  |                   | $ | 48,720  |  
|Accrued expenses and other                                                                                                                                                                                        |  |               | 45,367  |                   |   | 41,781  |  
|Customer advanced billings and payments                                                                                                                                                                           |  |               | 32,449  |                   |   | 18,272  |  
|Current portion of long-term debt                                                                                                                                                                                 |  |               |        |                   |   | 6,429   |  
|Income taxes payable                                                                                                                                                                                              |  |               | 1,232   |                   |   | 890     |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Total current liabilities                                                                                                                                                                                         |  |               | 116,305 |                   |   | 116,092 |  
|Long-term debt, excluding current installments                                                                                                                                                                    |  |               | 19,786  |                   |   | 20,964  |  
|Long-term deferred tax liabilities                                                                                                                                                                                |  |               | 946     |                   |   | 483     |  
|Postretirement benefits and other long-term liabilities                                                                                                                                                           |  |               | 9,783   |                   |   | 9,814   |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Total liabilities                                                                                                                                                                                                 |  |               | 146,820 |                   |   | 147,353 |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Commitments and contingencies                                                                                                                                                                                     |  |               |        |                   |   |        |  
|Series B redeemable convertible preferred stock (aggregate redemption value of $15,000), $.01 par value. 15,000 shares authorized, issued and
outstanding (net of issuance costs)                                 |  |               | 14,222  |                   |   | 14,222  |  
|Stockholders equity:                                                                                                                                                                                             |  |               |         |                   |   |         |  
|Preferred stock, $.01 par value. Authorized 5,000,000 shares (of which 500,000 are designated as Series A and 15,000 are designated as Series
B); no shares issued and outstanding (except Series B shares above) |  |               |        |                   |   |        |  
|Series A preferred stock, $.01 par value. Authorized 500,000 shares; no shares issued and outstanding                                                                                                             |  |               |        |                   |   |        |  
|Common stock, $.01 par value. Authorized 50,000,000 shares; issued and outstanding 17,237,331 and 16,914,052 shares as of June 30, 2006
and December 31, 2005, respectively                                       |  |               | 173     |                   |   | 169     |  
|Additional paid-in-capital                                                                                                                                                                                        |  |               | 107,735 |                   |   | 101,671 |  
|Retained earnings                                                                                                                                                                                                 |  |               | 36,550  |                   |   | 19,914  |  
|Treasury stock, no shares and 2,550 shares at cost as of June 30, 2006 and December 31, 2005, respectively                                                                                                        |  |               |        |                   |   | (22     | )
|Accumulated other comprehensive income                                                                                                                                                                            |  |               | 1,711   |                   |   | 436     |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Total stockholders equity                                                                                                                                                                                        |  |               | 146,169 |                   |   | 122,168 |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  
|Total liabilities, redeemable convertible preferred stock and stockholders equity                                                                                                                                |  | $             | 307,211 |                   | $ | 283,743 |  
|                                                                                                                                                                                                                  |  |               |         |                   |   |         |  

See accompanying notes to unaudited condensed consolidated financial statements.



2



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------- |  | --------------------------- | ------- | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                      |  | Three Months Ended June 30, |         |   | Six Months Ended June 30, |  
|                                                                      |  | 2006                        |         |   | 2005                      |   |        | 2006 |  |   | 2005    |  
|Revenue:                                                              |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Products                                                              |  | $                           | 108,008 |   |                           | $ | 75,474 |      |  | $ | 205,014 |   |  | $ | 147,209 |  
|Services                                                              |  |                             | 20,699  |   |                           |   | 19,174 |      |  |   | 41,460  |   |  |   | 36,095  |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total revenue                                                         |  | $                           | 128,707 |   |                           | $ | 94,648 |      |  | $ | 246,474 |   |  | $ | 183,304 |  
|                                                                      |  |                             |         |  
|Cost of goods sold and services:                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Products                                                              |  | $                           | 83,760  |   |                           | $ | 61,710 |      |  | $ | 159,694 |   |  | $ | 120,135 |  
|Services                                                              |  |                             | 9,962   |   |                           |   | 10,540 |      |  |   | 20,386  |   |  |   | 19,486  |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total cost of goods sold and services                                 |  | $                           | 93,722  |   |                           | $ | 72,250 |      |  | $ | 180,080 |   |  | $ | 139,621 |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                                          |  | $                           | 34,985  |   |                           | $ | 22,398 |      |  | $ | 66,394  |   |  | $ | 43,683  |  
|Selling, general and administrative expense                           |  |                             | 16,709  |   |                           |   | 14,812 |      |  |   | 33,704  |   |  |   | 29,002  |  
|Depreciation and amortization expense                                 |  |                             | 1,418   |   |                           |   | 1,332  |      |  |   | 2,865   |   |  |   | 2,655   |  
|Closure, severance and other                                          |  |                             | 193     |   |                           |   | 48     |      |  |   | 245     |   |  |   | 90      |  
|Interest expense                                                      |  |                             | 727     |   |                           |   | 1,076  |      |  |   | 1,431   |   |  |   | 2,091   |  
|Interest cost on postretirement benefit liability                     |  |                             | 50      |   |                           |   | 210    |      |  |   | 100     |   |  |   | 420     |  
|Interest income                                                       |  |                             | (55     | ) |                           |   | (13    | )    |  |   | (119    | ) |  |   | (65     | )
|Other, net                                                            |  |                             | 578     |   |                           |   | 474    |      |  |   | 129     |   |  |   | 394     |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Income before income taxes                                            |  | $                           | 15,365  |   |                           | $ | 4,459  |      |  | $ | 28,039  |   |  | $ | 9,096   |  
|Income tax provision                                                  |  |                             | 5,838   |   |                           |   | 1,913  |      |  |   | 10,655  |   |  |   | 3,675   |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income                                                            |  | $                           | 9,527   |   |                           | $ | 2,546  |      |  | $ | 17,384  |   |  | $ | 5,421   |  
|Preferred stock dividends                                             |  |                             | 375     |   |                           |   | 375    |      |  |   | 750     |   |  |   | 750     |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income allocable to common stockholders                           |  | $                           | 9,152   |   |                           | $ | 2,171  |      |  | $ | 16,634  |   |  | $ | 4,671   |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Earnings per sharebasic:                                             |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income                                                            |  | $                           | 0.54    |   |                           | $ | 0.14   |      |  | $ | 0.99    |   |  | $ | 0.29    |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Earnings per sharediluted:                                           |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income                                                            |  | $                           | 0.50    |   |                           | $ | 0.13   |      |  | $ | 0.91    |   |  | $ | 0.29    |  
|                                                                      |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Basic weighted average number of shares of common stock outstanding   |  |                             | 16,832  |   |                           |   | 15,934 |      |  |   | 16,748  |   |  |   | 15,875  |  
|Diluted weighted average number of shares of common stock outstanding |  |                             | 19,195  |   |                           |   | 16,249 |      |  |   | 19,096  |   |  |   | 16,146  |  

See accompanying notes to unaudited condensed consolidated financial statements.



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                  |  |                           |        |   |         |   |         |  
|--------------------------------------------------------------------------------- |  | ------------------------- | ------ | - | ------- | - | ------- | -
|                                                                                  |  | Six Months Ended June 30, |       
|                                                                                  |  | 2006                      |        |   | 2005(1) |  
|Cash flows from operating activities:                                             |  |                           |        |   |         |   |         |  
|Net income                                                                        |  | $                         | 17,384 |   |         | $ | 5,421   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                           |        |   |         |   |         |  
|Deferred income tax expense                                                       |  |                           | 294    |   |         |   | 395     |  
|Depreciation and amortization expense                                             |  |                           | 2,865  |   |         |   | 2,655   |  
|Non-cash interest expense                                                         |  |                           | 172    |   |         |   | 283     |  
|Stock compensation expense                                                        |  |                           | 1,098  |   |         |   | 901     |  
|Tax benefit of stock options exercised                                            |  |                           | 366    |   |         |   | 279     |  
|Revaluation of warrants                                                           |  |                           |       |   |         |   | 549     |  
|Interest cost on postretirement benefit liability                                 |  |                           | 100    |   |         |   | 420     |  
|Net payments on postretirement benefit liability                                  |  |                           | (398   | ) |         |   | (809    | )
|Loss (Gain) on the sale of property, plant and equipment                          |  |                           | 48     |   |         |   | (371    | )
|Change in assets and liabilities:                                                 |  |                           |        |   |         |   |         |  
|(Increase) decrease in trade accounts receivable                                  |  |                           | (8,955 | ) |         |   | 1,845   |  
|(Increase) decrease in inventories                                                |  |                           | (9,626 | ) |         |   | 2,547   |  
|Increase in prepaid expense and other current assets                              |  |                           | (624   | ) |         |   | (2      | )
|(Increase) decrease in long-term assets                                           |  |                           | 38     |   |         |   | (548    | )
|Decrease in accounts payable                                                      |  |                           | (9,426 | ) |         |   | (10,521 | )
|Increase (decrease) in accrued expenses and other                                 |  |                           | 1,695  |   |         |   | (11     | )
|Increase in other income tax payable                                              |  |                           | 328    |   |         |   |        |  
|Increase in customer advanced billings and payments                               |  |                           | 13,945 |   |         |   | 3,120   |  
|                                                                                  |  |                           |        |   |         |   |         |  
|Net cash provided by operating activities                                         |  |                           | 9,305  |   |         |   | 6,153   |  
|                                                                                  |  |                           |        |   |         |   |         |  
|Cash flows from investing activities:                                             |  |                           |        |   |         |   |         |  
|Capital expenditures for property, plant and equipment                            |  |                           | (2,473 | ) |         |   | (1,803  | )
|Proceeds from the sales of property, plant and equipment                          |  |                           | 29     |   |         |   | 928     |  
|Investments in joint venture                                                      |  |                           | (412   | ) |         |   |        |  
|                                                                                  |  |                           |        |   |         |   |         |  
|Net cash used in investing activities                                             |  |                           | (2,856 | ) |         |   | (875    | )
|                                                                                  |  |                           |        |   |         |   |         |  
|Cash flows from financing activities:                                             |  |                           |        |   |         |   |         |  
|Repayments under long-term revolving credit agreements                            |  |                           |       |   |         |   | (1,584  | )
|Repayments of long-term debt                                                      |  |                           | (7,607 | ) |         |   | (3,263  | )
|Proceeds from stock issuances related to stock options, net                       |  |                           | 2,060  |   |         |   | 1,832   |  
|Excess tax benefit of stock options exercised and restricted stock                |  |                           | 2,324  |   |         |   |        |  
|Change in bank overdrafts                                                         |  |                           | (2,909 | ) |         |   | (2,768  | )
|Dividends paid                                                                    |  |                           | (750   | ) |         |   | (750    | )
|Deferred financing fees                                                           |  |                           |       |   |         |   | (115    | )
|                                                                                  |  |                           |        |   |         |   |         |  
|Net cash used in financing activities                                             |  |                           | (6,882 | ) |         |   | (6,648  | )
|                                                                                  |  |                           |        |   |         |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                      |  |                           | 430    |   |         |   | 455     |  
|                                                                                  |  |                           |        |   |         |   |         |  
|Decrease in cash and cash equivalents                                             |  |                           | (3     | ) |         |   | (915    | )
|Cash and cash equivalents at beginning of period                                  |  |                           | 9,198  |   |         |   | 2,194   |  
|                                                                                  |  |                           |        |   |         |   |         |  
|Cash and cash equivalents at end of period                                        |  |                           | 9,195  |   |         | $ | 1,279   |  
|                                                                                  |  |                           |        |   |         |   |         |  
|Cash payments for:                                                                |  |                           |        |   |         |   |         |  
|Interest                                                                          |  | $                         | 1,065  |   |         | $ | 1, 634  |  
|Income taxes                                                                      |  | $                         | 7,043  |   |         | $ | 3,892   |  

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|(1) | The line item Net payments on postretirement benefit liability has been
reclassified from cash flows from financing activities to cash flows from operating activities for period presented. Net cash used in investing activities and Decrease in cash and cash equivalents in total were unaffected
from this reclassification. Refer to Note 1, Basis of Presentation and Reclassifications, in the accompanying Notes to Unaudited Condensed Consolidated Financial Statements for further information.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

See accompanying notes to unaudited condensed consolidated financial statements.



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) Basis of Presentation and Reclassifications

Basis of Presentation

The accompanying condensed consolidated interim financial statements and
related disclosures are unaudited and have been prepared by NATCO Group Inc. pursuant to accounting principles generally accepted in the United States of America (US GAAP) for interim consolidated financial statements and the rules and
regulations of the United States Securities and Exchange Commission. As permitted by these regulations, certain information and footnote disclosures that would typically be required in financial statements prepared in accordance with US GAAP
have been condensed or omitted. However, the Companys management believes that these statements reflect all the normal recurring adjustments necessary for a fair presentation, in all material respects, of the results of operations for the
periods presented, so that these interim financial statements are not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the
Companys Annual Report on Form 10-K filing for the year ended December 31, 2005.

To prepare financial statements in accordance
with generally accepted accounting principles, the Companys management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of
the financial statements, and reported amounts of revenues and expenses incurred during the reporting period. Actual results could differ from those estimates.

References to NATCO and the Company are used throughout this document and relate collectively to NATCO Group Inc. and its consolidated subsidiaries.

Reclassifications

Certain
reclassifications have been made to the fiscal year 2005 amounts in order to present these results on a comparable basis with amounts for fiscal year 2006. These reclassifications had no effect on net income.

The Companys previous accounting policy was to classify cash flows from its net postretirement benefit liability as a financing activity in our
consolidated statements of cash flows because the retirees covered were never employed by the Company and the decision to assume the obligation was a financing determination made at the time of the 1989 acquisition of National Tank Company and W.S.
Tyler, Inc. The estimated postretirement liability directly impacted the purchase price for these assets and also impacted the overall financing consideration and structure of the transaction.

Paragraph 18 of the Statement of Financial Accounting Standards (SFAS) No. 95 states financing activities include obtaining
resources from owners and providing them with a return on, and a return of, their investment; borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors
on long-term credit and paragraph 21 of SFAS No. 95 states Operating activities include all transactions and other events that are not defined as investing or financing activities. Since, the lines Net payments on
postretirement benefit liability on the Companys unaudited condensed consolidated statement of cash flow are not included in the scope of what is defined as financing activities in paragraph 18 of SFAS No. 95, the Company therefore
believes the lines Net payments on postretirement benefit liability on our unaudited condensed consolidated statement of cash flow relate to operating activities of the Company rather than financing activities as previously reported. The
Company has amended the unaudited condensed consolidated statement of cash flow included in this report to be in accordance with SFAS No. 95.



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



For the six months ended June 30, 2005, the Company reclassified the postretirement payments and
receipts as operating activities from financing activities in the unaudited consolidated statement of cash flow. For the six months ended June 30, 2005, this reclassification had the effect of reducing net cash provided by operating activities
of $809,000 and increasing net cash used in financing activities by $809,000 from that previously reported. This reclassification does not impact the unaudited condensed consolidated statement of operation or the Net cash used in investing
activities and Decrease in cash and cash equivalents in total on the unaudited condensed consolidated statement of cash flow.

(2)
Inventories

Inventories consisted of the following amounts:



|                                         |  |                |        |   |                   |   |        |  
|---------------------------------------- |  | -------------- | ------ | - | ----------------- | - | ------ | -
|                                         |  | June 30, 2006  |        |   | December 31, 2005 |  
|                                         |  | (unaudited)    |        |   |                   |  
|                                         |  | (in thousands) |       
|Finished goods                           |  | $              | 9,752  |   |                   | $ | 9,670  |  
|Work-in-process                          |  |                | 22,965 |   |                   |   | 15,138 |  
|Raw materials and supplies               |  |                | 20,510 |   |                   |   | 17,180 |  
|                                         |  |                |        |   |                   |   |        |  
|Inventories at FIFO and weighted average |  |                | 53,227 |   |                   |   | 41,988 |  
|Excess of FIFO over LIFO cost            |  |                | (5,948 | ) |                   |   | (4,794 | )
|                                         |  |                |        |   |                   |   |        |  
|Net inventories                          |  | $              | 47,279 |   |                   | $ | 37,194 |  
|                                         |  |                |        |   |                   |   |        |  

The Companys net inventories as of June 30, 2006 and December 31, 2005 by
valuation method are shown below:



|                      |  |                |        |                  |   |       
|--------------------- |  | -------------- | ------ | ---------------- | - | ------
|                      |  | June 30,2006   |        | December 31,2005
|                      |  | (unaudited)    |        |                 
|                      |  | (in thousands)
|FIFO                  |  | $              | 9,799  |                  | $ | 7,556 
|Weighted average cost |  |                | 771    |                  |   | 845   
|LIFO                  |  |                | 36,729 |                  |   | 28,793
|                      |  |                |        |                  |   |       
|Net inventories       |  | $              | 47,279 |                  | $ | 37,194
|                      |  |                |        |                  |   |       

There were no reductions in LIFO layers as of June 30, 2006 and December 31, 2005.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(3) Costs and Estimated Earnings on Uncompleted Contracts

Costs and estimated earnings on uncompleted contracts were as follows:



|                                                                  |  |                |         |   |                   |   |         |  
|----------------------------------------------------------------- |  | -------------- | ------- | - | ----------------- | - | ------- | -
|                                                                  |  | June 30, 2006  |         |   | December 31, 2005 |  
|                                                                  |  | (unaudited)    |         |   |                   |  
|                                                                  |  | (in thousands) |        
|Cost incurred on uncompleted contracts                            |  | $              | 168,214 |   |                   | $ | 109,757 |  
|Estimated earnings                                                |  |                | 54,101  |   |                   |   | 34,419  |  
|                                                                  |  |                |         |   |                   |   |         |  
|                                                                  |  |                | 222,315 |   |                   |   | 144,176 |  
|Less billings to date                                             |  |                | 216,626 |   |                   |   | 128,516 |  
|                                                                  |  |                |         |   |                   |   |         |  
|                                                                  |  | $              | 5,689   |   |                   | $ | 15,660  |  
|                                                                  |  |                |         |   |                   |   |         |  
|Included in the accompanying balance sheet under the captions(1): |  |                |         |   |                   |   |         |  
|Trade accounts receivable                                         |  | $              | 33,439  |   |                   | $ | 30,705  |  
|Customer advanced billings and payments                           |  |                | (27,750 | ) |                   |   | (15,045 | )
|                                                                  |  |                |         |   |                   |   |         |  
|                                                                  |  | $              | 5,689   |   |                   | $ | 15,660  |  
|                                                                  |  |                |         |   |                   |   |         |  

---

|(1) | Trade accounts receivable and Customer advanced billings and payments
in this table relate only to major contracts and therefore will not tie to the balance sheet accounts Trade accounts receivable and Customer advanced billings and payments.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

(4) Goodwill and Intangible Assets

In accordance
with SFAS No. 142, Goodwill and Other Intangible Assets, the Company evaluates intangible assets with indefinite lives, including goodwill, on an impairment basis, while intangible assets with a defined term, such as patents, are
amortized over the useful life of the asset.

