NATCO GROUP INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(MARK ONE)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002,

OR

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

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 1-15603

NATCO GROUP INC.
(Exact name of registrant as specified in its charter)

DELAWARE 22-2906892
(State or other jurisdiction of incorporation (I.R.S. Employer
or organization) Identification No.)

2950 NORTH LOOP WEST,
7TH FLOOR,
HOUSTON, TEXAS 77092
(Address of principal executive offices) (Zip Code)

713-683-9292
(Registrant's telephone number, including area code)

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

As of November 1, 2002, $0.01 par value per share, 15,803,797 shares

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NATCO GROUP INC.

FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002

TABLE OF CONTENTS

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PART I

ITEM 1. FINANCIAL STATEMENTS

NATCO GROUP INC. AND SUBSIDIARIES

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

See accompanying notes to unaudited condensed consolidated financial statements.

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NATCO GROUP INC. AND SUBSIDIARIES

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

See accompanying notes to unaudited condensed consolidated financial statements.

4

NATCO GROUP INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

See accompanying notes to unaudited condensed consolidated financial statements.

5

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) BASIS OF PRESENTATION

The accompanying condensed consolidated interim financial statements and
related disclosures are unaudited and have been prepared by NATCO Group Inc.,
("the Company") pursuant to generally accepted accounting principles for interim
financial statements and the rules and regulations of the Securities and
Exchange Commission. As permitted by these regulations, certain information and
footnote disclosures that would typically be required in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted. However, the Company's management believes that these
statements reflect all the normal recurring adjustments necessary for a fair
presentation, in all material respects, of the results of operations for the
periods presented, so that these interim financial statements are not
misleading. These condensed consolidated financial statements should be read in
conjunction with the financial statements and notes thereto included in the
Company's Form 10-K filing for the year ended December 31, 2001.

To prepare financial statements in accordance with generally accepted
accounting principles, the Company's management is required to make estimates
and assumptions that affect the reported amounts of assets and liabilities, and
disclosure of contingent assets and liabilities at the date of the financial
statements, and reported amounts of revenues and expenses incurred during the
reporting period. Actual results could differ from those estimates. Furthermore,
certain reclassifications have been made to fiscal year 2001 amounts in order to
present these results on a comparable basis with amounts for fiscal year 2002.
These reclassifications had no impact on net income.

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

(2) CAPITAL STOCK

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
originally issued. As of September 30, 2002, Class A Common Stock was the
Company's only class of equity securities outstanding.

During September 2001, the Company reacquired 39,700 shares of its Class A
common stock pursuant to a stock repurchase plan for $292,000, an average cost
of $7.35 per share. The cost to reacquire these shares was recorded as treasury
stock at September 30, 2001.

On February 1, 2001, NATCO issued 8,520 shares of Class B Common Stock to
the former shareholders of The Cynara Company ("Cynara"), in connection with the
achievement of certain performance criteria defined in the November 1998
purchase agreement. Goodwill was increased $85,000 as a result of this
transaction.

(3) EARNINGS PER SHARE

Basic earnings per share was computed by dividing net income by the weighted
average number of shares outstanding for the period. Diluted earnings per common
and potential common share was computed by dividing net income by the weighted
average number of common and potential common shares outstanding for the period.
For purposes of this calculation, outstanding employee stock options were
considered potential common shares. For the quarter ended September 30, 2002, no
potential common shares related to employee stock options were included in
diluted weighted average shares since the impact would have been a dilution of
the loss per share recorded. Diluted shares for the quarter ended September 30,
2001 included potential common shares related to employee stock options of
193,523 shares. For the nine months ended September 30, 2002 and 2001, diluted
shares included potential common shares related to employee stock options of
133,677 shares and 277,180 shares, respectively. Anti-dilutive stock options
were excluded from the calculation of potential common shares. For the quarter
ended September 30, 2002, all potential common shares related to employee stock
options, 115,179 shares, were anti-dilutive. If anti-dilutive shares were
included for the quarter ended September 30, 2001, the impact would have been a
reduction of 211,514 shares. Similarly, the impact of anti-dilutive shares for
the nine months ended September 30, 2002 and 2001, would have been a reduction
of 250,119 shares and 79,011 shares, respectively.

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(4) ACQUISITIONS

On March 19, 2001, the Company acquired all the outstanding share capital
of Axsia Group Limited ("Axsia"), a privately held 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 separation, 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
condensed consolidated financial statements since the date of acquisition. The
excess of the purchase price over the fair values of the net assets acquired was
being amortized over a twenty-year period, prior to the adoption of Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets" on January 1, 2002. See "Recent Accounting Pronouncements." Goodwill and
accumulated amortization related to the Axsia acquisition were $48.4 million and
$1.9 million, respectively, at September 30, 2002.

Assuming the Axsia acquisition occurred on January 1, 2001, the unaudited
pro forma results of the Company for the nine-month period ended September 30,
2001, 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 condensed 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, 2001, 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 Total Engineering Services Team, Inc.,
("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 proposed private placement of debt and recorded an unusual charge of
$680,000 for costs incurred related to the proposed offering.

(6) INVENTORIES

Inventories consisted of the following amounts:

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(7) COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS

Cost and estimated earnings on uncompleted contracts were as follows:

(8) LONG-TERM DEBT

The consolidated borrowings of the Company were as follows:

On March 16, 2001, the Company entered into a 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 the borrowing capacity in the U.K. from $5.0
million to $10.0 million. No other material modifications were made to the
agreement.

In July 2002, the Company's lenders approved the amendment of various
provisions of the term loan and revolving credit facility agreement, effective
April 1, 2002. This amendment revised certain restrictive debt covenants,
modified certain defined terms, allowed for future capital investment in the
Company's CO2 processing facility in West Texas, facilitates the issuance of up
to $7.5 million of subordinated indebtedness, increased the aggregate amount of
operating lease expense allowed during a fiscal year and permitted an increase
in borrowings under the export sales credit facility, without further consent,
up to a maximum of $20.0 million. These modifications will result in higher
commitment fee percentages and interest rates if the Funded Debt to EBITDA
ratio, as defined, exceeds 3 to 1.

