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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, 2005



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 an accelerated filer (as defined in Rule 12 b-2 of the Exchange Act).    Yes  x    No ̈



Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable
date:



As of July 31, 2005, $0.01 par value per share, 16,345,424 shares



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##### Table of Contents

NATCO GROUP INC.



FORM 10-Q

For the Quarter Ended June 30, 2005



TABLE OF CONTENTS



|           |  |                                                                                                             |  |         
|---------- |  | ----------------------------------------------------------------------------------------------------------- |  | --------
|           |  |                                                                                                             |  | Page No.
|PART I     |  | FINANCIAL INFORMATION                                                                                       |  |         
|           |  |                                                                                                            
|Item 1.    |  | Financial Statements                                                                                        |  | 3       
|           |  |                                                                                                            
|           |  | Condensed Consolidated Balance SheetsJune 30, 2005 (unaudited) and December 31, 2004                       |  | 3       
|           |  |                                                                                                            
|           |  | Unaudited Condensed Consolidated Statements of OperationsThree and Six Months Ended June 30, 2005 and 2004 |  | 4       
|           |  |                                                                                                            
|           |  | Unaudited Condensed Consolidated Statements of Cash FlowsSix Months Ended June 30, 2005 and 2004           |  | 5       
|           |  |                                                                                                            
|           |  | Notes to Unaudited Condensed Consolidated Financial Statements                                              |  | 6       
|           |  |                                                                                                            
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operation                        |  | 20      
|           |  |                                                                                                            
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                                  |  | 33      
|           |  |                                                                                                            
|Item 4.    |  | Controls and Procedures                                                                                     |  | 33      
|           |  |                                                                                                            
|PART II    |  | OTHER INFORMATION                                                                                           |  |         
|           |  |                                                                                                            
|Item 1.    |  | Legal Proceedings                                                                                           |  | 35      
|           |  |                                                                                                            
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                         |  | 35      
|           |  |                                                                                                            
|Item 6.    |  | Exhibits                                                                                                    |  | 36      
|           | 
|Signatures |  | 37                                                                                                         



2



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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, 2005 |         |   | December 31, 2004 |  
|                                                                                                                                                                                                                  |  | (unaudited)   |         |   |                   |  
|ASSETS                                                                                                                                                                                                            |  |               |         |   |                   |   |         |  
|Current assets:                                                                                                                                                                                                   |  |               |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                                                                                                         |  | $             | 1,279   |   |                   | $ | 2,194   |  
|Trade accounts receivable, less allowance for doubtful accounts of $1,012 and $1,229 as of June 30, 2005 and December 31, 2004
respectively                                                                       |  |               | 79,979  |   |                   |   | 83,556  |  
|Inventories                                                                                                                                                                                                       |  |               | 35,929  |   |                   |   | 38,639  |  
|Deferred income tax assets, net                                                                                                                                                                                   |  |               | 3,541   |   |                   |   | 3,395   |  
|                                                                                                                                                                                                                  |  |              
|Prepaid expenses and other current assets                                                                                                                                                                         |  |               | 3,624   |   |                   |   | 3,901   |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|Total current assets                                                                                                                                                                                              |  |               | 124,352 |   |                   |   | 131,685 |  
|Property, plant and equipment, net                                                                                                                                                                                |  |               | 34,606  |   |                   |   | 35,917  |  
|Goodwill, net                                                                                                                                                                                                     |  |               | 80,543  |   |                   |   | 80,676  |  
|Deferred income tax assets, net                                                                                                                                                                                   |  |               | 2,636   |   |                   |   | 3,216   |  
|Other assets, net                                                                                                                                                                                                 |  |               | 1,173   |   |                   |   | 1,083   |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|Total assets                                                                                                                                                                                                      |  | $             | 243,310 |   |                   | $ | 252,577 |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY                                                                                                                                      |  |               |         |   |                   |   |         |  
|Current liabilities:                                                                                                                                                                                              |  |               |         |   |                   |   |         |  
|Current installments of long-term debt                                                                                                                                                                            |  | $             | 6,526   |   |                   | $ | 6,526   |  
|Accounts payable                                                                                                                                                                                                  |  |               | 32,801  |   |                   |   | 45,373  |  
|Accrued expenses and other                                                                                                                                                                                        |  |               | 27,135  |   |                   |   | 27,840  |  
|Customer advances                                                                                                                                                                                                 |  |               | 13,424  |   |                   |   | 10,453  |  
|Income taxes payable                                                                                                                                                                                              |  |               | 456     |   |                   |   | 1,425   |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|Total current liabilities                                                                                                                                                                                         |  |               | 80,342  |   |                   |   | 91,617  |  
|Long-term debt, excluding current installments                                                                                                                                                                    |  |               | 34,091  |   |                   |   | 38,935  |  
|Long-term deferred tax liabilities                                                                                                                                                                                |  |               | 348     |   |                   |   | 387     |  
|Postretirement benefits and other long-term liabilities                                                                                                                                                           |  |               | 10,592  |   |                   |   | 11,226  |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|Total liabilities                                                                                                                                                                                                 |  |               | 125,373 |   |                   |   | 142,165 |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|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 16,268,586 and 15,890,534 shares as of June 30, 2005 and
December 31, 2004, respectively                                       |  |               | 159     |   |                   |   | 158     |  
|Additional paid-in capital                                                                                                                                                                                        |  |               | 98,189  |   |                   |   | 97,044  |  
|Accumulated retained earnings                                                                                                                                                                                     |  |               | 11,900  |   |                   |   | 7,229   |  
|Treasury stock, 474,767 and 852,819 shares at cost as of June 30, 2005 and December 31, 2004, respectively                                                                                                        |  |               | (6,468  | ) |                   |   | (8,335  | )
|Accumulated other comprehensive (loss) gain                                                                                                                                                                       |  |               | (65     | ) |                   |   | 94      |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|Total stockholders equity                                                                                                                                                                                        |  |               | 103,715 |   |                   |   | 96,190  |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  
|Commitments and contingencies                                                                                                                                                                                     |  |               |        |   |                   |   |        |  
|Total liabilities, redeemable convertible preferred stock and stockholders equity                                                                                                                                |  | $             | 243,310 |   |                   | $ | 252,577 |  
|                                                                                                                                                                                                                  |  |               |         |   |                   |   |         |  



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 OPERATIONS

(in thousands, except per share data)



|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                      |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |  
|                                                                      |  | 2005                        |        |   | 2004                      |   |        | 2005 |  |   | 2004    |  
|Revenues                                                              |  | $                           | 94,648 |   |                           | $ | 73,347 |      |  | $ | 183,304 |   |  | $ | 145,331 |  
|Cost of goods sold                                                    |  |                             | 72,250 |   |                           |   | 55,716 |      |  |   | 139,621 |   |  |   | 110,885 |  
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                                          |  |                             | 22,398 |   |                           |   | 17,631 |      |  |   | 43,683  |   |  |   | 34,446  |  
|Selling, general and administrative expense                           |  |                             | 14,812 |   |                           |   | 13,584 |      |  |   | 29,002  |   |  |   | 26,879  |  
|Depreciation and amortization expense                                 |  |                             | 1,332  |   |                           |   | 1,364  |      |  |   | 2,655   |   |  |   | 2,738   |  
|Closure and other                                                     |  |                             |       |   |                           |   | 85     |      |  |   |        |   |  |   | 85      |  
|Interest expense                                                      |  |                             | 1,076  |   |                           |   | 871    |      |  |   | 2,091   |   |  |   | 1,806   |  
|Write-off of unamortized loan costs                                   |  |                             |       |   |                           |   |       |      |  |   |        |   |  |   | 667     |  
|Interest cost on postretirement benefit liability                     |  |                             | 210    |   |                           |   | 225    |      |  |   | 420     |   |  |   | 450     |  
|Interest income                                                       |  |                             | (13    | ) |                           |   | (44    | )    |  |   | (65     | ) |  |   | (106    | )
|Other, net                                                            |  |                             | 522    |   |                           |   | 518    |      |  |   | 484     |   |  |   | 972     |  
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Income before income taxes                                            |  |                             | 4,459  |   |                           |   | 1,028  |      |  |   | 9,096   |   |  |   | 955     |  
|Income tax provision                                                  |  |                             | 1,913  |   |                           |   | 407    |      |  |   | 3,675   |   |  |   | 378     |  
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income                                                            |  | $                           | 2,546  |   |                           | $ | 621    |      |  | $ | 5,421   |   |  | $ | 577     |  
|Preferred stock dividends                                             |  |                             | 375    |   |                           |   | 375    |      |  |   | 750     |   |  |   | 750     |  
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income (loss) allocable to common stockholders                    |  | $                           | 2,171  |   |                           | $ | 246    |      |  | $ | 4,671   |   |  | $ | (173    | )
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Earnings (loss) per sharebasic                                       |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income (loss)                                                     |  | $                           | 0.14   |   |                           | $ | 0.02   |      |  | $ | 0.29    |   |  | $ | (0.01   | )
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Earnings (loss) per sharediluted:                                    |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income (loss)                                                     |  | $                           | 0.13   |   |                           | $ | 0.02   |      |  | $ | 0.29    |   |  | $ | (0.01   | )
|                                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Basic weighted average number of shares of common stock outstanding   |  |                             | 15,934 |   |                           |   | 15,923 |      |  |   | 15,875  |   |  |   | 15,915  |  
|Diluted weighted average number of shares of common stock outstanding |  |                             | 16,249 |   |                           |   | 16,033 |      |  |   | 16,146  |   |  |   | 15,915  |  



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, |        
|                                                                                            |  | 2005                      |         |   | 2004 |  
|Cash flows from operating activities:                                                       |  |                           |         |   |      |   |         |  
|Net income                                                                                  |  | $                         | 5,421   |   |      | $ | 577     |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |  |                           |         |   |      |   |         |  
|Deferred income tax expense (benefit)                                                       |  |                           | 395     |   |      |   | (159    | )
|Depreciation and amortization expense                                                       |  |                           | 2,655   |   |      |   | 2,738   |  
|Non-cash interest income                                                                    |  |                           |        |   |      |   | (74     | )
|Non-cash interest expense                                                                   |  |                           | 283     |   |      |   | 237     |  
|Write-off of unamortized loan costs                                                         |  |                           |        |   |      |   | 667     |  
|Tax benefit of stock options exercised                                                      |  |                           | 279     |   |      |   |        |  
|Revaluation of warrants                                                                     |  |                           | 549     |   |      |   |        |  
|Interest cost on postretirement benefit liability                                           |  |                           | 420     |   |      |   | 450     |  
|Restricted stock expense                                                                    |  |                           | 901     |   |      |   | 14      |  
|Gain on the sale of property, plant and equipment                                           |  |                           | (371    | ) |      |   | (9      | )
|Change in assets and liabilities:                                                           |  |                           |         |   |      |   |         |  
|(Increase) decrease in trade accounts receivable                                            |  |                           | 1,845   |   |      |   | (4,450  | )
|(Increase) decrease in inventories                                                          |  |                           | 2,547   |   |      |   | (4,136  | )
|Increase in prepaid expense and other current assets                                        |  |                           | (2      | ) |      |   | (574    | )
|Increase in long-term assets                                                                |  |                           | (548    | ) |      |   | (64     | )
|Decrease in accounts payable                                                                |  |                           | (10,521 | ) |      |   | (7,825  | )
|Decrease in accrued expenses and other                                                      |  |                           | (11     | ) |      |   | (1,747  | )
|Increase in customer advances                                                               |  |                           | 3,120   |   |      |   | 10,889  |  
|                                                                                            |  |                           |         |   |      |   |         |  
|Net cash provided by (used in) operating activities                                         |  |                           | 6,962   |   |      |   | (3,466  | )
|                                                                                            |  |                           |         |   |      |   |         |  
|Cash flows from investing activities:                                                       |  |                           |         |   |      |   |         |  
|Capital expenditures for property, plant and equipment                                      |  |                           | (1,803  | ) |      |   | (1,487  | )
|Proceeds from the sale of property, plant and equipment                                     |  |                           | 928     |   |      |   | 23      |  
|                                                                                            |  |                           |         |   |      |   |         |  
|Net cash used in investing activities                                                       |  |                           | (875    | ) |      |   | (1,464  | )
|                                                                                            |  |                           |         |   |      |   |         |  
|Cash flows from financing activities:                                                       |  |                           |         |   |      |   |         |  
|Net repayments under long-term revolving credit facilities                                  |  |                           | (1,584  | ) |      |   | (7,229  | )
|Repayments of long-term debt                                                                |  |                           | (3,263  | ) |      |   | (32,405 | )
|Borrowings of long-term debt                                                                |  |                           |        |   |      |   | 45,000  |  
|Proceeds from the issuance of preferred stock                                               |  |                           |        |   |      |   | 121     |  
|Issuance of common stock, net                                                               |  |                           | 1,832   |   |      |   | 359     |  
|Dividends paid                                                                              |  |                           | (750    | ) |      |   | (750    | )
|Deferred financing fees                                                                     |  |                           | (115    | ) |      |   | (886    | )
|Change in bank overdrafts                                                                   |  |                           | (2,768  | ) |      |   | 1,454   |  
|Net payments on postretirement benefit liability                                            |  |                           | (809    | ) |      |   | (884    | )
|                                                                                            |  |                           |         |   |      |   |         |  
|Net cash provided by (used in) financing activities                                         |  |                           | (7,457  | ) |      |   | 4,780   |  
|                                                                                            |  |                           |         |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                                |  |                           | 455     |   |      |   | 378     |  
|                                                                                            |  |                           |         |   |      |   |         |  
|Increase (decrease) in cash and cash equivalents                                            |  |                           | (915    | ) |      |   | 228     |  
|Cash and cash equivalents at beginning of period                                            |  |                           | 2,194   |   |      |   | 1,751   |  
|                                                                                            |  |                           |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                  |  | $                         | 1,279   |   |      | $ | 1,979   |  
|                                                                                            |  |                           |         |   |      |   |         |  
|Cash payments for:                                                                          |  |                           |         |   |      |   |         |  
|Interest                                                                                    |  | $                         | 1,634   |   |      | $ | 1,133   |  
|Income taxes                                                                                |  | $                         | 3,892   |   |      | $ | 239     |  