Goodwill

Net goodwill of $81.2 million and $80.9 million at June 30, 2006 and December 31, 2005, was comprised of $47.6 and $47.4 million for the Oil & Water Technologies reporting unit, $29.2 million and
$29.1 million for the Gas Technologies reporting unit, $4.4 million and $4.4 million for the Automation & Controls reporting unit, respectively. The increase of $0.3 million in net goodwill was due entirely to the fluctuation in the
exchange rates between the US currency and Canadian currency.

In accordance with SFAS No. 142, the Company tested each business
segment for impairment of goodwill at December 31, 2005, and, based upon the results of this testing, management determined that goodwill was not impaired. The Company will test each business segment for goodwill impairment annually, as
required by the pronouncement, or more frequently if there are indications of goodwill impairment. No additional testing was performed during the quarter ended June 30, 2006, as management noted no indications of goodwill impairment.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Intangible assets

Intangible assets subject to amortization as of June 30, 2006 and December 31, 2005 were:



|                          |  |                       |       |                          |   |                       |  |                          |       |  |   |    
|------------------------- |  | --------------------- | ----- | ------------------------ | - | --------------------- |  | ------------------------ | ----- |  | - | ---
|                          |  | As of June 30, 2006   |       | As of December 31, 2005 
|                          |  | Gross Carrying Amount |       | Accumulated Amortization |   | Gross Carrying Amount |  | Accumulated Amortization
|                          |  | (unaudited)           |       |                          |   |                      
|                          |  |                       |       | (in thousands)           |   |                      
|Type of Intangible Assets |  |                       |       |                          |   |                       |  |                          |       |  |   |    
|Deferred financing fees   |  |                       | 1,192 |                          | $ | 883                   |  | $                        | 1,112 |  | $ | 711
|Patents                   |  |                       | 582   |                          |   | 99                    |  |                          | 195   |  |   | 77 
|Other                     |  |                       | 693   |                          |   | 168                   |  |                          | 621   |  |   | 128
|                          |  |                       |       |                          |   |                      |  |                          |      |  |   |   
|                          |  |                       |       |                          |   |                       |  |                          |       |  |   |    
|Total                     |  | $                     | 2,467 |                          | $ | 1,149                 |  | $                        | 1,928 |  | $ | 916
|                          |  |                       |       |                          |   |                       |  |                          |       |  |   |    

The increase in intangible assets for the six months ended June 30, 2006 was primarily due to the
investment in intangible assets during the first quarter of 2006 when the Company purchased a 50% ownership interest in a joint venture that fabricates a pilotless ignition system for controlling gas-fired heaters used in connection with oil and gas
wellhead equipment.

Amortization expense of $132,000 and $151,000 was recognized related to primarily Deferred financing fees, Patents and
Other for the three and six months ended June 30, 2006 compared to $106,000 and $114,000 for the three and six months ended June 30, 2005. The estimated aggregate amortization expense for these Intangible assets for the fiscal year ending
December 31, 2006 is $225,000 and for each of the following four fiscal years; 2007$105,000; 2008$105,000; 2009$105,000; and 2010$105,000. For segment reporting purposes, these intangible assets and the related
accumulated amortization expense were allocated to each segment.

(5) Warranty Costs

Estimated future warranty obligations related to products are charged to cost of goods sold in the period in which the related revenue is recognized. A
tabular reconciliation of the changes in the Companys aggregate product warranty liability included in the Companys Condensed Consolidated Balance Sheet liability account Accrued expenses and other for the six months ended
June 30, 2006 is set forth below (unaudited, in thousands).



|                             |  |   |        |  
|---------------------------- |  | - | ------ | -
|Balance at December 31, 2005 |  | $ | 2,773  |  
|Payments/charges             |  |   | (1,233 | )
|Net accruals                 |  |   | 1,437  |  
|Foreign currency translation |  |   | 96     |  
|                             |  |   |        |  
|Balance at June 30, 2006     |  | $ | 3,073  |  
|                             |  |   |        |  

(6) Closure, Severance and Other

On December 15, 2005, the Board of Directors approved the final phase of restructuring the Companys UK operations by consolidating the
Gloucester, England office into our Camberley, England location. At June 30, 2006, the Company had a liability remaining of $198,000 with respect to this phase of the UK restructuring. The Company expects to incur additional costs in the three
months ended September 30, 2006 related to the



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



rationalization of office lease expenses associated with vacating the Gloucester site and consolidating facilities into a Camberley location, which will be
finalized as of September 30, 2006. These items are accounted for as Operating expense or as Closure, severance and other during the nine months ending September 30, 2006. As of June 30, 2006, $424,000 in costs were incurred and the
remaining costs were estimated to be from $2.0 million to $2.7 million.

During the third quarter of 2005, severance costs of approximately
$799,000 were recorded related to redundancy of certain personnel in the Companys UK operations. As of December 31, 2005, the Company had no remaining liability related to personnel.

Pursuant to an amendment to his then effective employment agreement with the Company entered into in September 2005, Mr. Patrick M. McCarthy agreed
to continue as President of the Company in exchange for certain benefits and payments which included, among other things, payment of certain severance benefits, a guaranteed bonus for 2005, acceleration of vesting of certain options, lapse in
restrictions on a portion of his restricted stock awards and continuation of certain health benefits following termination. The Company recorded a charge of $1.2 million in the third quarter of 2005 related to this amendment, in addition to the
previously accrued expense of $155,000 related to his 2005 bonus. The Company will incur additional charges with respect to the lapse of restrictions on the remaining two-thirds of the restricted stock awarded to Mr. McCarthy in 2005. A portion
of these charges was accrued and expensed over the then estimated remaining term of the prior employment agreement, as amended, through the effective date of the Employment Agreement. The Company did not incur additional charges with respect to
effectiveness of the Employment Agreement.

On June 26, 2006, the Company and Mr. McCarthy entered into an amended and restated
Employment Agreement (the Employment Agreement), which became effective July 1, 2006. Under the terms of the Employment Agreement, which was reviewed and approved by the Companys Board of Directors, Mr. McCarthy was named
as the Companys Chief Operating Officer and will continue to serve as President until July 1, 2009.

In December 2004, the
Company recorded severance expense of $1.3 million related to a restructuring plan that included involuntary termination of certain administrative and operating personnel in the UK and Canada. The Company recorded facility closure costs of $69,000
and made cumulative payments of $1.0 million in the first three quarters of 2005 related to this plan. The Company also recorded a gain of $388,000 on the sale of a facility in the UK during the first quarter of 2005. Additionally, the Company took
a valuation adjustment charge of approximately $249,000 for the year ended 2005, and a $245,000 valuation adjustment charge for six months ended June 30, 2006 related to this restructuring plan in Canada. The Company also reversed approximately
$216,000 of previously accrued amounts during 2005. At June 30, 2006, the Company had a liability of approximately $555,000 related to this restructuring plan.

On July 28, 2004, the Company entered into a Separation Agreement with Mr. Nathaniel A. Gregory, then the Companys CEO, pursuant to which Mr. Gregory stepped down as Chairman of the Board of
Directors on that date and agreed to resign from the Company on September 7, 2004. The Company recorded an expense of approximately $2.5 million related to (1) severance payments, (2) continuation of Mr. Gregorys welfare
benefits for a period of 36 months following separation, (3) extending the exercise dates for Mr. Gregorys outstanding options to 18 months following the separation date (for which the Company recorded approximately $62,000 for stock
based employee compensation expense), (4) payment of certain of his attorneys fees in connection with the Separation Agreement and (5) reimbursement of certain moving expenses. The Company paid $2.4 million of this amount through
December 31, 2005. As of June 30, 2006, the Company had a liability of $29,000 related to the separation agreement.



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Following is a summary of Closure, severance and other expense:



|                            |  |                                          |     |                                        |   |      |  |      |     |  |   |   
|--------------------------- |  | ---------------------------------------- | --- | -------------------------------------- | - | ---- |  | ---- | --- |  | - | --
|                            |  | For the three months ended
June 30, 2006 |     | For the six months ended
June 30, 2006
|                            |  | 2006                                     |     | 2005                                   |   | 2006 |  | 2005
|                            |  | (unaudited, in thousands)                |     | (unaudited, in thousands)             
|Severance                   |  | $                                        | 193 |                                        | $ |     |  | $    | 244 |  | $ | 42
|Leasehold termination       |  |                                          |    |                                        |   |     |  |      |    |  |   |  
|Contract expenses and other |  |                                          |    |                                        |   | 48   |  |      | 1   |  |   | 48
|                            |  |                                          |     |                                        |   |      |  |      |     |  |   |   
|                            |  | $                                        | 193 |                                        | $ | 48   |  | $    | 245 |  | $ | 90
|                            |  |                                          |     |                                        |   |      |  |      |     |  |   |   

A roll forward of the Companys accrued Closure, severance and other expense from
December 31, 2005 to June 30, 2006 follows (unaudited, in thousands):



|                             |  |   |       |  
|---------------------------- |  | - | ----- | -
|Balance at December 31, 2005 |  | $ | 2,197 |  
|Payments                     |  |   | (774  | )
|Severance accrual, net       |  |   | 245   |  
|Foreign exchange impact      |  |   | 53    |  
|                             |  |   |       |  
|Balance at June 30, 2006     |  |   | 1,721 |  
|                             |  |   |       |  

The estimated payment schedule for these liabilities at June 30, 2006 is $746,000 in 2006,
$541,000 in 2007, $0 in 2008 and $434,000 in 2009.

(7) Income Taxes

NATCOs effective income tax rate for the six months ended June 30, 2006 and 2005 was 38.0% and 40.4%, respectively, which exceeded the amount that would have resulted from applying the U.S. federal
statutory tax rate due to the impact of state income taxes, foreign income tax rate differentials, and the change in valuation allowances recorded. The decrease in the effective tax rate was primarily attributable to a decrease in permanent
differences due to the mark-to-market expense on warrants exercised in 2005. Our tax filings for various periods are subjected to audit by tax authorities in most jurisdictions where we conduct business. Although we believe we have adequately
provided for income taxes, the ultimate outcome of tax audits may differ from the amounts recorded in our financial statements. Such determinations could materially affect our financial results in that period or such periods for which such
determination is made.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(8) Debt

The Company had the following consolidated borrowings as of the date indicated(1):



|                                                                                                                                                                 |  |                |        |                   |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------ | ----------------- | - | ------ | -
|                                                                                                                                                                 |  | June 30,2006   |        | December 31, 2005 |  
|                                                                                                                                                                 |  | (unaudited)    |        |                   |  
|                                                                                                                                                                 |  | (in thousands) |       
|2004 term loan with variable interest rate (7.13% to 9.25% at June 30, 2006) and quarterly payments of principal and interest of
$1.6 million due March 31, 2007 |  | $              | 19,786 |                   | $ | 27,393 |  
|2004 revolving credit bank loans with variable interest rate and quarterly interest payments, due March 31, 2007                                                 |  |                |       |                   |   |       |  
|Revolving credit bank loans (export sales facility) with variable interest rate and monthly interest payments, due March 31,
2007                                |  |                |       |                   |   |       |  
|                                                                                                                                                                 |  |                |        |                   |   |        |  
|Total                                                                                                                                                            |  | $              | 19,786 |                   | $ | 27,393 |  
|Less current installments                                                                                                                                        |  |                |       |                   |   | (6,429 | )
|                                                                                                                                                                 |  |                |        |                   |   |        |  
|Long-term debt                                                                                                                                                   |  | $              | 19,786 |                   | $ | 20,964 |  
|                                                                                                                                                                 |  |                |        |                   |   |        |  

---

|(1) | On July 12, 2006, the Company entered into a new revolving credit facility pursuant to
which the term debt under the 2004 term loan became revolving debt under the 2006 revolving credit facilities with a maturity of June 30, 2011.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2004 Term Loan and Revolving Credit Facilities

Our 2004 term loan and revolving credit facilities,
in effect from March 2004 to July 12, 2006, provided for a term loan of $45.0 million and a revolving credit facility providing for aggregate additional borrowings of $35.0 million, consisting of a US revolving facility with a borrowing
capacity of $20.0 million, a Canadian revolving facility with a borrowing capacity of $5.0 million, and a UK revolving credit facility with a borrowing capacity of $10.0 million. These facilities were to mature on March 15, 2007.

Beginning in June 2004, the 2004 term loan and revolving credit facilities required quarterly payments of $1.6 million. We borrowed funds under the 2004
term loan and revolving credit facilities to retire debt outstanding under a 2004 term loan and revolving credit facilities as of March 15, 2004. At June 30, 2006 we have not classified any portion of this loan as current due to the
refinancing on July 12, 2006.

In 2006, we prepaid $4.4 million of the 2004 term loan and revolving credit facilities, of which $3.0
million was prepaid in the quarter ended June 30, 2006. In 2005, we prepaid $6.4 million of the 2004 term loan and revolving credit facilities. Additionally, we prepaid in 2005 $1.1 million, representing the remaining balance, on the long-term
promissory note on our manufacturing facility in Magnolia, Texas.

We incurred an additional $995,000 of deferred loan costs related to the
2004 term loan and revolving credit facilities, which we amortized as interest expense. We also incurred approximately $115,000 of deferred loan cost primarily during the first quarter of 2005 associated with an amendment to the 2004 term loan and
revolving credit facilities. This additional cost was amortized over the term of the amendment, which ended June 2005.

The 2004 term loan
and revolving credit facilities agreement provided for interest at a rate based upon the ratio of Funded Debt to EBITDA, as defined in the facilities and ranging from, at our election, (1) a high of



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



LIBOR plus 2.75% to a low of LIBOR plus 2.00% or (2) a high of a Base Rate plus 1.75% to a low of a Base Rate plus 1.00%. We paid commitment fees
related to this agreement on the undrawn portion of the facility, 0.375% as of June 30, 2006, depending upon the ratio of Funded Debt to EBITDA.

We had borrowings of $19.8 million outstanding under the term loan portion of the 2004 term loan and revolving credit facilities at June 30, 2006, which bore interest at 7.13% to 9.25% with a weighted average interest
rate of 7.49%. There were no borrowings outstanding for the revolving credit portion of the 2004 term loan and revolving credit facilities at June 30, 2006. We had letters of credit outstanding under the 2004 term loan and revolving credit
facilities of $9.1 million at June 30, 2006. Availability under our 2004 term loan and revolving credit facilities is reduced by the amount of our outstanding letters of credit and loans. Fees related to these letters of credit at June 30,
2006 were approximately 2.00% of the outstanding balance. These letters of credit support contract performance and warranties and were to expire at various dates through June 2008.

We and our operating subsidiaries guaranteed our 2004 term loan and revolving credit facilities agreement, which were secured by a first lien or first
priority security interest in or pledge of substantially all of the assets of the borrowers and certain subsidiaries, including accounts receivable, inventory, equipment, intangibles, equity interests in US subsidiaries, 661/3% of the equity interest in active, non-US subsidiaries and interests in certain contracts. Our assets and our
active US subsidiaries secure the US, Canadian and UK revolving facilities, assets of our Canadian subsidiary also secure the Canadian facility and assets of our UK subsidiaries also secure the UK facility. The US facility was guaranteed by each of
our US subsidiaries, while the Canadian and UK facilities were guaranteed by us, each of our US subsidiaries and the Canadian subsidiary or the UK subsidiaries, as applicable.

The 2004 term loan and revolving credit facilities agreement contained restrictive covenants including, among others, those that limit the amount of
Funded Debt to EBITDA, impose a minimum fixed charge coverage ratio and a minimum net worth requirement. We were in compliance with all restrictive debt covenants in our loan agreements as of June 30, 2006. In March 2005, the Companys
lenders approved the amendment of various provisions of the 2004 term loan and revolving facilities effective January 1, 2005. This amendment revised certain restrictive debt covenants for a two quarter period, modified certain defined terms
and changes the submission of financial statements to the lenders to more closely reflect the SEC requirements for furnishing financial information.

2006 Revolving Credit Facilities

On July 12, 2006, we entered into a new revolving facilities
agreement, referred to as the 2006 revolving credit facilities of a total of $85.0 million, consisting of a US revolving facility with a borrowing capacity of $65.0 million, a Canadian revolving facility with a borrowing capacity of $5.0 million and
a UK revolving facility with a borrowing capacity of $15.0 million, and terminated the 2004 term loan and revolving credit facilities. These 2006 revolving credit facilities are scheduled to mature on June 30, 2011. The borrowing capacities
under the 2006 revolving credit facilities agreement are not subject to any monthly borrowing base limitations. In addition to the base commitments, the new facilities permit the Company to require an increase in the aggregate borrowing capacity by
$50.0 million if certain requirements are met.

The 2006 revolving credit facilities agreement provides for interest at a rate based upon
the ratio of Funded Debt to EBITDA, as defined in the credit facility (EBITDA), and ranging from, at the Companys election, (1) a low of the London Interbank Offered Rate (LIBOR) plus 1.00% to a high of LIBOR plus
2.00% or (2) a low of a Base Rate, as defined in the credit facility (Base Rate) plus 0.00% to a high of a Base Rate plus 1.00%. The Company will pay commitment fees related to this agreement on the undrawn portion of the facility,
depending upon the ratio of Funded Debt to EBITDA, which were calculated at 0.25% at July 12, 2006.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Aggregate borrowings of $18.0 million were outstanding under 2006 revolving credit facilities at
July 12, 2006, which bore interest at an average rate of 8.25%. The Company had letters of credit outstanding of $9.3 million at July 12, 2006. Fees related to these letters of credit were approximately 1.0% of the outstanding balance at
July 12, 2006. These letters of credit support contract performance and warranties and expire at various dates through June 2008.