Amounts borrowed under the term loan bear interest at a rate of 4.26% per
annum as of September 30, 2002. Amounts borrowed under the revolving portion of
the facility bear interest 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 the London Inter-bank Borrowing Rate ("LIBOR") plus
3.00% to a low of LIBOR plus 1.75% or, (2) a high of a base rate plus 1.50% to a
low of a base rate plus 0.25%.

NATCO will pay commitment fees of 0.30% to 0.625% per year depending upon
the ratio of funded debt to EBITDA, on the undrawn portion of the facility.

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The revolving credit facility is guaranteed by all of the Company's
domestic subsidiaries and is secured by a first priority lien on substantially
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.

On February 6, 2002, the Company borrowed $1.5 million under a long-term
promissory note. This note accrues interest at the 90-day LIBOR plus 3.25% per
annum, and requires quarterly payments of principal of approximately $24,000 and
interest for five years beginning May 2002. This promissory note is
collateralized by a manufacturing facility in Magnolia, Texas that the Company
purchased in the fourth quarter of 2001.

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 $5.7 million were outstanding at
September 30, 2002. Letters of credit outstanding under the export sales credit
facility as of September 30, 2002 totaled $548,000. The export sales credit
facility is secured by specific project inventory and receivables, and is
partially guaranteed by the EXIM Bank. The export sales credit facility loans
mature in July 2004.

As of September 30, 2002, the Company was in compliance with all restrictive
debt covenants. NATCO had letters of credit outstanding under the revolving
credit facilities totaling $16.6 million at September 30, 2002. These letters of
credit constitute contract performance and warranty collateral and expire at
various dates through September 2005.

The Company had unsecured letters of credit, guarantees and bonds totaling
$180,000 at September 30, 2002.

(9) INCOME TAXES

NATCO's effective income tax rate for the nine months ended September 30,
2002 was 34.9%, which exceeded the amount that would have resulted from applying
the U.S. federal statutory tax rate due to the impact of state income taxes,
foreign income tax rate differentials and certain permanent book-to-tax
differences.

(10) INDUSTRY SEGMENTS

The Company's operations are organized into three separate business
segments: North American operations, a segment which primarily provides
traditional, standard and small custom production equipment and components,
replacement parts, used equipment and components, equipment servicing and field
operating support including operations of the Company's domestic membrane
facility; engineered systems, a segment which primarily provides customized and
more complex technological equipment, large scale integrated oil and gas
production systems, and equipment and services provided by certain international
operations, including Axsia; and automation and control systems, a segment which
provides control panels and systems that monitor and control oil and gas
production, as well as installation and start-up and other field services
related to instrumentation and electrical systems.

The accounting policies of the reportable segments were consistent with the
policies used to prepare the Company's condensed consolidated financial
statements for the respective periods presented. Summarized financial
information concerning the Company's reportable segments is shown in the
following table.

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(11) COMMITMENTS AND CONTINGENCIES

The Porta-Test International, Inc. ("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 23, 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 January
2002, the Company accrued $219,000 under this arrangement for the year ended
January 23, 2002, resulting in an increase in goodwill, of which $197,000 was
paid in August 2002. In April 2001, the Company paid $226,000 in accordance with
the purchase agreement. Any future liabilities incurred under this arrangement
will be recorded to goodwill.

(12) NEW ACCOUNTING PRONOUNCEMENTS

The Financial Accounting Standards Board ("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.

The Company adopted SFAS No. 142 on January 1, 2002. Intangible assets
subject to amortization under the pronouncement as of September 30, 2002 and
2001 are summarized in the following table:

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Amortization and interest expense of $230,000 and $180,000 were recognized
related to these assets for the quarters ended September 30, 2002 and 2001,
respectively, and $639,000 and $463,000 for the nine-month periods ended
September 30, 2002 and 2001, respectively. The estimated aggregate amortization
and interest expense for these assets for each of the following five fiscal
years is: 2002 -- $790,000; 2003 -- $555,000; 2004 -- $270,000; 2005 --
$228,000; and 2006 -- $70,000. For segment reporting purposes, these intangible
assets and the related amortization expense were recorded under "Corporate and
Eliminations," excluding the employment contracts which were allocated between
the engineered systems and North American operations business segments.

Goodwill was the Company's only intangible asset that required no periodic
amortization as of the date of the adoption of SFAS No. 142. Net goodwill at
September 30, 2002 was $80.4 million. The pro forma impact of applying SFAS No.
142 to operating results for the quarter and nine-month period ended September
30, 2001, would have been a reduction of amortization expense of $1.1 million
and $2.6 million, respectively, resulting in net income of $2.8 million and $6.3
million, respectively, and an increase in basic and diluted earnings per share
of $.07 and $.17, respectively.

In accordance with SFAS No. 142, the Company tested impairment of goodwill.
Based upon the testing performed, management determined that goodwill was not
impaired as of September 30, 2002. Therefore, no impairment charge was recorded
under SFAS No. 142 as of September 30, 2002. Goodwill will be tested for
impairment annually on December 31.

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.

On January 1, 2002, the Company adopted 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 did not
have a material impact on the Company's financial condition or results of
operations.

In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections."
This statement provides guidance for income statement classification of gains
and losses on extinguishment of debt and accounting for certain lease
modifications that have economic effects that are similar to sale-leaseback
transactions. SFAS No. 145 is effective for the Company in January 2003. The
Company will apply this pronouncement to future transactions, if applicable.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit or Disposal
Activities," which addresses significant issues regarding the recognition,
measurement and reporting of costs that are associated with exit and disposal
activities, including restructuring activities that are currently accounted for
pursuant to the guidance set forth in EITF Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity." SFAS No. 146 is effective for the Company in January 2003. The
Company has not determined the impact that this pronouncement will have on its
financial condition or results of operations.

