NATCO GROUP INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001 COMMISSION FILE NUMBER: 1-15603

NATCO GROUP INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 22-2906892
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)

2950 N. LOOP WEST, 7TH FLOOR, HOUSTON, TEXAS 77092
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
Registrant's telephone number, including area code: (713) 683-9292

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

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

State the aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant.

As of March 15, 2002 $70,884,837

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

As of March 15, 2002 Common Stock, $0.01 par value per share 15,803,797 shares

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the NATCO Group Inc. Notice of Annual Meeting of Stockholders and
Proxy Statement relating to the 2002 Annual Meeting of Shareholders, which the
Registrant intends to file within 120 days of December 31, 2001, are
incorporated by reference in Part III of this form.
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NATCO GROUP INC.
FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2001

TABLE OF CONTENTS

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PART I

ITEM 1. BUSINESS

NATCO Group Inc. (the "Company" or "NATCO") is a leading provider of
equipment, systems and services used in the production of crude oil and natural
gas, primarily at or near the wellhead, to separate oil and gas within a
production stream and to remove contaminants. Our products and services are used
in onshore and offshore fields in most major oil and gas producing regions in
the world. Separation and decontamination of a production stream is needed at
almost every producing well in order to meet the specifications of transporters
and end users.

We design and manufacture a diverse line of production equipment including:

- heaters, which prevent solids from forming in gas streams and reduces
the viscosity of oil;

- dehydration and desalting units, which remove water and salt from oil
and gas;

- separators, which separate wellhead production streams into oil, gas and
water;

- gas conditioning units and membrane separation systems, which remove
carbon dioxide and other contaminants from gas streams;

- control systems, which monitor and control production equipment; and

- water processing systems, which include systems for water re-injection,
oily water treatment and other treatment applications.

We offer our products and services as either integrated systems or
individual components primarily through three business lines:

- traditional production equipment and services, which provides
standardized components, replacement parts and used components and
equipment servicing;

- engineered systems, which provides customized, large scale integrated
oil and gas production systems; and

- automation and control systems, which provides and services control
panels and systems that monitor and control the production of oil and
gas.

We have designed, manufactured and marketed production equipment and
systems for 75 years. We operate nine primary manufacturing facilities located
in the U.S. and Canada and 41 sales and service facilities, 33 of which are
located in the U.S. and Canada, and eight of which are located outside of North
America. We believe that, among our competitors, we have the largest installed
base of production equipment in the industry. We have achieved our position in
the industry by maintaining technological leadership, capitalizing on our strong
brand name recognition and offering a broad range of products and services.

INDUSTRY

Demand for oil and gas production equipment and services is driven
primarily by the following:

- levels of production of oil and gas in response to worldwide demand;

- the changing production profiles of existing fields (meaning the mix of
oil, gas and water in the production stream and the level of
contaminants);

- the discovery of new oil and gas fields;

- the quality of new hydrocarbon production; and

- investment in exploration and production efforts by oil and gas
producers.

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We believe that the oil and gas production equipment and services market
continues to have significant growth potential due to the following:

- Increasing demand for oil and natural gas. According to the U.S.
Department of Energy, oil and natural gas consumption is expected to
increase at an average rate of 1.5% and 2.0%, respectively, in the United
States and 2.3% and 3.2%, respectively, per year word-wide through 2020.

- Long-term increased drilling activity. The number of operating rigs in
North America and internationally increased during recent years. The
average North American rig count for 2001 was 1,497 versus 1,263 for 2000
as published by Baker Hughes Incorporated. The international rig count as
of December 31, 2001 and 2000 was 752 and 705, respectively, as published
by Baker Hughes Incorporated. Although rig counts declined in late 2001
and into early 2002, we believe that rig counts will increase over the
long-term as demand for oil and gas products and services continues to
increase.

- Changing profile of existing production. The production profile of
existing fields changes over time, either naturally or due to
implementation of enhanced recovery techniques. Consequently, the mix of
oil, gas, water and contaminants changes, and the production stream
requires additional processing equipment.

- Increasing focus on large-scale projects. Due to the increased demand
for oil and gas, oil companies are pursuing larger and more complex
development projects that often require specialized production equipment.
These projects may be in remote locations, deepwater or harsh
environments and may involve complex production profiles and operations.

COMPETITIVE STRENGTHS

We believe that the following are our key competitive strengths:

- Market leadership and industry reputation. We have designed,
manufactured and marketed production equipment and systems for 75 years.
We believe that, among our competitors, we have the largest installed
base of production equipment in the industry. We will continue to enhance
our products and services in order to meet the demands of our customers.

- Technological leadership. We believe that we have established a
position of global technological leadership by pioneering the development
of innovative separation technologies. We continue to be a technological
leader in areas such as carbon dioxide separation using membrane
technology and oil-water emulsion treatment using dual-polarity
electrostatic technology. We hold 161 active U.S. and foreign patents and
continue to invest in research and development.

- Extensive line of products and services. We provide a broad range of
high quality production equipment and services, ranging from standard
processing and control equipment, to highly specialized engineered
systems and fully integrated solutions to our customers around the world.
By providing the broadest range of products and services in the industry,
we offer our customers the time and cost savings resulting from the use
of a single supplier for process engineering, design, manufacturing and
installation of production and related control systems.

- Experienced and focused management team. Our management team has
extensive experience in our industry with an average of over 20 years of
experience. We believe that our management team has successfully
demonstrated its ability to manage the growth of our business and the
integration of acquisitions. Additionally, our management team has a
substantial financial interest in our continued success through equity
ownership or incentives.

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BUSINESS STRATEGY

Our objective is to maximize cash flow by maintaining and enhancing our
position as a leading provider of equipment, systems and services used in the
production of crude oil and natural gas which we intend to achieve by pursuing
the following business strategies:

- Focusing on Customer Relationships. We believe that our customers
increasingly prefer to work on a regular basis with a small number of
leading suppliers. We believe our size, scope of products, technological
expertise and service orientation provide us with a competitive advantage
in establishing preferred supplier relationships with customers. We
intend to generate growth in revenue and market share by establishing new
and further developing existing customer relationships.

- Providing Integrated Systems and Solutions. We believe our integrated
design and manufacturing capabilities enable us to reduce our customers'
production equipment and systems costs and shorten delivery times. Our
strategy is to be involved in projects early, to provide the broadest and
most complete scope of equipment and services in our industry and to
focus on larger integrated systems.

- Introducing New Technologies and Products. Since our inception, we have
developed and acquired leading technologies that enable us to address the
global market demand for increasingly sophisticated production equipment
and systems. We will continue to pursue new technologies through internal
development, acquisitions and licenses.

- Pursuing Complementary Acquisitions. Our industry is highly fragmented
and contains many smaller competitors with narrow product lines and
geographic scope. We intend to continue to acquire companies that provide
complementary technologies, enhance our ability to offer integrated
systems or expand our geographic reach.

- Expanding International Presence. We have operated in various
international markets for more than 50 years. We intend to continue to
expand internationally in targeted geographic regions, such as Southeast
Asia, South America and West Africa.

RISKS RELATING TO OUR BUSINESS

A SUBSTANTIAL OR EXTENDED DECLINE IN OIL OR GAS PRICES COULD RESULT IN LOWER
EXPENDITURES BY THE OIL AND GAS INDUSTRY, THEREBY NEGATIVELY AFFECTING OUR
REVENUE.

Our business is substantially dependent on the condition of the oil and gas
industry and its willingness to spend capital on the exploration for and
development of oil and gas reserves. A substantial or extended decline in these
expenditures may result in the discovery of fewer new reserves of oil and gas,
adversely affecting the market for our production equipment and services. The
level of these capital expenditures is generally dependent on the industry's
view of oil and gas prices, which have been characterized by significant
volatility in recent years. Oil and gas prices are affected by numerous factors,
including:

- the level of exploration activity;

- worldwide economic activity;

- interest rates and the cost of capital;

- environmental regulation;

- tax policies;

- political requirements of national governments;

- coordination by the Organization of Petroleum Exporting Countries
("OPEC");

- the cost of producing oil and gas; and

- technological advances.

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WE MAY LOSE MONEY ON FIXED-PRICE CONTRACTS.

Some of our projects, including larger engineered systems projects, are
performed on a fixed-price basis. We are responsible for all cost overruns,
other than any resulting from change orders. Our costs and any gross profit
realized on our fixed-price contracts will often vary from the estimated amounts
on which these contracts were originally based. This may occur for various
reasons, including:

- errors in estimates or bidding;

- changes in availability and cost of labor and material; and

- variations in productivity from our original estimates.

These variations and the risks inherent in engineered systems projects may
result in reduced profitability or losses on our projects. Depending on the size
of a project, variations from estimated contract performance can have a
significant negative impact on our operating results or our financial condition.

WE HAVE RELIED AND WE EXPECT TO CONTINUE TO RELY ON A LIMITED NUMBER OF
CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR REVENUES.

There have been and are expected to be periods where a substantial portion
of our revenues is derived from a single customer or a small group of customers.
We had revenues of $15.7 million, or 5% of our total revenues, provided by
Anadarko and affiliates, $15.5 million, or 5% of total revenues, provided by
ChevronTexaco Corp. and affiliates, and $13.4 million, or 5% of total revenues
provided by BP and affiliates excluding CTOC, for the year ended December 31,
2001. No other customer provided 5% or more of total revenues during fiscal
2001. The CTOC project provided $10.9 million, or 4% of total revenues, for
fiscal 2001. The CTOC project is a $73.0 million contract awarded in 1999 to
supply gas treating and conditioning equipment for a project in Southeast Asia.
The project is a joint venture under the control of the Carigali-Triton
Operating Company ("CTOC"), which is principally owned by Petronas, the
Malaysian national oil company, and by BP. The project is located in the Gulf of
Thailand and produced approximately 20% of our revenues in 2000. As of December
31, 2001, the project was approximately 98% complete.

THE LOSS OF ONE OR MORE OF OUR CUSTOMERS COULD MATERIALLY HARM OUR BUSINESS AND
EARNINGS.

We expect to continue our practice of entering into relationships with
major oil companies and large independent producers. Many of these relationships
are non-binding arrangements in which both parties undertake to satisfy the
objectives of the relationship. They may be characterized as:

- blanket purchase orders for specified amounts of standardized equipment;

- project-specific integrated relationships; or

- ongoing informal working relationships.

The loss of one or more of these relationships could have a material
adverse effect on our business and results of operations.

THE DOLLAR AMOUNT OF OUR BACKLOG, AS STATED AT ANY GIVEN TIME, IS NOT
NECESSARILY INDICATIVE OF OUR FUTURE CASH FLOW.

Backlog consists of firm customer orders that have satisfactory credit or
financing arrangements in place, for which authorization to begin work or
purchase materials has been given and for which a delivery date has been
established. As of December 31, 2001, we had backlog of $101.3 million, of which
approximately 27% related to ExxonMobil, 11% related to a North Sea consortium
and 7% related to Halliburton/KBR.

We cannot assure you that the revenues projected in our backlog will be
realized, or if realized, will result in profits. To the extent that we
experience significant terminations, suspensions or adjustments in the scope of
our projects as reflected in our backlog contracts, we could be materially
adversely affected.

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Occasionally, a customer will cancel or delay a project for reasons beyond
our control. In the event of a project cancellation, we are generally reimbursed
for our costs but typically have no contractual right to the total revenues
expected from such project as reflected in our backlog. In addition, projects
may remain in our backlog for extended periods of time. If we were to experience
significant cancellations or delays of projects in our backlog, our results of
operations and financial condition could be materially adversely affected.

OUR ABILITY TO ATTRACT AND RETAIN SKILLED LABOR IS CRUCIAL TO THE PROFITABILITY
OF OUR FABRICATION AND SERVICES ACTIVITIES.

Our ability to succeed depends in part on our ability to attract and retain
skilled manufacturing workers, equipment operators, engineers and other
technical personnel. Our ability to expand our operations depends primarily on
our ability to increase our labor force. Demand for these workers is currently
high and the supply is limited. A significant increase in the wages paid by
competing employers could result in a reduction in our skilled labor force,
increases in the rates of wages we must pay or both. If this were to occur, the
immediate effect would be a reduction in our profits and the extended effect
would be diminishment of our production capacity and profitability and
impairment of our growth potential.

POSTRETIREMENT HEALTH CARE BENEFITS THAT WE PROVIDE TO CERTAIN FORMER EMPLOYEES
EXPOSE US TO POTENTIAL INCREASES IN FUTURE CASH OUTLAYS THAT CANNOT BE RECOUPED
THROUGH INCREASED PREMIUMS.

We are obligated to provide postretirement health care benefits to a group
of former employees who retired before June 21, 1989. For the year ended
December 31, 2001, our cash costs related to these benefits were $1.8 million,
net of reimbursement of $79,000 from the predecessor plan sponsor. At that date,
there were 556 retirees and surviving eligible dependents covered by the
specified postretirement benefit obligations. As of July 1, 2001, our
accumulated pre-tax postretirement benefit obligation was calculated to be
approximately $11.4 million as determined by actuarial calculations. We cannot
assure you that the costs of the actual benefits will not exceed those projected
or that future actuarial assessments of the extent of those costs will not
exceed the current assessment. Inflationary trends in medical costs may outpace
our ability to recoup these increases through higher premium charges, benefit
design changes or both. As a result, our actual cash costs of providing this
benefit may increase in the future and have a negative impact on our future cash
flow.

OUR INTERNATIONAL OPERATIONS MAY EXPERIENCE INTERRUPTIONS DUE TO POLITICAL AND
ECONOMIC RISKS.

We operate our business and market our products and services in oil and gas
producing areas throughout the world. We are, therefore, subject to the risks
customarily attendant to international operations and investments in foreign
countries. These risks increased with the acquisition of Axsia in March 2001,
and include:

- nationalization;

- expropriation;

- war and civil disturbances;

- restrictive actions by local governments;

- limitations on repatriation of earnings;

- changes in foreign tax laws; and

- changes in currency exchange rates.

The occurrence of any of these risks could have an adverse effect on
regional demand for our products and services or our ability to provide them. An
interruption of our international operations could have a material adverse
effect on our results of operations and financial condition.

The occurrence of some of these risks, such as changes in foreign tax laws
and changes in currency exchange rates, may have extended consequences.
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Axsia Group Limited ("Axsia"), the U.K. company we acquired in March 2001,
has made sales (as part of its ongoing business prior to the acquisition) and
has informed us that it expects to continue making sales of equipment and
services to customers in certain countries which are subject to U.S. government
trade sanctions ("Embargoed Countries"), including sales to the Iraqi national
oil companies permitted under the United Nations Oil-for-Food Program. Axsia's
sales to customers in Embargoed Countries were approximately 2 1/2% of our
consolidated revenue in 2001.

FUTURE ACQUISITIONS MAY BE DIFFICULT TO INTEGRATE, DISRUPT OUR BUSINESS AND
ADVERSELY AFFECT OUR OPERATING RESULTS.

We intend to continue our practice of acquiring other companies, assets and
product lines that complement or expand our existing business. We cannot assure
you that we will be able to successfully identify suitable acquisition
opportunities or finance and complete any particular acquisition. Furthermore,
acquisitions involve a number of risks and challenges, including:

- the diversion of our management's attention to the assimilation of the
operations and personnel of the acquired business;

- possible adverse effects on our operating results during the integration
process;

- potential loss of key employees and customers of the acquired companies;

- potential lack of experience operating in a geographic market of the
acquired business;

- an increase in our expenses and working capital requirements; and

- the possible inability to achieve the intended objectives of the
combination.

Any of these factors could adversely affect our ability to achieve
anticipated levels of cash flow from an acquired business or realize other
anticipated benefits of an acquisition.

OUR INSURANCE POLICIES MAY NOT COVER ALL PRODUCT LIABILITY CLAIMS.

Some of our products are used in potentially hazardous production
applications that can cause:

- personal injury;

- loss of life;

- damage to property, equipment or the environment; and

- suspension of operations.

We maintain insurance coverage against these risks in accordance with
standard industry practice. This insurance will not protect us against liability
for some kinds of events, including events involving pollution or losses
resulting from business interruption or acts of terrorism. We cannot assure you
that our insurance will be adequate in risk coverage or policy limits to cover
all losses or liabilities that we may incur. Moreover, we cannot assure you that
we will be able in the future to maintain insurance at levels of risk coverage
or policy limits that we deem adequate. Any future damages caused by our
products or services that are not covered by insurance or are in excess of
policy limits could have a material adverse effect on our business, results of
operations and financial condition.

LIABILITY TO CUSTOMERS UNDER WARRANTIES MAY MATERIALLY AND ADVERSELY AFFECT OUR
CASH FLOW.