The
2006 revolving credit facilities agreement is secured by a first lien or first priority security interest in or pledge of substantially all of the assets of the borrowers and certain subsidiaries, including accounts receivable, inventory, equipment,
intangibles, equity interests in US subsidiaries, 661/3% of the equity interest in active, non-US subsidiaries
and interests in certain contracts. Assets of the Company and its active US subsidiaries secure the US, Canadian, UK revolving facilities, assets of the Companys Canadian subsidiary also secure the Canadian facility and assets of the
Companys UK subsidiaries also secure the UK facility. The US facility is guaranteed by each US subsidiary of the Company, while the Canadian and UK facilities are guaranteed by NATCO Group Inc., each of its US subsidiaries and the Canadian
subsidiary or the UK subsidiaries, as applicable.

The 2006 revolving credit facilities agreement contains restrictive covenants
including, among others, those that limit the amount of Funded Debt to EBITDA, impose a minimum fixed charge coverage ratio and impose a minimum net worth requirement. Pursuant to the 2006 revolving credit facilities, NATCO is not permitted to make
any distributions of any property or cash to the Company or its stockholders other than dividends required under its Series B Preferred Stock and certain other dividends not to exceed, in the aggregate, $3.0 million per year, if certain conditions
related to Funded Debt to EBITDA and borrowing capacity are met or $1.5 million per year, in the aggregate, if such conditions are not met. Subject to certain restrictions, the Company also has the ability to buy back up to $25.0 million in value of
its common stock.

Promissory Note on Real Estate Loan

On February 6, 2002, the Company borrowed $1.5 million under a long-term promissory note to finance the purchase of a manufacturing facility in Magnolia, Texas. This note accrued interest at the 90-day LIBOR plus
3.25%, and required quarterly payments of principal of approximately $24,000 and interest for five years beginning May 2002, with a final balloon payment due February 2007. This promissory note was collateralized by the manufacturing facility in
Magnolia, Texas. This note was paid in full during the third quarter of 2005.

Export Sales Facility

On July 23, 2004, the Company and two of its subsidiaries entered into an international revolving credit agreement with Wells Fargo HSBC Trade Bank,
N.A. providing for loans of up to $10.0 million, subject to borrowing base limitations. This working capital facility for export sales is secured by specific project inventory and receivables, as well as certain other inventory, accounts receivable
and equipment, and is partially guaranteed by the US Export-Import Bank. Loans under this facility mature on March 31, 2007, and bear interest at either (1) a Base Rate, as defined in the agreement, less 0.25% or (2) LIBOR plus 2.00%,
at the Companys election. Letters of credit outstanding under this facility as of June 30, 2006 were $6.8 million. This facility had fees related to letters of credit of approximately 1.00% of the outstanding balance for the period
December 31, 2005 to June 30, 2006.

Other

At June 30, 2006, the Company also had unsecured letters of credit and bonds totaling $212,000 and performance guarantees totaling $37.5 million, which expire at various dates through January 2009.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(9) Postretirement Benefits

The Company maintains postretirement benefit plans that provide health care and life insurance benefits for retired employees of a predecessor company. These plans are accounted for in accordance with SFAS
No. 106, Employers Accounting for Postretirement Benefits Other than Pensions. The Company has recorded a liability based upon the actuarially determined accumulated postretirement benefit obligation associated with these
plans.

The Company has adopted SFAS No. 132, Employers Accounting for Pensions and Other Postretirement Benefits,
which revised disclosures about pension and other postretirement benefit plans. Disclosures regarding postretirement benefits represent health care and life insurance benefits for employees who were retired when the Company was acquired from
Combustion Engineering.

From May 2004 to December 31, 2005, the Company accounted for the prescription drug benefit under its retiree
medical plans in accordance with SFAS No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. This pronouncement required the Company to determine
whether or not the benefits provided under its plans were actuarially equivalent to the Medicare prescription drug-benefit. If the benefits provided were actuarially equivalent and this federal subsidy were deemed a significant event,
the Company was required to account for the federal subsidy attributable to past services as an actuarial gain under SFAS No. 106 and to reduce the accumulated postretirement benefit obligation. On December 31, 2005, the Company amended
the postretirement benefit plans to eliminate prescription drug coverage for post-age 65 participants along with increases in retiree premiums and elimination of dental coverage for one of the groups of retirees of a predecessor company. Under the
amended plans, retirees bear additional costs of coverage. As a result, SFAS No. 106-2 no longer applies to the Company starting January 1, 2006, and our SFAS No. 106 net periodic cost has been reduced since that date. As of
December 31, 2005 the recorded liability for the accumulated postretirement benefit obligation was $10.0 million, while the actuarially determined amount for this obligation was $7.8 million.

The following table summarizes the components of net periodic benefit cost under the Companys postretirement benefit plans as of June 30, 2006
and 2005, respectively:



|                                |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  
|------------------------------- |  | -------------------------- | ---- | - | ------------------------ | - | ---- | ---- |  | - | ---- | - |  | - | ---- | -
|                                |  | Three Months EndedJune 30, |      |   | Six Months EndedJune 30, |  
|                                |  | 2006                       |      |   | 2005                     |   |      | 2006 |  |   | 2005 |  
|                                |  | (unaudited, in thousands)  |     
|Unrecognized prior service cost |  | $                          | (334 | ) |                          | $ | (177 | )    |  | $ | (668 | ) |  | $ | (354 | )
|Interest cost                   |  |                            | 108  |   |                          |   | 210  |      |  |   | 215  |   |  |   | 420  |  
|Unrecognized loss               |  |                            | 276  |   |                          |   | 177  |      |  |   | 553  |   |  |   | 354  |  
|                                |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  
|Net periodic benefit cost(1)    |  | $                          | 50   |   |                          | $ | 210  |      |  | $ | 100  |   |  | $ | 420  |  

---

|(1) | Net periodic benefit cost is referred to as Interest cost on postretirement benefit
liability in the Unaudited Condensed Consolidated Statements of Operations and the reconciliation of the total segment profit to net income in Note 14, Industry Segments and Geographic Information.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

(10) Litigation

NATCO and its subsidiaries are
defendants or otherwise involved in a number of other legal proceedings in the ordinary course of their business. While we insure against the risk of these proceedings to the extent deemed prudent by our management, we can offer no assurance that
the type or value of this insurance will meet the liabilities that may arise from any pending or future legal proceedings related to our business activities. While we cannot predict the outcome of any legal proceedings with certainty, in the opinion
of management, our ultimate liability with respect to these pending lawsuits is not expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows.



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(11) Stock-Based Compensation

Stock-Based Compensation information under SFAS No. 123R

In December 2004, the Financial
Accounting Standards Board (FASB) issued SFAS No. 123 (Revised 2004), Share-Based Payment (123R). This amendment requires expensing of stock options and other share-based payments and supersedes SFAS No. 123 which
allowed companies to choose between expensing stock options or showing pro forma disclosure only. This standard became effective for the Company as of January 1, 2006 and applies to all awards granted, modified, cancelled or repurchased after
that date as well as the unvested portion of prior awards.

On November 10, 2005, the FASB issued a FASB Staff Position
(FSP) FAS 123 R-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company is currently evaluating the alternative methods provided in this Statement and has one year from the date
of its initial adoption of SFAS No. 123R to make a one-time election to employ one of the methods.

Certain of our employees and
non-employee directors participate in long-term incentive compensation plans that provide, among other things, for grants of options to acquire shares of the Companys common stock, and awards of restricted stock and other forms of stock-based
compensation. Stock options currently outstanding under these plans have no performance requirements, vest annually over periods of three to four years and have a maximum term of up to ten years. The Company had 941,373 shares available for future
awards under its incentive compensation plans as of June 30, 2006. Under SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as an expense over the
employees requisite service period. The requisite service period for stock options and fixed awards are based on the vesting period determined at date of grant. The requisite service period for performance-based awards is based on the best
estimate of the period over which the performance criteria is expected to be met. Under the Companys restricted stock program, the fair market value of the stock awards is determined on the date of grant and is amortized and ratably charged to
income. The program has both fixed and performance-based awards. Under SFAS No. 123R, fixed awards are amortized over the vesting period provided in the award (generally, from one to three years), while performance awards are amortized over the
period the Company expects will be required to meet the performance requirements. The Company uses a modified prospective application methodology permitted under SFAS No. 123R, which provides for certain changes to the method for valuing
share-based compensation. Under the modified prospective application, prior periods are not revised for comparative purposes.

The Company
values share-based options by applying the Black-Scholes-Merton Single OptionReduced Term valuation method which was previously used for the Companys pro forma information required under SFAS Nos. 123 and 148. This valuation model
requires management to make subjective assumptions about the volatility of the Companys common stock, the expected term of outstanding stock options, the Companys risk-free interest rate and expected dividend payments during the
contractual life of the options.

The following assumptions were used to determine the fair value of stock option awards granted during the
three and six months ended June 30, 2006:



|                        |  |                                 |  |                              
|----------------------- |  | ------------------------------- |  | -----------------------------
|                        |  | Three Months EndedJune 30, 2006 |  | Six Months EndedJune 30, 2006
|                        |  | (unaudited)                     |  | (unaudited)                  
|Expected term           |  | 6.0 years                       |  | 6.0 years                    
|Volatility              |  | 45.00%                          |  | 45.00%                       
|Risk-free interest rate |  | 4.76% - 4.91%                   |  | 4.22% - 4.91%                
|Dividend yield          |  | 0.00%                           |  | 0.00%                        



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Volatility was evaluated based upon historical data of the Companys stock price from the New
York Stock Exchange from the date of our initial public offering, January 28, 2000, to January 1, 2006.

The risk-free interest
rate, as determined on the date of grant, was based upon observed interest rates associated with U.S. Treasury zero coupon instruments with a term similar to the expected term calculated as discussed below. The Company does not anticipate paying any
dividends for the foreseeable future.

The expected term for options was six years and was computed using the Simplified Method
as permitted by SFAS No. 123R. This assumption was based on the Companys opinion that the current robust environment may not necessarily reflect future exercise behavior and that historical data for the previous years approximates this
term.

Share-based compensation expense was recognized in the Unaudited Condensed Consolidated Statement of Operations for the three months
and six months ended June 30, 2006 based on awards ultimately expected to vest. SFAS No. 123R requires forfeitures to be estimated at the date of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. Forfeitures were estimated at 8.5% and 2.5%, respectively for stock options granted and restricted stock awarded during the three and six months ended June 30, 2006 based on the Companys historical cancellation and
forfeiture experience. It was determined that the cumulative effect of compensation cost associated with the estimated forfeitures was immaterial.

The components of total estimated share-based compensation expense, related to all of the Companys share-based awards, recognized for the three and six months ended June 30, 2006 follow:



|                                                      |  |                                 |      |   |                               |   |       |  
|----------------------------------------------------- |  | ------------------------------- | ---- | - | ----------------------------- | - | ----- | -
|                                                      |  | Three Months EndedJune 30,
2006 |      |   | Six Months EndedJune 30, 2006 |  
|                                                      |  | (unaudited, in thousands)       |     
|Share-based compensation expense                      |  | $                               | 485  |   |                               | $ | 1,098 |  
|Less: Tax benefit of share-based compensation expense |  |                                 | (184 | ) |                               |   | (417  | )
|                                                      |  |                                 |      |   |                               |   |       |  
|Share-based compensation expense, net of tax          |  | $                               | 301  |   |                               | $ | 681   |  
|                                                      |  |                                 |      |   |                               |   |       |  

Reconciliation

A tabular reconciliation of the changes in long-term incentive compensation plans for the six months ended June 30, 2006 is set forth below
(unaudited).



|                             |  |                     |   |  |                               |       |                                          |      |                                        |   |       
|---------------------------- |  | ------------------- | - |  | ----------------------------- | ----- | ---------------------------------------- | ---- | -------------------------------------- | - | ------
|                             |  | Stock OptionsShares |   |  | WeightedAverageExercise Price |       | WeightedAverageRemainingContractual Term |      | Aggregate IntrinsicValue(in thousands)
|Balance at December 31, 2005 |  | 1,066,789           |   |  | $                             | 9.17  |                                          |      |                                        |   |       
|Granted                      |  | 222,221             |   |  | $                             | 35.53 |                                          |      |                                        |   |       
|Exercised                    |  | (251,648            | ) |  | $                             | 9.19  |                                          |      |                                        |   |       
|Canceled                     |  | (15,174             | ) |  | $                             | 9.65  |                                          |      |                                        |   |       
|                             |  |                     |   |  |                               |       |                                          |      |                                        |   |       
|Balance at June 30, 2006     |  | 1,022,188           |   |  | $                             | 14.89 |                                          | 6.90 |                                        | $ | 25,873
|Vested                       |  | 585,661             |   |  | $                             | 8.91  |                                          | 5.30 |                                        | $ | 18,324
|Unvested                     |  | 436,527             |   |  | $                             | 22.91 |                                          | 9.14 |                                        | $ | 7,549 

The weighted average grant date fair value of stock options granted during the three and six
months ended June 30, 2006 was $18.72 and $17.81, respectively. The weighted average grant date fair value of stock options granted during the three and six months ended June 30, 2005 was $4.92 at each such date. The total intrinsic



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



value of share options exercised during the three and six months ended June 30, 2006 was $5.2 million and $6.4 million, respectively, and for the three
and six months ended June 30, 2005 was $141,000 and $800,000, respectively. As of June 30, 2006 there was $4.2 million of unrecognized compensation cost related to stock options granted. This cost is expected to be recognized over a
weighted-average period of 2.4 years.

A tabular reconciliation of the changes in restricted stock for the six months ended June 30,
2006 is set forth below (unaudited).



|                              |  |                  |   |  |                                       |      
|----------------------------- |  | ---------------- | - |  | ------------------------------------- | -----
|                              |  | Number of Shares |   |  | WeightedAverage Grant Date Fair Value
|Unvested at December 31, 2005 |  | 238,071          |   |  | $                                     | 10.29
|Granted                       |  | 72,081           |   |  | $                                     | 32.87
|Vested                        |  | (45,000          | ) |  | $                                     | 9.99 
|                              |  |                  |   |  |                                       |      
|Unvested at June 30, 2006     |  | 265,152          |   |  | $                                     | 16.58

The weighted average grant date fair value of restricted shares awarded during the three and six
months ended June 30, 2006 was $35.78 and $32.87, respectively. The weighted average grant date fair value of restricted stock awarded during the three and six months ended June 30, 2005 was $11.26 and $9.76, respectively. The total
intrinsic value of restricted shares vested during the three and six months ended June 30, 2006 was $1.4 million and for the three and six months ended June 30, 2005 was $100,000. As of June 30, 2006 there was $3.1 million of
unrecognized compensation cost related to restricted stock arrangements. This cost is expected to be recognized over a weighted-average period of 1.6 years.

The Company may elect to issue new shares or treasury shares, if any, under its long-term incentive compensation plans. The Company currently has no treasury stock.

Pro Forma Information under SFAS No. 123 for Periods Prior to Fiscal 2006

Prior to the effective date of SFAS No. 123R, the Company accounted for its employee stock option plans by applying the provisions of Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock Based Compensation. SFAS No. 123 allowed entities to recognize as
expense over the vesting period, the fair value of all stock-based awards on the date of grant. If entities applied the provisions of APB Opinion No. 25, pro forma net income and earnings per share disclosures were required for all employee
stock option grants made in 1995 and subsequent years, as if the fair value-based method defined in SFAS No. 123 had been applied.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Pro forma disclosures required by SFAS No. 123 for the three and six months ended June 30,
2005 were as follows:



|                                                                                                                                   |  |                                                     |       |   |                               |   |       |  
|---------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------------------- | ----- | - | ----------------------------- | - | ----- | -
|                                                                                                                                   |  | Three Months EndedJune 30,
2005                     |       |   | Six Months EndedJune 30, 2005 |  
|                                                                                                                                   |  | (unaudited; in thousands, except per share amounts) |      
|Net income allocable to common stockholdersas reported                                                                            |  | $                                                   | 2,171 |   |                               | $ | 4,671 |  
|Add: Restricted stock expense, net of related tax effects                                                                          |  |                                                     | 466   |   |                               |   | 537   |  
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                                     | (143  | ) |                               |   | (285  | )
|                                                                                                                                   |  |                                                     |       |   |                               |   |       |  
|Pro forma income                                                                                                                   |  | $                                                   | 2,494 |   |                               | $ | 4,923 |  
|                                                                                                                                   |  |                                                     |       |   |                               |   |       |  
|Earnings per share:                                                                                                                |  |                                                     |       |   |                               |   |       |  
|Basicas reported                                                                                                                  |  | $                                                   | 0.14  |   |                               | $ | 0.29  |  
|Basicpro forma                                                                                                                    |  | $                                                   | 0.16  |   |                               | $ | 0.31  |  
|Dilutedas reported                                                                                                                |  | $                                                   | 0.13  |   |                               | $ | 0.29  |  
|Dilutedpro forma                                                                                                                  |  | $                                                   | 0.15  |   |                               | $ | 0.30  |  

The Company utilized the Black-Scholes-Merton valuation method to calculate the pro forma
information presented above. The following table summarizes assumptions used to determine pro forma compensation expense under SFAS No. 123 as of June 30, 2005:



|                        |  |              
|----------------------- |  | -------------
|Expected Term           |  | 3.5 7 years 
|Volatility              |  | 34%          
|Risk-free interest rate |  | 1.49%  6.52%
|Dividend yield          |  | 0.0%         

(12) Warrants

On March 25, 2003, the Company issued 15,000 shares of Series B Convertible Preferred Stock and warrants to purchase 248,800 shares of NATCOs common stock to a private investment fund. The warrants had an
exercise price of $10.00 per share of common stock and were to expire on March 25, 2006. The Company had the ability to force the exercise of the warrants if NATCOs common stock traded above $13.50 per share for 30 consecutive trading
days, at which point the holder could elect to (1) exercise the warrants in full, (2) exercise for the net amount of shares issuable after deduction of the exercise price from the current market price of the shares on the date preceding
the exercise date or (3) not to exercise the warrants, resulting in their termination. The warrants contained a provision whereby the holder could require the Company to make a net-cash settlement for the warrants in the case of a change in
control. The warrants were deemed to be derivative instruments and, therefore, the warrants were recorded at fair value as of the issuance date. Fair value, as agreed with the counter-party to the agreement, was calculated by applying a pricing
model that included subjective assumptions for stock volatility, expected term that the warrants would be outstanding, a dividend rate of zero and an overall liquidity factor. The Company recorded the resulting liability of $99,000 as of the
issuance date.