(13) POSTRETIREMENT BENEFITS

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, resulting in a cumulative unrecognized gain of $3.3 million.

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In accordance with SFAS No. 106, "Employers' Accounting for Postretirement
Benefits Other Than Pensions," this unrecognized gain will be amortized to
income over the remaining life expectancy of the plan participants.

(14) RELATED PARTY TRANSACTIONS

As previously agreed during 2001, the Company loaned an employee who is an
executive officer and director of the Company $216,000 on April 15, 2002, under
a full-recourse note arrangement which accrues interest at 6% per annum and
matures on July 31, 2003. The funds were used to pay tax burdens associated with
stock options exercised during 2001. Effective July 1, 2002, the note was
amended to extend the maturity date to July 31, 2004, and to require interest to
be calculated at an annual rate based on LIBOR plus 300 basis points, adjusted
quarterly, applied to the note balance as of June 30, 2002, including previously
accrued interest.

As of June 30, 2002, the Company had several outstanding notes receivable
from an employee who is an executive officer and director of the Company, with
principal and accrued interest totaling $3.4 million. The maturity of these
loans, which are full-recourse note arrangements, was July 31, 2003, and
interest accrued at rates ranging from 6% to 7.8% per annum. Effective July 1,
2002, the notes were amended to extend the maturity dates to July 31, 2004, and
to require interest to be calculated at an annual rate based on LIBOR plus 300
basis points, adjusted quarterly, applied to the notes balances as of June 30,
2002, including previously accrued interest.

(15) SUBSEQUENT EVENTS

As of November 4, 2002, the Company's management committed to a plan to
close a manufacturing and engineering facility in Edmonton, Alberta, Canada.
This plan includes the involuntary termination of plant workers and
administrative staff, the relocation of equipment and certain personnel to other
facilities and costs related to modifying certain operating lease arrangements.
The Company will begin implementing this plan during November 2002, and expects
to incur costs under this plan through the second quarter of 2003. The Company
recorded no liabilities related to this restructuring plan as of September 30,
2002, and has not yet quantified the overall cost of this restructuring.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Management's Discussion and Analysis includes forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (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 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 (see " -- Liquidity and Capital Resources"). The Company's expectations
about its business outlook, customer spending, oil and gas prices and the
business environment for the Company and the industry in general are only its
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 the Organization of
Petroleum Exporting Countries ("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 the Company operates.

The following discussion should be read in conjunction with the financial
statements, related notes and other financial information appearing elsewhere in
this Form 10-Q. Readers are also urged to carefully review and consider the
various disclosures advising interested parties of the factors that affect the
Company, including without limitation, the disclosures made under the caption
"Risk Factors" and the other factors and risks discussed in the Company's Annual
Report on Form 10-K as of December 31, 2001, and in subsequent reports filed
with the Securities and Exchange Commission. The Company expressly disclaims any
obligation or undertaking to release publicly any updates or revisions to any
Forward-Looking Statement to reflect any change in the Company's expectations
with regard thereto or any change in events, conditions or circumstances on
which any Forward-Looking Statement is based.

OVERVIEW

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

Our operations are organized into three separate business segments: North
American operations, a segment which primarily provides traditional, standard
and small custom production equipment and components, replacement parts, used
equipment and components, equipment servicing and field operating support
including operations of our domestic membrane facility; engineered systems, a
segment which primarily provides customized and more complex technological
equipment, large scale integrated oil and gas production systems, and equipment
and services provided by certain international operations, including Axsia; and
automation and control systems, a segment which provides control panels and
systems that monitor and control oil and gas production, as well as installation
and start-up and other field services related to instrumentation and electrical
systems.

CRITICAL ACCOUNTING POLICIES

The preparation of our consolidated financial statements requires management
to make certain estimates and assumptions that affect the results reported in
our consolidated financial statements and accompanying notes. These estimates
and assumptions are based on historical experience and on future expectations
that we believe to be reasonable under the circumstances. Note 2 to the
consolidated financial statements filed in our Annual Report on Form 10-K at
December 31, 2001, contains a summary of our significant accounting policies. We
believe the following accounting policy is the most critical in the preparation
of our condensed consolidated financial statements:

Revenue Recognition: Percentage-of-Completion Method. We recognize revenues
from significant contracts (greater than $250,000 and longer than four months in
duration) and all automation and control systems contracts and orders on the
percentage-of-completion method of accounting. Earned revenue is based on the
percentage that costs incurred to date relate to total estimated costs of the
project, after giving effect to the most recent estimates of total cost. The
timing of costs incurred, and therefore recognition of revenue, could be
affected by various internal or external factors including, but not limited to:
changes in project scope (change orders), changes in productivity, scheduling,
the cost and availability of labor, the cost and availability of raw materials,
the weather, client delays in providing approvals at benchmark stages of the

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project and the timing of deliveries from third-party providers of key
components. The cumulative impact of revisions in total cost estimate during the
progress of work is reflected in the period in which these changes become known.
Earned revenues reflect the original contract price adjusted for agreed claims
and change order revenues, if applicable. Losses expected to be incurred on the
jobs in progress, after consideration of estimated minimum recoveries from
claims and change orders, are charged to income as soon as such losses are
known. Claims for additional contract revenue are recognized if it is probable
that the claim will result in additional revenue and the amount can be reliably
estimated. We generally recognize revenue and earnings to which the
percentage-of-completion method applies over a period of two to six quarters. In
the event a project is terminated by our customer before completion, our
customer is liable for costs incurred under the contract. We believe that our
operating results should be evaluated over a term of several years to evaluate
performance under long-term contracts, after all change orders, scope changes
and cost recoveries have been negotiated and realized. We record revenues and
profits on all other sales as shipments are made or services are performed.

