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, 2002 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. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes ___ No X

State the aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was last sold, or the average bid and asked price of such common equity as of
the last business day of the registrant's most recently completed second fiscal
quarter.

As of June 30, 2002 $80,911,175

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 10, 2003 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 2003 Annual Meeting of Shareholders, which the
Registrant intends to file within 120 days of December 31, 2002, 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, 2002

TABLE OF CONTENTS

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PART I

ITEM 1. BUSINESS

NATCO Group Inc. 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, gas and water 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 hydrates from forming in gas streams and reduce
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, gas and water production and processing systems; and

- automation and control systems, which provides and services control
panels and systems that monitor and control oil and gas production, as
well as repair, testing and inspection services for existing systems.

We have designed, manufactured and marketed production equipment and
systems for more than 75 years. We operate eight primary manufacturing
facilities located in the U.S. and Canada and 36 sales and service facilities,
34 of which are located in the U.S. and Canada, and two 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.

General information about us can be found at www.natcogroup.com. Our Annual
Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form
8-K, as well as any amendments and exhibits to those reports, are available free
of charge through our website as soon as reasonably practicable after we file
them with, or furnish them to, the SEC.

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;

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- the quality of new hydrocarbon production; and

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

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, petroleum and natural gas consumption are expected
to increase at average rates of 1.7% and 1.8%, respectively, per year in
the United States through 2025, with higher consumption rates expected
worldwide.

- Long-term demand for oil and gas products should lead to increases in
drilling activity. The number of drilling rigs operating in North
America and internationally has fluctuated in recent years, depending on
market conditions. The average North American rig count for 2002 was
1,093 versus 1,497 for 2001 and 1,263 for 2000, as published by Baker
Hughes Incorporated. The international rig count as of December 31, 2002,
2001 and 2000 was 753, 752 and 705, respectively, as published by Baker
Hughes Incorporated. Although North American rig counts declined during
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, 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 more than
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, oil-water emulsion treatment using dual-polarity
electrostatic technology, seawater injection systems and complex produced
oily water treatment systems. We hold 35 active U.S. and equivalent
foreign patents and continue to invest in research and development.
Applications have been filed for nine additional patents in the U.S.

- 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 senior 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 grow our business and integrate acquisitions.

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Additionally, our management team has a substantial financial interest in
our continued success through equity ownership or incentives.

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. We intend to achieve this goal 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 expenditures is generally dependent on the industry's view of
future 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");

- political environment, including the threat of war and terrorism;
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- the cost of producing oil and gas;

- technological advances;

- relatively minor changes in the supply of and demand for oil and natural
gas; and

- weather conditions.

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 $28.8 million, or 10% of total revenues, provided by
ExxonMobil Corporation and affiliates, $17.2 million, or 6% of revenues,
provided by BP and affiliates excluding the Carigali-Triton Operating Company
SDN BHD ("CTOC"), and $16.5 million, or 5%, provided by ChevronTexaco Corp. and
affiliates, for the year ended December 31, 2002. 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. The CTOC
project provided $10.9 million, or 4% of total revenues, for fiscal 2001. The
CTOC project was a $73.0 million contract awarded in 1999 to supply gas treating
and conditioning equipment for a project in Southeast Asia, and was
substantially complete as of December 31, 2001. The CTOC project provided
approximately 20% of our revenues in 2000.

We have a number of ongoing relationships with major oil companies,
national oil companies and large independent producers. The loss of one or more
of these ongoing relationships could have an 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, 2002, we had backlog of $90.1 million, of which
approximately 32% related to ExxonMobil Corporation and affiliates, 13% related
to ChevronTexaco Corp. and affiliates and 6% related to Snamprogetti.