We typically warrant the workmanship and materials used in the equipment we
manufacture. At the request of our customers, we occasionally warrant the
operational performance of the equipment we manufacture. Failure of this
equipment to operate properly or to meet specifications may increase our costs
by requiring additional engineering resources, replacement of parts and
equipment or service or monetary reimbursement to a customer. Our warranties are
often backed by letters of credit. At December 31, 2001, we had provided to our
customers approximately $5.4 million in letters of credit related to warranties.
We have in

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the past received warranty claims and we expect to continue to receive them in
the future. To the extent that we should incur warranty claims in any period
substantially in excess of our warranty reserve, our results of operations and
financial condition could be materially and adversely affected.

WE MAY INCUR SUBSTANTIAL COSTS TO COMPLY WITH OUR ENVIRONMENTAL OBLIGATIONS.

In our equipment fabrication and refurbishing operations, we generate and
manage hazardous wastes. These include:

- waste solvents;

- waste paint;

- waste oil;

- washdown wastes; and

- sandblasting wastes.

We attempt to identify and address environmental issues before acquiring
properties and to utilize industry accepted operating and disposal practices
regarding the management and disposal of hazardous wastes. Nevertheless, either
others or we may have released hazardous materials on our properties or in other
locations where hazardous wastes have been taken for disposal. We may be
required by federal or state environmental laws to remove hazardous wastes or to
remediate sites where they have been released. We could also be subjected to
civil and criminal penalties for violations of those laws. Our costs to comply
with these laws may adversely affect our earnings.

OUR QUARTERLY SALES AND CASH FLOW MAY FLUCTUATE SIGNIFICANTLY.

A substantial amount of our revenues is derived from significant contracts
that are often performed over periods of two to six or more quarters. As a
result, our revenues and cash flow may fluctuate significantly from quarter to
quarter, depending upon our ability to replace existing contracts with new
orders and upon the extent of any delays in completing existing projects.

THE LOSS OF ANY MEMBER OF OUR SENIOR MANAGEMENT COULD ADVERSELY AFFECT OUR
RESULTS OF OPERATIONS.

Our success depends heavily on the continued services of our senior
management. These are the individuals who possess our bidding, procurement,
transportation, logistics, planning, project management, risk management and
financial skills. If we lost or suffered an extended interruption in the
services of one or more of our senior officers, our results of operations could
be adversely affected. Moreover, we cannot assure you that we will be able to
attract and retain qualified personnel to succeed members of our senior
management. We do not maintain key man life insurance.

COMPETITION COULD RESULT IN REDUCED PROFITABILITY AND LOSS OF MARKET SHARE.

Contracts for our products and services are generally awarded on a
competitive basis, and competition is intense. Historically, the existence of
overcapacity in our industry has caused increased price competition in many
areas of our business. The most important factors considered by our customers in
awarding contracts include:

- the availability and capabilities of our equipment;

- our ability to meet the customer's delivery schedule;

- price;

- our reputation;

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- our experience; and

- our safety record.

In addition, we may encounter obstacles in our international operations
that impair our ability to compete in individual countries. These obstacles may
include:

- subsidies granted in favor of local companies;

- import duties and fees imposed on foreign operators;

- taxes imposed on foreign operators;

- lower wage rates in foreign countries; and

- fluctuations in the exchange value of the United States dollar compared
with the local currency.

Any or all these factors could adversely affect our ability to compete and
thus adversely affect our results of operations.

A FURTHER ECONOMIC DECLINE COULD ADVERSELY AFFECT DEMAND FOR OUR PRODUCTS AND
SERVICES.

Economic growth in several of our key markets, including the United States
and Southeast Asia, declined during 2001 due to a world-wide recession, which
was exacerbated by significant terrorist acts in the United States during
September 2001. Current economic indicators and positive actions by the U.S.
Federal Reserve, including the lowering of interest rates, support a recovery in
the United States. The economic downturn in 2001 affected the economies in other
regions of the world and contributed to the decline in the price of oil. If the
United States economy were to decline further or if the economies of other
nations in which we do business were to experience further material problems,
the demand and price for oil and gas and, therefore, for our products and
services could decline, which would adversely affect our results of operations.

OUR ABILITY TO COMPETE SUCCESSFULLY IS DEPENDENT ON TECHNOLOGICAL ADVANCES IN
OUR PRODUCTS, AND OUR FAILURE TO RESPOND TIMELY OR ADEQUATELY TO TECHNOLOGICAL
ADVANCES IN OUR INDUSTRY MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.

Our ability to succeed with our long-term growth strategy is dependent on
the technological competitiveness of our products. If we are unable to innovate
and implement advanced technology in our products, other competitors may be able
to compete more effectively with us, and our business and results of operations
may be adversely affected.

OPERATIONS

We offer our products and services as either integrated systems or
individual components primarily through three business lines: traditional
production equipment and services, engineered systems and automation and control
systems.

TRADITIONAL PRODUCTION EQUIPMENT AND SERVICES

Traditional production equipment and services consists of production
equipment, replacement parts, and used equipment refurbishing and servicing,
which is sold primarily onshore in North America and in the Gulf of Mexico.
Through our NATCO Canada subsidiary, we provide traditional production equipment
with modifications to operate in a cold weather environment. The equipment built
for the North American oil and gas industry are "off the shelf" items or are
customized variations of standardized equipment requiring limited engineering.
We market our traditional production equipment and services through 31 sales and
service centers in the United States, two in Canada, one in Mexico and one in
Venezuela.

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Traditional production equipment includes:

- Separators. Separators are used for the primary separation of a
hydrocarbon stream into oil, water and gas. Our separator product line
includes:

- horizontal separators, which are used to separate hydrocarbon streams
with large volumes of gas, liquids or foam;

- vertical separators, which are used to separate hydrocarbon streams
containing contaminants including salt and wax;

- filter separators, which are used to remove particulate contaminants
from gas streams;

- Thermo Pak(TM) Units, which are used for the combined heating and
separating of production in cold climates; and

- Whirly Scrub(TM) V centrifugal separators, which are used as
state-of-the-art compact scrubbers.

- Oil Dehydration Equipment. Oil dehydrators are used to remove water
from oil. Our oil dehydration product line includes:

- horizontal PERFORMAX(R) treaters, which separate oil and water
mixtures using gravity and proprietary technology;

- Dual Polarity(R) electrostatic treaters, which dehydrate oil using
high voltage electrical coalescence;

- vertical treaters, which separate oil and water using gravity and
heat;

- Vertical Flow Horizontal (VFH(TM)) processors, which combine the
advantages of horizontal and vertical vessels to remove gas and water
from oil streams; and

- heater-treaters, which use heat to accelerate the dehydration process.

- Heaters. Heaters are used to reduce the viscosity of oil to improve
flow rates and to prevent hydrates from forming in gas streams. We
manufacture both standardized and customized direct and indirect fired
heaters. In each system, heat is transferred to the hydrocarbon stream
through a medium such as water, water/glycol, steam, salt or flue gas.
Our heater product line includes:

- indirect fired water bath heaters;

- vaporizers used to vaporize propane and other liquefied gases;

- salt bath heaters;

- steam bath heaters; and

- Controlled Heat Flux (CHF(TM)) heaters, which use flue gas to create a
heat transfer medium.

- Gas Conditioning Equipment. Gas conditioning equipment removes
contaminants from hydrocarbon and gas streams. Our gas conditioning
equipment includes:

- Cynara(R) membrane systems, which extract carbon dioxide from gas
streams;

- glycol dehydration equipment, which uses glycol to absorb water vapor
from gas streams;

- amine systems, which use amine to remove acidic gases such as hydrogen
sulfide and carbon dioxide from gas streams;

- Glymine(R) units, which combine the effects of glycol equipment and
amine systems;

- the BTEX-BUSTER(R), which virtually eliminates the emission of
volatile hydrocarbons associated with glycol dehydration reboilers; and

- DESI-DRI(R) Systems, which use highly compressed drying agents to
remove water vapor from gas streams.

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- Gas Processing Equipment. We offer standard and custom processing
equipment for the extraction of liquid hydrocarbons to meet feed gas and
liquid product requirements. We manufacture several standard mechanical
refrigeration units for the recovery of salable hydrocarbon liquids from
gas streams. Low Temperature Extractor (LTX(R)) units are mechanical
separation systems designed for handling high-pressure gas at the
wellhead. These systems remove liquid hydrocarbons from gas streams more
efficiently and economically than other methods.

- Carbon Dioxide Field Operations. We also provide gas-processing
facilities for the removal of carbon dioxide from hydrocarbon streams.
These facilities use our proprietary Cynara(R) membrane technology that
provides one of the most effective separation solutions for hydrocarbon
streams containing carbon dioxide. The primary market for these
facilities is production from wells such as those located in West Texas
in which carbon dioxide injection is used to enhance the recovery of oil
and gas reserves.

- Water Treatment Equipment. We offer a complete line of water treatment
and conditioning equipment for the removal of contaminants from water
extracted during oil and gas production. Our water treatment equipment
includes:

- PERFORMAX(R) Matrix Plate Coalescers, which are used in both primary
separation and final skimming applications;

- TriPack(TM) Corrugated Plate Interceptors, which are used to remove
oil and salable hydrocarbons from water;

- Oilspin AV(TM) and AVi(TM) liquid/liquid hydrocyclones, which are
compact centrifugal separation devices used in primary water treatment
applications;

- Tridair(TM) Sparger Gas Flotation units, which are used as secondary
water cleanup systems; and

- PowerClean(TM) Nutshell Filters, which are used where tertiary water
cleanup is required.

- Equipment Refurbishment. We source, refurbish and integrate used oil
and gas production equipment. Customers that purchase this equipment
benefit from reduced delivery times and lower equipment costs relative to
new equipment. The used equipment market is focused primarily in North
America, both onshore and offshore, although we have observed a growing
interest internationally. We have entered into agreements with major,
large independent oil companies in both the United States and Canada to
evaluate, track and refurbish used production equipment and may act as a
broker between another oil company and our customer or may purchase,
refurbish and sell used equipment to our customers. We believe that we
have one of the largest databases in the North American oil and gas
industry of available surplus production equipment. This database,
coupled with our extensive refurbishing facilities and experience,
enables us to respond to customer requests for refurbished equipment
quickly and efficiently.

- Parts, Service and Training. We provide replacement parts for our own
equipment and for equipment manufactured by others. Each branch of our
marketing network also serves as a local parts and service business. We
offer operational and safety training to the oil and gas production
industry. We use training programs as a marketing tool for our other
products and services.

ENGINEERED SYSTEMS

We design, engineer and manufacture engineered systems for large production
development projects throughout the world. We also provide start-up services for
our engineered products. Engineered systems typically require a significant
amount of technology, engineering and project management.

We market our engineered systems through our direct sales forces based in
Houston, Calgary, Camberley (UK), Gloucester (UK), Caracas, Singapore, Tokyo and
Villa Hermosa (Mexico), augmented by independent representatives in other
countries. We also use the unique oil testing capabilities at our research and

12

development facilities to market engineered systems. This capability enables us
to determine equipment specifications that best suit customers' requirements.

Engineered systems include:

- Integrated Oil and Gas Processing Trains. These consist of multiple
units that process oil and gas from primary separation through
contaminant removal. For example, we designed and are manufacturing and
assembling a module for a production facility situated off the coast of
West Africa that is capable of processing 138,000 barrels of oil per day.

- Floating Production Systems. These consist of large skid-mounted
processing units used in conjunction with semi-submersible, converted
tankers and other floating production vessels. Floating production
equipment must be specially designed to overcome the detrimental effects
of wave motion on floating vessels. We pioneered and patented the first
wave-motion production vessel internals system and continue to advance
this technology at our research and development facility using a
wave-motion table, which simulates a variety of sea states. We also
utilize Computational Fluid Dynamic modeling and Finite Element Analysis
to ensure that these facilities are optimally designed and are fabricated
to meet the durability requirements at defined sea states.

- Centrifugal Separations Systems. In order to substantially reduce the
size and weight of equipment for operators, we utilize our Porta-Test(R)
Revolution(TM) centrifugal separator inlet devices and Whirly Scrub(TM) I
inline centrifugal scrubbers to eliminate the need for large traditional
vessels.

- Dehydration and Desalting Systems. Dehydration and desalting involves
the removal of water and salt from an oil stream. Desalting is a
specialized form of dehydration. In this process, water is injected into
an oil stream to dissolve the salt and the saltwater is then removed from
the stream. Large production projects often use electrostatic technology
to desalt oil. We believe that we are the leading developer of
electrostatic technologies for oil treating and desalting. One of our
dehydration and desalting systems, the Electro Dynamic(TM) Desalter, can
be used in oil refineries, where stringent desalting requirements have
grown increasingly important. These requirements have increased as crude
quality has declined and catalysts have become more sensitive and
sophisticated, requiring lower levels of contaminants. The reduced number
of vessels employed by this system is particularly important in refinery
and offshore applications where space is at a premium.

- Large Gas Processing Facilities. We provide large gas processing
facilities for the separation, heating, dehydration and removal of
liquids and contaminants to produce pipeline-quality natural gas. We also
design, manufacture and, in some cases, operate gas-processing facilities
that remove carbon dioxide from hydrocarbon and gas streams. These
facilities use Cynara(R) membrane technology, which provides the most
cost-effective separation solution for gas streams containing more than
20% carbon dioxide. A primary market for this application is production
from gas wells, such as those located in Southeast Asia, which have
naturally occurring carbon dioxide.

- Water Re-injection Systems. We provide Sulfaject(TM) water re-injection
systems that are used both onshore and offshore in enhanced oil recovery
techniques. These systems remove contaminants from water to be injected
into a reservoir so that the formation or its production characteristics
are not adversely affected.

- Oily Water Cleanup Systems. We design and engineer systems that,
through the use of liquid/liquid hydrocyclone technology and induced or
dissolved gas flotation technology, remove oil and solids from a produced
water stream. Oily water cleanup is often required prior to the disposal
or re-injection of produced water.

- Downstream Facilities. We offer several technologies that have
crossover applications in the refinery and petrochemical sectors. Most
involve aspects of oil treating and water treating. We discussed above
the use in refineries of one of our dehydration and desalting systems. In
addition, we can provide DOX(TM) units to ethylene processors that clean
both heavy and light dispersed oil from water.

13

AUTOMATION AND CONTROL SYSTEMS

The primary market for automation and control systems is in offshore
applications throughout the world. We market and service these products through
a four-branch network primarily located in the Gulf Coast area. These automation
and control systems include:

- Control Systems. We design, assemble and install pneumatic, hydraulic,
electrical and computerized control panels and systems. These systems
monitor and change key parameters of oil and gas production systems. Key
parameters include wellhead flow control and emergency shutdown of
production and safety systems. A control system consists of a control
panel and related tubing, wiring, sensors and connections.

- Engineering and Field Services. We provide start-up support, testing,
maintenance, repair, renovation, expansion and upgrade of control systems
including those designed or installed by competitors. Our design and
engineering staff also provide contract electrical engineering services.

- SCADA Systems. Supervisory control and data acquisition ("SCADA")
systems provide remote monitoring and control of equipment, production
facilities, pipelines and compressors via radio, cellular phone,
microwave and satellite communication links. SCADA systems reduce the
number of personnel and frequency of site visits and allow for continued
production during periods of emergency evacuation, thereby reducing
operating costs.

MANUFACTURING FACILITIES

We operate nine primary manufacturing facilities ranging in size from
approximately 8,000 square feet to approximately 130,000 square feet of
manufacturing space. We own five of these facilities and lease the other four.

Our major manufacturing facilities are located in:

- Pittsburg, California. We manufacture the membranes for our bulk carbon
dioxide membrane separation equipment at this 8,000 square foot facility.

- Covington, Louisiana. We fabricate various types of water treatment
equipment as well as low-pressure production vessels at this 51,000
square foot facility.

- Harvey, Louisiana. We fabricate control panels for delivery throughout
the world at this 12,000 square foot climate-controlled facility.

- New Iberia, Louisiana. We fabricate packaged production systems for
delivery throughout the world at this 60,000 square foot and 16 acre
waterfront facility, which can handle large equipment systems. We
upgraded and expanded this facility in 2001.

- Electra, Texas. We produce various types of low- and high-pressure
production vessels as well as mounted skid packages at this 130,000
square foot facility.

- Houston, Texas. We fabricate control panels for delivery throughout the
world at this 8,000 square foot climate-controlled facility.

- Magnolia, Texas. We fabricate various types of low-pressure production
vessels as well as skid packages and refurbish used equipment at this
38,000 square foot facility.

- Calgary, Alberta, Canada. We produce heavy wall and cold weather
packaged equipment and systems primarily for the Canadian and Alaskan
markets at this 68,000 square foot facility.

- Edmonton, Alberta, Canada. We fabricate specialized production vessels
and skid packages at this 51,000 square foot facility.