RECENT ACCOUNTING PRONOUNCEMENTS

The Financial Accounting Standards Board ("FASB") approved Statement of
Financial Accounting Standards ("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. We adopted
SFAS No. 142 on January 1, 2002, and continued to amortize certain net assets
totaling $1.8 million at September 30, 2002, and recorded amortization and
interest expense related to those assets for the quarter and nine-month period
ended September 30, 2002 of $230,000 and $639,000, respectively. We ceased
periodic amortization of goodwill on the date of adoption. Net goodwill at
September 30, 2002 was $80.2 million. The pro forma impact of applying SFAS No.
142 to operating results for the quarter and nine-month period ended September
30, 2001, would have been a reduction of amortization expense of $1.1 million
and $2.6 million, respectively, resulting in net income of $2.8 million and $6.3
million, respectively, and an increase in basic and diluted earnings per share
of $.07 and $.17, respectively.

In accordance with SFAS No. 142, we tested impairment of goodwill. Based
upon the testing performed, we determined that goodwill was not impaired as of
September 30, 2002. Therefore, no impairment charge was recorded under SFAS No.
142 as of September 30, 2002. Goodwill will be tested for impairment annually on
December 31.

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
related 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 April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections."
This statement provides guidance for income statement classification of gains
and losses on extinguishment of debt and accounting for certain lease
modifications that have economic effects that are similar to sale-leaseback
transactions. SFAS No. 145 is effective for us in January 2003. We will apply
this pronouncement to future transactions, if applicable.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit or Disposal
Activities," which addresses significant issues regarding the recognition,
measurement and reporting of costs that are associated with exit and disposal
activities, including restructuring activities that are currently accounted for
pursuant to the guidance set forth in EITF Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity." SFAS No. 146 is effective for us in January 2003. We have not yet
determined the impact that this pronouncement will have on our financial
condition or results of operations.

ACQUISITIONS

On March 19, 2001, we acquired all the outstanding share capital of Axsia
Group Limited ("Axsia"), a privately held 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 separation, hydrogen production and other process equipment
systems. This acquisition was financed with borrowings under our term loan
facility, and was accounted for using the purchase method of accounting. Results
of operations for Axsia have been included in our condensed consolidated
financial statements since the date of acquisition. The excess of the purchase
price over the fair values of the net assets acquired was being amortized over a
twenty-year period, prior to the adoption of SFAS No. 142. Goodwill and
accumulated amortization related to the Axsia acquisition were $48.4 million and
$1.9 million, respectively, at September 30, 2002.

14

INDUSTRY AND BUSINESS ENVIRONMENT

We are a leading provider of equipment, systems and services used in the
production of crude oil and natural gas, primarily at 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 of 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.

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. During periods of lower demand, 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.

Changes in commodity prices have impacted our business over the past several
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") for the
years ended December 31, 2001 and 2000, as well as data related to the
nine-month periods ended September 30, 2002 and 2001, derived from published
reports by the U.S. Department of Energy, and the rotary rig count, as published
by Baker Hughes Incorporated.

- ---------------------------
(a) Data projected for September 2002 using the historical average deviation
between published wellhead and West Texas Intermediate crude prices for
the period January 1, 2001 to August 31, 2002.

The spot price of West Texas intermediate crude oil per barrel as of
September 30, 2002 was above $30 per barrel, but declined to approximately $27
per barrel as of November 1, 2002. The spot price of Henry Hub natural gas at
September 30, 2002, was approximately $4 per mcf. The rotary rig count for North
America, as published by Baker Hughes Incorporated, was 1,109 operating rigs, as
of November 1, 2002.

Average commodity future price quotes for crude oil per barrel and Henry Hub
natural gas per mcf on the New York Mercantile Exchange for delivery throughout
the twelve months ended November 30, 2003 were approximately $25 and $4,
respectively, as of November 6, 2002.

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

RESULTS OF OPERATIONS

In the first quarter of 2001, we changed the presentation of our 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.

Three Months Ended September 30, 2002 Compared to Three Months Ended
September 30, 2001

Revenues. Revenues of $66.6 million for the three months ended September 30,
2002 decreased $8.0 million, or 11%, from $74.5 million for the three months
ended September 30, 2001. The following table summarizes revenues by business
segment for the quarters ended September 30, 2002 and 2001, respectively.

15

North American operations revenues decreased $6.6 million, or 17%, for the
quarter ended September 30, 2002, as compared to the quarter ended September 30,
2001, due to an overall market decline in the U.S. and Canada. North American
rig counts declined 24% from 1,472 operating rotary rigs as of September 28,
2001 to 1,112 operating rotary rigs as of September 27, 2002. As a result, we
experienced lower revenues for traditional equipment, finished goods and our
domestic parts and services. Third-party revenues for Canadian operations
continued to decline due to similar poor market conditions, as Canadian rig
counts remained low at 237 operating rigs as of September 30, 2002.
Inter-company revenues for this business segment were $837,000 for the quarter
ended September 30, 2002, as compared to $1.3 million for the quarter ended
September 30, 2001.

Revenues for the engineered systems business segment decreased $3.9 million,
or 14%, for the quarter ended September 30, 2002, as compared to the quarter
ended September 30, 2001. This decrease was primarily due to a decline in
revenues contributed by our European operations, which provided $17.9 million of
revenues for the quarter ended September 30, 2001 as compared to $12.0 million
for the quarter ended September 30, 2002. Offsetting this decline was an
increase in other engineered systems projects, primarily in West Africa and
Southeast Asia. Engineered systems revenues of $23.7 million for the quarter
ended September 30, 2002 included approximately $210,000 of inter-company
revenues, as compared to $580,000 of inter-company revenues for the quarter
ended September 30, 2001.

Revenues for the automation and control systems business segment increased
$1.8, or 16%, for the quarter ended September 30, 2002, as compared to the
quarter ended September 30, 2001. This increase in revenues was the result of an
increase in the number of jobs in progress in 2002 relative to 2001, including
deep-water projects in the Gulf of Mexico, several projects in Africa and
certain inter-company projects that resulted in slightly higher inter-company
sales. Inter-company sales increased from $858,000 for the quarter ended
September 30, 2001 to $1.0 million for the quarter ended September 30, 2002.