We cannot guarantee 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 can fluctuate
in line with overall activity levels within our industry. 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, 2002, 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 539 retirees and surviving eligible dependents covered by the
specified postretirement benefit obligations. As of December 31, 2002, our
accumulated pre-tax postretirement benefit obligation was calculated to be
approximately $12.7 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 throughout the
world. We are, therefore, subject to the risks customarily attendant to
international operations and investments in foreign countries. Moreover, oil and
gas producing regions in which we operate include many countries in the Middle
East and other less developed parts of the world, where risks have increased
significantly in the recent past. We cannot accurately predict whether these
risks will increase or abate as a result of current military action in Iraq.
These risks include:

- nationalization;

- expropriation;

- war, terrorism 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.
Further, we may experience restrictions in travel to visit customers or start-up
projects, and we incur added costs by implementing security precautions. An
interruption of our

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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.

Axsia 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 Food-for-Oil
Program. Current outstanding receivables related to the Food-for-Oil Program,
which amounted to $711,000 at December 31, 2002, are supported by letters of
credit issued on Western banks and sanctioned by the United Nations. Axsia's
sales to customers in Embargoed Countries were approximately 3 1/2% of our
consolidated revenue in 2002 and approximately 2 1/2% of consolidated revenue in
2001.

FUTURE ACQUISITIONS, IF ANY, 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 businesses. We cannot
assure you that we will be able to successfully identify suitable acquisition
opportunities or to 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 AGAINST US OR
MAY BE INSUFFICIENT IN AMOUNT TO COVER SUCH 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 may 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.

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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, 2002, we had provided to our
customers approximately $6.0 million in letters of credit related to warranties.
We have received warranty claims in the past, 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.

OUR ABILITY TO SECURE AND RETAIN NECESSARY FINANCING MAY BE LIMITED.

Our ability to execute our growth strategies may be limited by our ability
to secure and retain reasonably priced financing. From time to time we have
utilized significant amounts of letters of credit to secure our performance on
large projects as well as provide warranties to our customers. Outstanding
letters of credit can consume a significant portion of our available liquidity
under our revolving credit facilities. Some of our competitors are larger
companies with better access to capital, which could give them a competitive
advantage over us should our access to capital be limited. Additionally, the
industry in which we compete is often characterized by significant cyclical
fluctuations in activity levels that can adversely impact our financial results.
Our revolving credit and term loan facilities contain restrictive loan covenants
with which we are required to comply. There is no assurance that our financial
results will be adequate to ensure we remain in compliance with these covenants
in the future, nor is there any assurance we can obtain amendments to or waivers
of these covenants should we not be in compliance.

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, state or foreign 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.

Our revenues are substantially 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.

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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;

- our technology;

- 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;

- 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 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 throughout 2001 due to a world-wide recession,
which was exacerbated by significant terrorist acts in the United States during
September 2001. Slower than expected economic growth in the United States during
2002, as well as in other regions of the world, contributed to a decline in
exploration and production activity in the oil and gas industry. 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

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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 traditional production equipment and services through 28 sales and
service centers in the United States, six in Canada, one in Mexico and one in
Venezuela.

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 and/or to coalesce liquids;

- 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;

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- salt bath heaters used to heat high pressure natural gas streams to
elevated temperatures above that obtained with indirect 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;

- Paques(TM) and Shell-Paques(TM) licensed desulfurization technology,
which utilizes a biological system to efficiently take hydrogen sulfide
out of gas streams;

- 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.

- 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
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

12

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.

- 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.

- 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 engineered systems through our direct sales forces based in
Houston, Texas; Calgary, Alberta, Canada; Camberley, England; Redruth, England;
Gloucester, England; Caracas, Venezuela; Singapore; and Tokyo, Japan, augmented
by independent representatives in other countries. We also use the unique oil
testing capabilities at our research and 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, during 2002, we designed, manufactured
and assembled a module for a production facility situated off the coast
of West Africa that is capable of processing 250,000 barrels of oil per
day.

- 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 and manufacture gas-processing facilities that remove carbon
dioxide from hydrocarbon streams. These facilities use Cynara(R) membrane
technology, which provides the most cost-effective separation solution
for hydrocarbon 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.