14

Our manufacturing operations are vertically integrated. This means we are
able to fabricate, heat treat, assemble, inspect and test our products at each
facility. Consequently, we are able to control the quality of our products and
the cost and schedule of our manufacturing activities.

Our New Iberia, Electra and Calgary facilities have been certified to ISO
9002 standards. ISO 9002 is an internationally recognized verification system
for quality management overseen by the International Standards Organization
based in Geneva, Switzerland. The certification is based on a review of our
programs and procedures designed to maintain and enhance quality production and
is subject to annual review and recertification.

We fabricate to the standards of the American Petroleum Institute, the
American Welding Society, the American Society of Mechanical Engineers and
specific customer specifications. We use welding and fabrication procedures in
accordance with the latest technology and industry requirements. We have
instituted training programs to upgrade skilled personnel and maintain high
quality standards. We believe that these programs generally enhance the quality
of our products and reduce their repair rate.

RESEARCH AND DEVELOPMENT

We believe we are an industry leader in the development of oil and gas
production equipment technology. We pioneered many of the original separation
technologies for converting unprocessed hydrocarbon fluids into salable oil and
gas. For example, we developed:

- the first high capacity oil and gas separator, which has been enhanced
with the development of our centrifugal inlet vortex tubes (Porta-Test(R)
Revolution(TM)) and other centrifugal separation technologies
(WhirlyScrub(TM) V's and I's);

- the first emulsion treating systems, which have been advanced through
the application of our Dual Polarity(TM), TriVolt(TM), TriGrid(TM),
TriGridmax(TM) and the EDD(TM) (ElectroDynamic Desalting(TM))
electrostatic oil treaters;

- a PC-based Load Responsive Controller(TM) (LRC(TM)) for controlling
electrostatic treaters remotely;

- a composite grid system for use in complex separation applications;

- DOX(TM) and OSX(TM) water filtration systems;

- the Oilspin AV(TM) and the automatic turndown capable AVi(TM)
liquid/liquid hydrocyclones;

- the Mozley Sandspin(TM) solid/liquid hydrocyclones and the Mozley
Wellspin(TM) wellhead desander;

- the Mozley SandClean(TM) System for cleanup of sand prior to offshore
discharge;

- the Tridair(TM) Single Cell VersaFlo(TM) flotation unit;

- the Subfloat(TM) submerged column flotation unit;

- high pressure indirect and Controlled Heat Flux(TM) (CHF(TM)) heaters;
and

- PERFORMAX(R) oil and water treating systems.

Our wave-motion compensating separator has become the industry standard for
floating production applications, and our electrostatic oil treating technology
is the most advanced in the industry. As of December 31, 2001, we held 161
active U.S. and foreign patents and numerous U.S. and foreign trademarks. We
also have applications pending for fifteen additional U.S. patents. In addition,
we are licensed under several patents held by others.

We operate a research and development facility in Tulsa, Oklahoma, at which
a number of test devices are used to simulate and analyze oil and gas production
processes. At our manufacturing facilities in Pittsburg, California, we are
engaged in active, ongoing research and development in the area of membrane
technology. We also have research and development operations at our facility in
Edmonton, Alberta, Canada.

15

At December 31, 2001, NATCO had approximately 35 employees engaged in
research and development or product commercialization activities.

MARKETING

Our products and services are marketed primarily through an internal sales
force augmented by technical applications specialists for specific customer
requirements. In addition, we maintain agency relationships in most energy
producing regions of the world to enhance our efforts in countries where we do
not have employees. Our traditional production equipment and services business
has 33 operating branches in North America through which we sell production
equipment, spare parts and services directly to oil and gas operators. Our
engineered systems business typically involves a significant pre-award effort
during which we must provide technical qualifications, evaluate the requirements
of the specific project, design a conceptual solution that meets the project
requirements and estimate our cost to provide the system to the customer in the
time frame required. Our automation and control systems business is primarily
marketed through our internal sales force.

CUSTOMERS

We devote a considerable portion of our marketing time and effort to
developing and maintaining relationships with key customers. Some of these
relationships are project specific, such as our participation in several Alaskan
projects with BP. However, our customer base ranges from independent operators
to major and national oil companies worldwide. In 2001, Anadarko and affiliates,
ChevronTexaco Corp. and affiliates, and BP and affiliates excluding CTOC, each
provided 5% of our consolidated revenue. No other customer contributed more than
5% of total revenues for the year ended December 31, 2001. Our level of
technical expertise, extensive distribution network and breadth of product
offerings contributes to the maintenance of good working relationships with our
customers.

BACKLOG

Backlog consists of firm customer orders for which satisfactory credit or
financing arrangements have been made, authorization has been given to begin
work or purchase materials and a delivery date has been scheduled.

Our sales backlogs at December 31, 2001, 2000 and 1999, were $101.3
million, $49.9 million and $76.5 million, respectively. Backlog at December 31,
2001 included a $27.4 million booking for ExxonMobil, and an $11.1 million
booking for a North Sea consortium. Backlog at December 31, 2000 included $12.5
million related to CTOC. Backlogs at December 31, 2001, 2000 and 1999, less the
CTOC project, were $99.8 million, $37.4 million and $18.0 million, respectively.
The improvement in backlog for the year ended December 31, 2001, was consistent
with our expectations and was due to the award of several projects in fiscal
2001 and the contribution of Axsia, acquired in March 2001.

Occasionally, a customer will cancel or delay a project for reasons beyond
our control. In the event of a project cancellation, we generally are reimbursed
for costs incurred but typically have no contractual right to the total revenues
reflected in our backlog. In addition, projects may remain in our backlog for
extended periods of time. If we were to experience significant cancellations or
delays of projects in our backlog, our results of operations and financial
condition could be materially adversely affected.

COMPETITION

Contracts for our products and services are generally awarded on a
competitive basis, and competition is intense. The most important factors
considered by customers in awarding contracts include the availability and
capabilities of equipment, the ability to meet the customer's delivery schedule,
price, reputation, experience and safety record.

16

Historically, the existence of overcapacity in the industry has caused
increased price competition in many areas of the business. In addition, we may
encounter obstacles in our international operations that impair our ability to
compete in individual countries. These obstacles may include:

- subsidies granted in favor of local companies;

- taxes, import duties and fees imposed on foreign operators;

- lower wage rates in foreign countries; and

- fluctuations in the exchange value of the United States dollar compared
with the local currency.

Any or all these factors could adversely affect our ability to compete and thus
adversely affect results of operations.

Our primary competitors in our traditional production equipment and
services business are Hanover Compressor Corp., as well as numerous privately
held, mainly regional companies. Competitors in our engineered systems business
include Petreco, a private company, Kvaerner Process Systems, UOP, Hanover APS,
U.S. Filter and numerous engineering and construction firms. The primary
competitors in our automation and control systems business are W Industries,
MMR-Radon, SECO and numerous privately held companies operating in the Gulf
Coast region.

We believe that we are one of the largest crude oil and natural gas
production equipment providers in North America and have one of the leading
market shares internationally. We further believe that our size, research and
development capabilities, brand names and marketing organization provide us with
a competitive advantage over the other participants in the industry.

ENVIRONMENTAL MATTERS

We are subject to environmental regulation by federal, state and local
authorities in the United States and in several foreign countries. Although we
believe that we are in substantial compliance with all applicable environmental
laws, rules and regulations ("laws"), the field of environmental regulation can
change rapidly with the enactment or enhancement of laws and stepped up
enforcement of these laws, either of which could require us to change or
discontinue certain business activities. At present, we are not involved in any
material environmental matters of any nature and are not aware of any material
environmental matters threatened against us.

EMPLOYEES

At December 31, 2001, we had approximately 1,730 employees. Of these,
approximately 110 were represented under collective bargaining agreements that
extend through July 2003. We believe that our relationships with our employees
are satisfactory.

ITEM 2. PROPERTIES

We operate nine primary manufacturing plants ranging in size from
approximately 8,000 square feet to approximately 130,000 square feet of
manufacturing space. We also own and lease distribution and service centers,
sales offices, and warehouses. We lease our corporate headquarters in Houston,
Texas. At December 31, 2001, we owned or leased approximately 1.0 million square
feet of facility of which approximately 511,000 square feet was leased, and
approximately 531,000 square feet was owned. Of the total manufacturing space,
approximately 276,000 square feet was located in the United States and
approximately 119,000 square feet was located in Canada.

17

The following chart summarizes the number of facilities owned or leased by
us by geographic region and business segment.

ITEM 3. LEGAL PROCEEDINGS

We are a party to various routine legal proceedings that are incidental to
our business activities. We insure against the risk of these proceedings to the
extent deemed prudent by our management, but we 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. We do
not, however, believe the pending legal proceedings, individually or taken
together, will have a material adverse effect on our results of operations or
financial condition.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the
fourth quarter of 2001.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our authorized common stock consists of 50,000,000 shares of common stock.
Prior to January 1, 2002, our common stock was divided into two classes
designated as "Class A common stock" and "Class B common stock." On January 1,
2002, all outstanding shares of Class B common stock were automatically
converted into shares of Class A common stock, at which time the authorized
common stock reverted to a single class designated as "common stock." There were
15,803,797 shares outstanding as of March 15, 2002. The approximate number of
record holders of our common stock was 42 at March 15, 2002. The number of
record holders of our common stock does not include the stockholders for whom
shares are held in a "nominee" or "street" name. There were 500,000 shares of
preferred stock authorized at March 15, 2002, of which none was issued. Our
common stock is traded on the New York Stock Exchange under the ticker symbol
NTG.

The following table sets forth, for the calendar quarters indicated, the
high and low sales prices of our Class A common stock reported by the NYSE. No
information is provided for the period prior to the initial public offering of
our Class A Common Stock on January 27, 2000.

18

We do not intend to declare or pay any dividends on our common stock in the
foreseeable future, but rather intend to retain any future earnings for use in
the business. Our credit facility limits our ability to pay dividends and other
distributions. Since we are a holding company, these restrictions have the
practical effect of precluding us from paying dividends on our common stock.

19

ITEM 6. SELECTED FINANCIAL DATA

The following summary consolidated historical financial information for the
periods and the dates indicated should be read in conjunction with our
consolidated historical financial statements. During 1998, we changed our fiscal
year-end to December 31 from March 31.

- ---------------

(1) In June 1997, we distributed our investment in Process Technology Holdings,
Inc. ("PTH") to our then sole stockholder in a tax-free transaction. In
accordance with generally accepted accounting principles, we accounted for
the results of operations of PTH as discontinued operations for all periods
presented. Accordingly, the net income of PTH is excluded from income (loss)
before income taxes in the statement of operations data for the periods
presented.

20

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

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

OVERVIEW

We offer products and services as either integrated systems or individual
components primarily through three business lines:

- traditional production equipment and services, through which we provide
standardized components, replacement parts and used components and
equipment servicing;

- engineered systems, through which we provide customized, large scale
integrated oil and gas production systems; and

- automation and control systems, through which we provide control panels
and systems that monitor and control oil and gas production.

We report three separate business segments: North American operations,
engineered systems and automation and control systems.

In January 2000, we completed our initial public offering of common stock,
resulting in the issuance of 5,178,807 shares of common stock with net proceeds
of $46.7 million. In July 2000, we changed our presentation of certain assets
that were acquired from The Cynara Company in November 1998, and the related
operating results, for segment reporting purposes. The majority of the assets
were reclassified to the North American operations business segment from the
engineered systems business segment. This change has been retroactively
reflected in all periods presented.

FORWARD-LOOKING STATEMENTS

Management's Discussion and Analysis of Financial Condition and Results of
Operations 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 (each a "Forward-Looking Statement"). 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 synergies and opportunities resulting from
recent acquisitions (see "--Acquisitions"), 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 anticipated backlog levels for 2002. Our expectations
about our business outlook, customer spending, oil and gas prices and the
business environment for our company and the industry in general are only our
expectations regarding these matters. No assurance can be given that actual
results may not differ materially from those in the Forward-Looking Statements
herein 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 in major
petroleum producing or consuming regions, the development of technology which
could lower overall finding and development costs, weather patterns and the
overall condition of capital and equity markets for countries in which we
operate.

The following discussion should be read in conjunction with the financial
statements, related notes and other financial information appearing elsewhere in
this Form 10-K. Readers are also urged to carefully review and consider the
various disclosures advising interested parties of the factors that affect us,
including, without limitation, the disclosures made under the caption "Risk
Factors" and the other factors and risks discussed in this Annual Report on Form
10-K 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

21

to any Forward-Looking Statement to reflect any change in our expectations with
regard thereto or any change in events, conditions or circumstances on which any
Forward-Looking Statement is based.

CRITICAL ACCOUNTING POLICIES

The preparation of our consolidated financial statements requires us to
make certain estimates and assumptions which affect the results reported in our
consolidated financial statements and accompanying notes. These estimates and
assumptions are based on historical experience and on our future expectations
that we believe to be reasonable under the circumstances. Note 2 to our
consolidated financial statements contains a summary of our significant
accounting policies. We believe the following accounting policy is the most
critical in the preparation of our consolidated financial statements:

Revenue Recognition: Percentage-of-Completion Method. We recognize revenues
from significant contracts (contracts greater than $250,000 and longer than four
months in duration) and all automation and controls 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 when revenues are recognized, could be
affected by various internal or external factors including: changes in project
scope (change orders), changes in productivity, the cost or scarcity of labor
and equipment, governmental regulations, the political environment, weather
patterns or the timing of client acceptances and approval at benchmark stages of
the project. The cumulative impact of revisions in total cost estimates during
the progress of work is reflected in the year in which these changes become
known. Earned revenue reflects the original contract price adjusted for agreed
claims and change order revenues, if applicable. Losses expected to be incurred
on the jobs in progress, after consideration of estimated minimum recoveries
from claims and change orders, are charged to income as soon as such losses are
known. Customers typically retain an interest in uncompleted projects, and we
generally recognize revenue and earnings to which the percentage of completion
method applies over a period of two to six quarters. We believe that our
operating results should be evaluated over a term of several years to evaluate
our 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.

ACQUISITIONS

In November 1998, we acquired all the outstanding common stock of The
Cynara Company ("Cynara"), a designer and manufacturer of specialized production
equipment utilizing membrane technology to separate bulk carbon dioxide from
natural gas streams, for approximately $15.5 million, 500,000 shares of our
common stock and the right to receive additional shares of common stock based
upon the financial performance of the Cynara assets. Ultimately, we issued
752,501 additional shares.

In January 2000, we acquired all the outstanding common stock of Porta-Test
International, Inc. ("Porta-Test"), a manufacturer of centrifugal devices used
to enhance the effectiveness of separation equipment, for approximately $7.0
million and the right to receive additional payments based upon the performance
of certain Porta-Test assets. See -- Commitments and Contingencies.

In February 2000, we acquired all the outstanding common stock of Modular
Production Equipment, Inc. ("MPE"), a designer and manufacturer of water
treatment separation systems specializing in hydrocyclone technology, for
approximately $2.7 million.

In April 2000, we acquired all the outstanding common stock of Engineering
Specialties Inc. ("ESI"), a provider of proprietary technologies for oily water
treatment and heavy metals removal from production at or near the wellhead, for
approximately $7.1 million.

On March 19, 2001, we acquired all the outstanding share capital of Axsia,
a privately held process and design company based in the United Kingdom, for
approximately $42.8 million, net of cash acquired. Axsia specializes in the
design and supply of water re-injection systems for oil and gas fields, oily
water treatment, oil

22

separation, hydrocyclone technology, hydrogen production and other process
equipment systems. This acquisition was financed with borrowings under our term
loan and revolving credit facility.

We accounted for each of the above transactions using the purchase method
of accounting.

INDUSTRY AND BUSINESS ENVIRONMENT

As a leading provider of wellhead process equipment, systems and services
used in the production of oil and 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 slow-down, revenues for service providers such as NATCO generally
decline, as existing projects are completed and new projects are postponed.
During periods of recovery, revenues for service providers can lag behind the
industry due to the timing of new project awards.

Over the past several years, our business has been impacted by fluctuations
in the oil and gas industry in the United States and Canada. In 1998 and
throughout 1999, the industry suffered the effects of a significant decline in
expenditures due to a sharp decline in hydrocarbon prices. In 2000, energy
prices rose significantly and the industry began a recovery. In 2001, energy
prices declined again in part as a response to higher prices in 2000, and in
part due to a general economic slow-down in the United States. As a consequence
of this volatility in energy prices, our business has been affected by several
cycles of spending by oil and gas companies over the past few years.