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

Gross Profit. Gross profit for the quarter ended September 30, 2002
decreased $5.7 million, or 28%, to $14.9 million, compared to $20.6 million for
the quarter ended September 30, 2001. As a percentage of revenue, gross margins
declined from 28% for the quarter ended September 30, 2001 to 22% for the
quarter ended September 30, 2002. The following table summarizes gross profit by
business segment for the quarters then ended:

Gross profit for the North American operations business segment decreased
$927,000, or 10%, for the quarter ended September 30, 2002, as compared to the
respective period in 2001. This decrease in margin was due primarily to a 17%
decline in revenues, partially offset by favorable margins on sales of
traditional equipment and domestic parts and services. As a percentage of
revenue, gross margins were 25% and 23% for the quarters ended September 30,
2002 and 2001, respectively.
16

Gross profit for the engineered systems business segment for the quarter
ended September 30, 2002 decreased $4.9 million, or 52%, primarily due to a 14%
decline in revenues for the engineered systems business segment, and the
completion of several higher margin projects during the quarter ended September
30, 2001. In addition, we experienced an increase in the under-absorption of
engineering overhead expense during the quarter ended September 30, 2002. Gross
margin as a percentage of revenues for engineered systems was 19% and 35% for
the quarters ended September 30, 2002 and 2001, respectively.

Gross profit for the automation and control systems business segment
increased $162,000, or 8%, for the quarter ended September 30, 2002, as compared
to the quarter ended September 30, 2001, due to a 16% increase in revenues for
the respective period. Gross margin as a percentage of revenue for the quarters
ended September 30, 2002 and 2001, was 17% and 19%, respectively.

Selling, General and Administrative Expense. Selling, general and
administrative expense of $13.3 million decreased $529,000, or 4%, for the
quarter ended September 30, 2002, as compared to the quarter ended September 30,
2001. This decrease was primarily related to a decline in research and
development expenditures and lower management incentive accruals tied to
profitability. Partially offsetting this decrease in expense was the cost
incurred during the quarter ended September 30, 2002, associated with our Mexico
office, opened in late 2001.

Depreciation and Amortization Expense. Depreciation and amortization expense
of $1.3 million for the quarter ended September 30, 2002, decreased $888,000, or
41%, compared to $2.2 million for the quarter ended September 30, 2001.
Depreciation expense of $1.3 million for the quarter ended September 30, 2002,
increased $258,000, or 25%, as compared to the respective period for 2001. This
increase was primarily due to the addition of capital assets purchased and
constructed during late 2001 and early 2002, including a significant expansion
of the Sacroc gas processing facility. Amortization expense for the quarter
ended September 30, 2002 was $17,000, as compared to $1.2 million for the
quarter ended September 30, 2001. This decline in amortization expense was
attributable to a change in accounting method prescribed by SFAS No. 142,
"Goodwill and Other Intangible Assets." This pronouncement, adopted on January
1, 2002, requires that goodwill no longer be amortized over a prescribed period
but rather intangible assets not assigned a useful life be evaluated annually
for impairment. See "Recent Accounting Pronouncements." Therefore, no goodwill
amortization was recorded for the quarter ended September 30, 2002, compared to
$1.1 million for the quarter ended September 30, 2001. The results for the third
quarter of 2001 also include amortization expense associated with certain
employment contracts that were fully amortized as of December 31, 2001.

Interest Expense. Interest expense was $1.3 million for the quarter ended
September 30, 2002, as compared to $1.5 million for the respective period in
2001. This decrease of $176,000, or 12%, was due primarily to a decline in the
weighted average interest rate on outstanding debt from 6.03% at September 30,
2001 to 4.44% at September 30, 2002.

Other, net. Other, net increased from a gain of $61,000 for the quarter
ended September 30, 2001, to a gain of $271,000 for the quarter ended September
30, 2002. The increase was primarily attributable to realized gains on foreign
currency exchange transactions associated with our Canadian operations.

Provision for Income Taxes. Income tax benefit for the quarter ended
September 30, 2002 was $427,000 compared to income tax expense of $1.5 million
for the quarter ended September 30, 2001. The primary reason for this decrease
in tax expense was a decline in income before income taxes, which was a loss of
$763,000 for the quarter ended September 30, 2002, as compared to income of $3.2
million for the respective period in 2001. The effective tax rate increased from
45.2% for the third quarter of 2001 to 56.0% for the third quarter of 2002.

Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001

Revenues. Revenues of $214.5 million for the nine months ended September 30,
2002 decreased $5.5 million, or 2%, from $220.0 million for the nine months
ended September 30, 2001. The following table summarizes revenues by business
segment for the nine-month periods ended September 30, 2002 and 2001,
respectively.

17

North American operations revenues decreased $6.4 million, or 6%, from
$110.8 million for the nine months ended September 30, 2001 to $104.4 million
for the nine months ended September 30, 2002. This decrease was due to an
overall market decline in the U.S. and Canada, as rig counts dropped from an
average of 1,569 operating rotary rigs for the nine months ended September 30,
2001 to an average of 1,081 operating rotary rigs for the nine months ended
September 30, 2002. This decrease in activity resulted in a decline in revenues
for sales of our traditional equipment, finished goods and domestic parts and
services. Third-party revenues for Canadian operations continued to decline due
to similar poor market conditions and certain project delays. Inter-company
revenues for this business segment were $2.4 million for the nine months ended
September 30, 2002, as compared to $3.6 million for the nine months ended
September 30, 2001.

Revenues for the engineered systems business segment remained relatively
constant for the nine months ended September 30, 2002, as compared to the nine
months ended September 30, 2001, as the completion of several projects in North
Africa and Southeast Asia were offset by bookings of new projects in late 2001
and early 2002. Engineered systems revenues of $79.1 million for the nine months
ended September 30, 2002 included approximately $923,000 of inter-company
revenues, as compared to $618,000 of inter-company revenues for the nine months
ended September 30, 2001.