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



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 (US GAAP) for interim
consolidated financial statements and the rules and regulations of the 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 principles 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/A filing for the year ended December 31, 2004.



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. Furthermore, certain reclassifications have been made to fiscal year 2004 amounts in order to present these results on a comparable basis with amounts for fiscal year 2005. These
reclassifications had no impact on net income.



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



(2) Employee Stock Options



The Company accounts 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 Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 allows entities to recognize as expense
over the vesting period, the fair value of all stock-based awards on the date of grant. If entities continue to apply the provision of APB Opinion No. 25, pro forma net income and earnings per share disclosures are 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. SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure, an amendment to FASB Statement
No. 123, issued in December 2002, provided alternative methods to transition to the fair value method of accounting for stock-based compensation, on a volunteer basis, and required additional disclosures at annual and interim reporting
dates. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and to provide the pro forma disclosures required by SFAS No. 123. In December 2004, FASB issued SFAS No. 123 (Revised 2004), Share-Based
Payment (SFAS 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 proforma disclosure
only. This standard is effective for the Company as of January 1, 2006 and will apply to all awards granted, modified, cancelled or repurchased after that date as well as unvested portion of prior awards. The Company will adopt the standard as of
the effective date. The Company is currently evaluating the total effect on the financial statements and the method to use when valuing stock options.



The Company determines pro forma net income and earnings per share by applying the Black-Scholes Single OptionReduced Term valuation method. This
valuation model requires management to make



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##### Table of Contents

NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



subjective assumptions about the volatility of NATCO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 table summarizes these pro forma net earnings and earnings per share amounts for the three and six months ended June 30, 2005 and 2004,
respectively.



|                                                                                                                                            |  |                                                    |       |   |                           |   |      |      |  |   |       |   |  |   |       |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------- | ----- | - | ------------------------- | - | ---- | ---- |  | - | ----- | - |  | - | ----- | -
|                                                                                                                                            |  | Three Months Ended June 30,                        |       |   | Six Months Ended June 30, |  
|                                                                                                                                            |  | 2005                                               |       |   | 2004                      |   |      | 2005 |  |   | 2004  |  
|                                                                                                                                            |  | (unaudited; in thousands, except per shareamounts) |      
|Net income (loss) allocable to common stockholdersas reported                                                                              |  | $                                                  | 2,171 |   |                           | $ | 246  |      |  | $ | 4,671 |   |  | $ | (173  | )
|Add: Restricted stock expense, net of related tax effects                                                                                   |  |                                                    | 466   |   |                           |   |     |      |  |   | 537   |   |  |   |      |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                                    | (143  | ) |                           |   | (141 | )    |  |   | (285  | ) |  |   | (290  | )
|                                                                                                                                            |  |                                                    |       |   |                           |   |      |      |  |   |       |   |  |   |       |  
|Pro forma income (loss)                                                                                                                     |  | $                                                  | 2,494 |   |                           | $ | 105  |      |  | $ | 4,923 |   |  | $ | (463  | )
|                                                                                                                                            |  |                                                    |       |   |                           |   |      |      |  |   |       |   |  |   |       |  
|Earnings (loss) per share:                                                                                                                  |  |                                                    |       |   |                           |   |      |      |  |   |       |   |  |   |       |  
|Basicas reported                                                                                                                           |  | $                                                  | 0.14  |   |                           | $ | 0.02 |      |  | $ | 0.29  |   |  | $ | (0.01 | )
|Basicpro forma                                                                                                                             |  | $                                                  | 0.16  |   |                           | $ | 0.01 |      |  | $ | 0.31  |   |  | $ | (0.03 | )
|                                                                                                                                            |  |                                                    |       |  
|Dilutedas reported                                                                                                                         |  | $                                                  | 0.13  |   |                           | $ | 0.02 |      |  | $ | 0.29  |   |  | $ | (0.01 | )
|Dilutedpro forma                                                                                                                           |  | $                                                  | 0.15  |   |                           | $ | 0.01 |      |  | $ | 0.30  |   |  | $ | (0.03 | )



(3) 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 Lime Rock Partners II, L.P. The warrants have an exercise price of $10.00 per share of common stock and expire on March 25, 2006. The Company can force the
exercise of the warrants if NATCOs common stock trades above $13.50 per share for 30 consecutive trading days, at which point the holder may 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 contain 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. The Company adjusted this liability to $745,000 as of June 30, 2005, from $196,000 at December 31, 2004 as a result of the change in the fair
value of the warrants based on the increase in our stock price from the date of issuance of the warrants. The Company recorded an expense of $345,000 and $549,000 for the quarter and six months ended June 30, 2005, respectively and an expense of
$33,000 and no expense for the quarter and six months ended June 30, 2004, respectively. Changes in fair value in future periods will be recorded in net income during the period of the change.



(4) Earnings (Loss) per Share



The Company computed basic earnings per share by dividing net income (loss)
allocable to common stockholders by the weighted average number of shares outstanding for the period. Net income allocable to common stockholders at June 30, 2005, represented net income less preferred stock dividends accrued. The Company determined
diluted earnings per common and potential common share at June 30, 2005, as net income



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



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, warrants and restricted stock outstanding. The effect of such incremental shares was 107,095 shares for the three months and 77,458 shares for the six months
ending June 30, 2005, respectively. These shares were considered common and potential common shares for purposes of calculating earnings per share at June 30, 2005, in accordance with SFAS No. 128, Earnings per Share. Outstanding
employee stock options were considered potential common shares for purposes of this calculation. The potential common shares related to employee stock options were 207,659 for the three months and 193,582 for the six months ended June 30, 2005,
respectively. If anti-dilutive shares were included for the three months and six months ended June 30, 2005, the impact would have been a reduction of 18,039 shares and 26,261 shares. For the six months ended June 30, 2004, all potential common
shares related to employee stock options were considered anti-dilutive as the Company recorded a net loss allocable to common stockholders during the period. Anti-dilutive stock options were excluded from the calculation of potential common shares.
If anti-dilutive shares were included in the calculation for the three-month and six-month periods ended June 30, 2004, the impact would have been a reduction of 232,898 shares and 223,168 shares. The following table presents the computation of
basic and diluted earnings (loss) per common and potential common share for the three and six months ended June 30, 2005 and 2004, respectively:



|                                                 |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|------------------------------------------------ |  | --------------------------------------------------- | ----- | -------------------------------- | -------------------- | ------ | ---------------- | - | ------------------ |  | - | -------------------- | - | ---------------- | ------ |  | - | ----
|                                                 |  | Three Months Ended June 30, 2005                    |       | Three Months Ended June 30, 2004
|                                                 |  | Income (Numerator)                                  |       |                                  | Shares (Denominator) |        | Per-Share Amount |   | Income (Numerator) |  |   | Shares (Denominator) |   | Per-Share Amount
|                                                 |  | (unaudited, in thousands, except per share amounts)
|Net income                                       |  | $                                                   | 2,546 |                                  |                      |        |                  |   |                    |  | $ | 621                  |   |                  |        |  |   |     
|Less: Preferred stock dividends accrued and paid |  |                                                     | (375  | )                                |                      |        |                  |   |                    |  |   | (375                 | ) |                  |        |  |   |     
|                                                 |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|Basic EPS:                                       |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|Income allocable to common stockholders          |  | $                                                   | 2,171 |                                  |                      | 15,934 |                  | $ | 0.14               |  | $ | 246                  |   |                  | 15,923 |  | $ | 0.02
|                                                 |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|Effect of dilutive securities:                   |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|Stock options, warrants and restricted stock     |  |                                                     |      |                                  |                      | 315    |                  |   |                    |  |   |                     |   |                  | 110    |  |   |     
|                                                 |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|Diluted EPS:                                     |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     
|Income allocable to common stockholders          |  | $                                                   | 2,171 |                                  |                      | 16,249 |                  | $ | 0.13               |  | $ | 246                  |   |                  | 16,033 |  | $ | 0.02
|                                                 |  |                                                     |       |                                  |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |     



|                                                 |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|------------------------------------------------ |  | --------------------------------------------------- | ----- | ------------------------------ | -------------------- | ------ | ---------------- | - | ------------------ |  | - | -------------------- | - | ---------------- | ------ |  | - | ----- | -
|                                                 |  | Six Months Ended June 30, 2005                      |       | Six Months Ended June 30, 2004 |                     
|                                                 |  | Income (Numerator)                                  |       |                                | Shares (Denominator) |        | Per-Share Amount |   | Income (Numerator) |  |   | Shares (Denominator) |   | Per-Share Amount |       
|                                                 |  | (unaudited, in thousands, except per share amounts) |      
|Net income                                       |  | $                                                   | 5,421 |                                |                      |        |                  |   |                    |  | $ | 577                  |   |                  |        |  |   |       |  
|Less: Preferred stock dividends accrued and paid |  |                                                     | (750  | )                              |                      |        |                  |   |                    |  |   | (750                 | ) |                  |        |  |   |       |  
|                                                 |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|Basic EPS:                                       |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|Income (loss) allocable to common stockholders   |  | $                                                   | 4,671 |                                |                      | 15,875 |                  | $ | 0.29               |  | $ | (173                 | ) |                  | 15,915 |  | $ | (0.01 | )
|                                                 |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|Effect of dilutive securities:                   |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|Stock options, warrants and restricted stock     |  |                                                     |      |                                |                      | 271    |                  |   |                    |  |   |                     |   |                  |       |  |   |       |  
|                                                 |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|Diluted EPS:                                     |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  
|Income (loss) allocable to common stockholders   |  | $                                                   | 4,671 |                                |                      | 16,146 |                  | $ | 0.29               |  | $ | (173                 | ) |                  | 15,915 |  | $ | (0.01 | )
|                                                 |  |                                                     |       |                                |                      |        |                  |   |                    |  |   |                      |   |                  |        |  |   |       |  