The following table summarizes the price of domestic crude oil per barrel
and the wellhead price of natural gas per thousand cubic feet ("mcf"), as
published by the U.S. Department of Energy, and the number of rotary drilling
rigs in operation, as published by Baker Hughes Incorporated, for the most
recent five years:

At December 31, 2001, the price of oil was $15.49 per barrel, the price of
gas had fallen to $2.38 per mcf, and the U.S. rig count was 887. It is generally
expected that spending for exploration and development efforts in the oil and
gas industry will continue to trend downward for some time in 2002.

From a longer-term perspective, the U.S. Department of Energy estimates
that world-wide demand for petroleum products will grow at an average annual
rate of 2.3% through 2020 and that demand for natural gas will increase at an
average annual rate of 3.2% through 2020. As demand continues to grow, and
reserves in the United States decline, producers and service providers in the
oil and gas industry rely more heavily on global sources of energy and expansion
into new markets. Furthermore, the industry continues to seek more innovative
and technologically efficient means to extract hydrocarbons from existing
fields. Due to depletion and the reworking of existing fields, production
profiles are changing, including the mix of oil and gas produced by a field, and
the use of enhanced recovery techniques in many fields can result in higher
levels of contaminants such as water and carbon dioxide. As a result, additional
and more complex equipment may be required to produce oil and gas from these
fields. In addition, many new oil and gas fields produce lower quality or
contaminated hydrocarbon streams that require more complex production equipment.
These trends increase the demand for our products and technology.

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

23

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000

Revenues. Revenues for the year ended December 31, 2001 increased $62.0
million, or 28%, to $286.6 million, from $224.6 million for the year ended
December 31, 2000. The following table summarizes revenues by business segment
for the years ended December 31, 2001 and 2000, respectively:

Revenues from our North American operations business segment for the year
ended December 31, 2001 increased $25.8 million, or 21%, to $149.5 million from
$123.7 million for the year ended December 31, 2000. This increase was due to an
increase in oilfield activity during fiscal 2000 through mid-2001 as a result of
favorable oil and gas prices. Although oil and gas prices began to decline in
late 2001, demand remained high for our traditional equipment and finished
goods. We also experienced increased demand for our domestic and export parts
and service business and our carbon dioxide field services business. Partially
offsetting these increases was a decline in revenues of $8.1 million provided by
our Canadian affiliate, as large projects were completed in fiscal 2000 and
several planned projects for fiscal 2001 were delayed. Inter-company revenues
for this business segment were approximately $5.2 million and $5.4 million for
the years ended December 31, 2001 and 2000, respectively.

Revenues from our engineered systems business segment for the year ended
December 31, 2001 increased $31.2 million, or 46%, to $99.0 million from $67.8
million for the year ended December 31, 2000. This increase was primarily due to
the acquisition of Axsia in March 2001, which contributed revenues of

24

$58.1 million for the year ended December 31, 2001. This increase was partially
offset by a decline in revenues earned under the CTOC project, which contributed
$45.9 million in revenues for the year ended December 31, 2000, as compared to
only $10.9 million for the year ended December 31, 2001. Excluding the impact of
the Axsia acquisition and the CTOC project, revenues for this business segment
increased $8.1 million during fiscal 2001 as compared to fiscal 2000, due
primarily to export projects including a number of projects in South America.
Engineered systems revenues of $99.0 million for the year ended December 31,
2001 included inter-company revenues of $748,000, as compared to $286,000 of
inter-company revenues for the year ended December 31, 2000.

Revenues from our automation and control systems business segment for the
year ended December 31, 2001 increased $4.9 million, or 12%, to $47.7 million
from $42.8 million for the year ended December 31, 2000. The increase was due to
higher demand for our control equipment, especially equipment provided for
deep-water projects, and an increase in field services performed for our
customers. Inter-company revenues declined from $4.1 million for the year ended
December 31, 2000 to $3.8 million for the year ended December 31, 2001.

The change in revenues for corporate and eliminations represents the
elimination of inter-company revenues as discussed above.

Gross Profit. Gross profit for the year ended December 31, 2001 increased
$14.3 million, or 23%, to $76.1 million from $61.8 million for the year ended
December 31, 2000. As a percentage of revenue, gross margins declined from 28%
for the year ended December 31, 2000 to 27% for the year ended December 31,
2001. The following table summarizes gross profit by business segment for the
years ended December 31, 2001 and 2000, respectively:

Gross profit from our North American operations business segment for the
year ended December 31, 2001 increased $6.9 million, or 24%, to $35.5 million
from $28.6 million for the year ended December 31, 2000. This increase in margin
was primarily due to a 21% increase in revenues from this segment and improved
margins on export parts and services and traditional finished goods. As a
percentage of revenue, gross margins for the segment were 24% and 23% for the
years ended December 31, 2001 and 2000, respectively.

Gross profit from our engineered systems business segment for the year
ended December 31, 2001 increased $6.9 million, or 28%, to $31.2 million from
$24.4 million for the year ended December 31, 2000. This increase was due
primarily to the acquisition of Axsia in March 2001, partially offset by lower
margin projects included in the sales mix for 2001 as compared to 2000.
Excluding the impact of Axsia and the CTOC project, gross margin increased $1.5
million related primarily to export projects. As a percentage of revenue, gross
margins for this segment were 32% and 36% for the years ended December 31, 2001
and 2000, respectively.

Gross profit from our automation and control systems business segment for
the year ended December 31, 2001 increased $550,000, or 6%, to $9.4 million from
$8.8 million for the year ended December 31, 2000. This margin improvement was
due to an increase in demand for electrical equipment which resulted in an
increase in segment revenues of 12%, partially offset by a shift from higher
margin quote jobs to time and materials jobs during fiscal 2001 as compared to
fiscal 2000. As a percentage of revenue, gross margins for this segment were 20%
and 21% for the years ended December 31, 2001 and 2000, respectively.

25

Selling, General and Administrative Expense. Selling, general and
administrative expense for the year ended December 31, 2001 increased $12.0
million, or 30%, to $51.5 million from $39.4 million for the year ended December
31, 2000. This increase was largely related to the execution of our business
plan and included:

- additional costs associated with the acquisition of Axsia;

- additional costs associated with the start-up of the Singapore and
Mexico offices;

- increased spending for technology and product development; and

- additional costs associated with employee medical claims.

Depreciation and Amortization Expense. Depreciation and amortization
expense for the year ended December 31, 2001 increased $3.0 million, or 59%, to
$8.1 million from $5.1 million for the year ended December 31, 2000.
Depreciation expense for the year ended December 31, 2001 increased $991,000, or
32%, to $4.1 million from $3.1 million for the year ended December 31, 2000.
This increase was primarily due to the inclusion of depreciation expense on
assets acquired through the purchase of Axsia in March 2001, and depreciation on
assets placed in service during fiscal 2001. Amortization expense for the year
ended December 31, 2001 increased $2.0 million, or 102%, to $4.0 million from
$2.0 million for the year ended December 31, 2000. This increase was primarily
due to amortization of goodwill associated with the Axsia acquisition in March
2001.

Unusual Charges. Unusual charges for the year ended December 31, 2001
increased $72,000, or 5%, to $1.6 million from $1.5 million for the year ended
December 31, 2000. The charge for fiscal 2001 included $920,000 related to
certain restructuring costs to streamline activities and consolidate offices in
connection with the acquisition of Axsia in March 2001, and an additional
$680,000 related to our decision to withdraw a private debt offering. The charge
for fiscal 2000 was primarily for compensation expense associated with the
employment agreement of an executive officer. The terms of the agreement
entitled the officer to a sum equal to an outstanding note and accrued interest,
totaling $1.2 million at December 31, 1999, upon the sale of the Company's Class
A common stock in an initial public offering. NATCO completed its initial public
offering on January 27, 2000, and, pursuant to the terms of the agreement, we
recorded compensation expense for the amount of the note and accrued interest,
including related payroll burdens, totaling $1.3 million. In addition, we
recorded relocation expenses totaling $208,000 associated with the consolidation
of two facilities following the acquisition of Porta-Test in January 2000.

Interest Expense. Interest expense for the year ended December 31, 2001
increased $3.4 million, or 211%, to $5.0 million from $1.6 million for the year
ended December 31, 2000. This increase was due to borrowings of $50.0 million
under a term loan arrangement to finance the purchase of Axsia, additional
borrowings under revolving credit facilities during fiscal 2001 as compared to
fiscal 2000, an increase in commitment fees under borrowing arrangements and an
increase in interest incurred for letter of credit arrangements due to an
increase in overall letters of credit outstanding.

Interest Cost on Postretirement Benefit Liability. Interest cost on
postretirement benefit liability decreased $399,000, or 31%, from $1.3 million
for the year ended December 31, 2000 to $888,000 for the year ended December 31,
2001. This decrease in interest cost was due to an amendment to the plan that
provides medical and dental coverage to retirees of a predecessor company. Under
the amended plan, retirees will bear more cost for coverages, thereby reducing
our projected liability and the related interest cost.

Interest Income. Interest income increased $479,000, or 265%, from
$181,000 for the year ended December 31, 2000 to $660,000 for the year ended
December 31, 2001. This increase in interest income was primarily due to
interest earned on a federal income tax refund paid during 2001 by the Canadian
taxing authorities.

Other Expense, net. Other expense, net of $429,000 for the year ended
December 31, 2001 relates primarily to foreign currency transaction gains and
losses incurred primarily at Axsia, and certain costs to exit derivative
arrangements acquired with the purchase of Axsia in March 2001.

26

Provision for Income Taxes. Income tax expense for the year ended December
31, 2001 decreased $1.5 million, or 27%, to $3.9 million from $5.3 million for
the year ended December 31, 2000. This decline in income tax expense was
primarily due to a decrease in income before income taxes, which was $9.3
million for the year ended December 31, 2001 as compared to $13.0 million for
the year ended December 31, 2000. This decrease in income tax expense was
partially offset by an increase in the effective tax rate from 41% to 42% for
the years ended December 31, 2000 and 2001, respectively, primarily due to the
impact of non-deductible goodwill amortization expense.

YEAR ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999

Revenues. Revenues for the year ended December 31, 2000 increased $54.6
million, or 32% to $224.6 million, from $169.9 million for the year ended
December 31, 1999. The following table summarizes revenues by business segment
for the years ended December 31, 2000 and 1999, respectively:

Revenues from our North American operations segment for the year ended
December 31, 2000 increased $41.4 million, or 50%, to $123.7 million from $82.3
million for the year ended December 31, 1999. This increase was due to an
increase in oilfield activity resulting from an overall increase in oil and gas
prices in 2000. We experienced increased demand for our production process
equipment, as well as in the domestic parts and service business. Also, our
Canadian operations provided increased revenues due to the acquisition of
Porta-Test in January 2000, and the completion of two significant gas plant
projects for Chevron Canada and several projects for Pemex. Partially offsetting
these increases was a decline in service revenues of $2.8 million due to the
early termination of a U.S. carbon dioxide gas-processing agreement by a
customer in the fourth quarter of 1999. Inter-company revenues for this business
segment were approximately $5.4 million and $2.7 million for the years ended
December 31, 2000 and 1999, respectively.

Revenues from our engineered systems business segment for the year ended
December 31, 2000 increased $15.3 million, or 29%, to $67.8 million from $52.5
million for the year ended December 31, 1999. This increase was primarily due to
the contribution of one customer, CTOC, which provided revenues of $45.9 million
for the year ended December 31, 2000 as compared to $14.6 million for the year
ended December 31, 1999. The acquisitions of MPE and ESI in February 2000 and
April 2000, respectively, also contributed to the increase in engineered systems
revenue. This increase in revenue was partially offset by a decline in other
domestic and international engineered systems, consistent with a decrease in
project awards by our customers throughout 1999 and early 2000 as a result of
lower natural gas prices in 1999. Engineered systems revenues of $67.8 million
for the year ended December 31, 2000 included inter-company revenues of
$286,000, as compared to $1.7 million of inter-company revenues for the year
ended December 31, 1999.

Revenues from our automation and control systems business segment for the
year ended December 31, 2000 increased $918,000, or 2%, to $42.8 million from
$41.8 million for the year ended December 31, 1999. Despite the completion of
several large projects in 1999, revenues for this business segment increased due
to stable demand for our automation and controls products and an increase in
inter-company revenues from $2.3 million for the year ended December 31, 1999 to
$4.1 million for the year ended December 31, 2000.

The change in revenues for corporate and eliminations represents the
elimination of inter-company revenues as discussed above.

27

Gross Profit. Gross profit for the year ended December 31, 2000 increased
$19.5 million, or 46%, to $61.8 million from $42.3 million for the year ended
December 31, 1999. As a percentage of revenue, gross margins improved to 28% for
the year ended December 31, 2000 compared to 25% for the year ended December 31,
1999. The following table summarizes gross profit by business segment for the
years ended December 31, 2000 and 1999, respectively:

Gross profit from our North American operations business segment for the
year ended December 31, 2000 increased $8.7 million, or 43%, to $28.6 million
from $20.0 million for the year ended December 31, 1999. This increase in margin
was primarily due to a 50% increase in revenues from this segment and improved
margins on export parts and services, as well as the contribution of Porta-Test,
which was acquired in January 2000. As a percentage of revenue, gross margins
for the segment were 23% and 24% for the years ended December 31, 2000 and 1999,
respectively.

Gross profit from our engineered systems business segment for the year
ended December 31, 2000 increased $10.9 million, or 81%, to $24.4 million from
$13.5 million for the year ended December 31, 1999. This increase was due
primarily to a 29% increase in revenues from this segment and higher margin
projects included in the sales mix for 2000 as compared to 1999. As a percentage
of revenue, gross margins for this segment were 36% and 26% for the years ended
December 31, 2000 and 1999, respectively.

Gross profit from our automation and control systems business segment
remained relatively constant from the year ended December 31, 1999 to the year
ended December 31, 2000. Revenues from this business segment increased 2%
primarily due to an increase in inter-company sales with little impact on gross
margin. As a percentage of revenue, gross margins for this segment were 21% for
each of the years ended December 31, 2000 and 1999.

Selling, General and Administrative Expense. Selling, general and
administrative expense for the year ended December 31, 2000 increased $7.1
million, or 22%, to $39.5 million from $32.4 million for the year ended December
31, 1999. This increase was largely related to the execution of our business
plan and included:

- additional costs associated with the acquisitions of Porta-Test, MPE and
ESI;

- increased spending for technology and product development;

- additional expenses related to being a public company; and

- continued investment in pre-order engineering expenses.

Depreciation and Amortization Expense. Depreciation and amortization
expense for the year ended December 31, 2000 increased $430,000, or 9%, to $5.1
million from $4.7 million for the year ended December 31, 1999. Depreciation
expense for the year ended December 31, 2000 decreased $555,000, or 15%, to $3.1
million from $3.7 million for the year ended December 31, 1999. This decrease
was primarily due to extending the service life of certain operational assets.
This decrease in depreciation expense for the year ended December 31, 2000 as
compared to the year ended December 31, 1999, was partially offset by: (1)
depreciation on the addition of capital assets during the last four quarters,
which included renovations and expansions of existing manufacturing plants such
as a drying plant at the Pittsburg, California facility, technological
improvements to management information systems and the purchase of computer
hardware and software, and acquisitions of and improvements to other equipment
used in the Company's business; and

28

(2) depreciation expense due to the inclusion of results from Porta-Test, MPE
and ESI, acquired during fiscal 2000. Amortization expense for the year ended
December 31, 2000 increased $913,000, or 90%, to $1.9 million from $1.0 million
for the year ended December 31, 1999. This increase was primarily due to
amortization of goodwill associated with the Porta-Test, MPE and ESI
acquisitions. Also, amortization expense increased due to an increase in
goodwill related to the acquisition of Cynara in November 1998. Pursuant to the
Cynara purchase agreement, we issued 325,836 shares and 418,145 shares of our
Class B common stock during September 1999 and June 2000, respectively, to
Cynara's former shareholders based upon the achievement of certain performance
criteria, and the cost of such shares was charged to goodwill.

Interest Expense. Interest expense for the year ended December 31, 2000
decreased $1.7 million, or 52%, to $1.6 million from $3.3 million for the year
ended December 31, 1999. This decrease was due primarily to a reduction of
long-term debt under our term loan and revolving credit facilities from $31.2
million at December 31, 1999 to $15.0 million at December 31, 2000. We retired
$27.9 million of long-term debt under our term loan facility during February
2000 with a portion of the proceeds from our initial public offering.

Unusual Charges. Unusual charges for the year ended December 31, 2000 were
$1.5 million. The charge was primarily for compensation expense associated with
the employment agreement of an executive officer. The terms of the agreement
entitled the officer to a sum equal to an outstanding note and accrued interest,
totaling $1.2 million at December 31, 1999, upon the sale of our Class A common
stock in an initial public offering. We completed our initial public offering on
January 27, 2000, and, pursuant to the terms of the agreement, we recorded
compensation expense for the amount of the note and accrued interest, including
related payroll burdens, totaling $1.3 million. In addition, we recorded
relocation expenses totaling $208,000 associated with the consolidation of two
facilities following the acquisition of Porta-Test.