- 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.

- 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.
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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. This technology
reduces the number and size of vessels employed by this system and is
particularly important in refinery and offshore applications where space
is at a premium.

- Water Injection Systems. We provide water injection systems used both
onshore and offshore to remove contaminants from water to be injected
into a reservoir during production so that the formation or its
production characteristics are not adversely affected. These systems may
involve media and cartridge filters, deaeration, chemical injection and
sulfate removal. Offshore facilities to treat raw seawater involving use
of sulfate removal membranes can be and often are very large projects,
and are increasingly necessary for field development in locations such as
West Africa. Water injection systems may also use our compact SeaJect(TM)
oxygen removal systems.

- Oily Water Cleanup Systems. We design and engineer systems that, through
the use of liquid/liquid hydro-cyclone 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. Through our
subsidiary operation in Camberley, England, we also design and supply
process facilities for hydrogen generation and purification, for use in
refineries and petrochemical plants or by industrial gas suppliers. In
addition, we can provide DOX(TM) units to ethylene processors that clean
both heavy and light dispersed oil from water.

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, 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 eight 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 three.

14

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 skid-mounted 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 skid packages at this 38,000 square foot facility. This
facility also refurbishes used equipment.

- 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.

Our manufacturing operations are vertically integrated. At most locations,
we are able to engineer, fabricate, heat treat, inspect and test our products.
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. This certification 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 re-certification.

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;

15

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

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

- the Mozley Sandspin(TM) solid/liquid hydro-cyclones 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;

- PERFORMAX(R) oil and water treating systems;

- SeaJect(TM) compact seawater deoxygenation system for removal of oxygen
in injection facilities; and

- Enhancements in Cynara(R) membrane fibers to allow for increased acid gas
separation efficiencies.

Our internal designs and devices used inside separators and other vessels
to compensate for wave motion have 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, 2002, we held 35 active U.S.
and equivalent foreign patents and numerous U.S. and foreign trademarks. We also
have applications pending for nine 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 facility 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 facilities
in the United Kingdom, where we primarily focus on water treatment developments.

At December 31, 2002, NATCO had 22 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 34 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 2002, ExxonMobil Corporation
and affiliates, BP and affiliates excluding CTOC, and ChevronTexaco Corp. and
affiliates, provided 10%, 6% and 5% of our consolidated revenues, respectively.
No other customer provided more than 5% of our consolidated revenues during
2002. 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.
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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, 2002, 2001 and 2000, were $90.1 million,
$101.3 million and $49.9 million, respectively. Backlog at December 31, 2002
included $28.7 million related to ExxonMobil Corporation and affiliates, and
$11.7 million for ChevronTexaco Corp. Backlog at December 31, 2001 included
$27.4 million for ExxonMobil Corporation and affiliates, and $11.1 million for a
North Sea consortium. Backlog at December 31, 2000 included $12.5 million
related to CTOC.

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.

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 our results of operations.

The primary competitors in the traditional production equipment and
services business include Hanover Compressor Corp., as well as numerous
privately held, mainly regional companies. Competitors in our engineered systems
business include Petreco, 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

17

environmental matters of any nature and are not aware of any material
environmental matters threatened against us.

EMPLOYEES

At December 31, 2002, we had approximately 1,700 employees. Of these,
approximately 80 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 eight 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, 2002, we owned or leased approximately 1.1 million square
feet of facility of which approximately 501,000 square feet was leased, and
approximately 551,000 square feet was owned. Of the total manufacturing space,
approximately 278,000 square feet was located in the United States and
approximately 100,000 square feet was located in Canada.

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 2002.

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 10, 2003. The number of record holders
of our common stock was 73 at March 10, 2003. 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.