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



(5) Inventories



Inventories consisted of the following amounts:



|                              |  |                |        |   |                   |   |        |  
|----------------------------- |  | -------------- | ------ | - | ----------------- | - | ------ | -
|                              |  | June 30, 2005  |        |   | December 31, 2004 |  
|                              |  | (unaudited)    |        |   |                   |  
|                              |  | (in thousands) |       
|Finished goods                |  | $              | 10,084 |   |                   | $ | 14,056 |  
|Work-in-process               |  |                | 13,861 |   |                   |   | 9,887  |  
|Raw materials and supplies    |  |                | 16,494 |   |                   |   | 19,116 |  
|                              |  |                |        |   |                   |   |        |  
|Inventories at FIFO           |  |                | 40,439 |   |                   |   | 43,059 |  
|Excess of FIFO over LIFO cost |  |                | (4,510 | ) |                   |   | (4,420 | )
|                              |  |                |        |   |                   |   |        |  
|                              |  | $              | 35,929 |   |                   | $ | 38,639 |  
|                              |  |                |        |   |                   |   |        |  



(6) Costs and Estimated Earnings on
Uncompleted Contracts



Cost and estimated earnings on
uncompleted contracts were as follows:



|                                                               |  |                |        |   |                   |   |         |  
|-------------------------------------------------------------- |  | -------------- | ------ | - | ----------------- | - | ------- | -
|                                                               |  | June 30, 2005  |        |   | December 31, 2004 |  
|                                                               |  | (unaudited)    |        |   |                   |  
|                                                               |  | (in thousands) |       
|Cost incurred on uncompleted contracts                         |  | $              | 70,829 |   |                   | $ | 98,328  |  
|Estimated earnings                                             |  |                | 19,105 |   |                   |   | 22,947  |  
|                                                               |  |                |        |   |                   |   |         |  
|                                                               |  |                | 89,934 |   |                   |   | 121,275 |  
|Less billings to date                                          |  |                | 80,290 |   |                   |   | 110,976 |  
|                                                               |  |                |        |   |                   |   |         |  
|                                                               |  | $              | 9,644  |   |                   | $ | 10,299  |  
|                                                               |  |                |        |   |                   |   |         |  
|Included in the accompanying balance sheet under the captions: |  |                |        |   |                   |   |         |  
|Trade accounts receivable                                      |  | $              | 19,427 |   |                   | $ | 19,396  |  
|Customer advances                                              |  |                | (9,783 | ) |                   |   | (9,097  | )
|                                                               |  |                |        |   |                   |   |         |  
|                                                               |  | $              | 9,644  |   |                   | $ | 10,299  |  
|                                                               |  |                |        |   |                   |   |         |  



(7) Closure, Severance and Other



In December 2004, the Company recorded severance expense
of $1.3 million related to the restructuring plan which included involuntary termination of certain administrative and operating personnel in the UK and Canada. The Company recorded facility closure costs of $42,000 and a gain on foreign exchange of
$15,000 and made payments of $515,000 in the first quarter 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. At June 30, 2005, the Company had a liability
of approximately $678,000 related to this restructuring plan.



In September 2004, the Company recorded severance expense of $210,000 related to staff reductions in Oil & Water Technologies segment. As of June 30, 2005, the Company had a $5,000 liability related to this matter.



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 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



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



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 (6) reimbursement of certain moving expenses. The Company has paid $2.4 million of this amount through June 30, 2005. As of June 30, 2005, the Company
had a liability of $67,000 related to the separation agreement.



The Company also agreed to (1) accelerate vesting of any of Mr. Gregorys outstanding options, (2) reimburse certain living and commuting expense through the separation date consistent with past practice, (3) continue providing
director and officer indemnification insurance for a period of time, (4) pay bonuses earned through the separation date pursuant to the Companys bonus plan and (5) continue to reimburse Mr. Gregorys office space in Connecticut through
December 31, 2004. The cost of these items has been or will be expensed in the period incurred. Under this Agreement, Mr. Gregory agreed to provide advisory services for a period of one year following the separation date, when and as requested by
the Board, and to release the Company from certain potential claims. The Company did not incur any cost related to this item during the year and, if incurred, will record as an expense in the period incurred. The parties also agreed on certain
procedures for the repayment of Mr. Gregorys then outstanding loans to the Company, which were paid in full on July 28, 2004.



In June 2004, the Company recorded and paid severance expense of $111,000 primarily associated with staff reductions in the Automation & Controls
segment and a subsidiary within the Oil & Water Technologies segment.



In December 2003, the Companys management approved additional restructuring costs including a plan to close a location in Singapore and recorded closure and other expense of $692,000, of which $515,000 related
to severance, $35,000 related to the termination of a lease arrangement and $142,000 related to employee relocation. The Company had no liability related to this restructuring plan as of June 30, 2005, and does not expect to incur additional costs
related to this office closure in 2005.



In September 2003, the
Company recorded expenses of $722,000 associated with a management-approved restructuring plan, which included the involuntary termination of certain administrative and operating personnel in connection with the closure of a manufacturing facility
in Covington, Louisiana, at the Companys corporate headquarters, at the Companys research and development facility in Tulsa, Oklahoma, and related to the consolidation of operations in the UK. Of the total expense recognized under this
restructuring plan, $640,000 related to post-employment benefits, which were accounted for in accordance with SFAS No. 112, Employers Accounting for Post-employment Benefits, an amendment of FASB Statements No. 5 and 43, and
$82,000 related to consultants fees, equipment moving costs and employee relocations, which were accounted for in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. During the year ended
December 31, 2004, the Company incurred an additional $51,000 of expense related to this restructuring plan, offset by accrual reversals as a result of changes in the assessment of liability under this plan totaling $77,000, resulting in an increase
in net income of $26,000 for the year ended December 31, 2004. The Company had a liability of $44,000 related to this restructuring plan as of June 30, 2005 and does not expect to incur additional costs in 2005.



Following is a summary of closure, severance and other expense included in
Other, net:



|                            |  |                                     |    |                                   |   |      |  |      |    |  |   |   
|--------------------------- |  | ----------------------------------- | -- | --------------------------------- | - | ---- |  | ---- | -- |  | - | --
|                            |  | For the three months Ended June 30, |    | For the six months Ended June 30,
|                            |  | 2005                                |    | 2004                              |   | 2005 |  | 2004
|                            |  | (unaudited, in thousands)          
|Severance                   |  | $                                   |   |                                   | $ | 85   |  | $    | 42 |  | $ | 85
|Leasehold termination       |  |                                     |   |                                   |   |     |  |      |   |  |   |  
|Contract expenses and other |  |                                     | 51 |                                   |   |     |  |      | 51 |  |   |  
|                            |  |                                     |    |                                   |   |      |  |      |    |  |   |   
|                            |  | $                                   | 51 |                                   | $ | 85   |  | $    | 93 |  | $ | 85
|                            |  |                                     |    |                                   |   |      |  |      |    |  |   |   



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



A roll forward of the Companys accrued closure, severance and other costs as of June 30, 2005
and December 31, 2004, follows (unaudited, in thousands):



|                             |  |   |       |  
|---------------------------- |  | - | ----- | -
|Balance at December 31, 2004 |  | $ | 1,547 |  
|Payments                     |  |   | (839  | )
|Severance                    |  |   | 42    |  
|Leasehold termination        |  |   |      |  
|Other (1)                    |  |   | 46    |  
|                             |  |   |       |  
|Balance at June 30, 2005     |  | $ | 796   |  
|                             |  |   |       |  

---

|(1) | Foreign exchange impact of $(5,000) and $51,000 of closure costs.
|--- | -----------------------------------------------------------------



The estimated payment of this liability at June 30, 2005 is $477,000 in 2005, $306,000 in 2006 and $13,000 in 2007.



(8) Long-Term Debt



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



|                                                                                                                                                           |  |                                   |        |   |                   |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------- | ------ | - | ----------------- | - | ------ | -
|                                                                                                                                                           |  | June 30, 2005                     |        |   | December 31, 2004 |  
|                                                                                                                                                           |  | (unaudited)                       |        |   |                   |  
|                                                                                                                                                           |  | (in thousands, exceptpercentages) |       
|Bank debt                                                                                                                                                  |  |                                   |        |   |                   |   |        |  
|2004 term loan with variable interest rate (5.69% to 5.94% at June 30, 2005) and quarterly payments of principal ($1,607) and interest, due
March 31, 2007 |  | $                                 | 36,964 |   |                   | $ | 40,179 |  
|2004 revolving credit bank loans with variable interest rate (5.50%7.50% at June 30, 2005) and quarterly interest payments, due March
31, 2007            |  |                                   | 2,509  |   |                   |   | 4,090  |  
|Promissory note with variable interest rate (6.50% at June 30, 2005) and quarterly payments of principal ($24) and interest, due February 8,
2007          |  |                                   | 1,144  |   |                   |   | 1,192  |  
|Revolving credit bank loans (export sales facility) with variable interest rate and monthly interest payments, due March 31,
2007                          |  |                                   |       |   |                   |   |       |  
|                                                                                                                                                           |  |                                   |        |   |                   |   |        |  
|Total                                                                                                                                                      |  | $                                 | 40,617 |   |                   | $ | 45,461 |  
|Less current installments                                                                                                                                  |  |                                   | (6,526 | ) |                   |   | (6,526 | )
|                                                                                                                                                           |  |                                   |        |   |                   |   |        |  
|Long-term debt                                                                                                                                             |  | $                                 | 34,091 |   |                   | $ | 38,935 |  
|                                                                                                                                                           |  |                                   |        |   |                   |   |        |  



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 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) the London Interbank Offered Rate (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, 2005 were $6.5 million. This facility had fees related to letters of credit of approximately 1.00% of the outstanding balance for the period
March 31, 2005 to June 30, 2005.



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



On March 15, 2004, the Company replaced its term loan and revolving facilities agreement with a new
term loan and revolving facilities agreement, referred to as the 2004 term loan and revolving credit facilities, which provides for a term loan of $45.0 million, 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 facility with a borrowing capacity of $10.0 million. All of the borrowing capacities under the 2004 revolving facilities agreement are subject to borrowing base
limitations.



The Company recorded a charge of $667,000 in
March 2004 to expense unamortized loan costs related to the 2001 term loan and revolving credit facilities, and incurred an additional $995,000 of deferred loan costs related to the 2004 term loan and revolving credit facilities, which will be
amortized as interest expense through the term of the facilities in March 2007. The Company 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 has been amortized over the term of the amendment which ended June 2005.



The 2004 term loan and revolving 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 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%. 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 0.375% at June 30, 2005.



Borrowings of $37.0 million were outstanding under the term loan portion of the 2004 term loan at June 30, 2005, and bore
interest at an average rate of 5.57%. Borrowings outstanding under the revolving credit portion of the 2004 term loan and revolving credit facility at June 30, 2005 were $2.5 million and bore interest at rates between 5.50% and 7.50%. The Company
had letters of credit outstanding under these revolving facilities of $15.9 million. Fees related to these letters of credit were approximately 2.25% of the outstanding balance at June 30, 2005. These letters of credit support contract performance
and warranties and expire at various dates through February 2008.



The 2004 term loan and revolving 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 and 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 Company paid commitment fees of 0.50% and 0.375% for the quarter ended June 30, 2005 on the undrawn portion of the revolving credit facilities of the 2004 term loan and revolving credit facilities, respectively.



The 2004 term loan and revolving 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. In March 2005, the Companys lenders approved an amendment of
various provisions of the 2004 term loan and revolving facilities effective January 1, 2005. This amendment revised certain restrictive debt covenants, modified certain defined terms and changes the submission of financial



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



statements to the lenders to more closely reflect the current SEC requirements for furnishing financial information. On June 30, 2005, the Company was in
compliance with all restrictive debt covenants under its loan agreements.



With respect to the 2004 term loan and revolving credit facilities, NATCO has agreed that it will not make any distributions of any property or cash to the Company or its stockholders except dividends required under
the Series B Preferred Stock provisions. No dividends were declared or paid to common stockholders during the quarter ended June 30, 2005. Dividends of $750,000 related to the Series B Preferred Stock were paid during the quarter ended June 30,
2005.