Revaluation Gain on Postretirement Benefit Liability. In December 2000, we
changed our method of accounting for gains and losses on our postretirement
benefit obligation. Rather than record gains and losses immediately to the
income statement, we now amortize gains or losses that exceed 10% of our
accumulated postretirement benefit obligation over the expected remaining lives
of the participants. Therefore, we did not record a gain or loss on the
revaluation of postretirement benefit liability for the year ended December 31,
2000. During the year ended December 31, 1999, a revaluation gain on
postretirement benefit liability of $1.0 million was recorded due to a change in
the actuarial discount rate used to calculate the net present value of the
underlying liability.

Provision for Income Taxes. Income tax expense for the year ended December
31, 2000 increased $3.8 million, or 245%, to $5.3 million from $1.5 million for
the year ended December 31, 1999. This increase in income tax expense was
primarily due to an increase in income before income taxes, which was $13.0
million for the year ended December 31, 2000 as compared to $2.2 million for the
year ended December 31, 1999. This increase in income tax expense was partially
offset by a decrease in the effective tax rate from 71% for 1999 to 41% for 2000
primarily due to the impact of non-deductible goodwill amortization expense.

Cumulative Effect of Change in Accounting Principle. A gain of $10,000,
net of tax, was recorded for the year ended December 31, 2000 related to the
cumulative effect of a change in the method used to account for gains and losses
on our postretirement benefit obligation. In accordance with APB Opinion No. 20,
"Accounting Changes," prior year financial statements were not restated for this
change.

LIQUIDITY AND CAPITAL RESOURCES

As of February 28, 2002, we had cash and working capital of $4.0 million
and $38.2 million, respectively. As of December 31, 2001, we had cash and
working capital of $3.1 million and $37.1 million, respectively, as compared to
$1.0 million and $49.1 million at December 31, 2000, respectively.

Net cash provided by (used in) operating activities for the years ended
December 31, 2001, 2000 and 1999 was $19.3 million, ($6.3) million and $15.1
million, respectively. The increase in net cash provided by operating activities
for fiscal 2001 was primarily due to collection of receivables at Axsia and an
increase in advance payments from customers, partially offset by an increase in
inventories.

29

Net cash used in investing activities for the years ended December 31,
2001, 2000 and 1999 was $57.7 million, $23.6 million and $2.6 million,
respectively. The primary use of funds for the year ended December 31, 2001 was
the acquisition of Axsia, which required the use of $48.3 million, and capital
expenditures of $10.0 million. Funds for the Axsia acquisition were borrowed
under a $50.0 million term loan facility. Capital expenditures for fiscal 2001
were financed with borrowings under our revolving credit facility and cash
generated from current operations. The primary use of funds for the year ended
December 31, 2000 was the acquisitions of Porta-Test, MPE and ESI, which
required the use of $17.1 million, and capital expenditures of $8.1 million.
These capital expenditures consisted primarily of renovations and expansions of
manufacturing plants, technological improvements to management information
systems and acquisitions of and improvements to other equipment, including an
upgrade to the membrane manufacturing facility in Pittsburg, California, which
was completed in the fourth quarter of 2000. Funds for the Porta-Test
acquisition in January 2000 were borrowed from our revolving credit facility.
These funds were repaid during February 2000 with the proceeds from our initial
public offering. Funds for the MPE acquisition in February 2000 were also
provided by our initial public offering. The ESI acquisition was financed with
net borrowings of $7.1 million under the revolving credit facilities. The
primary use of funds for the year ended December 31, 1999 was capital
expenditures of $3.6 million.

Net cash provided by (used in) financing activities for the years ended
December 31, 2001, 2000 and 1999 was $41.1 million, $29.7 million and ($13.4)
million, respectively. The primary source of funds for financing activities
during the year ended December 31, 2001, was borrowings of $50.0 million under
the term loan facility, partially offset by principal repayments of $5.3 million
under the term loan facility, net repayments of $747,000 under the revolving
credit facility, payments on postretirement benefit liability of $1.8 million
and repayment of short-term notes of $1.0 million. The primary source of funds
for financing activities during the year ended December 31, 2000 was our initial
public offering of common stock, which provided net proceeds of $46.7 million.
These proceeds were used primarily to retire $27.9 million of outstanding debt
under a term loan arrangement, to repay $3.0 million borrowed under the
revolving credit agreement for the purchase of Porta-Test and to repay $2.9
million of debt assumed in the acquisitions of Porta-Test and MPE. The use of
cash for financing activities during 1999 was due primarily to the repayment of
long-term debt.

We maintain revolving credit and term loan facilities, as well as a working
capital facility for export sales. The term loan provides for up to $50.0
million of borrowings and the revolving credit facilities provide 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 matures on March
15, 2006, and each of the revolving facilities matures on March 15, 2004. At
December 31, 2001, we had borrowings outstanding under the term loan facility of
$44.8 million and borrowings of $12.8 million outstanding under the revolving
credit facility and had issued $19.0 million in outstanding letters of credit
under this facility. Amounts borrowed under the term loan portion of this
facility currently bear interest at a rate of 4.25% per annum. Amounts borrowed
under the revolving portion of this facility will bear interest as follows:

- until April 1, 2002, at a rate equal to, at our election, either (1)
LIBOR plus 2.25% or (2) a base rate plus 0.75%; and

- on and after April 1, 2002, at a rate based upon the ratio of funded
debt to EBITDA and ranging from, at our election, (1) a high of LIBOR
plus 2.50% to a low of LIBOR plus 1.75% or (2) a high of a base rate plus
1.0% to a low of a base rate plus 0.25%.

We will pay commitment fees of 0.50% per year until April 1, 2002 and 0.30%
to 0.50% per year, depending upon the ratio of funded debt to EBITDA, on and
after April 1, 2002, in each case on the undrawn portion of the facility.

The revolving credit and term loan facility is guaranteed by all of our
domestic subsidiaries and is secured by a first priority lien on all inventory,
accounts receivable and other material tangible and intangible assets. In
addition, we have pledged 65% of the voting stock of our active foreign
subsidiaries. As of December 31, 2001,

30

we were in compliance with all debt covenants. The weighted average interest
rate of our borrowings under the term loan and revolving credit agreement on
that date was 4.31%.

The export sales credit facility provides for aggregate borrowings of $10.0
million, subject to borrowing base limitations, of which $1.1 million was
outstanding as of December 31, 2001. In addition, we had issued letters of
credit totaling $361,000 under the export facility as of that date. The export
sales credit facility is secured by specific project inventory and receivables
and is partially guaranteed by the Export-Import Bank of the United States. The
export sales credit facility loans mature in July 2004.

At February 28, 2002, borrowing base limitations reduced our available
borrowing capacity under the revolving credit facilities and export sales credit
agreement to $16.8 million and $2.2 million, respectively.

COMMITMENTS AND CONTINGENCIES

We have non-cancelable future commitments under debt and operating lease
arrangements over the next five years as follows: 2002--$10.9 million;
2003--$10.3 million; 2004--$23.5 million; 2005--$7.8 million; and 2006--$17.5
million.

The Porta-Test purchase agreement, executed in January 2000, contains a
provision to calculate a payment to certain former stockholders of Porta-Test
Systems, Inc. for a three-year period ended January 24, 2003, based upon sales
of a limited number of specified products designed by or utilizing technology
that existed at the time of the acquisition. Liability under this arrangement is
contingent upon attaining certain performance criteria, including gross margins
and sales volumes for the specified products. If applicable, payment is required
annually. In April 2001, we paid $226,000 under this arrangement related to the
year ended January 24, 2001. Any future liabilities incurred under this
arrangement will result in an increase in goodwill.

We have no special purpose entities or unconsolidated affiliates or
partnerships.

We believe that our operating cash flow, supported by our available
borrowing capacity, will be adequate to fund operations and non-cancelable
future commitments under debt and operating lease arrangements throughout 2002.
To the extent that management is successful in identifying additional
acquisition opportunities during 2002, the ability to finance these acquisitions
with debt and/or equity will be a critical element of the analysis of the
opportunities.

RELATED PARTY TRANSACTIONS

We do not own a minority interest in or guarantee obligations for any
related party. There are no debt obligations of related parties for which we
have responsibility but were not reported in our balance sheet.

We paid Capricorn Management, G.P., an affiliate company of Capricorn
Holdings, Inc., for administrative services, which included office space and
parking in Connecticut for our Chief Executive Officer, reception, telephone,
computer services and other normal office support relating to that space. Mr.
Herbert S. Winokur, Jr., one of our directors, is the Chairman and Chief
Executive Officer of Capricorn Holdings, Inc., and directly or indirectly
controls approximately 31% of our outstanding common stock. In addition, our
Chief Executive Officer, Mr. Gregory, is a non-salaried member in Capricorn
Holdings LLC, the general partner of Capricorn Investors II, L.P., a private
investment partnership. Capricorn Investors II, L.P. controls approximately 20%
of our common stock. Fees paid to Capricorn Management totaled $85,000, $75,000
and $75,000 for the years ended December 31, 2001, 2000 and 1999, respectively.
Commencing October 1, 2001, the fee increased to $28,750 quarterly due primarily
to an upward adjustment in Capricorn Management's underlying lease for office
space; this increase was reviewed and approved by the Audit Committee of our
Board of Directors. As of December 31, 1999, we recorded a receivable from
Capricorn Management for $5,000 related to expenses paid on its behalf. No
receivable existed at December 31, 2001 or 2000.

Under the terms of an employment agreement in effect prior to 1999, we
loaned our Chief Executive Officer $1.2 million in July 1999 to purchase 136,832
shares of common stock. During February 2000, after we completed the initial
public offering of our Class A common stock, we paid this executive officer a
bonus equal

31

to the principal and interest accrued under this note arrangement and recorded
compensation expense of $1.3 million. The officer used the proceeds of this
settlement, net of tax, to repay us approximately $665,000. The remaining loan
balance, including accrued interest, was $651,000 at December 31, 2001, and
continues to accrue interest at 6% annually. In addition, on October 27, 2000,
our board of directors agreed to provide a full recourse loan to this executive
officer to facilitate the exercise of certain outstanding stock options. This
loan matures on July 31, 2003, and provides interest stated at our then-current
borrowing rate, and principal equal to the cost to exercise the options plus any
personal tax burdens that result from the exercise. As of December 31, 2001, the
balance of the note (principal and accrued interest) due from this officer under
these loan arrangements was $3.3 million.

INFLATION AND CHANGES IN PRICES

The costs of materials (e.g., steel) for our products rise and fall with
their value in the commodity markets. Generally, increases in raw materials and
labor costs are passed on to our customers.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board ("FASB") approved
Statement of Financial Accounting Standards ("SFAS") No. 141, "Business
Combinations." This standard requires that any business combination initiated
after June 30, 2001 be accounted for using the purchase method of accounting.
This standard became effective on July 1, 2001. We adopted this standard on July
1, 2001, with no material effect on its financial condition or results of
operations.

The FASB approved SFAS No. 142, "Goodwill and Other Intangible Assets" in
June 2001. This pronouncement requires that intangible assets with indefinite
lives, including goodwill, cease being amortized and be evaluated on an
impairment basis. Intangible assets with a defined term, such as patents, would
continue to be amortized over the useful life of the asset. This pronouncement
becomes effective on January 1, 2002, for companies with a calendar year end. We
had net goodwill of $79.9 million as of December 31, 2001. Goodwill amortization
totaled $3.7 million for the year ended December 31, 2001. We have not yet
determined the impact that this pronouncement will have on our financial
condition or results of operations. As permitted by the standard, we will
determine and quantify our exposure under this pronouncement during fiscal 2002,
after completing the required impairment testing.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This standard provides guidance on reporting and
accounting for obligations associated with the retirement of long-lived tangible
assets and the associated retirement costs. This standard is effective for
financial statements issued for fiscal years beginning after June 15, 2002. We
have not yet determined the impact that this pronouncement will have on our
financial condition or results of operations.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement replaces SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of," and standardizes the accounting model to be used for
asset dispositions and related implementation issues. This pronouncement becomes
effective for financial statements issued for fiscal years beginning after
December 15, 2001. We have not yet determined the impact that this pronouncement
will have on our financial condition or results of operations.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our operations are conducted around the world in a number of different
countries. Accordingly, our 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. At NATCO Canada, most contracts are
denominated in Canadian dollars, and most of the costs incurred are in Canadian
dollars, thereby mitigating risks associated with currency fluctuations. At
Axsia, which is our U.K.-based operation acquired in March 2001, many contracts
are denominated in U.S. dollars, and occasionally in euros, whereas most of the
costs may be in British pounds sterling. Consequently, we have some currency
risk in our U.K. operations. Prior to the date of acquisition, Axsia had entered
into certain forward contract arrangements whereby it sold
32

U.S. dollars for future delivery at a specified strike price, in order to hedge
exposure to currency fluctuations on contracts denominated in U.S. dollars.
During the third and fourth quarters of 2001, we paid approximately $249,000 to
terminate these forward contracts. No forward contracts or other derivative
arrangements existed at December 31, 2001, and we do not currently intend to
enter into new forward contracts or other derivative arrangements as part of our
currency risk management strategy.

Our financial instruments are subject to changes in interest rates,
including our revolving credit and term loan facility and our working capital
facility for export sales. At December 31, 2001, we had $44.8 million
outstanding under the term loan portion of the revolving credit and term loan
facility. At December 31, 2001, outstanding borrowings under our revolving
credit agreement totaled $12.8 million. Borrowings under our revolving credit
agreement bear interest at floating rates. As of December 31, 2001, the weighted
average interest rate of borrowings under the revolving credit and term loan
facility was 4.31%. Borrowings outstanding under the export sales credit
facility were $1.1 million at December 31, 2001, and bore interest at 4.75%.

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, as of December 31, 2001, a 100 basis point
increase in interest rates under the borrowings would decrease our current year
net income and cash flow from operations by less than $350,000. This calculation
assumes no action on our part to mitigate our exposure. 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 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

To follow are our consolidated financial statements for the years ended
December 31, 2001, 2000 and 1999, as applicable, along with the Independent
Auditors' report:

33

INDEPENDENT AUDITORS' REPORT

The Board of Directors
NATCO Group Inc.:

We have audited the accompanying consolidated balance sheets of NATCO Group
Inc. and subsidiaries as of December 31, 2001 and 2000, and the related
consolidated statements of operations, stockholders' equity and comprehensive
income, and cash flows for each of the three years ended December 31, 2001.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of NATCO Group
Inc. and subsidiaries as of December 31, 2001 and 2000 and the results of their
operations and their cash flows for the years ended December 31, 2001, 2000 and
1999, in conformity with accounting principles generally accepted in the United
States of America.

As discussed in Note 15 to the Consolidated Financial Statements, the
Company changed its method of accounting for postretirement benefits in January
2000.

KPMG LLP

Houston, Texas
February 18, 2002

34

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes to consolidated financial statements.

35

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

See accompanying notes to consolidated financial statements.

36

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
COMPREHENSIVE INCOME
(DOLLARS IN THOUSANDS)

See accompanying notes to consolidated financial statements.

37

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)

See accompanying notes to consolidated financial statements.

38

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) ORGANIZATION

NATCO Group Inc. ("NATCO") was formed in June 1988 by Capricorn Investors,
L.P., which led a group of investors who provided capital for the Company to
acquire several businesses from Combustion Engineering, Inc. ("C-E"). On June
21, 1989, the Company acquired from C-E all of the outstanding common stock of
W.S. Tyler, Incorporated ("Tyler"), and National Tank Company, as well as the
net assets of certain foreign affiliates.

During 1992, NATCO contributed its common stock investment in Tyler and
$5.5 million in cash to Process Technology Holdings, Inc. ("PTH") in exchange
for all of the issued and outstanding common stock of PTH. In 1992 and 1993, PTH
and NATCO sold certain shares of PTH common stock to third parties and, during
1997, the Company completed a tax-free spin off of PTH to its stockholder.

On June 30, 1997, NATCO acquired Total Engineering Services Team, Inc.
("TEST"), and on November 18, 1998, NATCO acquired The Cynara Company
("Cynara"). The Company acquired Porta-Test International, Inc. ("Porta-Test")
on January 24, 2000.

On January 27, 2000, the Company completed an initial public offering of
7,500,000 shares of its Class A common stock at a price of $10.00 per share
(4,053,807 shares issued by the Company and 3,446,193 shares issued by selling
stockholders). On February 3, 2000, the underwriter exercised its over-allotment
option that resulted in the issuance of 1,125,000 additional shares of Class A
common stock.