Revenues for the automation and control systems business segment increased
$1.7 million, or 5%, from $36.2 million for the nine months ended September 30,
2001 to $37.9 million for the nine months ended September 30, 2002, primarily
due to an increase in the number of jobs in progress in 2002 relative to 2001,
including deep-water projects in the Gulf of Mexico, several projects in Africa
and certain inter-company projects which resulted in higher inter-company sales.
Inter-company sales increased from $2.8 million for the nine months ended
September 30, 2001 to $3.5 million for the nine months ended September 30, 2002.

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

Gross Profit. Gross profit for the nine months ended September 30, 2002
decreased $6.1, or 11%, to $50.8 million, compared to $56.9 million for the nine
months ended September 30, 2001. As a percentage of revenue, gross margins
declined from 26% for the nine months ended September 30, 2001, to 24% for the
nine months ended September 30, 2002. The following table summarizes gross
profit by business segment for the periods then ended:

Gross profit for the North American operations business segment increased
$417,000, or 2%, for the nine months ended September 30, 2002, as compared to
the respective period in 2001, despite a 6% decline in revenues for the business
segment. These margin improvements were attributable primarily to our Latin
American operations and favorable margins on domestic parts and services. As a
percentage of revenue, gross margins were 26% and 24% for the nine-month periods
ended September 30, 2002 and 2001, respectively.

18

Gross profit for the engineered systems business segment for the nine months
ended September 30, 2002 decreased $6.4 million, or 27%, compared to the nine
months ended September 30, 2001. This decrease was due to a 1% decline in
revenues for this business segment and a change in the sales mix for the
respective quarters, as several large higher-margin projects were nearing
completion in late 2001 and new project awards in 2002 were at more traditional
margin levels. Gross margin for engineered systems represented 21% and 29% of
the segment's revenues for the nine-month periods ended September 30, 2002 and
2001, respectively.

Gross profit for the automation and control systems business segment
decreased $125,000, or 2%, for the nine months ended September 30, 2002, as
compared to the nine months ended September 30, 2001, despite a 5% increase in
revenues earned by the business segment for the respective period. This decline
was attributable to an increase in lower-margin projects in 2002 and higher
inter-company sales. Gross margin as a percentage of revenue for the nine-month
periods ended September 30, 2002 and 2001, was 18% and 20%, respectively.

Selling, General and Administrative Expense. Selling, general and
administrative expense of $39.9 million increased $1.4 million, or 4%, for the
nine months ended September 30, 2002, as compared to the nine months ended
September 30, 2001. This increase was largely related to the following factors:
(1) nine months of operating expenses at Axsia during 2002 compared to less than
seven months operating expenses from the acquisition date through September 30,
2001, (2) start-up costs related to the Singapore office opened in March 2001 to
increase marketing efforts in Southeast Asia, and (3) start-up costs related to
the Mexico office opened in late-2001. Partially offsetting these increases was
a decline in management incentive accruals tied to profitability.

Depreciation and Amortization Expense. Depreciation and amortization expense
of $3.6 million for the nine months ended September 30, 2002, decreased $2.3
million, or 39%, compared to $6.0 million for the nine months ended September
30, 2001. Depreciation expense of $3.6 million for the nine months ended
September 30, 2002, increased $536,000, or 18%, as compared to the respective
period for 2001. This increase was primarily due to the acquisition of Axsia in
March 2001 and the addition of capital assets purchased and constructed during
late 2001 and early 2002, including the expansion of the Sacroc gas processing
facility. Amortization expense for the nine months ended September 30, 2002 was
$70,000, as compared to $2.9 million for the nine months ended September 30,
2001. This decline in amortization expense was attributable to a change in
accounting method prescribed by SFAS No. 142, "Goodwill and Other Intangible
Assets." This pronouncement, adopted on January 1, 2002, requires that goodwill
no longer be amortized over a prescribed period but rather intangible assets not
assigned a useful life be evaluated annually for impairment. See "Recent
Accounting Pronouncements." Therefore, no goodwill amortization was recorded for
the nine months ended September 30, 2002, compared to $2.6 million for the nine
months ended September 30, 2001. The results for the nine months ended September
30, 2001 also include amortization expense associated with certain employment
contracts that were fully amortized as of December 31, 2001.

Unusual Charges. Unusual charges for the nine months ended September 30,
2001 were $1.6 million, of which approximately $920,000 related to certain
restructuring costs to streamline activities and consolidate offices in
connection with our acquisition of Axsia in March 2001, and an additional
$680,000 related to our decision to withdraw a proposed private placement of
debt.

Interest Expense. Interest expense was $3.4 million for the nine months
ended September 30, 2002, as compared to $3.7 million for the respective period
in 2001. This decrease of $322,000, or 9%, was due primarily to a decline in the
weighted average interest rate on outstanding debt balanced from approximately
6.03% as of September 30, 2001 to approximately 4.44% as of September 30, 2002.

Interest Cost on Postretirement Benefit Liability. Interest cost on
postretirement benefit liability, related to a plan that provides medical and
dental coverage to retirees of a predecessor company, decreased $399,000, or
52%, from $766,000 for the nine months ended September 30, 2001 to $367,000 for
the nine months ended September 30, 2002. This decrease in interest cost was due
to a June 2001 amendment of this plan whereby retirees bear more cost for
coverage, reducing our projected liability and the related interest cost.

Other, net. Other, net increased from a gain of $46,000 for the nine months
ended September 30, 2001, to a gain of $236,000 for the nine months ended
September 30, 2002. The increase was primarily attributable to realized gains on
foreign currency exchange transactions associated with our Canadian operations.

Provision for Income Taxes. Income tax expense of $1.4 million for the nine
months ended September 30, 2002, decreased $1.6 from $3.0 million for the nine
months ended September 30, 2001. The primary reason for this decrease in tax
expense was a decrease in income before income taxes, which was $4.0 million for
the nine months ended September 30, 2002, as compared to $6.6 million for the
respective period in 2001. The effective tax rate declined from 44.8% for the
nine months ended September 30, 2001 to 34.9% for the nine months ended
September 30, 2002, due to the impact of eliminating non-deductible goodwill
amortization as per SFAS No. 142, "Goodwill and Other Intangible Assets." See
"Recent Accounting Pronouncements."