18

There were 5,000,000 shares of preferred stock authorized at March 10, 2003. On
March 13, 2003, we agreed to sell 15,000 shares of our Series B Convertible
Preferred Stock to a private investment fund. We expect this transaction to
close prior to the end of March 2003. See "Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations--Commitments and
Contingencies." 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 common stock reported by the NYSE. No
information is provided for the period prior to our initial public offering of
our common stock on January 27, 2000.

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 restricts our ability to pay dividends and
other distributions.

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.

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;

20

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

- automation and control systems, through which we provide control panels
and systems that monitor and control oil and gas production, as well as
repair, testing and inspection services for existing systems.

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
acquisitions (see "--Acquisitions"), indicated trends in the level of oil and
gas exploration and production and the effect of such conditions on our 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 2003. Our expectations about our business
outlook, customer spending, oil and gas prices and the business environment for
the industry, in general, and us, in particular, 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 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 Annual Report on 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 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 AND ESTIMATES

The preparation of our consolidated financial statements requires us 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 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 policies are the most
critical in the preparation of our consolidated financial statements.

21

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 certain 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 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 an availability of raw materials,
the weather, client delays in providing approvals at benchmark stages of the
project and the timing of deliveries from third-party providers of key
components. The cumulative impact of revisions in total cost estimates during
the progress of work is reflected in the period in which these changes become
known. Earned revenue reflects the original contract price adjusted for agreed
claims and change order revenues, if applicable. Losses expected to be incurred
on the jobs in progress, after consideration of estimated probable minimum
recoveries from claims and change orders, are charged to income as soon as such
losses are known. Claims for additional contract revenue are recognized if it is
probable 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
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.

Impairment Testing: Goodwill. As required by Statement of Financial
Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets,"
we evaluate goodwill annually for impairment by comparing the fair value of
operating assets to the carrying value of those assets, including any related
goodwill. As required by SFAS No. 142, we identify separate reportable units for
purposes of this evaluation. In determining carrying value, we segregate assets
and liabilities that, to the extent possible, are clearly identifiable by
specific reportable unit. All inter-company receivables/payables are excluded.
Certain corporate and other assets and liabilities, that are not clearly
identifiable by specific reportable unit, are allocated based on the ratio of
each unit's net assets relative to total net assets. The fair value is then
compared to the carrying value of the reportable unit to determine whether or
not impairment has occurred at the reportable unit level. In the event an
impairment is indicated, an additional test is performed whereby an implied fair
value of goodwill is determined through an allocation of the fair value to the
reporting unit's assets and liabilities, whether recognized or unrecognized, in
a manner similar to a purchase price allocation, in accordance with SFAS No.
141, "Business Combinations." Any residual fair value after this purchase price
allocation would be assumed to relate to goodwill. If the carrying value of the
goodwill exceeded the residual fair value, we would record an impairment charge
for that amount. Net goodwill was $79.0 million at December 31, 2002. No
impairment charge was recorded as of December 31, 2002.

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, as Class B Common Stock, which was converted to Class
A Common Stock, on a share-for-share basis, prior to December 31, 2002.

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.

22

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 hydro-cyclone 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.

In March 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 equipment for water re-injection systems for oil and gas
fields, oily water treatment, oil separation, hydrogen production and other oil
and gas processing 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 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"), 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:

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

(1)Average wellhead price of natural gas per mcf in the U.S. for the period
January 1, 2002 through November 30, 2002.

At December 31, 2002, the spot price of West Texas Intermediate crude oil
was $31.17 per barrel, the price of natural gas was $4.75 per mcf, and the U.S.
rig count was 862. At February 28, 2003, the spot price of West Texas
Intermediate crude oil was $36.98 per barrel, the price of Henry Hub natural gas
was $8.00 per mcf, as per the New York Mercantile Exchange, and the U.S. rig
count was 912, per Baker Hughes Incorporated. These spot prices reflect the
overall volatility of oil and gas commodity prices in the current and recent
years. Although increased commodity prices generally correlate directly with an
increase in spending by oil and gas companies for exploration and development
efforts, rig counts remain lower than expected based on historical experience.