On August 26, 2005, the investment fund exercised the warrants pursuant to the cashless exercise provision contained
in the warrant instrument, resulting in no cash payment to the Company. The number of shares of common stock issued to the investment fund was calculated based on the average of the closing price of the Companys shares on the New York Stock
Exchange for the ten trading-day period ending on the day prior to the exercise. The average price was $17.933, resulting in the issuance of 110,061 shares of common stock in exchange for the warrants.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(13) Earnings per Share

In accordance with SFAS No. 128 Earnings per Share, the Company computed basic earnings per share by dividing net income allocable to common stockholders by the weighted average number of shares
outstanding for the period. Net income allocable to common stockholders at June 30, 2006 represented net income less preferred stock dividends accrued. The Company determined diluted earnings per common and potential common share at
June 30, 2006 as net income allocable to common stockholders divided by the weighted average number of shares outstanding for the period, after applying the if-converted method to determine any incremental shares associated with
convertible preferred stock and restricted stock outstanding.

As of January 1, 2006, the Company adopted SFAS No. 123R and
computed incremental shares according to SFAS No. 123R requirements. The assumed proceeds used in Treasury Method include the windfall tax benefit related to unrecognized compensation expense. For the purpose of weighted average
shares calculation, the restricted shares which performance criteria have not been met were excluded.

If anti-dilutive common shares were
included for the three and six months ended June 30, 2006, the impact would have been a reduction of approximately 72,000 and 90,000 shares, respectively. The release of restricted stocks in the second quarter of 2006 and various new grants of
stock options accounted for the changes in the weighted average number of shares for basic and diluted common stocks for the three months and six months ended June 30, 2006. At June 30, 2006, the Company included 1.9 million shares
issuable upon conversion of the Series B Preferred Shares, as the inclusion of these shares was dilutive at the level of income in the three months and six months ended June 30, 2006.

The following table presents the computation of basic and diluted earnings per common and potential common share for the three and six months ended
June 30, 2006 and 2005, respectively:



|                                                    |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|--------------------------------------------------- |  | --------------------------------------------------- | ----- | -------------------------------- | ---------------------------------- | ------ | ---------------- | - | ------ |  | - | ---------------------------------- | - | ---------------- | ------ |  | - | ----
|                                                    |  | Three Months Ended June 30, 2006                    |       | Three Months Ended June 30, 2005
|                                                    |  | Income                                              |       |                                  | Weighted AverageShares Outstanding |        | Per-share Amount |   | Income |  |   | Weighted AverageShares Outstanding |   | Per-share Amount
|                                                    |  | (unaudited; in thousands, except per-share amounts)
|Net income                                          |  | $                                                   | 9,527 |                                  |                                    |        |                  |   |        |  | $ | 2,546                              |   |                  |        |  |   |     
|Less: Convertible preferred stock dividends accrued |  |                                                     | (375  | )                                |                                    |        |                  |   |        |  |   | (375                               | ) |                  |        |  |   |     
|                                                    |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Basic EPS:                                          |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Income allocable to common stockholders             |  |                                                     | 9,152 |                                  |                                    | 16,832 |                  | $ | 0.54   |  | $ | 2,171                              |   |                  | 15,934 |  | $ | 0.14
|                                                    |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Effect of dilutive securities:                      |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Warrants                                            |  |                                                     |       |                                  |                                    |       |                  |   |        |  |   |                                    |   |                  | 25     |  |   |     
|Stock options                                       |  |                                                     |       |                                  |                                    | 385    |                  |   |        |  |   |                                    |   |                  | 208    |  |   |     
|Restricted stock                                    |  |                                                     |       |                                  |                                    | 56     |                  |   |        |  |   |                                    |   |                  | 82     |  |   |     
|Convertible preferred stock                         |  |                                                     |       |                                  |                                    | 1,922  |                  |   |        |  |   |                                    |   |                  |       |  |   |     
|                                                    |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Diluted EPS:                                        |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Plus: Preferred stock dividends accrued             |  |                                                     | 375   |                                  |                                    |        |                  |   |        |  |   |                                   |   |                  |        |  |   |     
|                                                    |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Income allocable to common stockholders             |  | $                                                   | 9,527 |                                  |                                    | 19,195 |                  | $ | 0.50   |  | $ | 2,171                              |   |                  | 16,249 |  | $ | 0.13
|                                                    |  |                                                     |       |                                  |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



|                                                    |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|--------------------------------------------------- |  | --------------------------------------------------- | ------ | ------------------------------ | ---------------------------------- | ------ | ---------------- | - | ------ |  | - | ---------------------------------- | - | ---------------- | ------ |  | - | ----
|                                                    |  | Six Months Ended June 30, 2006                      |        | Six Months Ended June 30, 2005
|                                                    |  | Income                                              |        |                                | Weighted AverageShares Outstanding |        | Per-share Amount |   | Income |  |   | Weighted AverageShares Outstanding |   | Per-share Amount
|                                                    |  | (unaudited; in thousands, except per-share amounts)
|Net income                                          |  | $                                                   | 17,384 |                                |                                    |        |                  |   |        |  | $ | 5,421                              |   |                  |        |  |   |     
|Less: Convertible preferred stock dividends accrued |  |                                                     | (750   | )                              |                                    |        |                  |   |        |  |   | (750                               | ) |                  |        |  |   |     
|                                                    |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Basic EPS:                                          |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Income allocable to common stockholders             |  | $                                                   | 16,634 |                                |                                    | 16,748 |                  | $ | 0.99   |  | $ | 4,671                              |   |                  | 15,875 |  | $ | 0.29
|                                                    |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Effect of dilutive securities:                      |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Warrants                                            |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  | 21     |  |   |     
|Stock options                                       |  |                                                     |        |                                |                                    | 376    |                  |   |        |  |   |                                    |   |                  | 194    |  |   |     
|Restricted stock                                    |  |                                                     |        |                                |                                    | 50     |                  |   |        |  |   |                                    |   |                  | 56     |  |   |     
|Convertible preferred stock                         |  |                                                     |        |                                |                                    | 1,922  |                  |   |        |  |   |                                    |   |                  |       |  |   |     
|                                                    |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Diluted EPS:                                        |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Plus: Preferred stock dividends accrued             |  |                                                     | 750    |                                |                                    |        |                  |   |        |  |   |                                   |   |                  |        |  |   |     
|                                                    |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     
|Income allocable to common stockholders             |  | $                                                   | 17,384 |                                |                                    | 19,096 |                  | $ | 0.91   |  | $ | 4,671                              |   |                  | 16,146 |  | $ | 0.29
|                                                    |  |                                                     |        |                                |                                    |        |                  |   |        |  |   |                                    |   |                  |        |  |   |     

(14) Industry Segments and Geographic Information

NATCOs operating segments are Oil & Water Technologies, Gas Technologies and Automation & Controls.



| |  |  | The Oil & Water Technologies segment includes both standard and traditional oil and gas separation and dehydration equipment sales and related services and built-to-order
systems focused primarily on oil and water production and processing.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Gas Technologies segment includes our CO2membrane business, the assets and operating relationship related to our gas processing facilities in West Texas, H2S
removal technologies including Shell Paques and
other built-to-order gas-related technologies that focus on removing contaminants from the gas stream.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Automation & Controls segment focuses on sales of new control panels and systems which monitor and control oil and gas production, as well as field service activities
including repair, maintenance, testing and inspection services for existing systems.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

NATCO allocates corporate and other
expenses to each of the business segments. This allocation is based on headcount, total assets, revenues and bookings. Corporate assets are allocated to the segments based on the total assets of the segment. The accounting policies of the reportable
segments were consistent with the policies used to prepare the Companys condensed consolidated financial statements for the respective periods presented. The Company evaluates the performance of its operating segments based on total segment
profit, which is defined as net income before net interest expense, depreciation and amortization expense, closure, severance and other, interest cost on postretirement benefit liability, other, net and income taxes.



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Summarized financial information concerning the Companys reportable segments is shown in the
following table.



|                                    |  |                           |         |                 |   |                      |  |              |        |  |       |        |   |  |   |        
|----------------------------------- |  | ------------------------- | ------- | --------------- | - | -------------------- |  | ------------ | ------ |  | ----- | ------ | - |  | - | -------
|                                    |  | Oil & WaterTechnologies   |         | GasTechnologies |   | Automation &Controls |  | Eliminations |        |  | Total
|                                    |  | (unaudited, in thousands)
|Three Months Ended June 30, 2006    |  |                           |         |                 |   |                      |  |              |        |  |       |        |   |  |   |        
|Revenue from unaffiliated customers |  | $                         | 91,599  |                 | $ | 16,779               |  | $            | 20,328 |  | $     |       |   |  | $ | 128,706
|Inter-segment revenue               |  | $                         | 3,973   |                 | $ |                     |  | $            | 1,489  |  |       | (5,462 | ) |  | $ |       
|Segment profit                      |  | $                         | 8,252   |                 | $ | 7,411                |  | $            | 2,613  |  | $     |       |   |  | $ | 18,276 
|Total assets                        |  | $                         | 217,578 |                 | $ | 58,747               |  | $            | 30,886 |  | $     |       |   |  | $ | 307,211
|Capital expenditures                |  | $                         | 1,267   |                 | $ | 56                   |  | $            | 188    |  | $     |       |   |  | $ | 1,511  
|Depreciation and amortization       |  | $                         | 862     |                 | $ | 463                  |  | $            | 93     |  | $     |       |   |  | $ | 1,418  
|                                    |  |                           |         |                 |  
|Three Months Ended June 30, 2005    |  |                           |         |                 |   |                      |  |              |        |  |       |        |   |  |   |        
|Revenue from unaffiliated customers |  | $                         | 72,358  |                 | $ | 7,277                |  | $            | 15,013 |  | $     |       |   |  | $ | 94,648 
|Inter-segment revenue               |  | $                         | 232     |                 | $ |                     |  | $            | 816    |  | $     | (1,048 | ) |  | $ |       
|Segment profit                      |  | $                         | 2,487   |                 | $ | 3,815                |  | $            | 1,284  |  | $     |       |   |  | $ | 7,586  
|Total assets                        |  | $                         | 179,094 |                 | $ | 40,185               |  | $            | 24,031 |  | $     |       |   |  | $ | 243,310
|Capital expenditures                |  | $                         | 764     |                 | $ | 49                   |  | $            | 110    |  | $     |       |   |  | $ | 923    
|Depreciation and amortization       |  | $                         | 686     |                 | $ | 546                  |  | $            | 100    |  | $     |       |   |  | $ | 1,332  
|                                    |  |                           |         |                 |  
|                                    |  | Oil & WaterTechnologies   |         | GasTechnologies |   | Automation &Controls |  | Eliminations |        |  | Total
|                                    |  | (unaudited, in thousands)
|Six Months Ended June 30, 2006      |  |                           |         |                 |   |                      |  |              |        |  |       |        |   |  |   |        
|Revenue from unaffiliated customers |  | $                         | 176,632 |                 | $ | 29,481               |  | $            | 40,361 |  | $     |       |   |  | $ | 246,474
|Inter-segment revenue               |  | $                         | 4,009   |                 | $ |                     |  | $            | 2,328  |  | $     | (6,337 | ) |  | $ |       
|Segment profit                      |  | $                         | 13,883  |                 | $ | 13,482               |  | $            | 5,325  |  | $     |       |   |  | $ | 32,690 
|Total assets                        |  | $                         | 217,578 |                 | $ | 58,747               |  | $            | 30,886 |  | $     |       |   |  | $ | 307,211
|Capital expenditures                |  | $                         | 2,103   |                 | $ | 58                   |  | $            | 312    |  | $     |       |   |  | $ | 2,473  
|Depreciation and amortization       |  | $                         | 1,670   |                 | $ | 1,011                |  | $            | 184    |  | $     |       |   |  | $ | 2,865  
|                                    |  |                           |         |                 |  
|Six Months Ended June 30, 2005      |  |                           |         |                 |   |                      |  |              |        |  |       |        |   |  |   |        
|Revenue from unaffiliated customers |  | $                         | 139,072 |                 | $ | 15,174               |  | $            | 29,058 |  | $     |       |   |  | $ | 183,304
|Inter-segment revenue               |  | $                         | 523     |                 | $ |                     |  | $            | 1,923  |  | $     | (2,446 | ) |  | $ |       
|Segment profit                      |  | $                         | 3,917   |                 | $ | 7,880                |  | $            | 2,884  |  | $     |       |   |  | $ | 14,681 
|Total assets                        |  | $                         | 179,094 |                 | $ | 40,185               |  | $            | 24,031 |  | $     |       |   |  | $ | 243,310
|Capital expenditures                |  | $                         | 1,462   |                 | $ | 55                   |  | $            | 286    |  | $     |       |   |  | $ | 1,803  
|Depreciation and amortization       |  | $                         | 1,371   |                 | $ | 1,097                |  | $            | 187    |  | $     |       |   |  | $ | 2,655  

The following table reconciles total segment profit to net income as set forth below:



|                                                  |  |                            |        |                          |   |       |  |      |        |  |   |       
|------------------------------------------------- |  | -------------------------- | ------ | ------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|                                                  |  | Three Months EndedJune 30, |        | Six Months EndedJune 30,
|                                                  |  | 2006                       |        | 2005                     |   | 2006  |  | 2005
|                                                  |  | (unaudited, in thousands) 
|Total segment profit                              |  | $                          | 18,276 |                          | $ | 7,586 |  | $    | 32,690 |  | $ | 14,681
|Net interest expense                              |  |                            | 672    |                          |   | 1,063 |  |      | 1,312  |  |   | 2,026 
|Depreciation and amortization                     |  |                            | 1,418  |                          |   | 1,332 |  |      | 2,865  |  |   | 2,655 
|Closure, severance and other                      |  |                            | 193    |                          |   | 48    |  |      | 245    |  |   | 90    
|Interest cost on postretirement benefit liability |  |                            | 50     |                          |   | 210   |  |      | 100    |  |   | 420   
|Other, net                                        |  |                            | 578    |                          |   | 474   |  |      | 129    |  |   | 394   
|                                                  |  |                            |        |                          |   |       |  |      |        |  |   |       
|Net income before income taxes                    |  | $                          | 15,365 |                          | $ | 4,459 |  | $    | 28,039 |  | $ | 9,096 
|Income tax provision                              |  |                            | 5,838  |                          |   | 1,913 |  |      | 10,655 |  |   | 3,675 
|                                                  |  |                            |        |                          |   |       |  |      |        |  |   |       
|Net income                                        |  | $                          | 9,527  |                          | $ | 2,546 |  | $    | 17,384 |  | $ | 5,421 
|                                                  |  |                            |        |                          |   |       |  |      |        |  |   |       



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table provides further information on revenues by product line within the
Oil & Water Technologies segment for the three and six months ended June 30, 2006 and 2005.



|                                                |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|----------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                                |  | 2006                       |        |   | 2005                     |   |        | 2006 |  |   | 2005    |  
|                                                |  | (unaudited, in thousands)  |       
|Traditional/standard/used equipment             |  | $                          | 63,717 |   |                          | $ | 52,690 |      |  | $ | 119,463 |   |  | $ | 103,966 |  
|Built-to-order                                  |  |                            | 32,209 |   |                          |   | 20,116 |      |  |   | 61,778  |   |  |   | 36,269  |  
|Eliminations                                    |  |                            | (354   | ) |                          |   | (216   | )    |  |   | (600    | ) |  |   | (640    | )
|                                                |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Total Oil & Water Technologies segment revenues |  | $                          | 95,572 |   |                          | $ | 72,590 |      |  | $ | 180,641 |   |  | $ | 139,595 |  

(15) Recent Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of Accounting Research Bulletin (ARB) No. 43,
Chapter 4. SFAS No. 151 amends ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current period charges. In addition,
SFAS No. 151 requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. SFAS No. 151 became effective for inventory costs incurred during fiscal years beginning after
June 15, 2005. The Company adopted this pronouncement on June 15, 2005, with no material impact on its consolidated results of operations, financial position or cash flows.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, which amends APB Opinion No. 29. The guidance in
APB 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The amendment made by SFAS No. 153 eliminates
the exception for exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. This statement became effective on June 15, 2005. The Company adopted
the standard as of the effective date with no material impact on its consolidated results of operations, financial position or cash flows.

In March 2005, the FASB issued FASB Interpretation No. (FIN) 47, Accounting for Conditional Asset Retirement Obligations. FIN 47 clarifies that the term conditional asset retirement obligation, as used in SFAS
No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be
within control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Uncertainty about the timing and (or) method of settlement of a
conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an
asset retirement obligation. The Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of this standard did not have a material effect on the Companys consolidated results of
operations, financial position or cash flows.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
CorrectionsA Replacement of APB Opinion No. 20 and FASB Statement No. 3. The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154
requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that
(1) a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in
previously issued financial statements should be termed a restatement. The new



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of this
standard did not have a material effect on the Companys consolidated results of operations, financial position or cash flows.

In
June 2005, the FASB issued a FASB Staff Position No. 143-1 (FSP 143-1), Accounting for Electronic Equipment Waste Obligations, which provides guidance under SFAS No. 143 with respect to European operations that have been
adopted by the European Union. FSP 143-1 requires a commercial user to incur costs associated with the retirement of historical electrical equipment waste. FSP 143-1 became effective the later of June 8, 2005 or the date of the adoption of the
law by the applicable EU-member country. Adoption of FSP 143-1 by the Companys UK operations did not have a material effect on its consolidated results of operations, financial position or cash flows.

In September 2005, the FASBs Emerging Issues Task Force (EITF) issued EITF No. 04-13, Accounting for Purchases and Sales of Inventory
with the Same Counterparty. This pronouncement provides additional accounting guidance for situations involving inventory exchanges between parties to that contained in APB Opinion No. 29, Accounting for Nonmonetary
Transactions and SFAS No. 153, Exchanges of Nonmonetary Assets. The standard is effective for new arrangements entered into in reporting periods beginning after March 15, 2006, and to all inventory transactions that are
completed after December 15, 2006 for arrangements entered into prior to March 15, 2006. The adoption of this standard did not have a material effect on the Companys consolidated results of operations, financial position or cash
flows.