On February 8, 2000 and April 4, 2000, NATCO acquired Modular Production
Equipment, Inc. ("MPE") and Engineering Specialties, Inc. ("ESI"), respectively.

On March 19, 2001, NATCO acquired Axsia Group Limited ("Axsia"), a
privately held process and design company based in the United Kingdom.

The accompanying consolidated financial statements and all related
disclosures include the results of operations of the Company and its
majority-owned subsidiaries for the years ended December 31, 2001, 2000 and
1999. Furthermore, certain reclassifications have been made to fiscal 2000 and
fiscal 1999 amounts in order to present these results on a comparable basis with
amounts for fiscal 2001.

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

(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation. The consolidated financial statements include
the accounts of the Company and all of its majority-owned subsidiaries.
Significant inter-company accounts and transactions have been eliminated in
consolidation.

Concentration of Credit Risk. Concentrations of credit risk with respect
to trade receivables are limited due to the large number of customers comprising
the Company's customer base and their geographic dispersion. For the years ended
December 31, 2001 and 1999, no customer provided more than 10% of revenues.
However, during fiscal 2000, Carigali-Triton Operating Company, SDN BHD ("CTOC")
through its general contractor, Samsung, provided revenues of $45.9 million or
approximately 20% of total revenues, pursuant to a large project awarded in July
1999. No other customer provided more than 10% of revenues for the year ended
December 31, 2000. See Note 21, Industry Segments and Geographic Information.

Cash Equivalents. The Company considers all highly liquid investment
instruments with original maturities of three months or less to be cash
equivalents.

39

Restricted Cash. At December 31, 1998 cash in the amount of $883,000 was
pledged as collateral on outstanding letters of credit related to performance
and warranty guarantees, and was classified as restricted cash on the balance
sheet. No restricted cash existed at December 31, 2001, 2000 or 1999.

Inventories. Inventories are stated at the lower of cost or market. Cost
is determined using the last in, first out ("LIFO") method for NATCO domestic
inventories, average cost for TEST inventories and the first in, first out
("FIFO") method for all other inventories.

Property, Plant and Equipment. Property, plant and equipment are stated at
cost less an allowance for depreciation. Depreciation on plant and equipment is
calculated using the straight-line method over the assets' estimated useful
lives. Maintenance and repair costs are expensed as incurred; renewals and
betterments are capitalized. Upon the sale or retirement of properties, the
accounts are relieved of the cost and the related accumulated depreciation, and
any resulting profit or loss is included in income. The carrying values of
property, plant and equipment by location are reviewed annually and more often
if there are indications that these assets may be impaired.

Goodwill. Goodwill is being amortized on a straight-line basis over
periods of 20 to 40 years. The Company assesses the recoverability of this
intangible asset by determining whether the amortization over its remaining life
can be recovered through undiscounted future operating cash flows. Based on its
most recent analysis, the Company's management believes that no material
impairment of goodwill exists at December 31, 2001. Amortization expense for the
years ended December 31, 2001, 2000 and 1999 was $3.7 million, $2.0 million and
$739,000, respectively. Accumulated amortization at December 31, 2001 and 2000
was $6.4 million and $2.8 million, respectively.

Other Assets, Net. Other assets consist of prepaid pension assets,
long-term deposits, deferred financing costs and covenants not to compete.
Deferred financing costs and covenants not to compete are being amortized over
the term of the related agreements. Amortization expense for the years ended
December 31, 2001, 2000 and 1999 was $932,000, $554,000 and $570,000,
respectively.

Environmental Remediation Costs. The Company accrues environmental
remediation costs based on estimates of known environmental remediation
exposure. Such accruals are recorded when the cost of remediation is probable
and estimable, even if significant uncertainties exist over the ultimate cost of
the remediation. Ongoing environmental compliance costs, including maintenance
and monitoring costs, are expensed as incurred.

Revenue Recognition. Revenues from significant contracts (NATCO contracts
greater than $250,000 and longer than four months in duration and all TEST
contracts and orders) are recognized on the percentage of completion method.
Earned revenue is based on the percentage that incurred costs to date bear to
total estimated costs after giving effect to the most recent estimates of total
cost. The cumulative impact of revisions in total cost estimates during the
progress of work is reflected in the year in which the changes become known.
Earned revenue reflects the original contract price adjusted for agreed claims
and change order revenues, if any. Losses expected to be incurred on jobs in
progress, after consideration of estimated minimum recoveries from claims and
change orders, are charged to income as soon as such losses are known. Customers
typically retain an interest in uncompleted projects. Other revenues and related
costs are recognized when products are shipped or services are rendered to the
customer.

Stock-Based Compensation. Statement of Financial Accounting Standards
("SFAS") No. 123, "Accounting for Stock-Based Compensation," permits entities to
recognize as expense over the vesting period the fair value of all stock-based
awards on the date of grant. Alternatively, SFAS No. 123 allows entities to
continue to apply the provisions of Accounting Principles Board ("APB") Opinion
No. 25 and provide pro forma net income and earnings per share disclosures for
employee stock option grants made in 1995 and future years as if the
fair-value-based method defined in SFAS No. 123 had been applied. The Company
has elected to continue to apply the provision of APB Opinion No. 25 and provide
the pro forma disclosure provisions of SFAS No. 123.

Research and Development. Research and development costs are charged to
operations in the year incurred. The cost of equipment used in research and
development activities, which has alternative uses, is
40

capitalized as equipment and not treated as an expense of the period. Such
equipment is depreciated over estimated lives of 5 to 10 years. Research and
development expenses totaled $2.1 million, $1.8 million and $1.9 million for the
years ended December 31, 2001, 2000 and 1999, respectively.

Warranty Costs. Estimated future warranty obligations related to products
are charged to cost of goods sold in the period in which the related revenue is
recognized. Additionally, the Company provides some of its customers with
letters of credit covering potential warranty claims. At December 31, 2001 and
2000, the Company had $5.4 million and $931,000, respectively, in outstanding
letters of credit related to warranties.

Income Taxes. Deferred tax assets and liabilities are recognized for
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date.

In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the future generation of taxable income during the periods in
which those temporary differences become deductible. Management has considered
the scheduled reversal of deferred tax liabilities, projected future taxable
income and tax planning strategies in making this assessment.

Derivative Arrangements. Assets and liabilities associated with and
underlying derivative arrangements which do not qualify for hedge value
accounting are recorded at fair market value as of the balance sheet date with
any changes in fair value charged to income in the current period, in accordance
with SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities." The Company recorded a charge of $249,000 to exit certain
derivative arrangements that were acquired with the purchase of Axsia in March
2001. The Company had no derivative financial instruments as of December 31,
2001, 2000 or 1999.

Translation of Foreign Currencies. Financial statement amounts related to
foreign operations are translated into their United States dollar equivalents at
exchange rates as follows: (1) balance sheet accounts at year-end exchange
rates, and (2) statement of operations accounts at the weighted average exchange
rate for the period. The gains or losses resulting from such translations are
deferred and included in accumulated other comprehensive loss as a separate
component of stockholders' equity. Gains or losses from foreign currency
transactions are reflected in the consolidated statements of operations.

Use of Estimates. The Company's management has made estimates and
assumptions relating to the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities and the amounts of revenues and
expenses recognized during the period to prepare these financial statements in
conformity with generally accepted accounting principles. Actual results could
differ from those estimates.

Earnings per Common Share. Basic earnings per share excludes the dilutive
effect of common stock equivalents. The diluted earnings per common and common
equivalent share are computed by dividing net income by the weighted average
number of common and common equivalent shares outstanding. For the purposes of
this calculation, outstanding employee stock options are considered common stock
equivalents. In conformity with Securities and Exchange Commission requirements,
common stock, options and warrants, or other potentially dilutive instruments
which have been issued for nominal consideration during the periods covered by
the income statements presented, are reflected in earnings per share
calculations for all periods presented. Anti-dilutive stock options were
excluded from the calculation of common stock equivalents. The impact of these
anti-dilutive shares would have been a reduction of 145,000 shares and 36,000
shares for the years ended December 31, 2001 and 2000, respectively. There were
no anti-dilutive stock options for the year ended December 31, 1999.

41

The following table presents earnings per common share amounts computed
using SFAS No. 128:

(3) CAPITAL STOCK

On November 18, 1998, the Company's charter was amended to divide its
common stock into two classes: Class A common stock (45,000,000 shares) and
Class B common stock (5,000,000 shares). The two classes of common stock have
the same relative rights and preferences except the holders of the Class B
common stock have the right, voting separately as a class, to elect one member
of the Company's board of directors. Class B shares may be converted by the
holder to Class A shares at any time, and will automatically convert to Class A
shares on January 1, 2002.

On January 27, 2000, the Company completed an initial public offering of
7,500,000 shares of Class A common stock at a price of $10.00 per share
(4,053,807 shares issued by the Company and 3,446,193 shares issued by selling
stockholders). The proceeds to the Company, less underwriting fees, were $37.7
million. These funds were used to retire debt of $27.9 million under the term
loan facility, to repay borrowings of $3.0 million under the revolving credit
facility used to acquire Porta-Test, to retire $2.2 million of Porta-Test debt
acquired, to pay offering costs of $1.5 million and to fund other working
capital needs. On February 3, 2000, the underwriter exercised its over-allotment
option, which resulted in the issuance of 1,125,000 additional shares of Class A
common stock and proceeds of $10.5 million, net of underwriter's fees. Proceeds
from the over-allotment were used to complete the acquisition of MPE including
the repayment of $685,000 of debt acquired, and for other working capital needs.

During 1997, the Company provided a loan of $1.5 million (at an interest
rate of 10% per annum) to a director of the Company who is also an affiliate of
Capricorn Holdings, Inc. In March 1998, the related promissory note was amended
to change the interest rate to 11% per annum. The principal was to be due on the
date on which Capricorn Holdings, Inc. distributed its holdings of NATCO's
common stock to its partners. During 1998, the Company acquired an option at a
cost of approximately $200,000 to purchase 173,050 shares of NATCO's common
stock from the director at a price of $8.81 per share. At the Company's option,
the note provided that the obligation could be repaid with shares of NATCO's
common stock. The cost to acquire this option was recorded as treasury stock in
the accompanying consolidated balance sheets. During February 2000, the Company
exercised its option to acquire 173,050 shares of NATCO's

42

Class A common stock from the director for $1.5 million, which reduced the note
due from the director by the same amount. The shares were recorded as treasury
stock at cost in the accompanying consolidated balance sheet. The balance of the
note due from the director was repaid in June 2000.

In February 2001, June 2000 and September 1999, the Company issued 8,520
Class B shares, 418,145 Class B shares and 325,836 Class B shares, respectively,
to the former shareholders of Cynara, in connection with the achievement of
certain performance criteria defined in the November 1998 purchase agreement.
Goodwill was increased $85,000 in 2001, $4.1 million in 2000 and $3.4 million in
1999, as a result of these transactions.

In October 2000, the Company's board of directors approved a stock
repurchase plan under which up to 750,000 shares of the Company's Class A common
stock could be acquired. During fiscal 2001, the Company reacquired
approximately 118,000 shares of its Class A common stock under this repurchase
agreement for $867,000, an average cost of $7 per share. During 2000, the
Company reacquired 34,000 shares of its Class A common stock under this
repurchase plan for $243,000, an average cost of $7 per share. The cost to
reacquire these shares was recorded as treasury stock at December 31, 2001 and
2000, respectively.

(4) ACQUISITIONS

In November 1998, the Company completed the acquisition of Cynara from a
group of private investors for $5.3 million in cash, the assumption of $10.1
million in Cynara bank debt, and the issuance of 500,000 shares of NATCO Class B
common stock valued at $5.3 million. The purchase agreement also stipulated that
NATCO may be required to issue up to an additional 1,400,000 shares of Class B
common stock to Cynara's former shareholders based on certain performance
criteria defined in the purchase agreement. The Company issued 325,836 Class B
shares, 418,145 Class B shares and 8,520 Class B shares in September 1999, June
2000 and February 2001, respectively, as per this agreement, which resulted in
an increase in goodwill. See Note 3, Capital Stock. The funds used for the
acquisition of Cynara were provided by $5.3 million of equity and proceeds of
borrowings from a senior credit facility provided by a syndicate of major
international banks. The acquisition was accounted for as a purchase and the
results of Cynara have been included in the consolidated financial statements
since the date of acquisition. Goodwill at December 31, 2001 and 2000 was $17.6
million. Accumulated amortization was $2.3 million and $1.4 million for the
respective periods.

The Company acquired all the outstanding common stock of Porta-Test on
January 24, 2000, for approximately $6.3 million in cash, net of cash acquired,
which included payment of specific accrued liabilities of the former company and
the purchase of certain proprietary intellectual property of an associated U.S.
company, the issuance of a one-year promissory note for $1.0 million denominated
in Canadian dollars and a payment contingent upon certain operating criteria
being met. See Note 18, Commitments and Contingencies. This acquisition has been
accounted for using the purchase method of accounting, and results of operations
for Porta-Test have been included in NATCO's consolidated financial statements
since the date of acquisition. The excess of the purchase price over the fair
values of the net assets acquired is being amortized over a twenty-year period.
Goodwill and accumulated amortization related to the Porta-Test acquisition were
$5.3 million and $528,000, respectively, at December 31, 2001.

The Company acquired all the outstanding common stock of MPE on February 8,
2000, for approximately $2.4 million in cash, net of cash acquired, and the
issuance of a one-year promissory note for $338,000, which accrued interest at
10% per annum. This acquisition has been accounted for using the purchase method
of accounting, and results of operations for MPE have been included in NATCO's
consolidated financial statements since the date of acquisition. The excess of
the purchase price over the fair values of the net assets acquired is being
amortized over a twenty-year period. Goodwill and accumulated amortization
related to the MPE acquisition were $3.4 million and $338,000, respectively, at
December 31, 2001.

The Company acquired all the outstanding common stock of ESI on April 4,
2000 for approximately $7.1 million, net of cash and cash equivalents acquired,
subject to adjustment. This acquisition, which was financed with borrowings of
$7.1 million under the existing revolving credit facility and borrowings of $2.6
million under the existing export sales facility, was accounted for using the
purchase method of
43

accounting, and results of operations for ESI have been included in NATCO's
consolidated financial statements since the date of acquisition. The excess of
the purchase price over the fair values of the net assets acquired is being
amortized over a twenty-year period. Goodwill and accumulated amortization
related to the ESI acquisition were $6.0 million and $510,000, respectively, at
December 31, 2001.

On March 19, 2001, the Company acquired all the outstanding share capital
of Axsia, for approximately $42.8 million, net of cash acquired. Axsia
specializes in the design and supply of water reinjection systems for oil and
gas fields, oily water treatment, oil separation, hydrocyclone technology,
hydrogen production and other process equipment systems. This acquisition was
financed with borrowings under NATCO's term loan facility and was accounted for
using the purchase method of accounting. Results of operations for Axsia have
been included in NATCO's consolidated financial statements since the date of
acquisition. The purchase price of $45.0 million was allocated as follows: $2.2
million of cash acquired, $38.4 million of current assets excluding cash, $2.0
million of long-term assets excluding goodwill and $46.0 million of current
liabilities. The excess of the purchase price over the fair value of the net
assets acquired is being amortized over a twenty-year period. Goodwill and
accumulated amortization expense related to the Axsia acquisition were $48.4
million and $1.9 million, respectively, at December 31, 2001. Although the Axsia
purchase price allocation has not yet been finalized, NATCO's management does
not believe that the final purchase price allocation will differ materially from
that as of December 31, 2001.

Assuming the Axsia acquisition occurred on January 1 of the respective
year, the unaudited pro forma results of the Company for the twelve months ended
December 31, 2001, and 2000, respectively, would have been as follows:

These pro forma results assume debt service costs associated with the Axsia
acquisition, net of tax effect, calculated at the Company's effective tax rate
for the applicable period, and nondeductible goodwill amortization. Although
prepared on a basis consistent with NATCO's consolidated financial statements,
these pro forma results do not purport to be indicative of the actual results
which would have been achieved had the acquisition been consummated on January 1
of the respective year, and are not intended to be a projection of future
results.

Effective January 8, 2001, the Company entered into a Compromise Settlement
Agreement with the former owner of TEST, which resulted in a cash payment of
$1.5 million to NATCO on May 31, 2001, to settle certain contingencies related
to NATCO's acquisition of TEST in 1997. The proceeds of this payment, net of
related costs, were used to reduce goodwill associated with the TEST
acquisition.

(5) UNUSUAL CHARGES

In June 2001, the Company recorded an unusual charge of $1.6 million. The
charge consisted of $920,000 pursuant to an approved plan to close and merge an
existing NATCO office into the operations of Axsia, as well as other
streamlining actions associated with the acquisition. This charge included costs
for severance, office consolidation and other expenses. Also, the Company
withdrew a public debt offering and recorded an unusual charge of $680,000 for
costs incurred related to the proposed offering.