From a longer-term perspective, the U.S. Department of Energy estimates
that U.S. demand for petroleum products will grow at an average annual rate of
1.7% through 2025 and that U.S. demand for natural gas will increase at an
average annual rate of 1.8% through 2025. As demand grows and reserves in the
United States decline, producers and service providers in the oil and gas
industry may continue to rely more

23

heavily on global sources of energy and expansion into new markets. The industry
continues to seek more innovative and technologically efficient means to extract
hydrocarbons from existing fields, as production profiles change. As a result,
additional and more complex equipment may be required to produce oil and gas
from these fields, especially since many new oil and gas fields produce lower
quality or contaminated hydrocarbon streams, requiring more complex production
equipment. In general, these trends should increase the demand for our products
and services.

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

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001

Revenues. Revenues for the year ended December 31, 2002 increased $3.0
million, or 1%, to $289.5 million, from $286.6 million for the year ended
December 31, 2001. The following table summarizes revenues by business segment
for the years ended December 31, 2002 and 2001, respectively:

24

Revenues from our North American operations business segment for the year
ended December 31, 2002 decreased $7.8 million, or 5%, to $137.4 million from
$145.1 million for the year ended December 31, 2001. This decrease was directly
related to a decline in oilfield activity throughout 2002. The average North
American rotary rig count declined from 1,497 for the year ended December 31,
2001 to 1,093 for the year ended December 31, 2002. Although revenues for our
traditional equipment and finished goods declined, results for our Latin
American operations and CO2 gas-processing operations and field services
improved during 2002 relative to 2001. Revenues from our Canadian operations
decreased as Canadian rotary rig counts continued to decline from an average of
341 for the year ended December 31, 2001 to an average of 263 for the year ended
December 31, 2002. Inter-segment revenues for this business segment were
approximately $917,000 and $781,000 for the years ended December 31, 2002 and
2001, respectively.

Revenues from our engineered systems business segment for the year ended
December 31, 2002 increased $8.0 million, or 8%, to $107.0 million from $99.0
million for the year ended December 31, 2001. This increase was primarily due to
several large projects, primarily in West Africa, that provided revenues of
approximately $31.0 million during 2002, offset by a decline in revenues from
our U.K.-based operations and a decline in revenues earned in Southeast Asia,
with the substantial completion of the CTOC project in late 2001. Engineered
systems revenues of $107.0 million for the year ended December 31, 2002 included
inter-segment revenues of $1.8 million, as compared to $748,000 of inter-segment
revenues for the year ended December 31, 2001.

Revenues from our automation and control systems business segment for the
year ended December 31, 2002 increased $4.4 million, or 9%, to $52.1 million
from $47.7 million for the year ended December 31, 2001. The increase was due to
higher demand for our control equipment and field services, partially associated
with repair projects in the Gulf of Mexico following several tropical weather
systems in 2002. Inter-segment revenues increased from $3.8 million for the year
ended December 31, 2001 to $4.3 million for the year ended December 31, 2002.

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

Gross Profit. Gross profit for the year ended December 31, 2002 decreased
$5.9 million, or 8%, to $70.2 million from $76.1 million for the year ended
December 31, 2001. As a percentage of revenue, gross margins declined from 27%
for the year ended December 31, 2001 to 24% for the year ended December 31,
2002. The following table summarizes gross profit by business segment for the
years ended December 31, 2002 and 2001, respectively:

Gross profit from our North American operations business segment for the
year ended December 31, 2002 increased $2.1 million, or 6%, to $37.6 million
from $35.5 million for the year ended December 31, 2001. This increase in margin
was primarily due to the contribution of our Latin American operations and our
CO2 gas-processing operations and field services, reflecting increased
throughput from the expansion at our Sacroc facility. As a percentage of
revenue, gross margins for the segment were 27% and 24% for the years ended
December 31, 2002 and 2001, respectively.