In September 2005, The SEC staff revised EITF No. D-98, Classification and Measurement of Redeemable Securities
primarily to provide guidance on (1) the earnings per share treatment of redeemable common stock and (2) the application of EITF No. D-98 to share-based payment arrangements with employees. The guidance on the earnings per share treatment
of redeemable common stock in EITF No. D-98 to share-based payment arrangements with employees is effective in the first fiscal period beginning after September 15, 2005. The Company adopted EITF No. D-98 as of the effective date as it relates
to the earnings per share treatment of redeemable common stock and has applied the application to share-based payment arrangements with employees concurrently with the adoption of SFAS No. 123R.

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instrumentsan amendment of FASB Statements
No. 133 and 140 which is effective for fiscal years beginning after September 15, 2006. The statement was issued to clarify the application of FASB Statement No. 133 to beneficial interests in securitized financial assets and to
improve the consistency of accounting for similar financial instruments, regardless of the form of the instruments. The Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial
position or cash flows and will adopt it on or before the effective date.

In March 2006, the FASB issued SFAS No. 156,
Accounting for Servicing of Financial Assetsan amendment of FASB Statement No. 140 which is effective for fiscal years beginning after September 15, 2006. This statement was issued to simplify the accounting for servicing
rights and to reduce the volatility that results from using different measurement attributes. The Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or cash
flows and will adopt it on or before the effective date.

In March 2006, the EITF issued EITF No. 05-01, Accounting for the
Conversion of an Instrument that Became Convertible upon the Issuers Exercise of a Call Option. This issue requires that the issuance of equity securities to settle a debt instrument that became convertible on the issuers exercise
of a call option be accounted



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NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



for as a conversion if the debt instrument contains a substantive conversion feature as of its issuance date. Absent a substantive conversion feature, it
should be accounted for as a debt extinguishment. EITF No. 05-01 is effective for periods beginning after June 28, 2006. The Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of
operations, financial position or cash flows and will adopt it on the effective date.

In March 2006, the EITF issued EITF No. 06-03,
How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation). EITF No. 06-03 requires that the presentation of taxes assessed by a
governmental authority that are directly imposed on a revenue-producing transaction between a seller and a customer on either a gross (included in revenues and costs) or a net (excluded from revenues) basis is an accounting policy decision that
should be disclosed pursuant to APB Opinion No. 22. In addition, if any of such taxes are reported on a gross basis, a company should disclose, on an aggregate basis, the amounts of those taxes in interim and annual financial statements for
each period for which an income statement is presented if those amount are significant. This issue will be applied to financial reports for interim and annual reporting periods beginning after December 15, 2006. The Company currently reports
Revenue on a net basis. The Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or cash flows and will adopt it on or before the effective date.

In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes. This Interpretation clarifies the accounting for
uncertainty in income taxes recognized in an enterprises financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return as well as provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and
transition. The interpretation is effective for fiscal years beginning after December 15, 2006. The Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or
cash flows and will adopt it on or before the effective date.

(16) Subsequent Event

On July 20, 2006, the Company sold 29% of its investment in NATCO Japan Company Ltd. to Modec Inc. and Daiichi Jitsugyo, Ltd., an existing
shareholder, for a total cash consideration of $3.0 million to expand the reach of NATCO Japans product technologies and addressable markets, including the floating production, storage and off loading (FPSO) vessel market. The Companys
investment in NATCO Japan Company Ltd. after the sale equals 60%.



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Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

Managements Discussion and Analysis includes forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words believe, expect, plan, intend, estimate,
project, will, could, may and similar expressions are intended to identify forward-looking statements. Forward-looking statements in this document include, but are not limited to, discussions regarding
indicated trends in the level of oil and gas exploration and production and the effect of such conditions on the Companys results of operations (see Industry and Business Environment), future uses of and requirements for
financial resources (see Liquidity and Capital Resources), and bookings and backlog levels in 2006 (see Liquidity and Capital Resources). Our expectations about our business outlook, customer spending, oil and gas
prices, our business environment and that of the industry in general are only our expectations regarding these matters. Actual results may differ materially from those expressed in the forward-looking statements for reasons including, but not
limited to: market factors such as pricing and demand for petroleum related products, the level of petroleum industry exploration and production expenditures, the effects of competition, world economic conditions, the level of drilling activity, the
legislative environment in the United States and other countries, policies of OPEC, conflict involving the United States or in major petroleum producing or consuming regions, acts of terrorism, the development of technology that could lower overall
finding and development costs, weather patterns, the overall condition of capital and equity markets for countries in which we operate.

Overview

Our organization has three operating segments: Oil & Water Technologies, Gas Technologies and Automation & Controls.



| |  |  | The Oil & Water Technologies segment includes both standard and traditional oil and gas separation and dehydration equipment sales and related services and built-to-order
systems focused primarily on oil and water production and processing.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Gas Technologies segment includes our CO2membrane business, the assets and operating relationship related to our gas processing facilities in West Texas, H2S
removal technologies including Shell Paques and
other built-to-order gas-related technologies that focus on removing contaminants from the gas stream.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Automation & Controls segment focuses on sales of new control panels and systems which monitor and control oil and gas production, as well as field service activities
including repair, maintenance, testing and inspection services for existing systems.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

On July 18, 2006, the Company
entered into a joint venture agreement with Scomi Group BHD to pursue CO2processing opportunities, initially in the
South East Asia market. On July 20, 2006, the Company announced the sale of 25% of its investment in NATCO Japan Company Ltd, to Modec Inc. and Daiichi Jitsugyo, Ltd., an existing shareholder, for a total cash consideration of $3 million,
before expenses, to expand the reach of NATCO Japans product technologies and addressable markets, including the floating production, storage and off loading (FPSO) vessel market.

Critical Accounting Policies

The preparation of our consolidated financial statements requires us to
make certain estimates and assumptions that affect the results reported in our condensed consolidated financial statements and accompanying notes. These estimates and assumptions are based on historical experience and on our future expectations that
we believe to be reasonable under the circumstances. Note 2 to the consolidated financial statements filed in our Annual Report on Form 10-K for the year ended December 31, 2005, contains a summary of our significant accounting policies. We
believe the following accounting policies are the most critical in the preparation of our condensed consolidated financial statements:

Revenue Recognition: Percentage of Completion Method. We recognize revenues and related costs when products are shipped or services are rendered for (1) time and materials and service contracts, (2) manufactured



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goods produced in standard manufacturing operations and sold in the ordinary course of business through regular marketing channels and (3) certain
customized manufactured goods that are smaller jobs with less customization, making them similar to such standard manufactured goods (that is, contracts valued at $250,000 or less having contract durations of four months or less). We recognize
revenues using the percentage of completion method on contracts greater than $250,000 and having contract durations in excess of four months that represent customized, engineered orders of our products and qualify for such treatment in accordance
with the requirements of AICPA Statement of Position 81-1, Accounting for Performance of Certain Production-Type Contracts (SOP 81-1). In addition, we use the percentage of completion method on all Automation & Controls
segments equipment fabrication and sales projects that qualify for such treatment in accordance with the requirements of SOP 81-1. The Automation & Controls segment sells customized products fabricated to order pursuant to a large
number of smaller contracts with durations of two to three months, with occasional large systems projects of longer duration. The segment does not produce standard units or maintain an inventory of products for sale. Due to the nature of the
segments equipment fabrication and sales operations, and the potential for wide variations in our results of operations that could occur from applying the as shipped methodology to smaller contracts for these customized, fabricated goods, this
segment recognizes revenues, regardless of contract value or duration, applying the percentage of completion method. For the six months ended June 30, 2006, approximately 49.6% of total Company revenues were recorded on an as
shipped or as performed basis and approximately 50.4% were recorded using the percentage of completion method.

With
respect to contract revenues recorded utilizing the percentage of completion method, earned revenue is based on the percentage that costs incurred to date relate to total estimated costs of the project, after giving effect to the most recent
estimates of total cost. Total estimated contract cost is a critical accounting estimate because it can materially affect revenue and net income and it requires us to make judgments about matters that are uncertain. Total costs expected to be
incurred, and therefore recognition of revenue, could be affected by various internal or external factors including, but not limited to: changes in project scope (change orders), changes in productivity, scheduling, the cost and availability of
labor, the cost and availability of raw materials, the weather, client delays in providing approvals at benchmark stages of the project and the timing of deliveries from third-party providers of key components. The cumulative impact of revisions in
total cost estimates during the progress of work is reflected in the period in which these changes become known. Earned revenue reflects the original contract price adjusted for agreed claims and change order revenues, if applicable. Losses expected
to be incurred on the jobs in progress, after consideration of estimated probable minimum recoveries from claims and change orders, are charged to income as soon as such losses are known. Claims for additional contract revenue are recognized if it
is probable the claim will result in additional revenue and the amount can be reliably estimated. We generally recognize revenue and earnings to which the percentage of completion method is applied over a period of two to six quarters. In the event
a project is terminated by our customer before completion, our customer is liable for costs incurred under the contract. We believe our operating results should be evaluated over a term of one to three years to evaluate our performance under
long-term contracts, after all change orders, scope changes and cost recoveries have been negotiated and realized.

Estimates are
subjective in nature and it is possible that we could have used different estimates of total contract costs in our calculation of revenue recognized using the percentage of completion method. For the six months ended June 30, 2006, the Company
had $98.1million in revenues attributable to open percentage completion projects having an aggregate gross margin of 26.9%. If we had used a different estimate of total contract costs for each contract in progress at June 30, 2006, a 1%
increase or decrease in the estimated margin earned on each contract would have increased or decreased each of total revenue and pre-tax income for the six months ended June 30, 2006, by approximately $1.3 million. At June 30, 2006, the
Company had one contract in a loss position estimated at $747,000.

Impairment Testing: Goodwill. As required by Statement of
Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, we evaluate goodwill annually for impairment by comparing the fair value of operating assets to the carrying value of those assets,
including any related goodwill. As required by SFAS No. 142, we identify separate reportable units for purposes of this evaluation. In determining carrying



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value, we segregate assets and liabilities that, to the extent possible, are clearly identifiable by specific reportable unit. Certain corporate and other
assets and liabilities, that are not clearly identifiable by specific reportable unit, are allocated in accordance with the standard. Fair value is determined by discounting projected future cash flows at our cost of capital rate, as calculated. In
determining projected future cash flows for each segment, we make assumptions regarding the following key indicators: future market and sales growth rates (domestic and international), cost inflation, margin expectations, capital expenditure levels
and tax levels. The fair value is then compared to the carrying value of the reportable unit to determine whether or not impairment has occurred at the reportable unit level. In the event an impairment is indicated, an additional test is performed
whereby an implied fair value of goodwill is determined through an allocation of the fair value to the reporting units assets and liabilities, whether recognized or unrecognized, in a manner similar to a purchase price allocation, in
accordance with SFAS No. 141, Business Combinations. Any residual fair value after this purchase price allocation would be assumed to relate to goodwill. If the carrying value of the goodwill exceeded the residual fair value, we
would record an impairment charge for that amount.

Net goodwill of $81.2 million and $80.9 million at June 30, 2006 and
December 31, 2005, was comprised of $47.6 and $47.4 million for the Oil & Water Technologies reporting unit, $29.2 million and $29.1 million for the Gas Technologies reporting unit, $4.4 million and $4.4 million for the
Automation & Controls reporting unit, respectively. The increase of $0.3 million in net goodwill was due entirely to the fluctuation in the exchange rates between the US currency and Canadian currency.

In accordance with SFAS No. 142, the Company tested each business segment for impairment of goodwill at December 31, 2005, and, based upon the
results of this testing, management determined that goodwill was not impaired. The Company will test each business segment for goodwill impairment annually, as required by the pronouncement, or more frequently if there are indications of goodwill
impairment. No additional testing was performed during the quarter ended June 30, 2006, as management noted no indications of goodwill impairment.

Deferred Income Tax Assets: Valuation Allowance. We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. SFAS No. 109 requires us to provide a valuation
allowance for any deferred income tax assets we believe may not be utilized through future operations. Deferred income tax assets, not requiring valuation allowances largely relates to US post-retirement obligations, accrued liabilities and reserves
that have not been deducted for tax purposes, and the carryforward of foreign tax credits. Based upon the level of historical taxable income and projected future taxable income over the periods to which our deferred tax assets are deductible in the
US and Canadian tax jurisdictions, we believe it is more likely than not we will realize the benefits of these deductible differences and carry forwards. However, the amount of the deferred tax asset considered realizable could change if future
taxable income differs from our projections in the US and Canadian tax jurisdictions. In all other foreign tax jurisdictions, we are currently not considering projections of future taxable income to determine the realizability of our deductible
differences and carryforwards. As of June 30, 2006, we have a valuation allowance of $1.4 million related to our UK operations and another $134,000 related to other international operations.

Recent Accounting Pronouncements

In
November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4. SFAS No. 151 amends ARB No. 43, Chapter 4, to clarify that abnormal
amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current period charges. In addition, SFAS No. 151 requires that allocation of fixed production overhead to inventory be based on
the normal capacity of the production facilities. SFAS No. 151 became effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company adopted this pronouncement on June 15, 2005, with no material
impact on its consolidated results of operations, financial position or cash flows.

In December 2004, the FASB issued SFAS No. 153,
Exchanges of Nonmonetary Assets, which amends APB Opinion No. 29. The guidance in APB 29, Accounting for Nonmonetary Transactions, is based on the



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principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The amendment made by SFAS No. 153
eliminates the exception for exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. This statement became effective on June 15, 2005. The
Company adopted the standard as of the effective date with no material impact on its consolidated results of operations, financial position or cash flows.

In March 2005, the FASB issued FIN 47, Accounting for Conditional Asset Retirement Obligations. FIN 47 clarifies that the term conditional asset retirement obligation, as used in SFAS No. 143,
Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within control
of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Uncertainty about the timing and (or) method of settlement of a conditional asset
retirement obligation should be factored into the measurement of the liability when sufficient information exists. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement
obligation. The Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of this standard did not have a material effect on the Companys consolidated results of operations, financial
position or cash flows.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error CorrectionsA Replacement
of APB Opinion No. 20 and FASB Statement No. 3. The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary
change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of
depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements
should be termed a restatement. The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of this standard did not have a material effect on
the Companys consolidated results of operations, financial position or cash flows.

In June 2005, the FASB issued a FASB Staff
Position No. 143-1 (FSP 143-1), Accounting for Electronic Equipment Waste Obligations, which provides guidance under SFAS No. 143 with respect to European operations that have been adopted by the European Union. FSP 143-1
requires a commercial user to incur costs associated with the retirement of historical electrical equipment waste. FSP 143-1 became effective the later of June 8, 2005 or the date of the adoption of the law by the applicable EU-member country.
Adoption of FSP 143-1 by the Companys UK operations did not have a material effect on its consolidated results of operations, financial position or cash flows.

In September 2005, the FASBs Emerging Issues Task Force (EITF) issued EITF No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty. This pronouncement provides
additional accounting guidance for situations involving inventory exchanges between parties to that contained in APB Opinion No. 29, Accounting for Nonmonetary Transactions and SFAS No. 153, Exchanges of Nonmonetary
Assets. The standard is effective for new arrangements entered into in reporting periods beginning after March 15, 2006, and to all inventory transactions that are completed after December 15, 2006 for arrangements entered into prior
to March 15, 2006. The adoption of this standard did not have a material effect on the Companys consolidated results of operations, financial position or cash flows.

In September 2005, The SEC staff revised EITF No. D-98, Classification and Measurement of Redeemable Securities primarily to provide guidance
on (1) the earnings per share treatment of redeemable common stock and (2) the application of EITF No. D-98 to share-based payment arrangements with employees. The guidance on the earnings per share treatment of redeemable common stock in
EITF No. D-98 to share-based payment arrangements with employees is effective in the first fiscal period beginning after September 15, 2005. The Company adopted



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EITF No. D-98 as of the effective date as it relates to the earnings per share treatment of redeemable common stock and has applied the application to
share-based payment arrangements with employees concurrently with the adoption of SFAS No. 123R.

In February 2006, the FASB issued
SFAS No. 155, Accounting for Certain Hybrid Financial Instrumentsan amendment of FASB Statements No. 133 and 140 which is effective for fiscal years beginning after September 15, 2006. The statement was issued to
clarify the application of FASB Statement No. 133 to beneficial interests in securitized financial assets and to improve the consistency of accounting for similar financial instruments, regardless of the form of the instruments. The Company is
in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or cash flows and will adopt it on or before the effective date.

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assetsan amendment of FASB Statement
No. 140 which is effective for fiscal years beginning after September 15, 2006. This statement was issued to simplify the accounting for servicing rights and to reduce the volatility that results from using different measurement
attributes. The Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or cash flows and will adopt it on or before the effective date.

In March 2006, the EITF issued EITF No. 05-01, Accounting for the Conversion of an Instrument that Became Convertible upon the Issuers
Exercise of a Call Option. This issue requires that the issuance of equity securities to settle a debt instrument that became convertible on the issuers exercise of a call option be accounted for as a conversion if the debt instrument
contains a substantive conversion feature as of its issuance date. Absent a substantive conversion feature, it should be accounted for as a debt extinguishment. EITF No. 05-01 is effective for periods beginning after June 28, 2006. The
Company is in the process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or cash flows and will adopt it on the effective date.

In March 2006, the EITF issued EITF No. 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented
in the Income Statement (That Is, Gross versus Net Presentation). EITF No. 06-03 requires that the presentation of taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction between a seller
and a customer on either a gross (included in revenues and costs) or a net (excluded from revenues) basis is an accounting policy decision that should be disclosed pursuant to APB Opinion No. 22. In addition, if any of such taxes are reported
on a gross basis, a company should disclose, on an aggregate basis, the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented if those amount are significant. This issue will be
applied to financial reports for interim and annual reporting periods beginning after December 15, 2006. The Company currently reports Revenue on a net basis. The Company is in the process of evaluating the impact, if any, of this standard on
its consolidated results of operations, financial position or cash flows and will adopt it on or before the effective date.

In June 2006,
the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with FASB Statement
No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return as well as
provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The interpretation is effective for fiscal years beginning after December 15, 2006. The Company is in the
process of evaluating the impact, if any, of this standard on its consolidated results of operations, financial position or cash flows and will adopt it on or before the effective date.