Pursuant to an employment agreement, an executive officer was entitled to a
bonus upon the occurrence of any sale or public offering of the Company. The
bonus equaled one and one-half percent (1.5%) of the

44

value of all securities owned by stockholders of the Company prior to the sale
or offering, including common stock valued at the price per share received in
either the sale or public offering, and any debt held by such stockholders. In
July 1999, the Company amended the employment agreement to eliminate the bonus
and agreed to loan the officer $1.2 million to purchase 136,832 shares of common
stock. Per the agreement, the officer would receive a bonus equal to the
outstanding principal and interest of the note upon the sale or public offering
of the Company. During February 2000, after the Company completed an initial
public offering of its Class A common stock, NATCO recorded expense of $1.3
million in settlement of its obligation under this agreement. The officer used
the proceeds, net of tax, to repay the Company approximately $665,000. The
outstanding balance of this note at December 31, 2001, was $651,000. The loan
accrues interest at 6% annually.

During the first quarter of 2000, NATCO incurred relocation charges of
approximately $208,000 associated with the consolidation of an existing Company
facility with a facility that was acquired in connection with the acquisition of
Porta-Test.

(6) INVENTORIES

Inventories consisted of the following amounts:

At December 31, 2001 and 2000, inventories valued using the LIFO method and
included above amounted to $29.5 million and $22.3 million, respectively. For
the year ended December 31, 1999, liquidations of LIFO layers resulted in a
reduction of cost of sales of $21,000. There were no reductions in the LIFO
layers for the years ended December 31, 2001 and 2000.

(7) COST AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS

Cost and estimated earnings on uncompleted contracts were as follows:

45

(8) PROPERTY, PLANT AND EQUIPMENT, NET

The components of property, plant and equipment, were as follows:

Depreciation expense was $4.1 million, $3.1 million and $3.7 million,
respectively, for the years ended December 31, 2001, 2000 and 1999. The Company
leases certain machinery and equipment to its customers, generally for periods
of one month to one year. The cost of leased machinery and equipment was $5.3
million and $5.1 million, and the related accumulated depreciation was $3.5
million and $3.4 million, at December 31, 2001 and 2000, respectively. Lease and
rental income of $1.2 million, $581,000 and $450,000 for the years ended
December 31, 2001, 2000 and 1999, respectively, were included in revenues.

(9) OTHER ASSETS, NET

Other assets consisted of the following:

Deferred financing costs are amortized over the life of the related debt
instruments (three and five years). Accumulated amortization was $1.2 million
and $552,000 at December 31, 2001 and 2000, respectively.

(10) ACCRUED EXPENSES AND OTHER

Accrued expense and other consisted of the following:

46

(11) SHORT-TERM DEBT

In conjunction with the purchase of Porta-Test in January 2000, the Company
issued a one-year promissory note for $1 million denominated in Canadian
dollars, which accrued interest at 15% per annum. On January 24, 2001, the note
was repaid along with accrued interest.

During February 2000, the Company issued a one-year promissory note, face
value of $338,000, with interest payable per annum at 10%, in conjunction with
the acquisition of MPE. In February 2001, the Company paid $206,000 as principal
and interest.

(12) LONG-TERM DEBT

The consolidated borrowings of the Company are as follows:

The aggregate future maturities of long-term debt for the next five years
ended December 31 summarize as follows: 2002--$7.0 million; 2003--$7.0 million;
2004--$20.8 million; 2005--$7.0 million; and 2006--$16.8 million.

On March 16, 2001, the Company entered into a new credit facility that
consisted of a $50.0 million term loan, a $35.0 million U.S. revolving facility,
a $10.0 million Canadian revolving facility and a $5.0 million U.K. revolving
facility. The term loan matures on March 15, 2006, and each of the revolving
facilities matures on March 15, 2004. In October 2001, the Company amended this
revolving credit agreement to reduce the borrowing capacity in the U.S. from
$35.0 million to $30.0 million, and to increase its borrowing capacity in the
U.K. from $5.0 million to $10.0 million. No other material modifications were
made to the agreement.

Amounts borrowed under the term loan bear interest at a rate of 4.25% per
annum as of December 31, 2001. Amounts borrowed under the revolving portion of
the facility bear interest as follows:

- until April 1, 2002, at a rate equal to, at the Company's election,
either (1) the London Interbank Offered Rate ("LIBOR") plus 2.25% or (2)
a base rate plus 0.75%; and

- on and after April 1, 2002, at a rate based upon the ratio of funded
debt to EBITDA (as defined in the credit facility) and ranging from, at
the Company's election, (1) a high of LIBOR plus 2.50% to a low of LIBOR
plus 1.75% or, (2) a high of a base rate plus 1.0% to a low of a base
rate plus 0.25%.

47

NATCO will pay commitment fees of 0.50% per year until April 1, 2002 and
0.30% to 0.50% per year following 2002, depending upon the ratio of funded debt
to EBITDA, on and after April 1, 2002, in each case on the undrawn portion of
the facility.

The revolving credit facility is guaranteed by all the Company's domestic
subsidiaries and is secured by a first priority lien on all inventory, accounts
receivable and other material tangible and intangible assets. NATCO has also
pledged 65% of the voting stock of its active foreign subsidiaries.

Borrowings of $50.0 million under the term loan facility were used
primarily for the acquisition of Axsia. The remaining borrowings, along with
additional borrowings under the revolving credit facility, were used to repay
$16.5 million outstanding under a predecessor revolving credit and term loan
facility.

As of December 31, 2001, the Company was in compliance with all restrictive
debt covenants. NATCO had letters of credit outstanding under the revolving
credit facilities totaling $19.0 million at December 31, 2001. These letters of
credit constitute contract performance and warranty collateral and expire at
various dates through October 2004.

The Company maintains a working capital facility for export sales that
provides for aggregate borrowings of $10.0 million, subject to borrowing base
limitations, under which borrowings of $1.1 million were outstanding at December
31, 2001. Letters of credit outstanding under the export sales credit facility
as of December 31, 2001 totaled $361,000. The export sales credit facility loans
are secured by specific project inventory and receivables, are partially
guaranteed by the EXIM Bank and mature in July 2004.

The Company had unsecured letters of credit totaling $944,000 at December
31, 2001.

On November 20, 1998, a revolving credit and term loan facility was put
into place with a syndicate of major international banks. The credit facility
provides for a $32.0 million revolving credit line ($22.0 million available in
the U.S., $10.0 million available in Canada) to finance eligible accounts
receivable and inventories, and a $32.5 million term loan. Indebtedness under
the credit facility bears interest at a floating rate based, at the Company's
option, upon (i) the Base Rate, or Canadian prime rate with respect to Base Rate
Loans, plus the Margin Percentage or (ii) the London Interbank Offered Rate for
one, two, three or six months, plus the Margin Percentage. The Margin Percentage
for Base Rate and Canadian prime rate loans varies from 1.00% to 0.00% depending
on the Company's debt to capitalization ratio; and the Margin Percentage for
Eurodollar loans varies from 2.50% to 1.00% depending on the Company's debt to
capitalization ratio. The term borrowings mature on November 30, 2003. During
October 2000, the Company amended the revolving credit and term loan facility to
extend the maturity date of the revolving credit facility to January 1, 2003.
These agreements contain affirmative covenants including financial requirements
related to minimum net worth, debt to capitalization ratio, and fixed charge
coverage ratio, as well as restrictions on NATCO making any distributions of any
property or cash to the Company in excess of an agreed sum without prior lender
approval, and requires commitment fees in accordance with standard banking
practices. The loan was collateralized by substantially all the assets of the
Company and its subsidiaries, as well as a guarantee by the Company. As of
December 31, 2000, the Company was in compliance with all restrictive covenants.

During the first quarter of 2000, NATCO retired all outstanding debt under
the term loan facility utilizing the proceeds from the initial public offering
of the Company's Class A common stock. In addition, the Company borrowed $3.0
million under the revolving credit facility to finance the acquisition of
Porta-Test, which was repaid during February 2000. The Company borrowed $7.1
million under the revolving credit facility and $2.6 million under the facility
for export sales during April 2000 to finance the purchase of ESI. In August
2000, the Company retired all outstanding borrowings under the export sales
facility. Net borrowings under the revolving credit facility for the year ended
December 31, 2000 were $11.6 million.

Dividend Restrictions. With respect to its credit facilities, NATCO has
agreed that it will not make any distributions of any property or cash to the
Company or its stockholders' in excess of 50% of net income less excess cash
flow beginning in 2001. No dividends were declared or paid during the years
ended December 31, 2001, 2000 and 1999.

48

(13) INCOME TAXES

Income tax expense (benefit) consisted of the following components:

Temporary differences related to the following items that give rise to
deferred tax assets and liabilities were as follows:

At December 31, 2001, the Company recorded a valuation allowance of $1.3
million related to certain deferred tax assets acquired with the purchase of
Axsia in March 2001. No valuation allowance was recorded related to the
Company's deferred tax assets during fiscal 2000 because it was the opinion of
management that future operations will more likely than not generate sufficient
taxable income to realize the deferred tax assets. At December 31, 2001, the
Company had net operating loss carry-forwards for federal income tax purposes of
$3.1 million that were available to offset future federal income tax through
2021.

49

Income tax expense differs from the amount computed by applying the U.S.
federal income tax rate of 34% to income from continuing operations before
income taxes as a result of the following:

A provision has not been made for U.S. income taxes that would be payable
if undistributed earnings of foreign subsidiaries were distributed to the
Company in the form of dividends, since it is management's intention to reinvest
such earnings permanently in the related foreign operations.

Federal income tax returns for fiscal years beginning with 1998 are open
for review by the Internal Revenue Service.

(14) STOCKHOLDERS' EQUITY

CEO Stock Options. In connection with the engagement of the Chief
Executive Officer of the Company, the Company granted to him options to purchase
National Tank Company common stock that were subsequently converted to options
to purchase common stock of the Company. At December 31, 2001 and 2000, these
options related to an aggregate of 346,113 shares and 264,363 shares,
respectively, of the Company's common stock.

Stock Appreciation Rights. During 1994, NATCO adopted the National Tank
Company Stock Appreciation Rights Plan (the National Tank Plan). The National
Tank Plan provided for grants to officers and key employees of NATCO of rights
to the appreciation in value of a stated number of shares of NATCO common stock.
Value was to be determined by a committee of the NATCO Board of Directors. The
maximum number of rights issuable under the National Tank Plan was 500,000.
Rights vested over a three-year period.

Individual Stock Options. On July 1, 1997, the Board of Directors of the
Company approved the exchange of rights outstanding under the National Tank
Plan, discussed previously, for individual options to purchase common stock of
the Company. Compensation expense was recognized to the extent that the
projected fair market value of the stock on the exchange date exceeded the
exercise price of the options. Furthermore, additional stock options were
granted under this plan with an exercise price equal to the fair market value of
the shares on the date of grant. Accordingly, no compensation expense was
recorded for these additional grants. The individual stock options granted on
July 1, 1997 vested ratably over a period of three or four years. The maximum
term of these options was 10 years. At December 31, 2001 and 2000, an aggregate
of 527,701 and 764,204 stock options, respectively, remained outstanding under
this plan.

50

Stock Option Plans. In January 1998 and February 1998, the Company adopted
the Directors Compensation Plan and the Employee Stock Incentive Plan. These
plans authorize the issuance of options to purchase up to an aggregate of
760,000 shares of Company common stock. The options vest over periods of up to
four years. The maximum term under these options is ten years. At December 31,
2001, 2000 and 1999, options relating to an aggregate of 743,920 shares, 743,953
shares and 455,085 shares, respectively, were outstanding under these plans.

NATCO Group Inc. 2001 Stock Incentive Plan. In November 2000, the Board of
Directors of the Company approved and authorized the issuance of up to 300,000
shares of the Company's common stock for the 2000 Employee Stock Option Plan. On
May 24, 2001, the Company's stockholders approved the NATCO Group Inc. 2001
Stock Incentive Plan, which superceded and replaced the 2000 Plan in its
entirety, and increased the number of shares as to which options or awards may
be granted under the plan to a maximum of 1,000,000 shares. At December 31,
2001, options relating to an aggregate of 795,826 shares were outstanding under
this plan. No options were outstanding under this plan as of December 31, 2000.

The following table summarizes the transactions of the Company's stock
option plans for the years ended December 31, 2001, 2000 and 1999:

Pro forma information regarding net income and earnings per share is
required by SFAS No. 123, and has been determined by applying the Black-Scholes
Single Option--Reduced Term valuation method. This valuation model requires
management to make highly subjective assumptions about volatility of NATCO's
common stock, the expected term of outstanding stock options, the Company's
risk-free interest rate and

51

expected dividend payments during the contractual life of the options.
Volatility of stock prices was evaluated based upon historical data from the New
York Stock Exchange from the date of the initial public offering, January 28,
2000, to February 1, 2002. Volatility was calculated at 52% as of December 31,
2001, but was stepped-down by 10% per year for the next four years to reflect
expected stabilization. The following table summarizes other assumptions used to
determine pro forma compensation expense under SFAS No. 123 as of December 31,
2001:

Risk-free rates were determined based upon U.S. Treasury obligations as of
the option date and outstanding for a similar term. The Company does not intend
to pay dividends on its common stock during the term of the options outstanding
as of December 31, 2001.

For the year ended December 31, 1999, the Company accounted for its
employee stock options under the minimum value method permitted by SFAS No. 123
under the assumptions of a risk free rate of 5.5% and an expected life of
options of 10 years for options issued after March 31, 1998. For options issued
prior to March 31, 1998, the risk free rate of return used was 7% and the
expected life used was 7.5 years.

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma net earnings and earnings per share for the years ended December 31,
2001, 2000 and 1999 were as follows:

Because SFAS No. 123 requires pro forma amounts for options granted
beginning in 1995, the pro forma expense will likely increase in future years as
the new option grants become subject to the pricing model.

Preferred Stock Purchase Rights

In May 1998, the Board of Directors of the Company declared a dividend of
one preferred share purchase right for each outstanding share of common stock
and for each share of common stock thereafter issued prior to the time the
rights become exercisable. When the rights become exercisable, each right will
entitle the holder to purchase one one-hundredth of one share of Series A Junior
Participating Preferred Stock at a price of $72.50 in cash. Until the rights
become exercisable, they will be evidenced by the certificates or ownership of
NATCO's common stock, and they will not be transferable apart from the common
stock.

The rights will become exercisable following the tenth day after a person
or group announces acquisition of 15% or more of the Company's common stock or
announces commencement of a tender offer, the consummation of which would result
in ownership by the person or group of 15% or more of the Company's common
stock. If a person or group were to acquire 15% or more of the Company's common
stock, each right would become a right to buy that number of shares of common
stock that would have a market value of two times the exercise price of the
right. Rights beneficially owned by the acquiring person or group would,
however, become void.

At any time prior to the time the rights become exercisable, the board of
directors may redeem the rights at a price of $0.01 per right. At any time after
the acquisition by a person or group of 15% or more but less

52

than 50% of the common stock, the board may redeem all or part of the rights by
issuing common stock in exchange for them at the rate of one share of common
stock for each two shares of common stock for which each right is then
exercisable. The rights will expire on May 15, 2008 unless previously extended
or redeemed.

(15) CHANGE IN ACCOUNTING PRINCIPLE

Effective January 1, 2000, NATCO recorded the cumulative effect of a change
in accounting principle related to gains and losses on postretirement benefit
obligation. Prior to December 31, 2000, gains and losses that resulted from
experience or assumption changes were recorded as a charge to current income in
the period of the change. Under SFAS No. 106, "Employers' Accounting for
Postretirement Benefits Other Than Pensions," NATCO revised its method of
accounting for these gains and losses to amortize the net gain or loss that
exceeds 10% of the Company's adjusted postretirement benefit obligation over the
remaining life expectancy of the plan participants. The newly adopted accounting
principle is preferable in the circumstances because the deferral of unrealized
gains and losses is more common in practice and results in less volatility in
net periodic postretirement benefit cost. A gain of $10,000, net of tax, was
recorded in the consolidated statement of income as of December 31, 2000, as a
result of this change in accounting principle. The pro forma impact on earnings
of this change for the year ended December 31, 1999 was a reduction of $598,000.
See Note 16, Pension and Other Postretirement Benefits.

(16) PENSION AND OTHER POSTRETIREMENT BENEFITS

The Company has adopted SFAS No. 132, which revised disclosures about
pension and other postretirement benefit plans. Disclosures regarding pension
benefits represent the plan for certain union employees of a foreign subsidiary.
Disclosures regarding postretirement benefits represent health care and life
insurance benefits for employees who were retired when the Company was acquired
from C-E.