Gross profit from our engineered systems business segment for the year
ended December 31, 2002 decreased $8.0 million, or 26%, to $23.2 million from
$31.2 million for the year ended December 31, 2001, despite an 8% increase in
revenues. This decline was due to the completion of several high-margin projects
during 2001 in Southeast Asia and within our U.K.-based operations, partially
offset by new projects for 2002
25

awarded at more traditional margins. As a percentage of revenue, gross margins
for this segment were 22% and 32% for the years ended December 31, 2002 and
2001, respectively.

Gross profit from our automation and control systems business segment for
the years ended December 31, 2002 and 2001 remained constant, despite a 9%
increase in revenues for the period, primarily due to an increase in labor costs
attributable to higher medical benefit costs and an unfavorable mix of labor and
materials in 2002 compared to 2001. As a percentage of revenue, gross margins
for this segment were 18% and 20% for the years ended December 31, 2002 and
2001, respectively.

Selling, General and Administrative Expense. Selling, general and
administrative expense for the year ended December 31, 2002 increased $2.5
million, or 5%, to $53.9 million from $51.5 million for the year ended December
31, 2001. This increase was largely related to the following factors:

- one year of operating expenses at Axsia during 2002 compared to nine
months during fiscal 2001;

- additional costs associated with the start-up of the Singapore office in
March 2001;

- costs associated with the start-up of the Mexico marketing office opened
in late 2001; and

- additional costs associated with employee medical claims.

Depreciation and Amortization Expense. Depreciation and amortization
expense for the year ended December 31, 2002 decreased $3.2 million, or 39%, to
$5.0 million from $8.1 million for the year ended December 31, 2001.
Depreciation expense for the year ended December 31, 2002 increased $764,000, or
19%, to $4.9 million from $4.1 million for the year ended December 31, 2001.
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 in late 2001 and 2002, including a significant upgrade
of our drying plant facility in Pittsburg, California, and the expansion of our
gas-processing plant at the Sacroc field. Amortization expense for the year
ended December 31, 2002 decreased $3.9 million, or 98%, to $92,000 from $4.0
million for the year ended December 31, 2001. This decrease 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 year ended December 31, 2002,
compared to $3.7 million for the year ended December 31, 2001. In addition, the
results for the year ended December 31, 2001 include amortization expense
associated with certain employment contracts that were fully amortized as of
December 31, 2001.

Closure and Other. Closure and other charges for the year ended December
31, 2002 of $548,000 related to the closure of a manufacturing and engineering
facility in Edmonton, Alberta, Canada. Costs include the involuntary termination
of certain employees, relocation of equipment and certain personnel and the
modification of related operating lease arrangements. At December 31, 2002, our
remaining accrued liability related to this restructuring was $304,000, and we
expect to incur additional relocation and shop moving costs which will be
expensed as incurred through the second quarter of 2003. During the year ended
December 31, 2001, we incurred a charge totaling $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.

Interest Expense. Interest expense for the year ended December 31, 2002
decreased $414,000, or 8%, to $4.5 million from $4.9 million for the year ended
December 31, 2001. This decrease was due to a decline in outstanding debt from
$58.6 million at December 31, 2001 to $52.4 million at December 31, 2002. The
weighted average interest rate of our outstanding borrowings remained constant
for the respective periods.

Interest Cost on Postretirement Benefit Liability. Interest cost on
postretirement benefit liability decreased $417,000, or 47%, from $888,000 for
the year ended December 31, 2001 to $471,000 for the year ended December 31,
2002. 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.
26

Interest Income. Interest income decreased $412,000, or 62%, from $660,000
for the year ended December 31, 2001 to $248,000 for the year ended December 31,
2002. This change 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 $400,000 for the year ended
December 31, 2002, declined $29,000, or 7%, compared to the year ended December
31, 2001. The change relates primarily to foreign currency transaction gains and
losses incurred through our operations in the United Kingdom and Canada.