19

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2002, we had cash and working capital of $2.4 million
and $42.7 million, respectively, as compared to cash and working capital of $3.1
million and $37.1 million, respectively, at December 31, 2001.

Net cash provided by operating activities for the nine months ended
September 30, 2002 was $1.1 million, compared to $15.0 million for the nine
months ended September 30, 2001. Factors that contributed to the decrease in
cash provided by operating activities during 2002 included an increase in trade
accounts receivable and a decline in customer advance payments.

Net cash used in investing activities for the nine months ended September
30, 2002 was $4.3 million, of which $3.9 million was used for capital
expenditures. During the nine months ended September 30, 2001, $54.0 million was
used for investing activities primarily related to the acquisition of Axsia,
which required $48.2 million, and capital expenditures of $6.4 million.

Net cash provided by financing activities for the nine months ended
September 30, 2002 and 2001, was $2.0 million and $40.3 million, respectively.
The primary source of funds for financing activities for the nine months ended
September 30, 2002 was net borrowings of $6.6 million under long-term revolving
credit facilities and borrowings of $1.5 million under a new long-term debt
arrangement, offset by repayments of $5.3 million under long term facilities.
The primary source of funds for financing activities during the nine months
ended September 30, 2001 was borrowings of $50.0 million under the term loan
facility, partially offset by net repayments of $6.6 million under long-term
revolving credit facilities, repayments of $3.5 million under the term loan
facility and repayments of $1.0 million under short-term note arrangements.

We borrowed $1.5 million under a long-term promissory note arrangement on
February 6, 2002. This note accrues interest at the 90-day London Interbank
Offered Rate ("LIBOR") plus 3.25% per annum, and requires quarterly payments of
principal of approximately $24,000 and interest for five years beginning May
2002. This promissory note is collateralized by our manufacturing facility in
Magnolia, Texas that we purchased in the fourth quarter of 2001.

On March 16, 2001, we entered into a 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, we 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 our borrowing capacity in the U.K. from $5.0
million to $10.0 million. No other material modifications were made to the
agreement.

In July 2002, our lenders approved the amendment of various provisions of
the term loan and revolving credit facility agreement, effective April 1, 2002.
This amendment revised certain restrictive debt covenants, modified certain
defined terms, allowed for future capital investment in our CO2 processing
facility in West Texas, facilitates the issuance of $7.5 million of subordinated
debt, increased the aggregate amount of operating lease expense allowed during a
fiscal year and permitted an increase in borrowings under the export sales
credit facility, without further consent, up to a maximum of $20.0 million.
These modifications will result in higher commitment fee percentages and
interest rates if the Funded Debt to EBITDA ratio, as defined, exceeds 3 to 1.

Amounts borrowed under the term loan facility bear interest at 4.26% per
annum as of September 30, 2002. Amounts borrowed under the revolving facilities
bear interest at a rate based upon the ratio of funded debt to EBITDA (as
defined in the credit facility) and ranging from, at our election, (1) a high of
LIBOR plus 3.00% to a low of LIBOR plus 1.75% or, (2) a high of a base rate plus
1.50% to a low of a base rate plus 0.25%.

As of September 30, 2002, the weighted average interest rate of our
borrowings under the revolving credit facilities was 4.75%.

We will pay commitment fees of 0.30% to 0.625% per year, depending upon the
ratio of funded debt to EBITDA, on the undrawn portion of the facility.

The revolving credit facility is guaranteed by all of our domestic
subsidiaries and is secured by a first priority lien on substantially all
inventory, accounts receivable and other material tangible and intangible
assets. We have also pledged 65% of the voting stock of our active foreign
subsidiaries.

On March 19, 2001, we borrowed the entire $50.0 million available under the
term loan portion of the facility and used $45.0 million to purchase all the
outstanding share capital of Axsia. The remaining borrowings of $5.0 million,
along with additional borrowings under the revolving credit facility, were used
to repay $16.5 outstanding under a predecessor revolving credit and term loan
facility. As of September 30, 2002, we had borrowings of $39.5 million
outstanding under the term loan facility.

20

As of September 30, 2002, we were in compliance with all restrictive debt
covenants. We had letters of credit outstanding under the revolving credit
facilities totaling $16.6 million at September 30, 2002. These letters of credit
constitute contract performance and warranty collateral and expire at various
dates through September 2005.

We maintain 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 $5.7 million were outstanding as of September 30,
2002. Letters of credit outstanding under this facility at September 30, 2002
totaled $548,000. The export sales credit facility is secured by specific
project inventory and receivables, and is partially guaranteed by the EXIM Bank.
The export sales credit facility loans mature in July 2004.

We had unsecured letters of credit, guarantees and bonds outstanding at
September 30, 2002 of $180,000.

Our sales backlog at September 30, 2002 was $108.3 million compared to $95.7
million at September 30, 2001. Backlog increased primarily due to new project
bookings for engineered systems in late 2001 and throughout 2002, which offset a
decline in bookings for traditional equipment and electrical equipment and
instrumentation products.

At September 30, 2002, borrowing base limitations and outstanding letters of
credit reduced our available borrowing capacity under the term loan and
revolving credit agreement and export sales credit agreement to $25.3 million
and $440,000, respectively. We are actively considering a capital investment at
our CO2 processing plant in West Texas that would require additional cash
outlays beginning in late 2002. We are currently reviewing financing
alternatives and may consider, for instance, asset-backed debt related to the
Sacroc gas processing operation and various forms of subordinated debt, some of
which might include stock purchase warrants. Each of these alternatives will
require the approval of our senior secured lenders. Additionally, there is no
assurance we will remain in compliance with existing restrictive loan covenants
and, therefore, may be required to request amendments or waivers of some or all
of these covenants in the future. We believe these amendments or waivers can be
obtained, if necessary, on reasonable terms. Although no assurances can be
given, we believe that our operating cash flow, supported by our borrowing
capacity and additional financing obtained for capital investment, will be
adequate to fund operations for at least the next twelve months. Should we
decide to pursue acquisition opportunities, the determination of our ability to
finance these acquisitions will be a critical element of the analysis of the
opportunities.