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Industry and Business Environment

As one of the leading providers of wellhead process equipment, systems and services used in the production of oil and gas, our revenue and results of operations are closely tied to demand for oil and gas products and
spending by oil and gas companies for exploration and development of oil and gas reserves. These companies generally invest more in exploration and development efforts during periods of favorable oil and gas commodity prices, and invest less during
periods of unfavorable oil and gas prices. As supply and demand change, commodity prices fluctuate, producing cyclical trends in the industry. During periods of lower demand, revenue for service providers such as NATCO generally decline, as existing
projects are completed, new projects are postponed and pricing decreases due to competitive pressures. During periods of recovery or growth, revenue for process equipment providers can lag behind the industry due to the timing of new project awards.

Changes in commodity prices have impacted our business over the past several years. The following table summarizes the average price of
domestic crude oil and Brent crude oil per barrel, the wellhead price of natural gas per thousand cubic feet (mcf), as published by the U.S. Department of Energy; the number of rotary drilling rigs in operation, as published by Baker
Hughes Incorporated, for the six months ended June 30, 2006 and 2005, as well as averages for the years ended December 31, 2005 and 2004:



|                                                            |  |                          |       |                                 |   |       |  |      |       |  |   |      
|----------------------------------------------------------- |  | ------------------------ | ----- | ------------------------------- | - | ----- |  | ---- | ----- |  | - | -----
|                                                            |  | Six Months EndedJune 30, |       | Twelve Months EndedDecember 31,
|                                                            |  | 2006                     |       | 2005                            |   | 2005  |  | 2004
|Average price of crude oil per barrel in the U.S.           |  | $                        | 66.89 |                                 | $ | 51.41 |  | $    | 56.54 |  | $ | 41.47
|Average price of Brent crude oil per barrel                 |  | $                        | 65.69 |                                 | $ | 49.69 |  | $    | 54.47 |  | $ | 38.26
|Average wellhead price of natural gas per mcf in the U.S.   |  | $                        | 6.84  |                                 | $ | 5.95  |  | $    | 7.52  |  | $ | 5.50 
|Average U.S. rig count                                      |  |                          | 1,576 |                                 |   | 1,308 |  |      | 1,380 |  |   | 1,190
|Average International rig count (excludes North America)(1) |  |                          | 904   |                                 |   | 856   |  |      | 850   |  |   | 781  

---

|(1) | The Iran and Sudan rig counts were discontinued from the Baker Hughes publication beginning
January 2006. For comparative purposes, the 2005 and 2004 rig count numbers presented above exclude Iran and Sudan.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Historically, we have viewed operating rig counts as a benchmark of spending in the US oil and gas industry for exploration and development efforts. Our standard and traditional equipment sales, parts and services business generally
correlates to changes in rig activity, but tends to lag behind the North American rig count trend.

From a longer-term perspective, the US
Department of Energy projects that the worldwide and US demand for and consumption of petroleum and natural gas products will increase through 2030, with expected global higher consumption rates, driven by demand for refined products and the use of
natural gas to power plants that generate electricity. As demand grows and reserves in the United States decline, producers and service providers in the oil and gas industry may continue to rely more heavily on global sources of energy and expansion
into new markets. The industry continues to seek more innovative and technologically efficient means to extract hydrocarbons from existing fields, as production profiles change. As a result, additional and more complex equipment may be required to
produce oil and gas from these fields. Also, many new oil and gas fields produce lower quality or contaminated hydrocarbon streams, requiring more complex production equipment. In general, these trends should increase the demand for our products and
services.

Results of Operations

The
following discussion of our historical results of operations and financial condition should be read in conjunction with our condensed consolidated financial statements and related notes.



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Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005 (unaudited)

Consolidated

Revenue and Gross Profit



|                                   |  |                                          |         |   |        |   |        |                  |  |   |        |   |  |    |  
|---------------------------------- |  | ---------------------------------------- | ------- | - | ------ | - | ------ | ---------------- |  | - | ------ | - |  | -- | -
|                                   |  | Three Months EndedJune 30,               |         |   | Change |   |        | PercentageChange | 
|                                   |  | 2006                                     |         |   | 2005   |   |        |                 
|                                   |  | (unaudited)                              |        
|                                   |  | (in thousands, except percentage change) |        
|Revenue(1)                         |  | $                                        | 128,706 |   |        | $ | 94,648 |                  |  | $ | 34,058 |   |  | 36 | %
|Cost of goods sold and services(1) |  |                                          | 93,721  |   |        |   | 72,250 |                  |  |   | 21,471 |   |  | 30 | %
|                                   |  |                                          |         |   |        |   |        |                  |  |   |        |   |  |    |  
|Gross profit                       |  | $                                        | 34,985  |   |        | $ | 22,398 |                  |  |   | 12,587 |   |  | 56 | %
|Gross margin                       |  |                                          | 27      | % |        |   | 24     | %                |  |   | 3      | % |  | 13 | %

---

|(1) | The table above includes inter-segment elimination amounts for both revenue and cost of goods
sold and services of $5.5 million and $1.0 million for the three months ended June 30, 2006 and 2005, respectively.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Revenue.Revenue of $128.7 million for the three months ended June 30, 2006 increased $34.1 million, or 36%, from $94.6 million for the three months ended June 30, 2005 as a result of increased business activity from each
of our three operating segments, particularly in the Oil & Water Technologies segment.

Gross Profit.Gross profit for the
three months ended June 30, 2006 increased $12.6 million, or 56%, to $35.0 million, compared to $22.4 million for the three months ended June 30, 2005. As a percentage of revenue, gross margin was 27% and 24% for the quarters ended
June 30, 2006 and June 30, 2005, respectively.

Oil & Water Technologies Segment



|                                |  |                                          |        |   |        |   |        |                  |  |   |        |   |  |    |  
|------------------------------- |  | ---------------------------------------- | ------ | - | ------ | - | ------ | ---------------- |  | - | ------ | - |  | -- | -
|                                |  | Three Months EndedJune 30,               |        |   | Change |   |        | PercentageChange | 
|                                |  | 2006                                     |        |   | 2005   |   |        |                 
|                                |  | (unaudited)                              |       
|                                |  | (in thousands, except percentage change) |       
|Revenue                         |  | $                                        | 95,572 |   |        | $ | 72,590 |                  |  | $ | 22,982 |   |  | 32 | %
|Cost of goods sold and services |  |                                          | 74,413 |   |        |   | 58,247 |                  |  |   | 16,166 |   |  | 28 | %
|                                |  |                                          |        |   |        |   |        |                  |  |   |        |   |  |    |  
|Gross profit                    |  | $                                        | 21,159 |   |        | $ | 14,343 |                  |  | $ | 6,816  |   |  | 48 | %
|Gross margin                    |  |                                          | 22     | % |        |   | 20     | %                |  |   | 2      | % |  | 10 | %

Oil & Water Technologies segment revenue increased $23.0 million, or 32%, for the three
months ended June 30, 2006, compared to the three months ended June 30, 2005. $11.4 million of the increase was attributable to an increase in the built-to-order Oil & Water Technologies projects associated with increased activity
in the international oil and gas market and $11.6 million of the increased revenues were from higher North American activities reflecting rig count trend, increased productivity through owned facilities and an increase in subcontractor activities in
North America.

Inter-segment revenues for this business segment were $4.0 million for the three months ended June 30, 2006 compared
to $232,000 for the three months ended June 30, 2005.

Gross profit for the Oil & Water Technologies segment increased $6.8
million, or 48%, for the three months ended June 30, 2006, compared to the three months ended June 30, 2005 primarily due to the increase in sales partially offset with an estimated loss provision recorded for projected cost overruns on
one of our projects amounting to approximately $1.0 million. As a percentage of revenue, gross margin was 22% and 20% for the three month period ended June 30, 2006 and 2005, respectively. The increase in gross margin, net of the recorded loss
provision, reflected the favorable impact of increased business, pricing impact and overall job execution process improvements.



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##### Table of Contents

Gas Technologies Segment



|                                |  |                                          |        |   |        |   |       |                  |  |   |       |    |  |     |   
|------------------------------- |  | ---------------------------------------- | ------ | - | ------ | - | ----- | ---------------- |  | - | ----- | -- |  | --- | --
|                                |  | Three Months EndedJune 30,               |        |   | Change |   |       | PercentageChange | 
|                                |  | 2006                                     |        |   | 2005   |   |       |                 
|                                |  | (unaudited)                              |       
|                                |  | (in thousands, except percentage change) |       
|Revenue                         |  | $                                        | 16,779 |   |        | $ | 7,277 |                  |  | $ | 9,502 |    |  | 131 | % 
|Cost of goods sold and services |  |                                          | 7,844  |   |        |   | 2,370 |                  |  |   | 5,474 |    |  | 231 | % 
|                                |  |                                          |        |   |        |   |       |                  |  |   |       |    |  |     |   
|Gross profit                    |  | $                                        | 8,935  |   |        | $ | 4,907 |                  |  | $ | 4,028 |    |  | 82  | % 
|Gross margin                    |  |                                          | 53     | % |        |   | 67    | %                |  |   | (14   | )% |  | (21 | )%

Revenue of $16.8 million for the three months ended June 30, 2006 for the Gas Technologies
segment increased $9.5 million, or 131%, compared to $7.3 million for the three months ended June 30, 2005. This increase was due primarily to the $8.0 million South East Asian built-to-order project and a 1.5 million increase in membrane
sales.

Gross profit for the Gas Technologies segment for the three months ended June 30, 2006 increased $4.0 million, or 82%,
compared to the three months ended June 30, 2005. This increase was due primarily to higher built-to-order project and membrane replacement activity. Gross margin, as a percentage of revenue, was 53% and 67% for the three months ended
June 30, 2006 and 2005, respectively. The decrease in gross margin reflects the project mix primarily attributable to the higher percentage of built-to-order projects in the quarter, which generally have lower margins than membrane sales and
CO2processing operations.

Automation & Controls Segment



|                                |  |                                          |        |   |        |   |        |                  |  |   |       |   |  |    |  
|------------------------------- |  | ---------------------------------------- | ------ | - | ------ | - | ------ | ---------------- |  | - | ----- | - |  | -- | -
|                                |  | Three Months EndedJune 30,               |        |   | Change |   |        | PercentageChange | 
|                                |  | 2006                                     |        |   | 2005   |   |        |                 
|                                |  | (unaudited)                              |       
|                                |  | (in thousands, except percentage change) |       
|Revenue                         |  | $                                        | 21,817 |   |        | $ | 15,829 |                  |  | $ | 5,988 |   |  | 38 | %
|Cost of goods sold and services |  |                                          | 16,926 |   |        |   | 12,681 |                  |  |   | 4,245 |   |  | 33 | %
|                                |  |                                          |        |   |        |   |        |                  |  |   |       |   |  |    |  
|Gross profit                    |  | $                                        | 4,891  |   |        | $ | 3,148  |                  |  | $ | 1,743 |   |  | 55 | %
|Gross margin                    |  |                                          | 22     | % |        |   | 20     | %                |  |   | 2     | % |  | 10 | %

Revenue for the Automation & Controls segment of $21.8 million for the three months ended
June 30, 2006 increased $6.0 million, or 38%, compared to $15.8 million for the three months ended June 30, 2005. This increase was primarily due to the continued Gulf of Mexico field services work related to the after-effects of
hurricanes Katrina and Rita of approximately $3.0 million and packaged automation product sales contributing approximately $3.0 million.

Inter-segment revenues for this business segment were $1.5 million for the three months ended June 30, 2006, compared to $816,000 for the three months ended June 30, 2005.

Gross profit for the Automation & Controls segment increased $1.7 million, or 55%, for the three months ended June 30, 2006 compared to the
three months ended June 30, 2005. This increase was primarily due to the increased revenues. Gross margins, as a percentage of revenues, was 22% and 20% for the three months ended June 30, 2006 and 2005, respectively. The improvement in
gross margin reflects the higher business activity as well as improved pricing.

Selling, General and Administrative Expense.Selling, general and administrative expense of $16.7 million for the three months ended June 30, 2006, increased $1.9 million, or 13%, compared to the three months ended June 30, 2005. This increase was attributable to an approximate
$700,000 increase in incentive compensation



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##### Table of Contents

related to increased income results. An additional $1.2 million increase was primarily due to higher support expenses related to increased business activity
that included approximately $500,000 in distribution and services expenses, related to standard and traditional equipment sales partially offset with reduced overhead and other expenses.

Overall headcount increased from 1,732 employees at June 30, 2005 to 1,890 employees at June 30, 2006 primarily in our manufacturing and field
service staffing levels as a direct result of the higher business activity.

Depreciation and Amortization Expense. Depreciation and
amortization expense of $1.4 million for the three months ended June 30, 2006, increased $86,000, or 6%, compared to the three months ended June 30, 2005. The increase was attributable primarily to depreciation from the addition of
operating equipment and to the amortization of intangible assets associated with our investment in a joint venture that fabricates a pilotless burner ignition system for controlling gas-fired heaters used in connection with oil and gas wellhead
equipment.

Closure, Severance and Other. Closure, severance and other expenses of $193,000 for the three months ended June 30,
2006 represented additional charges related to severance expense associated with a former employee from a restructuring plan that was initiated in the fourth quarter of 2004. Closure, severance and other expenses of $48,000 for the three months
ended June 30, 2005 represented closure costs related to the December 2004 restructuring plan.

Interest expense.
Interest expense of $727,000 for the three months ended June 30, 2006 decreased by $349,000, or 32%, compared to the three months ended June 30, 2005 due to reductions in outstanding debt and lower bank fees, partially offset by higher
interest rates.

Interest Cost on Postretirement Benefit Liability. Interest cost on postretirement liability of $50,000 for the
three months ended June 30, 2006 decreased $160,000, or 76%, compared to the three months ended June 30, 2005, primarily due to plan amendments that included the reductions of certain benefits.

Interest Income.Interest income of $55,000 for the three months ended June 30, 2006 increased $42,000 compared to the three months ended
June 30, 2005, reflecting the higher cash balances during the current period and higher interest rates.

Other, net.Other, net
was a net loss of $578,000 for the three months ended June 30, 2006, related primarily to net realized and unrealized foreign exchange transaction losses in our UK and Canadian operations. Other, net was a net loss of $474,000 for the three
months ended June 30, 2005 related primarily to net realized and unrealized foreign currency exchange transaction losses and expense related to the change in valuation of the then outstanding warrants to purchase our common stock.

Provision for Income Taxes.Income tax expense for the three months ended June 30, 2006 was $5.8 million compared to $1.9 million for the
three months ended June 30, 2005. The change in tax expense was primarily attributable to an increase in pre-tax income to $15.4 million for the three months ended June 30, 2006 from pre-tax income of $4.5 million for the three months
ended June 30, 2005. The effective tax rate for the three months ended June 30, 2006 was 38.0% compared to 42.9% for the three months ended June 30, 2005. The decrease in the effective tax rate was primarily attributable to a decrease
in permanent differences due to the mark-to-market expense on warrants exercised in 2005.



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##### Table of Contents

Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005 (unaudited)

Consolidated

Revenue and Gross Profit



|                                   |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |    |  
|---------------------------------- |  | ---------------------------------------- | ------- | - | ------ | - | ------- | ---------------- |  | - | ------ | - |  | -- | -
|                                   |  | Six Months EndedJune 30,                 |         |   | Change |   |         | PercentageChange | 
|                                   |  | 2006                                     |         |   | 2005   |   |         |                 
|                                   |  | (unaudited)                              |        
|                                   |  | (in thousands, except percentage change) |        
|Revenue(1)                         |  | $                                        | 246,474 |   |        | $ | 183,304 |                  |  | $ | 63,170 |   |  | 34 | %
|Cost of goods sold and services(1) |  |                                          | 180,080 |   |        |   | 139,621 |                  |  |   | 40,459 |   |  | 29 | %
|                                   |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |    |  
|Gross profit                       |  | $                                        | 66,394  |   |        | $ | 43,683  |                  |  | $ | 22,711 |   |  | 52 | %
|Gross margin                       |  |                                          | 27      | % |        |   | 24      | %                |  |   | 3      | % |  | 13 | %

---

|(1) | The table above includes inter-segment elimination amounts for both revenues and cost of
goods sold and services of $6.3 million and $2.4 million for the six months ended June 30, 2006 and 2005, respectively.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Revenue.Revenue of $246.5 million for the six months ended June 30, 2006 increased $63.2 million, or 34%, from $183.3 million for the six months ended June 30, 2005 as a result of increased business activity from each of
our three operating segments, particularly in the Oil & Water Technologies segment.

Gross Profit.Gross profit for the six
months ended June 30, 2006 increased $22.7 million, or 52%, to $66.4 million, compared to $43.7 million for the six months ended June 30, 2005. As a percentage of revenues, gross margin was 27% and 24% for the quarters ended
June 30, 2006 and June 30, 2005, respectively.

Oil & Water Technologies Segment



|                                |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |    |  
|------------------------------- |  | ---------------------------------------- | ------- | - | ------ | - | ------- | ---------------- |  | - | ------ | - |  | -- | -
|                                |  | Six Months Ended June 30,                |         |   | Change |   |         | PercentageChange | 
|                                |  | 2006                                     |         |   | 2005   |   |         |                 
|                                |  | (unaudited)                              |        
|                                |  | (in thousands, except percentage change) |        
|Revenue                         |  | $                                        | 180,641 |   |        | $ | 139,595 |                  |  | $ | 41,046 |   |  | 29 | %
|Cost of goods sold and services |  |                                          | 140,261 |   |        |   | 112,407 |                  |  |   | 27,854 |   |  | 25 | %
|                                |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |    |  
|Gross profit                    |  | $                                        | 40,380  |   |        | $ | 27,188  |                  |  | $ | 13,192 |   |  | 49 | %
|Gross margin                    |  |                                          | 22      | % |        |   | 20      | %                |  |   | 2      | % |  | 10 | %

Oil & Water Technologies segment revenue increased $41.0 million, or 29%, for the six
months ended June 30, 2006, compared to the six months ended June 30, 2005. Approximately $26.0 million of this increase was due to international and domestic increased business activities and project awarding along with improved job
execution in built-to-order projects both domestically and internationally. Approximately $15.0 million increase was due to continued strength in sales of our traditional and standard equipment and services.

Inter-segment revenues for this business segment were $4.0 million for the six months ended June 30, 2006, compared to $523,000 for the six months
ended June 30, 2005.