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 accrues interest at the 90-day LIBOR plus 3.25%, and requires quarterly payments of principal of approximately $24,000 and interest
for five years beginning May 2002, with a final balloon payment due February 2007. The outstanding balance of this note was $1.14 million at June 30, 2005 and bore interest at 6.50%. This promissory note is collateralized by the manufacturing
facility in Magnolia, Texas.



The Company previously maintained
a working capital facility for export sales that provided for aggregate borrowings of $10.0 million, subject to borrowing base limitations, which renewed on July 23, 2004 and expires on March 31, 2007. The export sales credit facility is secured by
specific project inventory and receivables, and is partially guaranteed by the US Export-Import Bank. The Company has fees related to letters of credit under this facility, which are approximately 1% of the outstanding balance.



The Company also had unsecured letters of credit and bonds totaling $181,000
and guarantees totaling $23.1 million at June 30, 2005.



(9) Income Taxes



NATCOs effective income tax rate for the six months
ended June 30, 2005 was 40.4%, 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, losses in foreign subsidiaries,
changes in valuation allowances recorded and certain permanent book-to-tax differences. There are certain prior tax returns currently under review by taxing authorities. Although we believe we have adequately provided for income taxes, the ultimate
outcome 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)



(10) Business Segments



NATCO restructured its organization effective as of January 1, 2005 in order to improve our execution and customer focus.
The new reporting units are Oil & Water Technologies, Gas Technologies and Automation & Controls.



| |  |  | The Oil & Water Technologies group includes our traditional oil and gas separation and dehydration equipment sales and related services, our extensive North American branch
distribution network, and our worldwide engineered systems group, all of which are focused primarily on oil and water production and processing systems.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Gas Technologies group 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 gas-related technologies that focus on removing contaminants from the gas stream.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Automation & Controls group remains unchanged, focusing 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 income before net interest expense, income taxes, depreciation and amortization expense, closure and other, write-off of
unamortized loan costs, other, net and accounting changes.



Certain segment amounts previously reported for the three and six months ended June 30, 2004 have been reclassified to conform to the presentation of segment amounts reported for the three and six months ended June 30, 2005.



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



|                                     |  |                           |         |   |                 |   |                     |  |              |        |  |       |        |   |  |   |        
|------------------------------------ |  | ------------------------- | ------- | - | --------------- | - | ------------------- |  | ------------ | ------ |  | ----- | ------ | - |  | - | -------
|                                     |  | Oil & WaterTechnologies   |         |   | GasTechnologies |   | Automation& Control |  | Eliminations |        |  | Total
|                                     |  | (unaudited, in thousands)
|Three Months Ended June 30, 2005     |  |                           |         |   |                 |   |                     |  |              |        |  |       |        |   |  |   |        
|Revenues from unaffiliated customers |  | $                         | 72,358  |   |                 | $ | 7,277               |  | $            | 15,013 |  |       |       |   |  | $ | 94,648 
|Inter-segment revenues               |  |                           | 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  
|                                     |  |                           |         |   |                
|Three Months Ended June 30, 2004     |  |                           |         |   |                 |   |                     |  |              |        |  |       |        |   |  |   |        
|Revenues from unaffiliated customers |  | $                         | 53,707  |   |                 | $ | 10,718              |  | $            | 8,922  |  |       |       |   |  | $ | 73,347 
|Inter-segment revenues               |  |                           |        |   |                 |   |                    |  |              | 717    |  | $     | (717   | ) |  |   |       
|Segment profit                       |  |                           | (1,114  | ) |                 |   | 4,887               |  |              | 274    |  |       |       |   |  |   | 4,047  
|Total assets                         |  |                           | 181,963 |   |                 |   | 44,725              |  |              | 18,164 |  |       |       |   |  |   | 244,852
|Capital expenditures                 |  |                           | 508     |   |                 |   | 130                 |  |              | 11     |  |       |       |   |  |   | 649    
|Depreciation and amortization        |  |                           | 721     |   |                 |   | 542                 |  |              | 101    |  |       |       |   |  |   | 1,364  



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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



|                                     |  |                           |         |   |                 |   |                     |  |              |        |  |       |        |   |  |   |        
|------------------------------------ |  | ------------------------- | ------- | - | --------------- | - | ------------------- |  | ------------ | ------ |  | ----- | ------ | - |  | - | -------
|                                     |  | Oil & WaterTechnologies   |         |   | GasTechnologies |   | Automation& Control |  | Eliminations |        |  | Total
|                                     |  | (unaudited, in thousands)
|Six Months Ended June 30, 2005       |  |                           |         |   |                 |   |                     |  |              |        |  |       |        |   |  |   |        
|Revenues from unaffiliated customers |  | $                         | 139,072 |   |                 | $ | 15,174              |  | $            | 29,058 |  |       |       |   |  | $ | 183,304
|Inter-segment revenues               |  |                           | 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  
|                                     |  |                           |         |   |                
|Six Months Ended June 30, 2004       |  |                           |         |   |                 |   |                     |  |              |        |  |       |        |   |  |   |        
|Revenues from unaffiliated customers |  | $                         | 108,053 |   |                 | $ | 17,542              |  | $            | 19,736 |  |       |       |   |  | $ | 145,331
|Inter-segment revenues               |  |                           | 186     |   |                 |   |                    |  |              | 1,564  |  | $     | (1,750 | ) |  |   |       
|Segment profit                       |  |                           | (873    | ) |                 |   | 8,005               |  |              | 435    |  |       |       |   |  |   | 7,567  
|Total assets                         |  |                           | 181,963 |   |                 |   | 44,725              |  |              | 18,164 |  |       |       |   |  |   | 244,852
|Capital expenditures                 |  |                           | 1,294   |   |                 |   | 136                 |  |              | 57     |  |       |       |   |  |   | 1,487  
|Depreciation and amortization        |  |                           | 1,455   |   |                 |   | 1,081               |  |              | 202    |  |       |       |   |  |   | 2,738  



The following table
reconciles total segment profit to net income:



|                                    |  |                             |       |                           |   |       |  |      |        |  |   |      
|----------------------------------- |  | --------------------------- | ----- | ------------------------- | - | ----- |  | ---- | ------ |  | - | -----
|                                    |  | Three Months Ended June 30, |       | Six Months Ended June 30,
|                                    |  | 2005                        |       | 2004                      |   | 2005  |  | 2004
|                                    |  | (unaudited; in thousands)  
|Total segment profit                |  | $                           | 7,586 |                           | $ | 4,047 |  | $    | 14,681 |  | $ | 7,567
|Net interest expense                |  |                             | 1,273 |                           |   | 1,052 |  |      | 2,446  |  |   | 2,150
|Depreciation and amortization       |  |                             | 1,332 |                           |   | 1,364 |  |      | 2,655  |  |   | 2,738
|Closure and other                   |  |                             |      |                           |   | 85    |  |      |       |  |   | 85   
|Write-off of unamortized loan costs |  |                             |      |                           |   |      |  |      |       |  |   | 667  
|Other, net                          |  |                             | 522   |                           |   | 518   |  |      | 484    |  |   | 972  
|                                    |  |                             |       |                           |   |       |  |      |        |  |   |      
|Net income before income taxes      |  |                             | 4,459 |                           |   | 1,028 |  |      | 9,096  |  |   | 955  
|Income tax provision                |  |                             | 1,913 |                           |   | 407   |  |      | 3,675  |  |   | 378  
|                                    |  |                             |       |                           |   |       |  |      |        |  |   |      
|Net income                          |  | $                           | 2,546 |                           | $ | 621   |  | $    | 5,421  |  | $ | 577  
|                                    |  |                             |       |                           |   |       |  |      |        |  |   |      



The Companys
geographic data related to total assets for continuing operations for the six months ended June 30, 2005 and 2004 were as follows:



|              |  |               |         |        |   |                |  |       |        |              |   |       |  |   |        
|------------- |  | ------------- | ------- | ------ | - | -------------- |  | ----- | ------ | ------------ | - | ----- |  | - | -------
|              |  | United States |         | Canada |   | United Kingdom |  | Other |        | Consolidated
|June 30, 2005 |  |               |         |        |   |                |  |       |        |              |   |       |  |   |        
|Total assets  |  | $             | 149,044 |        | $ | 22,751         |  | $     | 69,188 |              | $ | 2,327 |  | $ | 243,310
|June 30, 2004 |  |               |         |        |   |                |  |       |        |              |   |       |  |   |        
|Total assets  |  | $             | 146,037 |        | $ | 17,137         |  | $     | 77,118 |              | $ | 4,560 |  | $ | 244,852



(11) Pension and Other
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, Employers Accounting for Postretirement
Benefits Other than Pensions. The Company has recorded a liability for the actuarially determined accumulated postretirement benefit obligation associated with these plans.



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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



On December 31, 2003, the President of the United States signed into law the Medicare Prescription
Drug Improvement and Modernization Act of 2003. In May 2004, the Financial Accounting Standards Board issued FSP FAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of
2003. This pronouncement requires the Company to determine whether or not the benefit provided under its plans is actuarially equivalent to the Medicare prescription drug-benefit. If the benefit provided is actuarially equivalent
and this federal subsidy is deemed a significant event, the Company is required to account for the federal subsidy attributable to past services as an actuarial gain under FSP SFAS No. 106 and to reduce the accumulated postretirement benefit
obligation. For the portion of the federal subsidy attributable to current or future service, the Company is required to reduce net periodic postretirement benefit cost while the employee provides the service. The Companys actuary made a
preliminary assessment that the benefits provided under its postretirement benefit plans are actuarially equivalent and that this law could reduce the Companys overall accumulated postretirement benefit obligation by $2.2 million, and thereby
reduce the annual net periodic benefit cost associated with these plans. Based on this assessment, for the year ended December 31, 2004, net periodic benefit cost was reduced by approximately $374,000, of which $170,000 related to a reduction of
interest cost and $204,000 related to a reduction of the amortization of the cumulative experience loss, to reflect the most recent estimate of the Companys net periodic benefit cost under these postretirement benefit plans.



The following table summarizes the components of net periodic benefit cost
under the Companys postretirement benefit plans as of June 30, 2005 and 2004, respectively:



|                                |  |                             |      |   |                           |   |      |      |  |   |      |   |  |   |      |  
|------------------------------- |  | --------------------------- | ---- | - | ------------------------- | - | ---- | ---- |  | - | ---- | - |  | - | ---- | -
|                                |  | Three Months Ended June 30, |      |   | Six Months Ended June 30, |  
|                                |  | 2005                        |      |   | 2004                      |   |      | 2005 |  |   | 2004 |  
|                                |  | (unaudited, in thousands)   |     
|Unrecognized prior service cost |  | $                           | (177 | ) |                           | $ | (146 | )    |  | $ | (354 | ) |  | $ | (292 | )
|Interest cost                   |  |                             | 210  |   |                           |   | 221  |      |  |   | 420  |   |  |   | 442  |  
|Unrecognized loss               |  |                             | 177  |   |                           |   | 150  |      |  |   | 354  |   |  |   | 300  |  
|                                |  |                             |      |   |                           |   |      |      |  |   |      |   |  |   |      |  
|Net periodic benefit cost       |  | $                           | 210  |   |                           | $ | 225  |      |  | $ | 420  |   |  | $ | 450  |  
|                                |  |                             |      |   |                           |   |      |      |  |   |      |   |  |   |      |  



In the second quarter
of 2005, modifications were made to increase the level of contributions provided to the plans by the plan participants.



(12) 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.