RELATED PARTY TRANSACTIONS

As previously agreed during 2001, we loaned an employee who is an executive
officer and director of the Company $216,000 on April 15, 2002, under a
full-recourse note arrangement which accrues interest at 6% per annum and
matures on July 31, 2003. The funds were used to pay tax burdens associated with
stock options exercised during 2001. Effective July 1, 2002, the note was
amended to extend the maturity date to July 31, 2004, and to require interest to
be calculated at an annual rate based on LIBOR plus 300 basis points, adjusted
quarterly, applied to the note balance as of June 30, 2002, including previously
accrued interest.

As of June 30, 2002, we had several outstanding notes receivable from an
employee who is an executive officer and director of the Company, with principal
and accrued interest totaling $3.4 million. The maturity of these loans, which
are full-recourse note arrangements, was July 31, 2003, and interest accrued at
rates ranging from 6% to 7.8% per annum. Effective July 1, 2002, the notes were
amended to extend the maturity dates to July 31, 2004, and to require interest
to be calculated at an annual rate based on LIBOR plus 300 basis points,
adjusted quarterly, applied to the notes balances as of June 30, 2002, including
previously accrued interest.

21

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our operations are conducted around the world in a number of different
countries. Accordingly, future earnings are exposed to changes in foreign
currency exchange rates. The majority of our foreign currency transactions
relate to operations in Canada and the U.K. In Canada, most contracts are
denominated in Canadian dollars, and most of the costs incurred are in Canadian
dollars, thereby mitigating risks associated with currency fluctuations. In the
U.K., many of our sales contracts and material purchases are denominated in a
currency other than British pounds sterling, primarily U.S. dollars and euros,
whereas our engineering and overhead costs are principally denominated in
British pounds sterling. Consequently, we have currency risk in our U.K.
operations. No forward contracts or other derivative arrangements existed at
September 30, 2002, and we do not currently intend to enter into forward
contracts or other derivative arrangements as part of our currency risk
management strategy.

Our financial instruments are subject to change in interest rates, including
our revolving credit and term loan facility and our working capital facility for
export sales. At September 30, 2002, we had borrowings of $39.5 million
outstanding under the term loan portion of the revolving credit and term loan
facility, at an interest rate of 4.26%. Borrowings, which bear interest at
floating rates, outstanding under the revolving credit agreement at September
30, 2002, totaled $14.8 million. As of September 30, 2002, the weighted average
interest rate of our borrowings under revolving credit facilities was 4.75%.
Borrowings under the working capital facility for export sales at September 30,
2002 totaled $5.7 million and accrued interest at 4.75%. Borrowings under the
long-term arrangement secured by our Magnolia manufacturing facility totaled
$1.4 million at September 30, 2002, and accrued interest at 5.00%.

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

22

ITEM 4. CONTROLS AND PROCEDURES

CONTROLS AND PROCEDURES

Members of our management team, including our chief executive officer and
chief financial officer, have reviewed our disclosure controls and procedures,
as defined by the Securities and Exchange Commission in Rule 13a-14(c) of the
Securities Exchange Act of 1934, within 90 days of this Quarterly Report on Form
10-Q, in an effort to evaluate the effectiveness of the design and operation of
these controls. Based upon this review, our management has determined that
disclosure controls and procedures operate such that important information is
collected in a timely manner, provided to management and made known to our chief
executive officer and chief financial officer, as appropriate, to allow timely
decisions regarding disclosure in our public filings.

In addition, no significant changes have been made to our internal controls
and procedures subsequent to September 30, 2002, and no corrective actions are
anticipated as we noted no significant deficiencies or material weaknesses in
our control structure.

23

PART II

ITEM 1. 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, 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 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

The certifications by our chief executive officer and chief financial
officer required by Section 906 of the Sarbanes-Oxley Act of 2002 have been
provided to the Securities and Exchange Commission accompanying this Quarterly
Report on Form 10-Q.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) See Index of Exhibits for a list of those exhibits filed herewith, which
index includes and identifies management contracts or compensatory plans
or arrangements required to be filed as exhibits to this Form 10-Q by
Item 601(10)(iii) of Regulation S-K.

(b) Reports on Form 8-K. We filed no reports on Form 8-K during the three
months ended September 30, 2002.

(c) Index of Exhibits

- ----------
** Management contracts or compensatory plans or arrangements.

26

SIGNATURES

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

NATCO Group Inc.
(Registrant)

By: /s/ J. MICHAEL MAYER
-----------------------------------
Name: J. Michael Mayer
Senior Vice President and
Chief Financial Officer

Date: November 13, 2002

By: /s/ RYAN S. LILES
-----------------------------------
Name: Ryan S. Liles
Vice President and Controller
(Principal Accounting Officer)

Date: November 13, 2002

27

CERTIFICATIONS

I, Nathaniel A. Gregory, certify that:

1. I have reviewed this quarterly report on Form 10-Q of NATCO Group Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:

a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;

b. evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and

c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):

a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and

b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.

Date: November 13, 2002
------------------

/s/ NATHANIEL A. GREGORY
-----------------------------------
Nathaniel A. Gregory
Chief Executive Officer

28

CERTIFICATIONS

I, J. Michael Mayer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of NATCO Group Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:

a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;

b. evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and

c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):

a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and

b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.

Date: November 13, 2002
------------------

/s/ J. MICHAEL MAYER
-----------------------------------
J. Michael Mayer
Chief Financial Officer

29

EXHIBIT INDEX

- ----------
** Management contracts or compensatory plans or arrangements.

31