Gross profit for the Oil & Water Technologies segment increased $13.2 million, or 49%, for the six
months ended June 30, 2006, compared to the six months ended June 30, 2005. $5.9 million of the increase was due to escalating activity in built-to-order projects both domestically and internationally and $7.0 million of the increase was
due to our continued strength in sales of our traditional and standard equipment and services. Increased profitability and margin were also reflected of job execution improvements as well as pricing increases especially in North American activities.
As a percentage of revenues, gross margin was 22% and 20% for the six month periods ended June 30, 2006 and 2005, respectively.



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##### Table of Contents

Gas Technologies Segment



|                                |  |                                          |        |   |        |   |        |                  |  |   |        |    |  |     |   
|------------------------------- |  | ---------------------------------------- | ------ | - | ------ | - | ------ | ---------------- |  | - | ------ | -- |  | --- | --
|                                |  | Six Months EndedJune 30,                 |        |   | Change |   |        | PercentageChange | 
|                                |  | 2006                                     |        |   | 2005   |   |        |                 
|                                |  | (unaudited)                              |       
|                                |  | (in thousands, except percentage change) |       
|Revenue                         |  | $                                        | 29,481 |   |        | $ | 15,174 |                  |  | $ | 14,307 |    |  | 94  | % 
|Cost of goods sold and services |  |                                          | 12,950 |   |        |   | 5,150  |                  |  |   | 7,800  |    |  | 151 | % 
|                                |  |                                          |        |   |        |   |        |                  |  |   |        |    |  |     |   
|Gross profit                    |  | $                                        | 16,531 |   |        | $ | 10,024 |                  |  | $ | 6,507  |    |  | 65  | % 
|Gross margin                    |  |                                          | 56     | % |        |   | 66     | %                |  |   | (10    | )% |  | (15 | )%

Revenue of $29.5 million for the six months ended June 30, 2006 for the Gas Technologies
segment increased $14.3 million, or 94%, compared to $15.2 million for the six months ended June 30, 2005. This increase was primarily due to higher built-to-order project activity levels of $10.9 million (primarily related to a major South
East Asian project), increased membrane sales of $2.5 million and higher CO2processing revenues of $850,000.

There were no inter-segment revenues for this business segment for the six months ended June 30, 2006 and 2005.

Gross profit for the Gas Technologies segment for the six months ended June 30, 2006 increased $6.5 million, or 65%, compared to the six months
ended June 30, 2005. Gross margin as a percentage of revenue for Gas Technologies was 56% and 66% for the six-month periods ended June 30, 2006 and 2005, respectively. The decrease in gross margin reflects the project mix primarily
attributable to the higher percentage of built-to-order projects during the year, which generally have lower margins than membrane sales and CO2processing operations.

Automation & Controls Segment



|                                |  |                                          |        |   |        |   |        |                  |  |   |        |   |  |    |  
|------------------------------- |  | ---------------------------------------- | ------ | - | ------ | - | ------ | ---------------- |  | - | ------ | - |  | -- | -
|                                |  | Six Months EndedJune 30,                 |        |   | Change |   |        | PercentageChange | 
|                                |  | 2006                                     |        |   | 2005   |   |        |                 
|                                |  | (unaudited)                              |       
|                                |  | (in thousands, except percentage change) |       
|Revenue                         |  | $                                        | 42,689 |   |        | $ | 30,981 |                  |  | $ | 11,708 |   |  | 38 | %
|Cost of goods sold and services |  |                                          | 33,206 |   |        |   | 24,510 |                  |  |   | 8,696  |   |  | 35 | %
|                                |  |                                          |        |   |        |   |        |                  |  |   |        |   |  |    |  
|Gross profit                    |  | $                                        | 9,483  |   |        | $ | 6,471  |                  |  | $ | 3,012  |   |  | 47 | %
|Gross margin                    |  |                                          | 22     | % |        |   | 21     | %                |  |   | 1      | % |  | 5  | %

Revenue for the Automation & Controls segment of $42.7 million increased $11.7 million,
or 38%, for the six months ended June 30, 2006, compared to $31.0 million for the six months ended June 30, 2005. This increase was primarily due to the continued Gulf of Mexico field services work related to the after effects of
hurricanes Katrina and Rita of approximately $3.7 million, an increase in the packaged automation product sales contributing approximately $5.8 million and an increase in our International field service work primarily in Angola and Kazakhstan of
approximately $2.2 million.

Inter-segment revenues for this business segment were $2.3 million for the six months ended June 30, 2006
compared to $1.9 million for the six months ended June 30, 2005.

Gross profit for the Automation & Controls segment
increased $3.0 million, or 47%, for the six months ended June 30, 2006 compared to the six months ended June 30, 2005. This increase was primarily due to the increased revenues. Gross margin as a percentage of revenue was 22% and 21% for
the six months ended June 30, 2006 and 2005, respectively.



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Selling, General and Administrative Expense.Selling, general and administrative expense of $33.7
million for the six months ended June 30, 2006, increased $4.7 million, or 16%, compared to the six months ended June 30, 2005. Approximately $700,000 of the increase was in selling and pre-ordering engineering expenses and $1.0 million
was in distribution and services expenses attributable to the higher business activity. An additional $1.6 million increase was primarily due to higher support expenses related to increased business activity and an approximate $1.0 million of higher
incentive compensation related to increased income results.

Overall headcount increased from 1,732 employees at June 30, 2005 to
1,890 employees at June 30, 2006 primarily in our manufacturing and field service staffing levels as a direct result of the higher business activity.

Depreciation and Amortization Expense. Depreciation and amortization expense of $2.9 million for the six months ended June 30, 2006, increased $210,000, or 8%, compared to the six months ended
June 30, 2005. The increase was attributable primarily to depreciation from the addition of operating equipment and to the amortization of intangible assets associated with our investment in a joint venture that fabricates a pilotless burner
ignition system for controlling gas-fired heaters used in connection with oil and gas wellhead equipment.

Closure, severance
and other. Closure, severance and other expenses of $245,000 for the six months ended June 30, 2006 represented additional charges related to severance expense associated with a former employee from a restructuring plan that was initiated
in the fourth quarter of 2004. Closure, severance and other expenses of $90,000 for the six months ended June 30, 2005 represented $40,000 of valuation adjustment charge related to severance expense associated with a former employee from a
restructuring plan that was recorded in the fourth quarter of 2004 and $50,000 representing other closure costs.

Interest expense.
Interest expense of $1.4 million for the six months ended June 30, 2006 decreased by $660,000, or 32%, compared to the six months ended June 30, 2005 due primarily to reduced debt levels, lower bank fees partially offset from higher
interest rates.

Interest Cost on Postretirement Benefit Liability. Interest cost on postretirement liability of $100,000 for the
six months ended June 30, 2006 decreased $320,000, or 76%, compared to the six months ended June 30, 2005, primarily due to plan amendments that included the reductions of certain benefits.

Interest Income.Interest income of $119,000 for the six months ended June 30, 2006 increased $54,000, or 83%, compared to the six months
ended June 30, 2005 reflecting the higher cash balances during the current period and higher interest rates.

Other, net.Other, net was a net loss of $129,000 for the six months ended June 30, 2006, related primarily to net realized and unrealized foreign exchange transaction gains in our UK operations of $202,000 offset by foreign exchange transaction losses
in our Canada and Japan operations of $257,000 and $47,000 respectively. Other, net was a net loss of $394,000 for the six months ended June 30, 2005 related primarily to net realized and unrealized foreign currency exchange transaction gains
from foreign operations of $180,000, offset by $549,000 of expense related to the change in valuation of the then outstanding warrants to purchase our common stock.

Provision for Income Taxes.Income tax expense for the six months ended June 30, 2006 was $10.7 million compared to $3.7 million for the six months ended June 30, 2005. The change in tax expense was
primarily attributable to an increase in pre-tax income to $28.0 million for the six months ended June 30, 2006 from pre-tax income of $9.1 million for the six months ended June 30, 2005. The effective tax rate for the six months ended
June 30, 2006 was 38.0% compared to 40.4% for the six months ended June 30, 2005. The decrease in the effective tax rate was primarily attributable to a decrease in permanent differences due to the mark-to-market expense on warrants
exercised in 2005.



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Liquidity and Capital Resources

Financial Condition and Liquidity

The 2004 term loan and revolving credit facilities originally set
to mature on March 15, 2007 were replaced by revolving credit facilities providing for an aggregate borrowing capacity of up to $85.0 million on July 12, 2006. We believe our cash from operations and borrowing capacity are adequate for our
current financing and working capital needs. We intend to consider and, if feasible, to make strategic acquisitions of other companies, assets and product lines that complement our existing businesses. We cannot assure we will be able to
successfully identify suitable acquisition opportunities, complete any particular acquisition or be able to finance a transaction.

Debt Facilities

We maintain revolving credit facilities, as well as a working capital facility for export sales.

2004 Term Loan and Revolving Credit Facilities

Our 2004 term loan and revolving credit facilities, in effect from March 2004 to July 12, 2006, provided for a term loan of $45.0 million and a revolving credit facility providing for aggregate additional
borrowings of $35.0 million, consisting of a US revolving facility with a borrowing capacity of $20.0 million, a Canadian revolving facility with a borrowing capacity of $5.0 million, and a UK revolving credit facility with a borrowing capacity of
$10.0 million. These facilities were to mature on March 15, 2007.

Beginning in June 2004, the 2004 term loan and revolving credit
facilities required quarterly payments of $1.6 million. We borrowed funds under the 2004 term loan and revolving credit facilities to retire debt outstanding under a prior term loan and revolving credit facilities as of March 15, 2004. At
June 30, 2006 we have not classified any portion of this loan as current due to the refinancing on July 12, 2006.

In 2006, we
prepaid $4.4 million of the 2004 term loan and revolving credit facilities, of which $3.0 million was prepaid in the quarter ended June 30, 2006. In 2005, we prepaid $6.4 million of the 2004 term loan and revolving credit facilities.
Additionally, we prepaid $1.1 million, representing the remaining balance, on the long term promissory note on our manufacturing facility in Magnolia, Texas.

We incurred an additional $995,000 of deferred loan costs related to the 2004 term loan and revolving credit facilities, which we amortized as interest expense. We also incurred approximately $115,000 of deferred loan
cost primarily during the first quarter of 2005 associated with an amendment to the 2004 term loan and revolving credit facilities. This additional cost was amortized over the term of the amendment, which ended June 2005.

The 2004 term loan and revolving credit facilities agreement provided for interest at a rate based upon the ratio of Funded Debt to EBITDA, as defined in
the facilities, and ranging from, at our election, (1) a high of LIBOR plus 2.75% to a low of LIBOR plus 2.00% or (2) a high of a Base Rate plus 1.75% to a low of a Base Rate plus 1.00%. We paid commitment fees related to this agreement on
the undrawn portion of the facility, 0.375% as of June 30, 2006, depending upon the ratio of Funded Debt to EBITDA.

We had borrowings
of $19.8 million outstanding under the term loan portion of the 2004 term loan and revolving credit facility at June 30, 2006, which bore interest at 7.13% to 9.25% with a weighted average interest rate of 7.49%. There were no borrowings
outstanding for the revolving credit portion of the 2004 term loan and revolving credit facilities at June 30, 2006. We had letters of credit outstanding under the 2004 term loan and revolving credit facilities of $9.1 million at June 30,
2006. Availability under our 2004 term loan and revolving credit facilities is reduced by the amount of our outstanding letters of credit and loans. Fees related to these letters of credit at June 30, 2006 were approximately 2.00% of the
outstanding balance. These letters of credit support contract performance and warranties and were to expire at various dates through June 2008.



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We and our operating subsidiaries guaranteed our 2004 term loan and revolving credit facilities
agreement, which were secured by a first lien or first priority security interest in or pledge of substantially all of the assets of the borrowers and certain subsidiaries, including accounts receivable, inventory, equipment, intangibles, equity
interests in US subsidiaries, 661/3% of the equity interest in active, non-US subsidiaries and interests in
certain contracts. Our assets and our active US subsidiaries secure the US, Canadian and UK revolving facilities, assets of our Canadian subsidiary also secure the Canadian facility and assets of our UK subsidiaries also secure the UK facility. The
US facility was guaranteed by each of our US subsidiaries, while the Canadian and UK facilities were guaranteed by us, each of our US subsidiaries and the Canadian subsidiary or the UK subsidiaries, as applicable.

The 2004 term loan and revolving credit facilities agreement contained restrictive covenants including, among others, those that limit the amount of
Funded Debt to EBITDA, impose a minimum fixed charge coverage ratio and a minimum net worth requirement. We were in compliance with all restrictive debt covenants in our loan agreements as of June 30, 2006.

2006 Revolving Credit Facilities

On
July 12, 2006, we entered into a new revolving facilities agreement, referred to as the 2006 revolving credit facilities of $85.0 million consisting of a US revolving facility with a borrowing capacity of $65.0 million, a Canadian revolving
facility with a borrowing capacity of $5.0 million and a UK revolving facility with a borrowing capacity of $15.0 million, and terminated the term loan and revolving credit facilities agreement dated March 15, 2004. The 2006 revolving credit
facilities are scheduled to mature on June 30, 2011. The borrowing capacities under the 2006 revolving credit facilities agreement are not subject to any monthly borrowing base limitations. In addition to the base commitments, the new
facilities permit the Company to require an increase in the aggregate borrowing capacity by $50 million if certain requirements are met.

The 2006 revolving credit facilities agreement provides for interest at a rate based upon the ratio of Funded Debt to EBITDA, as defined in the credit facility (EBITDA), and ranging from, at the Companys election,
(1) a high of the London Interbank Offered Rate (LIBOR) plus 2.00% to a low of LIBOR plus 1.00% or (2) a high of a Base Rate plus 1.00% to a low of a Base Rate plus 0.00%. The Company will pay commitment fees related to this
agreement on the undrawn portion of the facility, depending upon the ratio of Funded Debt to EBITDA, which were calculated at 0.25% at July 12, 2006. Aggregate borrowings of $18.0 million were outstanding under 2006 revolving credit facilities
at July 12, 2006, which bore interest at an average rate of 8.25%. The Company prepaid $1.8 million of the 2004 term loan and revolving credit facilities on July 12, 2006. The Company had letters of credit outstanding under the 2004 term
loan and revolving credit facilities of $9.3 million at that date, which became outstanding under the 2006 revolving credit facilities agreement. Fees related to these letters of credit were approximately 1.0% of the outstanding balance at
July 12, 2006. These letters of credit support contract performance and warranties and expire at various dates through June 2008.

The
2006 revolving credit facilities agreement is secured by a first lien or first priority security interest in or pledge of substantially all of the assets of the borrowers and certain subsidiaries, including accounts receivable, inventory, equipment,
intangibles, equity interests in US subsidiaries, 661/3% of the equity interest in active, non-US subsidiaries
and interests in certain contracts. Assets of the Company and its active US subsidiaries secure the US, Canadian, UK revolving facilities, assets of the Companys Canadian subsidiary also secure the Canadian facility and assets of the
Companys UK subsidiaries also secure the UK facility. The US facility is guaranteed by each US subsidiary of the Company, while the Canadian and UK facilities are guaranteed by NATCO Group Inc., each of its US subsidiaries and the Canadian
subsidiary or the UK subsidiaries, as applicable.

The 2006 revolving credit facilities agreement contains restrictive covenants
including, among others, those that limit the amount of Funded Debt to EBITDA, impose a minimum fixed charge coverage ratio and impose a minimum net worth requirement. Pursuant to the 2006 revolving credit facilities, NATCO is not permitted to make
any distributions of any property or cash to the Company or its stockholders other than dividends required



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under its Series B Preferred Stock and certain other dividends not to exceed, in the aggregate, $3.0 million per year, if certain conditions related to
Funded Debt to EBITDA and borrowing capacity are met, or $1.5 million per year, in the aggregate, if such conditions are not met. Subject to certain restrictions, the Company also has the ability to buy back up to $25.0 million in value of its
common stock.

Promissory Note on Real Estate Loan

On February 6, 2002, the Company borrowed $1.5 million under a long-term promissory note to finance the purchase of a manufacturing facility in Magnolia, Texas. This note accrued interest at the 90-day LIBOR plus
3.25%, and required quarterly payments of principal of approximately $24,000 and interest for five years beginning May 2002, with a final balloon payment due February 2007. This promissory note was collateralized by the manufacturing facility in
Magnolia, Texas. This note was paid in full during the third quarter of 2005.

Export Sales Facility

On July 23, 2004, the Company and two of its subsidiaries entered into an international revolving credit facilities with Wells Fargo HSBC Trade Bank,
N.A. providing for letters of credit and loans of up to $10.0 million, subject to borrowing base limitations. This working capital facility for export sales is secured by specific project inventory and receivables, as well as certain other
inventory, accounts receivable and equipment, and is partially guaranteed by the US Export-Import Bank. Loans under this facility mature on March 31, 2007, and bear interest at either (1) a Base Rate, as defined in the agreement, less
0.25% or (2) LIBOR plus 2.00%, at the Companys election. This facility replaced a similar export sales credit facility that terminated on July 23, 2004. Letters of credit outstanding under this facility as of June 30, 2006 were
$6.8 million. This facility had fees related to letters of credit of approximately 1.00% of the outstanding balance for the period January 1, 2006 to June 30, 2006. In addition, we had unsecured letters of credit and bonds totaling
$212,000 at June 30, 2006.

As of June 30, 2006, available borrowing capacity under the 2004 term loan and revolving credit was
$25.5 million. As of July 12, 2006, the available borrowing capacity under the 2006 revolving credit facilities was $54.3 million. Although no assurances can be given, we believe that our operating cash flow, supported by our borrowing
capacity, will be adequate to fund operations for at least the next twelve months. Should we decide to pursue acquisition opportunities, the determination of our ability to finance these acquisitions will be a critical element of the analysis of the
opportunities.

Working capital

As of
June 30, 2006, we had cash and other working capital of $9.2 million and $72.0 million respectively, compared to $9.2 million and $49.1 million as of December 31, 2005, respectively. The increase in working capital from December 31,
2005 to June 30, 2006 of $22.9 million was due to the increase in trade receivables and inventory, primarily work in progress attributable to increased business activity.