Intangible assets subject to amortization as of June 30, 2005 and 2004 were:



|                         |  |                           |       |                          |   |                       |  |                          |       |  |   |    
|------------------------ |  | ------------------------- | ----- | ------------------------ | - | --------------------- |  | ------------------------ | ----- |  | - | ---
|                         |  | As of June 30, 2005       |       | As of June 30, 2004     
|Type of Intangible Asset |  | Gross Carrying Amount     |       | Accumulated Amortization |   | Gross Carrying Amount |  | Accumulated Amortization
|                         |  | (unaudited, in thousands)
|Deferred financing fees  |  | $                         | 1,109 |                          | $ | 539                   |  | $                        | 885   |  | $ | 81 
|Patents                  |  |                           | 185   |                          |   | 65                    |  |                          | 165   |  |   | 44 
|Other                    |  |                           | 584   |                          |   | 101                   |  |                          | 534   |  |   | 297
|                         |  |                           |       |                          |   |                       |  |                          |       |  |   |    
|Total                    |  | $                         | 1,878 |                          | $ | 705                   |  | $                        | 1,584 |  | $ | 422
|                         |  |                           |       |                          |   |                       |  |                          |       |  |   |    



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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



Amortization and interest expense of $161,000 and $80,000 were recognized related to these assets for
the three months ended June 30, 2005 and 2004, respectively and $318,000 and $261,000 for the six months ended June 30, 2005 and 2004, respectively. During the first quarter of 2004, the Company recorded expense of $667,000 related to the write-off
of deferred financing fees, resulting from the retirement of the 2001 term loan and revolving credit facilities. See Note 8, Long-Term Debt. The estimated aggregate amortization and interest expense for these assets for each of the following five
fiscal years is: 2005$509,000; 2006$402,000; 2007$132,000; 2008$36,000; and 2009$72,000. For segment reporting purposes, these intangible assets and the related amortization expense were allocated to each segment.



Net goodwill of $80.5 million was the Companys only
intangible asset that did not require periodic amortization as of June 30, 2005. The decrease of $133,000 in the value of goodwill during the six months ended June 30, 2005 related entirely to currency exchange rate fluctuations.



In accordance with SFAS No. 142, the Company tested each business segment for
impairment of goodwill at December 31, 2004, 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 six months ended June 30, 2005, as management noted no indications of goodwill impairment.



(13) Litigation



Magnum Transcontinental Corp. Arbitration and Petroserv, S.A. v. National Tank Company, 165thJud. Dist.
Ct., Harris Co., TX (Cause No. 200418769). These matters stemmed from an agreement among NATCO Group, Magnum Transcontinental Corporation, the US procurement arm and Petroserv S.A., and Zephyr Offshore, Inc., a Petroserv subsidiary, to
manufacture and install a processing plant on a Petroserv rig, and Petroservs agency agreement with NATCO for certain projects in Brazil. NATCO claimed Magnum owed it $418,990 under the plant manufacturing agreement for additional work
performed in excess of the days agreed in the contract. NATCO submitted the matter to binding American Arbitration Association arbitration on October 29, 2003. In the arbitration, Magnum originally counter-claimed for $4,685,000, alleging breach of
contract. Magnum amended its answer and counter-claim in the arbitration on July 16, 2004, reducing its total amount claimed to $1,304,000. At an arbitration hearing held in October 2004, Magnum further reduced its counter claim by $570,000. On
February 11, 2005, the arbitrator awarded NATCO the full amount of its claim, plus interest, and granted Magnum a total of $58,000 on its counterclaim. Neither party appealed the arbitrators determination within the period provided and Magnum
paid NATCO approximately $410,000 on March 24, 2005.



After
NATCO filed its request for arbitration, Petroserv submitted a mediation request under its representation agreement with NATCO, claiming unpaid agency fees on several contracts, including the Magnum contract. No resolution resulted from the
mediation, which was held on January 23, 2004. NATCO believed any fees owed to Petroserv under the agency agreement were offset by NATCOs claims against Magnum. NATCO disputed that it owed any fees for the Magnum work or any work obtained in
Brazil after the representation agreement terminated in early 2003. Petroserv served a collections suit in state court in May 2004, seeking over $731,323, plus attorneys fees, interest and court costs, representing amounts allegedly due under
the representation agreement on several contracts, including the Magnum Transcontinental contract. NATCO filed a counterclaim in this action, claiming breach of the agency agreement and fiduciary obligations Petroserv owed to NATCO. A second
unsuccessful mediation was held in the case in August 2004. On March 11, 2005, NATCO and Petroserv agreed to settle this lawsuit, with NATCO paying approximately $420,000 to Petroserv for commissions earned, accrued interest and legally recoverable
attorneys fees. NATCO applied the funds received in the Magnum arbitration discussed above to this settlement payment.



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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



Jose Corona, Individually and as Personal Representative of the Estate of Noe Corona, Sr., et al.
v. NATCO Group Inc. and Jaime Liendo, 381stJudicial District Court, Starr County, Texas (Cause No.
DC-04-175).This lawsuit, filed in 2004, arose from a 2003 automobile accident involving an employee of one of our subsidiaries and Noe Corona, Sr., who died from injuries sustained in
the accident. Original and subsequent pleadings did not specify damages. Voluntary mediation was conducted on March 30, 2005, without success. Plaintiffs amended their pleadings on April 15, 2005 seeking damages of up to $30 million related to
mental anguish, grief, bereavement, loss of society, companionship, damage to the familial relationship, and loss of care, counseling, and guidance allegedly suffered by six surviving adult children, as well as funeral and medical expenses and pain
and suffering of Noe Corona. A second mediation was held on May 24, 2005, and the parties agreed to settle all plead and potential claims arising from the accident. The settlement, which is confidential, was funded by insurance, with NATCO paying a
$100,000 deductible.



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.



(14) Recent Accounting Pronouncements



In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an
amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends Accounting Research Bulletin 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 on June 15, 2005. The Company
adopted this pronouncement on June 15, 2005, with no material impact on its results of operations, financial position or cash flows.



In December 2004, FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS 123R). This amendment requires expensing of
stock options and other share-based payments and supercedes SFAS No. 123 which allowed companies to choose between expensing stock options or showing proforma disclosure only. This standard is effective for the Company as of January 1, 2006 and
will apply to all awards granted modified, cancelled or repurchased after that date as well as the unvested portion of prior awards. The Company will adopt the standard as of the effective date. The Company expects to record additional compensation
expense at that time.



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 with no material impact on its results of operations, financial position or cash flows.



In December 2004, the FASB issued FASB Staff Position No. 109-1 (FSP
109-1), Application of FASB Statement No. 109, Accounting for Income Taxes (SFAS No. 109) to the Tax Deduction on Qualified



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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



Production Activities Provided by the American Jobs Creation Act of 2004, which provides guidance on the recently enacted American Jobs Creation Act
of 2004 (the Jobs Creation Act). The Jobs Creation Act provides a tax deduction for income from qualified domestic production activities. FSP 109-1 provides for the treatment of the deduction as a special deduction as described in SFAS
No. 109. As such, the deduction will have no effect on existing deferred tax assets and liabilities. The impact of the deduction is to be reported in the period in which the deduction is claimed on our US tax return. FSP 109-1 became effective as of
January 1, 2005. We do not expect that this deduction will have a significant impact on our effective tax rate in current or future years.



In December 2004, the FASB issued FASB Staff Position No. 109-2 (FSP 109-2), Accounting and Disclosure Guidance for the Foreign
Repatriation Provision within the American Jobs Creation Act of 2004,which provides guidance under SFAS No. 109 with respect to recording the potential impact of the repatriation provisions of the Jobs Creation Act on a companys income
tax expense and deferred tax liability. FSP 109-2 states that a company is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Creation Act on its plan for reinvestment or repatriation of foreign
earnings for purposes of applying SFAS No. 109. We have not yet decided on whether, and to what extent, we might elect to repatriate foreign earnings under the provisions in the Jobs Creation Act. Any such repatriation under the Jobs Creation Act
must occur by December 31, 2005. Accordingly, our consolidated financial statements do not reflect a provision for taxes related to this election. The maximum amount we could elect to repatriate at this time is approximately $1.0 million.



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 Company will adopt the standard as of the effective date and does not expect the adoption of FIN 47 to have a material effect on the Companys financial position, cash flows or
results of operations for the year ending December 31, 2005.



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 nonfinancial 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 Company will adopt the standard as of the effective date and is currently evaluating the impact, if any, on the Companys 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



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NATCO GROUP INC. AND SUBSIDIARIES



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)



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. Our UK operations are subject to the new FSP 143-1, which did not have a material effect on the Companys financial position, cash flows or results of operations as of June 30, 2005.



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 2005 (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 and the
overall condition of capital and equity markets for countries in which we operate.



Risk Factors



The following discussion should
be read in conjunction with the financial statements, related notes and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q. Readers also are urged to review and consider carefully the various disclosures advising
interested parties of the factors that affect our business, including but not limited to, the disclosures made under the caption Risk Factors and the other factors and risks discussed in our Annual Report on Form 10-K/A for the year
ended December 31, 2004, and in subsequent reports filed with the Securities and Exchange Commission. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statement to reflect any
change in our expectations or any change in events, conditions or circumstances on which any forward-looking statement is based. In addition, you should consider the following risk:



As previously disclosed, our President has the right to make a one-time election under his employment agreement, as amended,
to terminate his employment within ten (10) days of September 7, 2005 (the nine-month anniversary of Mr. Clarke being named Chief Executive Officer of the Company. If the President so elects, he would be entitled to receive severance benefits equal
to two times his base salary, his pro rata bonus through the date of termination, continuation of health care coverage for a period of 18 months following termination, immediate vesting of all options on the termination date and lapse of
restrictions on any restricted stock on such date. The President has agreed with the Companys Board any grants of options and restricted stock made to him in 2005 would be forfeited if he exercises this election. The Company has not recognized
any costs related to this election.



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Overview



In July 2004, the Board of Directors announced the resignation of the Companys then Chief Executive Officer effective in September 2004, and named
John U. Clarke, then an independent director of the Company, as Chairman and interim CEO. The Board of Directors conducted a search for a replacement and appointed Mr. Clarke as Chief Executive Officer in December 2004.



We restructured our organization effective as of January 1, 2005 in order to
improve our execution and customer focus. By organizing our business segments to better concentrate our proprietary technologies on specific end-use markets, we believe we can be more responsive to our customers needs as well as to new market
opportunities. In addition, we expect to establish clearer roles and responsibilities for our senior management team with appropriate levels of accountability and performance metrics to improve execution while at the same time increasing financial
transparency for our shareholders. For financial reporting purposes, we allocated corporate and other expenses to each of the segments, rather than segregating these costs on a standalone basis. The new segments are Oil & Water Technologies, Gas
Technologies and Automation & Controls.



| |  |  | The Oil & Water Technologies group includes our traditional oil and gas separation and dehydration equipment sales and related services, our extensive North American branch
distribution network, and our worldwide engineered systems group, all of which are focused primarily on oil and water production and processing systems.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Gas Technologies group 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 gas-related technologies that
focus on removing contaminants from the gas stream.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Automation & Controls group remains unchanged, focusing 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.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As a result of these changes and others, we expect to benefit from greater efficiencies and revenue growth while immediately pursuing cost reduction initiatives designed to reduce expenses by at least $10 million over
the next 12-18 months, half of which are expected to be realized in 2005. These initiatives include:



| |  |  | The strategic repositioning of our UK-based subsidiary, Axsiapart of the Oil & Water Technologies groupand efficiency gains due to better integration of Axsias
engineering and marketing capabilities with those of NATCOs Houston-based engineering and global marketing groups. Approximately 50 positions have been eliminated from the Axsia organization through the end of the second quarter or scheduled
for elimination as part of this effort. As a result of the improved integration of our engineering and global marketing groups, we expect to be better positioned to service expanding markets in Russia, the Middle East, Latin America, Africa and
Asia.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Rationalization of our manufacturing assets and North American branch networkboth part of the Oil & Water Technologies group. Manufacturing efficiencies will be achieved
at our primary manufacturing facilities and elsewhere through the application of lean management techniques designed to eliminate excess manufacturing capacity, increase capacity utilization and improve productivity.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A reduction in operating expenses within the branch network will be accomplished through higher field personnel utilization rates and a general reduction of overhead costs.
Additionally, we expect to achieve revenue enhancements from greater product pull through and the identification of new customer market sales opportunities.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A reduction in operating, interest and general and administrative expenses arising from improved procurement practices, inventory management, overhead reductions and working capital
discipline.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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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/A for the year ended December 31, 2004, 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 from significant contracts (greater than $250,000 and longer than four
months in duration) and certain automation and control systems contracts and orders on the percentage-of-completion method of accounting. 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. The timing of costs 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 revenues reflect 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 that 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 applies over a period of two to six quarters. In the event a project is terminated by the customer before completion, our customer is liable for costs incurred under the contract. We believe that our
operating results should be evaluated over a term of several years to evaluate performance under long-term contracts, after all change orders, scope changes and cost recoveries have been negotiated and realized. We record revenues and profits on all
other sales as shipments are made or services are performed.