In December 1999, the Company entered into an agreement with Tyler and
Capricorn Investors L.P., through which the Company assumed responsibility for
the retired employee health and life insurance obligations of Tyler. The
liability accrued with respect to these obligations, as determined by an
independent actuarial firm, was $1.1 million. In consideration of this
agreement, Tyler paid the Company $475,000 in cash and assigned a portion of the
federal income tax refund due to Tyler in the amount of approximately $600,000.
Tyler remitted $600,000 in January 2000 as settlement of this arrangement.

In December 2000, NATCO changed the method used to record gains and losses
on its postretirement benefit obligation, which resulted in a gain of $10,000,
net of tax, for the year ended December 31, 2000, and an unrecognized loss of
$1.5 million. See Note 15, Change in Accounting Principle.

On May 1, 2001, the Company amended a postretirement benefit plan that
provided medical and dental coverage to retirees of a predecessor company. Under
the amended plan, retirees bear additional costs of coverage. Significant plan
changes include higher deductibles, prescription coverage under a drug card
program and the elimination of dental benefits. As of July 1, 2001, the Company
obtained a third-party valuation of its liability under this plan arrangement,
as amended. Based upon this valuation, the effect of this amendment was a $6.4
million reduction in the Company's postretirement benefit liability. As of
December 31, 2001, a cumulative unrecognized loss of $3.6 million existed
related to this postretirement benefit plan. In accordance with SFAS No. 106,
"Employers' Accounting for Postretirement Benefits Other Than Pensions," the
benefit associated with the plan amendment will be amortized to income as a
prior service cost adjustment over the remaining life expectancy of the plan
participants. Additionally, the cumulative unrecognized loss will be amortized
to expense over the remaining life expectancy of the plan participants.

In November 2001, the Company agreed to maintain benefits at pre-amendment
levels for a specified class of retirees in exchange for expense reimbursement
from the former sponsor of the postretirement benefit plan. The agreement
requires reimbursement of $79,000 per year for each of the four succeeding
years. Pursuant to this arrangement, the Company received $79,000 as
reimbursement of postretirement benefit expenses for 2001, and recorded a
receivable for the present value of the future benefits of $291,000.

53

In August 2001, the participants of the Canadian pension plan voted to
terminate contributions to the plan and receive actuarially determined cash
distributions. As of December 31, 2001, the Company had not formally announced
the termination of the pension plan, and continued to fund the plan based upon
plan provisions.

The following table sets forth the plan's benefit obligation, fair value of
plan assets, and funded status at December 31, 2001 and 2000.

Defined Contribution Plans. The Company and its subsidiaries each have
defined contribution pension plans covering substantially all nonunion hourly
and salaried employees who have completed three months of service. Employee
contributions of up to 3% of each covered employee's compensation are matched
100% by the Company, with an additional 2% of covered employee's compensation
matched at 50%. In addition, the Company may make discretionary contributions as
profit sharing contributions. Company contributions to the plan totaled $1.8
million, $1.4 million and $1.6 million for the years ended December 31, 2001,
2000 and 1999, respectively.

(17) OPERATING LEASES

The Company and its subsidiaries lease various facilities and equipment
under non-cancelable operating lease agreements. These leases expire on various
dates through September 2006, excluding a lease arrangement for a facility at
Axsia that requires lease commitments until the facility is sublet to another
party. Future minimum lease payments required under operating leases that have
remaining non-cancelable lease terms in excess of one year at December 31, 2001,
were as follows: 2002--$3.9 million, 2003--$3.3 million, 2004--$2.7 million,
2005--$811,000, and 2006--$674,000. Total expense for operating leases for the
years ended December 31, 2001, 2000 and 1999 was $5.3 million, $4.4 million and
$3.5 million, respectively.

For a discussion of lease and rental income, see Note 7, Property, Plant
and Equipment, net.

(18) RELATED PARTIES

The Company paid Capricorn Management, G.P., an affiliate company of
Capricorn Holdings, Inc., for administrative services, which included office
space and parking in Connecticut for the Company's Chief Executive Officer,
reception, telephone, computer services and other normal office support relating
to that space. Mr. Herbert S. Winokur, Jr., one of the Company's directors, is
the Chairman and Chief Executive Officer of Capricorn Holdings, Inc., and
directly or indirectly controls approximately 31% of the Company's common stock.
In addition, the Company's Chief Executive Officer, Mr. Gregory, is a
non-salaried member in Capricorn Holdings LLC, the general partner of Capricorn
Investors II, L.P., a private investment partnership. Capricorn Investors II,
L.P. controls approximately 20% of the Company's common stock. Fees paid to
Capricorn Management totaled $85,000, $75,000 and $75,000 for the years ended
December 31, 2001, 2000 and 1999, respectively. Commencing October 1, 2001, the
fee increased to $28,750 per quarter due primarily to upward adjustments in
Capricorn Management's underlying lease for office space; this increase was
reviewed and approved by the Audit Committee of the Company's Board of
Directors. As of December 31, 1999, the Company recorded a receivable from
Capricorn Management for $5,000 related to expenses paid on its behalf. No
receivable existed at December 31, 2001 or 2000.

For the year ended December 31, 1999, PTH paid $84,000 to the Company for
tax consulting and analysis services. No receivable from PTH existed at December
31, 2001 or 2000, as the tax consulting arrangement terminated during January
2000.

55

During 1997, the Company loaned $1.5 million (at a rate of 10% per annum)
to a director of the Company who was also an affiliate of Capricorn Holdings
Inc. In March 1998, the related promissory note was amended to change the
interest rate to 11% per annum. The principal was due on the date on which
Capricorn Investors L.P. distributed its holding of NATCO common stock to its
partners. During 1998, NATCO acquired an option at a cost of $200,000 to
purchase 173,050 shares of its common stock from the director at a price of
$8.81 per share. At NATCO's option, the note could be repaid with shares of the
Company's common stock. The cost to acquire the option was recorded as treasury
stock in the accompanying consolidated balance sheet. A note arrangement with a
director, recorded as a $1.9 million current asset at December 31, 1999, was
partially settled during February 2000, when the Company exercised an option to
purchase 173,050 shares of its common stock from this director at a cost of $1.5
million. The remaining balance of the note was repaid during June 2000.

Under the terms of an employment agreement in effect prior to 1999, the
Company loaned its Chief Executive Officer $1.2 million in July 1999 to purchase
136,832 shares of common stock. During February 2000, after the Company
completed an initial public offering of its Class A common stock, NATCO paid
this executive officer a bonus equal to the principal and interest accrued under
this note arrangement and recorded compensation expense of $1.3 million. The
officer used the proceeds of this settlement, net of tax, to repay the Company
approximately $665,000. The remaining loan balance and accrued interest was
$651,000 at December 31, 2001, and continues to accrue interest at 6% annually.
In addition, on October 27, 2000, the Company's board of directors agreed to
provide a full recourse loan to this executive officer to facilitate the
exercise of certain outstanding stock options. This loan matures on July 31,
2003, and provides interest stated at the Company's then-current borrowing rate,
and principal equal to the cost to exercise the options plus any personal tax
burdens that result from the exercise. As of December 31, 2001, the balance of
the note (principal and accrued interest) due from this officer under these loan
arrangements was $3.3 million. See Note 5, Unusual Charges.

During December 1999, the Company assumed the postretirement pension
liability of a former affiliate, Tyler. In February 2000, the Company received
$600,000 from Tyler as settlement of an agreement entered into between Tyler,
Capricorn Investors L.P. and the Company, whereby the Company assumed
responsibility for the retired employee health and life insurance obligations of
Tyler. See Note 16, Pension and Other Postretirement Benefits.

(19) COMMITMENTS AND CONTINGENCIES

The Porta-Test purchase agreement, executed in January 2000, contains a
provision to calculate a payment to certain former stockholders of Porta-Test
Systems, Inc. for a three-year period ended January 24, 2003, based upon sales
of a limited number of specified products designed by or utilizing technology
that existed at the time of the acquisition. Liability under this arrangement is
contingent upon attaining certain performance criteria, including gross margins
and sales volumes for the specified products. If applicable, payment is required
annually. In April 2001, the Company paid $226,000 under this arrangement
related to the year ended January 24, 2001. Any future liabilities incurred
under this arrangement will result in an increase in goodwill.

(20) CHANGE IN ACCOUNTING ESTIMATE

During April 2000, the Company extended the service life of a carbon
dioxide gas-processing plant based upon the extension of an agreement to operate
the facility. The effect on net income and basic and diluted earnings per share
before the cumulative effect of a change in accounting principle was an increase
of $305,000 and $.02, respectively, for the year ended December 31, 2000.

(21) LITIGATION

The Company is a party to various routine legal proceedings. These
primarily involve commercial claims, products liability claims and workers'
compensation claims. We cannot predict the outcome of these lawsuits, legal
proceedings and claims with certainty. Nevertheless, we believe that the outcome
of all of these

56

proceedings, even if determined adversely, would not have a material adverse
effect on our business or financial condition.

(22) INDUSTRY SEGMENTS AND GEOGRAPHIC INFORMATION

The Company has adopted the provisions of SFAS No. 131, "Disclosures About
Segments of an Enterprise and Related Information." The Company's business units
have separate management teams and infrastructures that offer different products
and services. The business units have been aggregated into three reportable
segments (described below) since the long-term financial performance of these
reportable segments is affected by similar economic conditions.

In the first quarter of 2001, the Company changed the presentation of its
reportable segments by combining the traditional production equipment and
services business segment with the NATCO Canada business segment, to form the
North American Operations business segment. This change has been retroactively
reflected in all periods presented.

North American Operations: This segment consists of the U.S. Sales &
Service business unit and the Company's Canadian subsidiary. The U.S. Sales &
Service business unit designs, engineers, manufactures, and provides start-up
services for production equipment, which is generally less complex than those
units provided by Engineered Systems, and provides replacement parts, field and
shop servicing of equipment, and used equipment refurbishing. NATCO Canada
provides design, engineering, manufacturing and start-up services for production
equipment, as well as replacement parts, field and shop servicing of equipment
and used equipment refurbishing. NATCO Canada also provides selective
manufacturing services for the Engineered Systems segment. The principal market
for the U.S. Sales & Service business unit is the U.S. onshore and offshore
market and the international market. Customers include major multi-national,
independent and national or state-owned companies. The principal markets for
NATCO Canada are the oil and gas producing regions of Canada. Customers include
major multi-national and independent companies.

Engineered Systems: This segment consists of five business units; U.S.
Engineered Systems, NTC Technical Services, NATCO Japan, NATCO Venezuela and
Axsia, that provide design, engineering, manufacturing and start-up services for
engineered process systems. The principal markets for this segment include all
major oil and gas producing regions of the world including North America, South
America, Europe, the Middle East, Africa and the Far East. Customers include
major multi-national, independent and national or state-owned companies.

Automation and Control Systems: TEST is the sole business unit reported in
this segment. This unit designs, manufactures, installs and services
instrumentation and electrical control systems. The principal markets for this
segment include all major oil and gas producing regions of the world including
North America, South America, Europe, Kazakhstan, Africa and the Far East.
Customers include major multi-national, independent and national or state-owned
companies. This segment was formerly named instrumentation and electrical
systems.

The accounting policies of the reportable segments are the same as those
described in Note 2. The Company evaluates the performance of its operating
segments based on income before net interest expense, income taxes, depreciation
and amortization expense, accounting changes and nonrecurring items. Summarized
financial information concerning the Company's reportable segments is shown in
the following table.

In July 2000, the Company changed its presentation of certain assets that
were acquired from Cynara in November 1998, and the related operating results,
for segment reporting purposes. The majority of the assets were reclassified to
the traditional production equipment and services business segment from the
engineered systems business segment. This change has been retroactively
reflected in all periods presented.

57

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

The Company's geographic data for continuing operations for the years ended
December 31, 2001, 2000 and 1999 were as follows:

Equipment for large international projects is generally manufactured in the
U.S. Therefore, revenues and results of operations related to these projects
were presented as derived from the United States for purposes of this geographic
presentation.

Corporate expenses consist of corporate overhead and research and
development expenses.

58

(23) QUARTERLY DATA

The following tables summarize unaudited quarterly information for the
years ended December 31, 2001, 2000 and 1999:

(24) OFFICE CLOSURE

Prior to 1997, the Company began winding down the operations of NATCO U.K.
Ltd. These activities include transferring the net assets and employees at the
Company's parts and service business to a new U.S. subsidiary, NATCO London,
Inc., and resolving pending severance, office closure and leasehold issues.
During 1999, the Company reached favorable settlements related to various
amounts owed to and by customers and vendors related to a number of contracts
entered into between 1993 and 1995. An accrual for the costs associated with
these various claims had been made during fiscal years 1995 through 1998 based
on the best available information at that time. As a result of favorable
settlements, the Company revised its previous estimates and reversed $314,000 of
these accruals during the year ended December 31, 1999.

(25) NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board ("FASB") approved
SFAS No. 141, "Business Combinations." This standard requires that any business
combination initiated after June 30, 2001 be accounted for using the purchase
method of accounting. This standard became effective on July 1, 2001. The
Company does not expect this pronouncement to have a material effect on its
financial condition or results of operations.

The FASB approved SFAS No. 142, "Goodwill and Other Intangible Assets" in
June 2001. This pronouncement requires that intangible assets with indefinite
lives, including goodwill, cease being amortized and be evaluated on an
impairment basis. Intangible assets with a defined term, such as patents, would
continue to be amortized over the useful life of the asset. This pronouncement
becomes effective on January 1,

59

2002, for companies with a calendar year end. The Company had net goodwill of
$80.9 million as of September 30, 2001. Goodwill amortization totaled $2.6
million for the nine months ended September 30, 2001. The Company has not yet
determined the impact that this pronouncement will have on its financial
condition or results of operations. As permitted by the standard, the Company
will determine and quantify its exposure under this pronouncement during fiscal
2002, after completing the required impairment testing.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This standard provides guidance on reporting and
accounting for obligations associated with the retirement of long-lived tangible
assets and the associated retirement costs. This standard is effective for
financial statements issued for fiscal years beginning after June 15, 2002. The
Company has not yet determined the impact that this pronouncement will have on
its financial condition or results of operations.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement replaces SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," and standardizes the accounting model to be used for
asset dispositions and related implementation issues. This pronouncement becomes
effective for financial statements issued for fiscal years beginning after
December 15, 2001. The Company has not yet determined the impact that this
pronouncement will have on its financial condition or results of operations.

(26) SUBSEQUENT EVENTS

On January 1, 2002, all outstanding shares of the Company's Class B common
stock, 334,719 shares, were converted to Class A common stock, on a share for
share basis, in accordance with the terms under which the Class B shares were
issued.

In February 2002, the Company borrowed $1.5 million from Wells Fargo Bank
N.A. under a promissory note arrangement that requires quarterly principal and
interest payments over a five-year term beginning May 2002, with interest
accruing at a variable rate of LIBOR + 3.25%. This obligation was collateralized
by the Magnolia manufacturing facility that was purchased in 2001.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

There are no changes or disagreements with accountants on accounting and
financial disclosure matters during the periods for which consolidated financial
statements have been presented within this document.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information on our directors is set forth in the section entitled
"Election of Directors" in the Proxy Statement for the Annual Meeting of
Stockholders to be held on May 23, 2002, which section is incorporated herein by
reference.

ITEM 11. EXECUTIVE COMPENSATION

The information for this item is set forth in the section entitled
"Director and Executive Management Compensation" in the Proxy Statement for the
Annual Meeting of Stockholders to be held on May 23, 2002, which section is
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information concerning security ownership of certain beneficial owners
and management is set forth in the sections entitled "Voting Securities and
Principal Holders Thereof" and "Security Ownership of Management" in the Proxy
Statement for the Annual Meeting of Stockholders to be held on May 23, 2002,
which sections are incorporated by reference.

60

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information concerning certain relationships and related transactions
is included under the caption "Certain Relationships and Transactions" in the
Proxy Statement for the Annual Meeting of Stockholders to be held on May 23,
2002, which sections are incorporated by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Index to Financial Statements, Financial Statement Schedules and
Exhibits

- ---------------

* Included herewith
** Management contracts or compensatory plans or arrangements.

63

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized, in the City of Houston, State of
Texas, on the 28th day of March 2002.

NATCO GROUP INC.
(Registrant)

/s/ NATHANIEL A. GREGORY
By:
--------------------------------------

Nathaniel A. Gregory
Chief Executive Officer and
Chairman of the Board of Directors

Pursuant to the requirements of the Securities Act of 1934, this report has
been signed below by the following persons in the capacities indicated, on March
28th, 2002.

64

EXHIBIT INDEX

- ---------------

* Included herewith
** Management contracts or compensatory plans or arrangements.