Cash Flow



|                                                             |  |                                  |        |   |      |   |        |  
|------------------------------------------------------------ |  | -------------------------------- | ------ | - | ---- | - | ------ | -
|                                                             |  | For the Six Months EndedJune 30, |       
|                                                             |  | 2006                             |        |   | 2005 |  
|                                                             |  | (in thousands)                   |       
|                                                             |  | (Unaudited)                      |       
|Net cash provided by (used in):                              |  |                                  |        |   |      |   |        |  
|Operating activities                                         |  | $                                | 9,305  |   |      | $ | 6,153  |  
|Investing activities                                         |  |                                  | (2,856 | ) |      |   | (875   | )
|Financing activities                                         |  |                                  | (6,882 | ) |      |   | (6,648 | )
|Effect of exchange rate changes on cash and cash equivalents |  |                                  | 430    |   |      |   | 455    |  
|                                                             |  |                                  |        |   |      |   |        |  
|Net increase (decrease) in cash                              |  | $                                | (3     | ) |      | $ | (915   | )
|                                                             |  |                                  |        |   |      |   |        |  

Net cash provided by operating activities for the six months ended June 30, 2006 was $9.3
million compared to $6.1 million provided by operating activities for the six months ended June 30, 2005. The increase in net cash



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provided by operating activities in 2006, compared to 2005 was largely due to the significant increase in net income in the six months ended June 30,
2006 versus 2005 as adjusted for non-cash items and offset by a significant increase in working capital consisting primarily of higher trade receivables and inventories, as a result of increased business activity. Trade receivables will fluctuate
depending on business levels, invoice terms, timing of collections and, for large projects particularly, achieving contractual milestones that permit invoicing for interim payments.

Net cash used in investing activities for the six months ended June 30, 2006 was $2.9 million compared to net cash used in investing activities of
$875,000 for the six months ended June 30, 2005. The primary use of funds for the six months ended June 30, 2006 was for capital expenditures of $2.5 million and investment in other long-term intangible assets of $412,000. The primary use
of funds for the six months ended June 30, 2005 was for capital expenditures of $1.8 million, offset by $928,000 in proceeds from the sale of certain operating assets.

Net cash used in financing activities for the six months ended June 30, 2006 and 2005 was $6.9 million and $6.6 million, respectively. The primary
use of cash for the six months ended June 30, 2006 was repayment of debt under revolving lines of credit and long-term debt totaling $7.6 million, of which $4.4 million represented prepayment of the 2004 term loan and revolving credit
facilities, $2.9 million related to bank overdrafts and $750,000 related to dividends paid to our preferred stockholders. Sources of cash for the six months ended June 30, 2006 were $1.1 million of proceeds from the exercise of stock options
along with $2.3 million attributable to the tax benefit of stock options exercised and restricted stock vested.

Preferred Shares

On March 25, 2003, we issued 15,000 shares of Series B Convertible Preferred Stock (Series B Preferred Shares), and
warrants to purchase 248,800 shares of our common stock, to a private investment fund, for an aggregate price of $15.0 million. Approximately $99,000 of the aggregate purchase price was allocated to the warrants. Proceeds from the issuance of these
securities, net of related issuance costs of $679,000, were used to reduce our outstanding revolving debt balances and for other general corporate purposes.

Each of the Series B Preferred Shares has a face value of $1,000 and pays a cumulative dividend of 10% per annum of face value, which is payable semi-annually on June 15 and December 15 of each year,
except the initial dividend payment which was payable on July 1, 2003. Each of the Series B Preferred Shares is convertible, at the option of the holder, into (1) a number of shares of common stock equal to the face value of such Series B
Preferred Share divided by the conversion price, which was $7.805 (or an aggregate of 1,921,845 shares) at June 30, 2006, and (2) a cash payment equal to the amount of dividends on such share that have accrued since the prior semi-annual
dividend payment date.

In the event of a change in control, as defined in the certificate of designations for the Series B Preferred
Shares, each holder of the Series B Preferred Shares has the right to convert the Series B Preferred Shares into common stock or to cause the Company to redeem for cash some or all of the Series B Preferred Shares at an aggregate redemption price
equal to the greater of (1) the sum of (a) $1,000 (adjusted for stock splits, stock dividends, etc.) multiplied by the number of shares to be redeemed, plus (b) an amount (not less than zero) equal to the product of $500 (adjusted for
stock splits, stock dividends, etc.) multiplied by the aggregate number of Series B Preferred Shares to be redeemed less the sum of the aggregate amount of dividends paid in cash since the issuance date, plus any gain on the related stock warrants,
and (2) the aggregate face value of the Series B Preferred Shares plus the aggregate amount of dividends that have accrued on such shares since the last dividend payment date.

We have the right to call for redemption, the Series B Preferred Shares for cash on or after March 25, 2008, at a redemption price per share equal
to the face value of the Series B Preferred Shares plus the amount of dividends that have been accrued but not paid since the most recent semi-annual dividend payment date.

Due to the cash redemption features upon a change in control as described above, the Series B Preferred Shares do not qualify for permanent equity
treatment in accordance with the Emerging Issues Task Force Topic D-98: Classification and Measurement of Redeemable Securities, which specifically requires that permanent



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equity treatment be precluded for any security with redemption features that are not solely within the control of the issuer. Therefore, we have accounted
for the Series B Preferred Shares as temporary equity in the accompanying balance sheet, and have not assigned any value to our right to redeem the Series B Preferred Shares on or after March 25, 2008.

If the Series B Preferred Shares are redeemed under contingent redemption features, any redemption amount greater than carrying value would be recorded
as a reduction of income allocable to common shareholders when the event becomes probable.

If we were to fail to pay dividends for two
consecutive periods or any redemption price due with respect to the Series B Preferred Shares for a period of 60 days following the payment date, we would be in default under the terms of such shares. During a default period, (1) the dividend
rate on the Series B Preferred Shares would increase to 10.25% and (2) we would be restricted from paying dividends on, or redeeming or acquiring our common or other outstanding stock, with limited exceptions. If we were to fail to set aside or
make payments in cash of any redemption price due with respect to the Series B Preferred Shares, and the holders elect, our right to redeem the shares may be terminated.

Warrants

The warrants issued to the private investment fund had an exercise price of $10.00 per
share of common stock and were to expire on March 25, 2006. The Company adjusted this liability to fair value from the date of issuance through the date of exercise and recorded an expense of $1.8 million for the year ended December 31,
2005.

On August 26, 2005, the investment fund exercised in full warrants to purchase Company common stock pursuant to a cashless
exercise provision contained in the warrant instrument, which resulted in no cash payment to the Company. The final number of shares of common stock issued to the investment fund was calculated based on the average of the closing price of the
Companys shares on the New York Stock Exchange for the ten trading-day period ending on the day prior to the exercise. The average price was $17.933, resulting in the issuance of 110,061 shares of common stock in exchange for the warrants.

Bookings and Backlog

Bookings

The Companys bookings for the three months and six months ended June 30, 2006 and 2005 were:



|                          |  |                            |         |                          |   |         |  |      |         |  |   |        
|------------------------- |  | -------------------------- | ------- | ------------------------ | - | ------- |  | ---- | ------- |  | - | -------
|                          |  | Three Months EndedJune 30, |         | Six Months EndedJune 30,
|                          |  | 2006                       |         | 2005                     |   | 2006    |  | 2005
|                          |  | (unaudited, in thousands) 
|Bookings:                 |  |                            |         |                          |   |         |  |      |         |  |   |        
|Oil & Water Technologies. |  | $                          | 81,062  |                          | $ | 103,712 |  | $    | 193,877 |  | $ | 181,792
|Gas Technologies          |  |                            | 61,057  |                          |   | 5,869   |  |      | 81,593  |  |   | 17,404 
|Automation & Controls.    |  |                            | 18,764  |                          |   | 16,713  |  |      | 39,758  |  |   | 30,857 
|                          |  |                            |         |                          |   |         |  |      |         |  |   |        
|Total bookings            |  | $                          | 160,883 |                          | $ | 126,294 |  | $    | 315,228 |  | $ | 230,053
|                          |  |                            |         |                          |   |         |  |      |         |  |   |        

Our bookings were $160.9 million compared to $126.3 million for the three months ended
June 30, 2006 and 2005, and $315.2 million compared to $230.1 million for the six months ended June 30, 2006 and 2005, respectively. Bookings decreased $22.6 million or 22% in the Oil & Water Technologies segment primarily due to
the timing of built-to-order projects, increased $55.2 million in the Gas Technologies segment primarily due to a $46.0 million CO2membrane plant award along with additional membrane replacement orders and an increase of $2.1 million or 12% in the Automation & Controls segment primarily due to an increase in our time and material work in the Gulf of
Mexico for the three months ended June 30, 2006 when compared to the three months ended June 30, 2005.



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Backlog

The Companys backlog as of June 30, 2006 and December 31, 2005 were:



|                         |  |                    |         |                         |   |        
|------------------------ |  | ------------------ | ------- | ----------------------- | - | -------
|                         |  | As of June 30,2006 |         | As of December 31, 2005
|                         |  | (unaudited)        |         |                        
|                         |  | (in thousands)    
|Backlog:                 |  |                    |         |                         |   |        
|Oil & Water Technologies |  | $                  | 167,017 |                         | $ | 149,772
|Gas Technologies         |  |                    | 62,538  |                         |   | 10,426 
|Automation & Controls    |  |                    | 10,224  |                         |   | 10,826 
|                         |  |                    |         |                         |   |        
|Total backlog            |  | $                  | 239,779 |                         | $ | 171,024
|                         |  |                    |         |                         |   |        

Our sales backlog at June 30, 2006 was $239.8 million, compared to $171.0 million at
December 31, 2005. Backlog increased by $17.2 million in the Oil & Water Technologies segment, increased by $52.1 million in the Gas Technologies segment and decreased by $0.6 million in the Automation & Controls segment from
December 31, 2005 to June 30, 2006.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Our operations are
conducted around the world in a number of different countries. Accordingly, future earnings are exposed to changes in foreign currency exchange rates. The majority of our foreign currency transactions relate to operations in Canada and the UK. In
Canada, most contracts are denominated in Canadian dollars, and most of the costs incurred are in Canadian dollars, which mitigates risks associated with currency fluctuations. In the UK, many of our sales contracts and material purchases are
denominated in a currency other than British pounds sterling, primarily US dollars and euros, whereas our engineering and overhead costs are principally denominated in British pounds sterling. We have currency risk on our UK activities because a
significant portion of their current backlog is in US dollars. We attempt to minimize our exposure to foreign currency exchange rate risk by requiring settlement in our functional currencies, when possible. However, we do not currently enter into
forward contracts or other currency-related derivative hedge arrangements.

Our financial instruments are subject to changes in interest
rates, including our revolving credit and term loan facilities and our working capital facility for export sales. At June 30, 2006, we had borrowings of $19.8 million outstanding under the term loan portion of the 2004 term loan and revolving
credit facilities, at interest rates of 7.13% and 9.25%. We have replaced our 2004 term loan and revolving credit facilities on July 12, 2006 as discussed in detail in Note 8, Debt.

Based on past market movements and possible near-term market movements, we do not believe that potential near-term losses in future earnings, fair values
or cash flows from changes in interest rates are likely to be material. Assuming our current level of borrowings, a 100 basis point increase in interest rates under our variable interest rate facilities would decrease our current quarter net income
and our cash flow from operations by $31,000. In the event of an adverse change in interest rates, we could take action to mitigate our exposure. However, due to the uncertainty of actions that could be taken and the possible effects, this
calculation assumes no such actions. Furthermore, this calculation does not consider the effects of a possible change in the level of overall economic activity that could exist in such an environment.



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Item 4.Controls and Procedures

Controls and Procedures

We maintain controls and procedures designed to ensure that the information that we are required to disclose in the reports we file with or submit to the
SEC under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Commissions rules and is accumulated and communicated to our management, including its
principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially
affect our internal control over financial reporting. It should be noted that the design of any system of internal control is based, in part, upon assumptions about the likelihood of certain future events, and there can be no assurance that any
design will be successful in achieving its stated objectives under all potential future conditions, regardless of how remote. In addition, an internal control system, no matter how well conceived and operated, can only provide reasonable, not
absolute, assurance the objectives of the internal control system will be met. Therefore, we do not expect our disclosure controls to prevent all errors and fraud.

As of June 30, 2006, we carried out an evaluation, with the participation of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures, (as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective
as of June 30, 2006.



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PART IIOTHER INFORMATION

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

The
following table summarizes the surrenders of the Companys equity securities during the three months ended June 30, 2006:



|                                 |  |                                  |  |                              |       |                                                                             |  |                                                                                     | 
|-------------------------------- |  | -------------------------------- |  | ---------------------------- | ----- | --------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------- | 
|Period                           |  | TotalNumber ofSharesPurchased(1) |  | AveragePricePaid perShare(2) |       | Total Number ofShares Purchasedas Part ofPubliclyAnnounced Plansor Programs |  | ApproximateDollar Value ofShares that MayYet be PurchasedUnder the Plansor
Programs
|April 1 to 30, 2006              |  |                                  |  |                              |       |                                                                             |  |                                                                                     | 
|May 1 to 31, 2006                |  |                                  |  |                              |       |                                                                             |  |                                                                                     | 
|June 1 to 30, 2006               |  | 450                              |  | $                            | 32.51 |                                                                             |  |                                                                                     | 
|                                 |  |                                  |  |                              |       |                                                                             |  |                                                                                     | 
|Three months ended June 30, 2006 |  | 450                              |  |                              |       |                                                                             |  |                                                                                     | 
|                                 |  |                                  |  |                              |       |                                                                             |  |                                                                                     | 

---

|(1) | This acquisition of equity securities was the result of the surrender of restricted stock to pay required tax withholding on the lapse of restrictions on the restricted stock,
pursuant to the terms of the Companys shareholder approved equity compensation plans and the terms of the equity grants pursuant to those plans.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The purchase price of a share of stock used for tax withholding is the price of the stock on the date of lapse of the restrictions of the restricted stock, based on the average of
the high and low reported sales prices of the Companys common stock on that date.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Item 4.Submission of Matters to a Vote of Security Holders

The annual meeting
of stockholders of NATCO Group Inc. was held on May 10, 2006 in Houston, Texas. At the annual meeting, the holders of 14,637,550 shares of NATCO common stock out of 16,966,052 common shares entitled to vote as of the record date and holders of
15,000 shares of preferred stock having voting power equivalent to 1,921,845 shares of common stock out of 15,000 preferred shares entitled to vote as of the record date were represented in person or by proxy, constituting a quorum. Holders of
common stock and preferred stock voted as a single class on all proposals, resulting in 16,559,395 total voting shares present at the meeting and 18,887,897 total voting shares as of the record date.

Proposals submitted to a vote of security holders were:

(1) Election of two Class II members of the Board of Directors, each to hold office for a three-year term expiring at the annual meeting of stockholders in 2009.



|                      |  |                         |  |          |  |                
|--------------------- |  | ----------------------- |  | -------- |  | ---------------
|                      |  | Number of Voting Shares
|                      |  | For                     |  | Withheld |  | Broker Non-Vote
|Keith K. Allan        |  | 16,551,371              |  | 8,024    |  |               
|George K. Hickox, Jr. |  | 16,551,271              |  | 8,124    |  |               

(2) Ratification of KPMG LLP as our independent public accountants for the fiscal
year ending December 31, 2006.



|                        |  |         |  |          
|----------------------- |  | ------- |  | ---------
|Number of Voting
Shares
|For                     |  | Against |  | Abstained
|16,395,783              |  | 160,875 |  | 2,737    

(3) Approval of the NATCO Group Inc. 2006 Long-Term Incentive Compensation Plan:



|                        |  |           |  |          
|----------------------- |  | --------- |  | ---------
|Number of Voting
Shares
|For                     |  | Against   |  | Abstained
|8,500,742               |  | 6,062,081 |  | 1,717    



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Each of the proposals was approved by the requisite number of votes necessary for its adoption.
Subsequent to the adoption of the 2006 Long-Term Incentive Compensation Plan by the stockholders, and consistent with its authority under the plan approved by the stockholders, the Board of Directors approved certain amendments to the plan to
provide for: 1) a minimum one-year restriction on performance awards and a minimum three-year restriction on tenure awards regardless of the recipients position at the Company with regard to full value awards granted under Sections 8, 9 and
10; 2) the Committee (as defined in the Plan) being unable to waive such restriction periods except in the case of death, disability, retirement, involuntary separation without cause or change in control; and 3) amendment of the Amendment and
Termination section to require stockholder approval in the case of a material modification of the eligibility requirements for plan participation. A copy of the amended and restated plan is included as Exhibit 10.1 to this report.



Item 5.Other Events

On August 8, 2006, NATCO Group Inc. announced that Richard W.
FitzGerald was resigning from his position of Senior Vice President and Chief Financial Officer of the Company. His resignation is effective August 23, 2006. John U. Clarke, Chairman and Chief Executive Officer of the Company, will act as chief
financial officer following Mr. FitzGeralds departure, until a permanent replacement is named. A copy of the press release announcing these matters is attached as Exhibit 99.1 and is incorporated into this report by reference.

Item 6.Exhibits



|            |  |                                                                                                                                                                                                  
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                      
|10.1        |  | Amended and Restated 2006 Long-Term Incentive Compensation Plan                                                                                                                                  
|            | 
|31.1        |  | Certification of Chief Executive Officer of NATCO Group Inc. pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                            
|            | 
|31.2        |  | Certification of Chief Financial Officer of NATCO Group Inc. pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                            
|            | 
|32.1        |  | Certification of Chief Executive Officer and Chief Financial Officer of NATCO Group Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
|            | 
|99.1        |  | Press Release dated August 8, 2006 regarding resignation of Chief Financial Officer effective August 23, 2006                                                                                    



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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.



|                     |  |                  |  |                                                                        
|-------------------- |  | ---------------- |  | -----------------------------------------------------------------------
|                     |  | NATCO GROUP INC.
|                     |  |                 
|Date: August 9, 2006 |  | By:              |  | /s/    JOHN U.
CLARKE                                                  
|                     |  |                  |  | John U. Clarke Chairman of the Board and Chief Executive Officer       
|                     |  |                 
|Date: August 9, 2006 |  | By:              |  | /s/    RICHARD W.
FITZGERALD                                           
|                     |  |                  |  | Richard W. FitzGerald Senior Vice President and Chief Financial Officer



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