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 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. 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 was $80.5 million at June 30, 2005. The modest decrease in the value of
goodwill for the three months ended June 30, 2005 related entirely to currency exchange rate fluctuations.



In accordance with SFAS No. 142, the Company tested each business segment for impairment of goodwill at December 31, 2004, 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, 2005, 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 net



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deferred income tax assets we believe may not be utilized through future operations. As of June 30, 2005, we have a $258,000 valuation allowance related to
the realizability of certain US tax attributes related to Axsia, a valuation allowance of $2.2 million related to Axsias UK operations, and another $269,000 related to other foreign operations. 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 tax jurisdiction, we believe it is more likely than not we will realize the benefits of these deductible differences and carry forwards,
net of the existing valuation allowances at June 30, 2005, in the US tax jurisdiction. However, the amount of the deferred tax asset considered realizable, and thus the amount of these valuation allowances, could change if future taxable income
differs from our projections in the US tax jurisdiction. The realizability of our deductible differences and carry forwards in our foreign tax jurisdictions will be dependent on the level of future taxable income in those jurisdictions.



Recent Accounting Pronouncements





In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends Accounting Research Bulletin 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 on June 15, 2005. The Company adopted this pronouncement on June 15, 2005, with no material impact on its results of operations, financial position or cash flows.



In December 2004, FASB issued SFAS No. 123 (Revised 2004), Share-Based
Payment (SFAS 123R). This amendment requires expensing of stock options and other share-based payments and supercedes SFAS No. 123 which allowed companies to choose between expensing stock options or showing proforma
disclosure only. This standard is effective for the Company as of January 1, 2006 and will apply to all awards granted modified, cancelled or repurchased after that date as well as the unvested portion of prior awards. The Company will adopt the
standard as of the effective date. The Company expects to record additional compensation expense at that time.



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 results of operations, financial position or cash flows.



In December 2004, the FASB issued FASB Staff Position No. 109-1 (FSP 109-1), Application of FASB Statement No. 109, Accounting for
Income Taxes (SFAS No. 109) to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004, which provides guidance on the recently enacted American Jobs Creation Act of 2004 (the
Jobs Creation Act). The Jobs Creation Act provides a tax deduction for income from qualified domestic production activities. FSP 109-1 provides for the treatment of the deduction as a special deduction as described in SFAS No. 109. As
such, the deduction will have no effect on existing deferred tax assets and liabilities. The impact of the deduction is to be reported in the period in which the deduction is claimed on our US tax return. FSP 109-1 became effective as of January 1,
2005. We do not expect that this deduction will have a significant impact on our effective tax rate in current or future years.



In December 2004, the FASB issued FASB Staff Position No. 109-2 (FSP 109-2), Accounting and Disclosure Guidance for the Foreign
Repatriation Provision within the American Jobs Creation Act of 2004,which provides guidance under SFAS No. 109 with respect to recording the potential impact of the repatriation provisions of the Jobs Creation Act on a companys income
tax expense and deferred tax liability. FSP 109-2 states that a



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company is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Creation Act on its plan for reinvestment or
repatriation of foreign earnings for purposes of applying SFAS No. 109. We have not yet decided on whether, and to what extent, we might elect to repatriate foreign earnings under the provisions in the Jobs Creation Act. Any such repatriation under
the Jobs Creation Act must occur by December 31, 2005. Accordingly, our consolidated financial statements do not reflect a provision for taxes related to this election. The maximum amount we could elect to repatriate at this time is approximately
$1.0 million.



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 Company will adopt the standard as of the effective date and does not expect the adoption of FIN 47 to have a material effect on the Companys financial
position, cash flows or results of operations for the year ended December 31, 2005.



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 nonfinancial 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 Company will adopt the standard as of the effective date and is currently evaluating the impact, if any, on the Companys 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. Our UK operations are subject to the new FSP
143-1, which did not have a material effect on the Companys financial position, cash flows or results of operations as of June 30, 2005.



Industry and Business Environment



As a leading provider of wellhead process equipment, systems and services used in the production of crude oil and natural gas, our revenues 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, revenues
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, revenues for service providers can lag behind the
industry due to the timing of new project awards.



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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 equipment sales 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 US demand for and consumption of petroleum and natural gas products will increase through 2025, with higher consumption rates expected worldwide, 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, especially since 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. The following table summarizes the prices of domestic crude oil per barrel and the wellhead prices of natural gas per thousand cubic feet (mcf) for the six months ended June 30, 2005 and 2004, as well as averages for the
years ended December 31, 2004 and 2003, derived from published reports by the U.S. Department of Energy, and the rotary rig count, as published by Baker Hughes Incorporated.



|                                                          |  |                           |       |                         |   |       |  |      |       |  |   |      
|--------------------------------------------------------- |  | ------------------------- | ----- | ----------------------- | - | ----- |  | ---- | ----- |  | - | -----
|                                                          |  | Six Months Ended June 30, |       | Year Ended December 31,
|                                                          |  | 2005                      |       | 2004                    |   | 2004  |  | 2003
|Average price of crude oil per barrel in the U.S.         |  | $                         | 51.41 |                         | $ | 36.82 |  | $    | 41.47 |  | $ | 27.56
|Average wellhead price of natural gas per mcf in the U.S. |  | $                         | 6.89  |                         | $ | 5.39  |  | $    | 5.50  |  | $ | 4.97 
|Average U.S. rig count                                    |  |                           | 1,308 |                         |   | 1,141 |  |      | 1,190 |  |   | 1,030



At June 30, 2005, the
spot price of West Texas Intermediate crude oil was $56.35 per barrel and the price of Henry Hub natural gas was $7.01 per million British thermal units, or mmbtu, per the Dow Jones Energy Service. These spot prices reflect the overall volatility of
oil and gas commodity prices in the current and recent years. At June 30, 2005, the US rig count was 1,355 per Baker Hughes Incorporated.



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.



Certain segment
amounts previously reported for the three and six months ended June 30, 2004 have been reclassified to conform to the presentation of segment amounts reported for the three and six months ended June 30, 2005.



Results of Operations



Three Months Ended June 30, 2005 Compared to Three Months Ended June 30, 2004 (unaudited)



Revenues.Revenues of $94.6 million for the three months ended June
30, 2005 increased $21.3 million, or 29%, from $73.3 million for the three months ended June 30, 2004. The following table summarizes revenues by business segment for the three months ended June 30, 2005 and 2004, respectively.



|                         |  |                                          |        |   |        |   |        |                   |  |   |        |   |  |     |   
|------------------------ |  | ---------------------------------------- | ------ | - | ------ | - | ------ | ----------------- |  | - | ------ | - |  | --- | --
|                         |  | Three Months EndedJune 30,               |        |   | Change |   |        | Percentage Change | 
|                         |  | 2005                                     |        |   | 2004   |   |        |                  
|                         |  | (unaudited)                              |       
|                         |  | (in thousands, except percentage change) |       
|Oil & Water Technologies |  | $                                        | 72,590 |   |        | $ | 53,664 |                   |  | $ | 18,926 |   |  | 35  | % 
|Gas Technologies         |  |                                          | 7,277  |   |        |   | 10,718 |                   |  |   | (3,441 | ) |  | (32 | )%
|Automation & Controls    |  |                                          | 15,829 |   |        |   | 9,682  |                   |  |   | 6,147  |   |  | 63  | % 
|Eliminations             |  |                                          | (1,048 | ) |        |   | (717   | )                 |  |   | (331   | ) |  | 46  | % 
|                         |  |                                          |        |   |        |   |        |                   |  |   |        |   |  |     |   
|Total                    |  | $                                        | 94,648 |   |        | $ | 73,347 |                   |  | $ | 21,301 |   |  | 29  | % 
|                         |  |                                          |        |   |        |   |        |                   |  |   |        |   |  |     |   



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Oil & Water Technologies revenues increased $18.9 million, or 35%, for the three months ended June
30, 2005, compared to the three months ended June 30, 2004, due to increased demand for our products caused by increased exploration and development activity overall in the oil and gas industry. The average number of operating rotary rigs in the
U.S. increased from 1,163 for the second quarter of 2004 to 1,336 for the second quarter of 2005, with Canadian rig counts increasing from an average of 202 to 241. This increase in activity contributed to improved sales of our traditional and
standard equipment and services in North America and improved revenue from our built-to-order projects domestically and internationally. Inter-segment revenues for this business segment were $232,000 for the three months ended June 30, 2005,
compared to $(43,000) for the three months ended June 30, 2004.



Revenues of $7.3 million for the three months ended June 30, 2005 for the Gas Technologies segment decreased $3.4 million, or 32%, compared to $10.7 million for the three months ended June 30, 2004. This decrease was primarily due to lower
revenue from built to order projects, partially offset by increased throughput at our West Texas gas processing facility. There were no inter-segment revenues for this business segment for the three months ended June 30, 2005.



Revenues for the Automation & Controls segment of $15.8 million increased
$6.1 million, or 63%, for the three months ended June 30, 2005, compared to $9.7 million for the three months ended June 30, 2004. Activity levels for the second quarter of 2005 improved due to growth in revenue from our West Africa operations and
increased levels of activity in the Gulf of Mexico. Inter-segment sales increased from $760,000 for the three months ended June 30, 2004 to $816,000 for the three months ended June 30, 2005.



The change in revenues for Eliminations represents the elimination of
inter-segment revenues discussed above.



Gross Profit.Gross profit for the three months ended June 30, 2005 increased $4.8 million, or 27%, to $22.4 million, compared to $17.6 million for the three months ended June 30, 2004. As a percentage of revenue, gross profit remained the same at 24% for the
quarter ended June 30, 2005 compared to the quarter ended June 30, 2004. The following table summarizes gross profit by business segment for the periods indicated:



|                         |  |                                          |        |        |   |        |                  |   |       |   |  |     |   
|------------------------ |  | ---------------------------------------- | ------ | ------ | - | ------ | ---------------- | - | ----- | - |  | --- | --
|                         |  | Three Months Ended June 30,              |        | Change |   |        | PercentageChange |  
|                         |  | 2005                                     |        | 2004   |   |       
|                         |  | (unaudited)                              |       
|                         |  | (in thousands, except percentage change) |       
|Oil & Water Technologies |  | $                                        | 14,343 |        | $ | 10,101 |                  | $ | 4,242 |   |  | 42  | % 
|Gas Technologies         |  |                                          | 4,907  |        |   | 5,812  |                  |   | (905  | ) |  | (16 | )%
|Automation & Controls    |  |                                          | 3,148  |        |   | 1,718  |                  |   | 1,430 |   |  | 83  | % 
|                         |  |                                          |        |        |   |        |                  |   |       |   |  |     |   
|Total                    |  | $                                        | 22,398 |        | $ | 17,631 |                  | $ | 4,767 |   |  | 27  | % 
|                         |  |                                          |        |        |   |        |                  |   |       |   |  |     |   



Gross profit for the
Oil & Water Technologies segment increased $4.2 million, or 42%, for the three months ended June 30, 2005, compared to the three months ended June 30, 2004, primarily due to a 35% increase in revenues between the respective periods. As a
percentage of revenue, gross margins were 20% and 19% for the three months ended June 30, 2005 and 2004, respectively. Improvements in margins resulted primarily from the sales of traditional and standard equipment and services.



Gross profit for the Gas Technologies segment for the three months ended June
30, 2005 decreased $905,000, or 16%, compared to the three months ended June 30, 2004, due to a 32% decrease in revenues between the respective periods primarily associated with our built to order projects and lower membrane sales. This was
partially offset by increased margins from our gas processing operations. Gross margin as a percentage of revenues for Gas Technologies was 67% and 54% for the three-month periods ended June 30, 2005 and 2004, respectively.



Gross profit for the Automation & Controls segment increased $1.4
million, or 83%, for the three months ended June 30, 2005 compared to the three months ended June 30, 2004, due to a 63% increase in revenues for



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the segment during the 2005 period and a favorable revenue composition. Gross margin as a percentage of revenue for the three months ended June 30, 2005 and
2004, respectively, was 20% and 18%.



Selling, General and
Administrative Expense.Selling, general and administrative expense of $14.8 million for the three months ended June 30, 2005, increased $1.2 million, or 9%, compared to the three months ended June 30, 2004. This increase relates primarily to
increased compensation expense from the expected lapse of restrictions on certain performance-based equity incentives in July 2005 related to the increase in our stock price during the second quarter of 2005. Overall headcount increased from 1,679
employees at June 30, 2004 to 1,732 employees at June 30, 2005.



Depreciation and Amortization Expense.Depreciation and amortization expense of $1.3 million for the three months ended June 30, 2005, decreased $32,000, or 2%, compared to the three months ended June 30, 2004.



Interest Cost on Postretirement Benefit Liability. Interest cost on
postretirement liability of $210,000 for the three months ended June 30, 2005 decreased $15,000, or 7%, compared to the three months ended June 30, 2004, primarily due to the impact of changes to the Medicare laws enacted by the U.S. Congress in
December 2003.



Other, net.Other, net was an expense of
$522,000 for the three months ended June 30, 2005, related primarily to $345,000 of expense resulting from the change in valuation of the outstanding warrants to purchase our common stock and to net realized and unrealized foreign exchange
transaction losses. Other, net was an expense of $518,000 for the three months ended June 30, 2004 related primarily to net realized and unrealized foreign exchange transaction losses.



Provision for Income Taxes.Income tax expense for the three months ended June 30, 2005 was $1.9 million compared to
$407,000 for the three months ended June 30, 2004. The change in tax expense was primarily attributable to an increase in pre-tax income of $3.4 million to $4.5 million for the three months ended June 30, 2005 from income of $1.0 million for the
three months ended June 30, 2004. The effective tax rate was 42.8% and 40.0% for the three-month periods ended June 30, 2005 and 2004, respectively.



Six Months Ended June 30, 2005 Compared to Six Months Ended June 30, 2004 (unaudited)



Revenues.Revenues of $183.3 million for the six months ended June 30, 2005 increased $38.0 million, or 26%, from
$145.3 million for the six months ended June 30, 2004. The following table summarizes revenues by business segment for the six months ended June 30, 2005 and 2004, respectively.



|                         |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |     |   
|------------------------ |  | ---------------------------------------- | ------- | - | ------ | - | ------- | ---------------- |  | - | ------ | - |  | --- | --
|                         |  | Six Months Ended June 30,                |         |   | Change |   |         | PercentageChange | 
|                         |  | 2005                                     |         |   | 2004   |   |         |                 
|                         |  | (unaudited)                              |        
|                         |  | (in thousands, except percentage change) |        
|Oil & Water Technologies |  | $                                        | 139,595 |   |        | $ | 108,239 |                  |  | $ | 31,356 |   |  | 29  | % 
|Gas Technologies         |  |                                          | 15,174  |   |        |   | 17,542  |                  |  |   | (2,368 | ) |  | (13 | )%
|Automation & Controls    |  |                                          | 30,981  |   |        |   | 21,300  |                  |  |   | 9,681  |   |  | 45  | % 
|Eliminations             |  |                                          | (2,446  | ) |        |   | (1,750  | )                |  |   | (696   | ) |  | 40  | % 
|                         |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |     |   
|Total                    |  | $                                        | 183,304 |   |        | $ | 145,331 |                  |  | $ | 37,973 |   |  | 26  | % 
|                         |  |                                          |         |   |        |   |         |                  |  |   |        |   |  |     |   



Oil & Water
Technologies revenues increased $31.4 million, or 29%, for the six months ended June 30, 2005, compared to the six months ended June 30, 2004, primarily due to increased demand for our products caused by overall increased exploration and development
activity in the oil and gas industry. The average number of operating rotary rigs in the U.S. increased from 1,141 for the first six months of 2004 to 1,308 for the first six months of 2005, with Canadian rig counts increasing from an average of 365
to 381. This increase in activity contributed to improved sales of our traditional and standard equipment and services and our built to order projects. Inter-segment revenues for this business segment were $523,000 for the six months ended June 30,
2005, compared to $186,000 for the six months ended June 30, 2004.



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Revenues of $15.2 million for the six months ended June 30, 2005 for the Gas Technologies segment
decreased $2.4 million, or 13%, compared to $17.5 million for the six months ended June 30, 2004. This decrease was primarily due to a reduction in built to order projects and decreased membrane sales. This was partially offset by increased
throughput at our gas processing facilities. There were no inter-segment revenues for this business segment for the six months ended June 30, 2005.



Revenues for the Automation & Controls segment increased $9.7 million, or 45%, for the six months ended June 30, 2005, compared to the six months
ended June 30, 2004. Activity levels for the first six months of 2005 improved due to increased level of activity in the Gulf of Mexico and growth in international sales and service. Inter-segment sales increased from $1.6 million for the six months
ended June 30, 2004 to $1.9 million for the six months ended June 30, 2005.



The change in revenues for Eliminations represents the elimination of inter-segment revenues discussed above.



Gross Profit.Gross profit for the six months ended June 30, 2005 increased $9.2 million, or 27%, to $43.7 million, compared to $34.4 million for
the six months ended June 30, 2004. As a percentage of revenue, gross profit remained constant from period to period at 24% for the six months ended June 30, 2005 and 2004, respectively. The following table summarizes gross profit by business
segment for the periods indicated:



|                         |  |                                          |        |        |   |                  |  |   |       |  |    |  
|------------------------ |  | ---------------------------------------- | ------ | ------ | - | ---------------- |  | - | ----- |  | -- | -
|                         |  | Six Months EndedJune 30,                 |        | Change |   | PercentageChange | 
|                         |  | 2005                                     |        | 2004   |   |                 
|                         |  | (unaudited)                              |       
|                         |  | (in thousands, except percentage change) |       
|Oil & Water Technologies |  | $                                        | 27,188 |        | $ | 21,369           |  | $ | 5,819 |  | 27 | %
|Gas Technologies         |  |                                          | 10,024 |        |   | 9,811            |  |   | 213   |  | 2  | %
|Automation & Controls    |  |                                          | 6,471  |        |   | 3,266            |  |   | 3,205 |  | 98 | %
|                         |  |                                          |        |        |   |                  |  |   |       |  |    |  
|Total                    |  | $                                        | 43,683 |        | $ | 34,446           |  | $ | 9,237 |  | 27 | %
|                         |  |                                          |        |        |   |                  |  |   |       |  |    |  



Gross profit for the
Oil & Water Technologies segment increased $5.8 million, or 27%, for the six months ended June 30, 2005, compared to the six months ended June 30, 2004, primarily due to a 29% increase in revenues between the respective periods. As a percentage
of revenue, gross margins were constant at 20% for the six-month periods ended June 30, 2005 and 2004, respectively.



Gross profit for the Gas Technologies segment for the six months ended June 30, 2005 increased $213,000, or 2%, compared to the six months ended June 30,
2004, primarily due to increased revenues and improved margins from our gas processing operations, partially offset by a decrease in revenues from built to order projects. Gross margin as a percentage of revenues for Gas Technologies was 66% and 56%
for the six months ended June 30, 2005 and 2004, respectively.



Gross profit for the Automation & Controls segment increased $3.2 million, or 98%, for the six months ended June 30, 2005 compared to the six months ended June 30, 2004, due to a 45% increase in revenues for the segment during the 2005
period and a decrease in production expenses. Gross margin as a percentage of revenue for the six months ended June 30, 2005 and 2004, was 21% and 15%, respectively.



Selling, General and Administrative Expense.Selling, general and administrative expense of $29.0 million for the six
months ended June 30, 2005, increased $2.1 million, or 8%, compared to the six months ended June 30, 2004. This increase in expense relates primarily to increased compensation from the lapse of restrictions on performance-based equity incentives
award related to the increase in our stock price during the second quarter of 2005, higher incentive compensation based on operating results and higher administrative costs, partially offset by the gain on the sale of a UK facility of $388,000
during the first quarter of 2005. Overall headcount increased from 1,679 employees at June 30, 2004 to 1,732 employees at June 30, 2005.



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Depreciation and Amortization Expense.Depreciation and amortization expense of $2.7 million for
the six months ended June 30, 2005, decreased $83,000, or 3%, compared to the results for the six months ended June 30, 2004.



Write-off of Unamortized Loan Costs. We recorded a write-off of unamortized loan costs of $667,000 in March 2004 related to the retirement of our
2001 term loan and revolving credit facilities.



Interest
Cost on Postretirement Benefit Liability. Interest cost on postretirement liability of $420,000 for the six months ended June 30, 2005 decreased $30,000, or 7%, compared to the six months ended June 30, 2004, primarily due to the impact of
changes to the Medicare laws enacted by the U.S. Congress in December 2003.



Other, net.Other, net was an expense of $484,000 for the six months ended June 30, 2005, related primarily to net realized and unrealized foreign exchange transaction gains, partially offset by $549,000 of
expense related to the change in valuation of the outstanding warrants to purchase our common stock. Other, net was an expense of $972,000 for the six months ended June 30, 2004 related primarily to net realized and unrealized foreign exchange
transaction losses.



Provision for Income Taxes.Income
tax expense for the six months ended June 30, 2005 was $3.7 million compared to $378,000 for the six months ended June 30, 2004. The change in tax expense was attributable to an increase in pre-tax income to $9.1 million for the six months ended
June 30, 2005 from $955,000 for the six months ended June 30, 2004. The effective tax rate was 40.4% and 40.0% for the six months ended June 30, 2005 and 2004, respectively.



Liquidity and Capital Resources



As of June 30, 2005, we had cash and working capital of $1.3 million and $44.0 million, respectively, as compared to cash and working capital of $2.2
million and $40.1 million, respectively, at December 31, 2004.



Net cash provided by operating activities for the six months ended June 30, 2005 was $7.0 million, compared to $3.5 million used for the six months ended June 30, 2004. The increase in cash provided by operating activities is related to the
increase in net income and a decrease in accounts receivable and inventories offset partially by a reduction in accounts payable.



Net cash used in investing activities for the six months ended June 30, 2005 was $875,000, which included $1.8 million of capital expenditures, offset by
$928,000 in proceeds from the sale of certain operating assets. For the six months ended June 30, 2004, cash used in investing activities was $1.5 million and related primarily to capital expenditures.



Net cash used in financing activities for the six months ended June 30, 2005
was $7.5 million. The primary use of funds for these financing activities was long-term debt repayments of $4.8 million, a reduction of bank overdrafts of $2.8 million and payment of dividends of $750,000 partially offset by $1.8 million of proceeds
from the exercise of stock options by employees and former employees. For the six months ended June 30, 2004, the primary source of funds for financing activities was borrowings of $45.0 million under our 2004 term loan and revolving credit
facilities, used to retire borrowings under our 2001 term loan and revolving credit facilities, including net repayments of $7.2 million under revolving credit arrangements and $32.4 million under the term loan portion of the related agreement. In
addition, we incurred $886,000 of deferred financing fees associated with an amendment to the 2004 term loan and revolving credit facilities.



We maintain revolving credit and term loan facilities, as well as a working capital facility for export sales. Our prior term loan, in effect during 2003
and most of the first quarter of 2004, provided an initial $50.0 million of borrowings and the revolving credit facilities provided for up to $30.0 million of borrowings in the United States, up to $10.0 million of borrowings in Canada and up to
$10.0 million of borrowings in the United Kingdom, subject to borrowing base limitations. The term loan was to mature on March 31, 2006, and each of the revolving facilities was to mature on March 31, 2004. These facilities were entered into in
2001, and we refer to these facilities as the 2001 term loan and revolving credit facilities.



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On March 15, 2004, we replaced our 2001 term loan and revolving credit facilities with a term loan and
revolving credit arrangement that provides for a term loan of $45.0 million and a revolving credit facility providing for aggregate additional borrowings of $35.0 million, comprised 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. All of the borrowing capacities under the 2004 revolving credit facilities are subject
to borrowing base limitations.



The 2004 term loan and
revolving facilities require quarterly payments of $1.6 million, beginning in June 2004, and mature on March 15, 2007. We borrowed funds under the 2004 term loan and revolving credit facilities to retire debt outstanding under the 2001 term loan and
revolving credit facilities as of March 15, 2004.



We recorded
a charge of $667,000 in March 2004 to expense unamortized loan costs related to our 2001 term loan and revolving credit facilities, and incurred an additional $995,000 of deferred loan costs related to the 2004 term loan and revolving credit
facilities, which will be amortized as interest expense through maturity of the facilities in March 2007. 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 has been amortized over the term of the amendment which ended June 2005.



The 2004 term loan and revolving 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 our election, (1) a high of the London Interbank Offered Rate, or 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 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 0.375% as of June 30, 2005.



We had borrowings of $37.0 million outstanding under the term loan portion of
the 2004 term loan at June 30, 2005, which bore interest at 5.69% to 5.94%. Borrowings outstanding under the revolving credit portion of the 2004 term loan and revolving credit facility at June 30, 2005 were $2.5 million at interest rates of 5.50%
to 7.50%. We had letters of credit outstanding under the 2004 revolving credit facilities of $15.9 million at June 30, 2005. Availability under our 2004 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, 2005 were approximately 2.25% of the outstanding balance. These letters of credit support contract performance and warranties and expire at various dates through February 2008.



We and our operating subsidiaries guarantee our 2004 term loan and
revolving facilities agreement, which 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. 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 is guaranteed by each of our US subsidiaries, while the Canadian and UK facilities are guaranteed by us, each of our US subsidiaries and the Canadian subsidiary or the UK subsidiaries, as applicable.



We paid commitment fees of 0.50% and 0.375% for the quarter ended June 30,
2005 on the undrawn portion of the revolving credit facility of the 2004 term loan and revolving credit facilities, respectively.



The 2004 term loan and revolving 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 a minimum net worth requirement. We were in compliance with all restrictive debt covenants in our loan agreements as of June 30, 2005. 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, 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.



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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 letters of credit and loans of up to $10 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) the London Interbank Offered Rate (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, 2005 were $6.5 million. This facility had fees related to letters of credit of approximately 1.00% of the outstanding balance for the period January 1, 2005 to June 30, 2005.



At June 30, 2005, available borrowing capacity under the 2004 term loan and
revolving credit agreement and the export sales credit agreement were $13.3 million and $5.8 million, respectively. 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.



We had unsecured letters of credit and bonds totaling $181,000 and
guarantees totaling $23.1 million at June 30, 2005.



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 Lime Rock Partners II, L.P., 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, 2005, 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. On June 15, 2005, we paid
dividends of $750,000 on our Series B Preferred Shares related to the period January 1, 2005 through June 30, 2005.



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. If the holder of the Series B Preferred Shares converts upon a change in control occurring on or before March 25, 2006,
the holder would also be entitled to receive cash in an amount equal to the dividends that would have accrued through March 25, 2006 less the sum of the aggregate amount of dividends paid in cash through the date of conversion, and the aggregate
amount of dividends accrued in prior periods but not yet paid.



We have the right to redeem 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.



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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 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%, (2) the holders of the Series B Preferred Shares would have the right to elect or appoint a second director to the Board of Directors and (3) 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.



The warrants issued to Lime Rock Partners II, L.P. have an exercise price of $10.00 per share of common stock and expire on March 25, 2006. We can force the exercise of the warrants if our common stock trades above $13.50 per share for 30
consecutive days, at which point the holder may 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. As of August 5, 2005, our stock has traded above the $13.50 level for 14 trading days. The warrants contain a provision whereby the holder could require us 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
resulting liability, originally recorded at $99,000, was recorded at $745,000 as of June 30, 2005, from $196,000 at December 31, 2004 reflecting the change in the fair value of the warrants. The Company recorded an expense of $345,000 and $549,000
for the quarter and six months ended June 30, 2005, respectively and an expense of $33,000 and no expense for the quarter and six months ended June 30, 2004, respectively. Similarly, changes in fair value in future periods will be recorded in net
income during the period of the change.



Our bookings were
$126.3 million and $230.1 million compared to $79.3 million and $183.4 million for the three and six months ended June 30, 2005 and 2004, respectively. Bookings increased $49.0 million and $55.7 million in the Oil & Water Technologies segment
and $8.4 million and $4.7 million in the Automation & Controls segment for the three and six months ended June 30, 2005 and 2004, respectively. In the Gas Technologies segment, bookings decreased $10.4 million and $13.7 million for the three and
six months ended June 30, 1005 and 2004, respectively.



Our
sales backlog at June 30, 2005 was $124.3 million, compared to $102.0 million at June 30, 2004. Backlog increased $37.1 million for the Oil & Water Technologies segment, reflecting an increase in oilfield activity in 2005 compared to 2004.
Backlog decreased $5.5 million for the Automation & Control segment, reflecting the completion of major projects building control panels for a customer in Kazakhstan. Gas Technologies backlog decreased $9.3 million primarily related to the
timing of awards related to built to order contracts.





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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 U.K. 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 U.K., many of our sales contracts and material purchases are denominated in a currency other than British pounds sterling, primarily U.S. 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.



The warrants issued to the holders of our Series B Preferred Shares provide
for a net-cash settlement in the event of a change in control, as defined in the warrants. Consequently, we use derivative accounting to record the warrant transaction. The liability representing the fair value of this derivative arrangement was
recorded at $99,000 as of the date of issuance, March 25, 2003, and was adjusted to $745,000 as of June 30, 2005, to reflect the change in fair value of the warrants during the period. A cumulative expense of $646,000 has been recorded related to
these warrants since issuance, including an expense of $549,000 for the six months ended June 30, 2005. Fair value, as agreed with the counter-party to the agreement, was based on a pricing model that included subjective assumptions concerning the
volatility of our common stock, the expected term that the warrants would be outstanding, an expected dividend rate of zero and an overall liquidity factor. At each reporting date, the liability will be adjusted to current fair value, with any
changes in fair value reported in earnings during the period of change. As such, we may be exposed to certain income fluctuations based upon changes in the fair market value of this liability due to changes in the price of our common stock, as well
as other factors.



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, 2005, we had borrowings of $37.0 million outstanding under the term loan portion of the 2004 term loan
and revolving credit facilities, at interest rates of 5.69% and 5.94%. We had borrowings of $2.5 million outstanding under the revolving credit portion of these facilities at June 30, 2005, at an interest rate of 5.50% to 7.50%. Borrowings under the
long-term arrangement secured by our Magnolia manufacturing facility totaled $1.1 million and accrued interest at 6.50%.



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
by $58,000 and decrease our cash flow from operations by $102,000. 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.



Item 4.Controls and Procedures



Controls and Procedures



Members of our
management team, including our Chief Executive Officer and our Chief Financial Officer, have reviewed our disclosure controls and procedures, as defined by the Securities and Exchange Commission in Rule 13a-15(e) of the Securities Exchange Act of
1934, as of June 30, 2005, in an effort to evaluate the effectiveness of the design and operation of these controls. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and
procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms.



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There have been no changes in our internal control over financial reporting that have materially
affected, or are reasonably likely to materially affect, our internal control over financial reporting.



We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control system
are met and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. Our disclosure controls and procedures are designed to provide reasonable assurance of
achieving their objectives, and, following the changes in our internal controls implemented prior to this quarter, the Chief Executive Officer and Chief Financial Officer believe that our disclosure controls and procedures were effective at the
reasonable assurance level as of June 30, 2005.



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PART IIOTHER INFORMATION



Item 1.Legal Proceedings



The only pending legal proceeding involving NATCO or one of its subsidiaries previously reported to be material is the Jose Corona matter. The following provides an update to the discussions in our prior SEC reports.



Jose Corona, Individually and as Personal Representative of
the Estate of Noe Corona, Sr., et al. v. NATCO Group Inc. and Jaime Liendo, 381stJudicial District Court, Starr County,
Texas (Cause No. DC-04-175).This lawsuit, filed in 2004, arose from a 2003 automobile accident involving an employee of one of our subsidiaries and Noe Corona, Sr., who died from
injuries sustained in the accident. Original and subsequent pleadings did not specify damages. Voluntary mediation was conducted on March 30, 2005, without success. Plaintiffs amended their pleadings on April 15, 2005 seeking damages of up to $30
million related to mental anguish, grief, bereavement, loss of society, companionship, damage to the familial relationship, and loss of care, counseling, and guidance allegedly suffered by six surviving adult children, as well as funeral and medical
expenses and pain and suffering of Noe Corona. A second mediation was held on May 24, 2005, and the parties agreed to settle all plead and potential claims arising from the accident. The settlement, which is confidential, was funded by insurance,
with NATCO paying a $100,000 deductible.



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.



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



The annual meeting of stockholders of NATCO Group Inc. was held on May 26, 2005 in Houston, Texas. At the annual meeting, the holders of 15,365,460 shares
of NATCO common stock out of 16,176,834 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 17,287,305 total voting shares present at the meeting and
18,098,679 total voting shares as of the record date.



Proposals submitted to a vote of security holders were:



(1) Election of three Class I members of the Board of Directors, each to hold office for a three-year term expiring at the annual meeting of stockholders in 2008.



|                    |  |                         |  |          |  |                
|------------------- |  | ----------------------- |  | -------- |  | ---------------
|                    |  | Number of Voting Shares
|                    |  | For                     |  | Withheld |  | Broker Non-Vote
|John U. Clarke      |  | 16,933,845              |  | 353,460  |  |               
|Patrick M. McCarthy |  | 16,946,595              |  | 340,710  |  |               
|Thomas C. Knudson   |  | 17,280,612              |  | 6,693    |  |               



(2)
Ratification of KPMG LLP as our independent public accountants for the fiscal year beginning January 1, 2005.



|                        |  |           |  |          
|----------------------- |  | --------- |  | ---------
|Number of Voting Shares
|For                     |  | Against   |  | Abstained
|16,030,397              |  | 1,187,408 |  | 69,500   



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Each of the proposals was approved by the requisite number of votes necessary for their adoption.



Item 6.Exhibits



|            |  |                                                                                                                                                                                                               
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                   
|10.1        |  | First Amendment to International Revolving Credit Agreement dated August 5, 2005 among NATCO Group Inc, National Tank Company and Total Engineering Services Team, Inc., and Wells Fargo HSBC
Trade Bank, N.A.
|            | 
|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             



36



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##### Table of Contents

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, 2005 |  | By:              |  | /s/    JOHN U.
CLARKE                                                  
|                     |  |                  |  | Chairman of the Board and Chief Executive Officer                      
|                     |  |                 
|Date: August 9, 2005 |  | By:              |  | /s/    RICHARD W.
FITZGERALD                                           
|                     |  | Name:            |  | Richard W. FitzGerald Senior Vice President and Chief Financial Officer



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##### Table of Contents

EXHIBIT INDEX



|            |  |                                                                                                                                                                                                                 
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                     
|10.1        |  |  First Amendment to International Revolving Credit Agreement dated August 5, 2005 among NATCO Group Inc, National Tank Company and Total Engineering Services Team, Inc., and Wells Fargo
HSBC Trade Bank, N.A.
|            | 
|31.1        |  |  Certification of Chief Executive Officer of NATCO Group Inc. pursuant to 15 U.S.C. §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. §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. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002                    



38