Provision for Income Taxes. Income tax expense for the year ended December
31, 2002 decreased $2.2 million, or 56%, to $1.7 million from $3.9 million for
the year ended December 31, 2001. This decline in income tax expense was
primarily due to a decrease in income before income taxes, which was $5.6
million for the year ended December 31, 2002 as compared to $9.3 million for the
year ended December 31, 2001. The decrease in the effective tax rate from 42.1%
for the year ended December 31, 2001 to 30.5% for the year ended December 31,
2002, was due primarily to no longer recognizing non-deductible goodwill
amortization expense, as per SFAS No. 142, adopted January 1, 2002.

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 $25.5 million, or 21%, to $145.1 million from
$119.7 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 CO2 gas-processing and 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-segment
revenues for this business segment were approximately $781,000 and $1.3 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 $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-segment revenues of $748,000, as compared to $268,000 of
inter-segment revenues for the year ended December 31, 2000.

27

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-segment 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 inter-segment eliminations
represents the elimination of inter-segment 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 consistent at 24% for
the years ended December 31, 2001 and 2000.

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.

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.
28

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.

Closure and Other. Closure and other 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.

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 41.1% to 42.1%
for the years ended December 31, 2000 and 2001, respectively, primarily due to
the impact of non-deductible goodwill amortization expense.

29

LIQUIDITY AND CAPITAL RESOURCES

As of February 28, 2003, we had cash and working capital of $2.6 million
and $47.1 million, respectively. As of December 31, 2002, we had cash and
working capital of $1.7 million and $34.6 million, respectively, as compared to
$3.1 million and $37.1 million at December 31, 2001, respectively.

Net cash provided by (used in) operating activities for the years ended
December 31, 2002, 2001 and 2000 was $9.7 million, $19.3 million and ($6.3)
million, respectively. The decrease in net cash provided by operating activities
for fiscal 2002 was primarily due to lower net income, as well as an increase in
accounts receivable and a decrease in customer advance payments, partially
offset by a decline in inventory levels.

Net cash used in investing activities for the years ended December 31,
2002, 2001 and 2000 was $5.6 million, $57.7 million and $23.6 million,
respectively. The primary use of funds for the year ended December 31, 2002 was
for capital expenditures of $5.3 million, which included an expansion of our
gas-processing facility in the Sacroc field. 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, which included
the purchase of a shop facility in Magnolia, Texas, expansion of and improvement
to our facilities in New Iberia, Louisiana, and improvements to our Sacroc
gas-processing plant in west Texas. 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. 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.

Net cash provided by (used in) financing activities for the years ended
December 31, 2002, 2001 and 2000 was ($5.4) million, $41.1 million and $29.7
million, respectively. The primary use of funds for financing activities for the
year ended December 31, 2002 was the repayment of long-term debt of $7.1 million
and benefit payments under our postretirement benefit plan of $1.9 million,
partially offset by long-term borrowings of $1.5 million and a $1.9 million
increase in bank overdrafts. 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.

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, 2002, we had borrowings outstanding under the term loan facility of
$37.8 million and borrowings of $9.0 million outstanding under the revolving
credit facility and had issued $17.4 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 4.21% per annum. Amounts borrowed
under the revolving portion of this facility bear interest at a rate based upon
the ratio of funded debt to EBITDA, as defined in the credit facility

30

("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 0.30% to 0.50% per year, depending upon the
ratio of funded debt to EBITDA on the undrawn portion of the facility.

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 allowed for future capital investment in our CO2 gas-processing
facility at Sacroc in west Texas, and revised certain debt covenants, modified
certain defined terms, 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 exceeds 3 to 1.

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. The revolving credit and term loan facility contains restrictive
covenants which, among other things, limit the amount of funded debt to EBITDA,
imposes a minimum fixed charge coverage ratio, a minimum asset coverage ratio
and a minimum net worth requirement. As of December 31, 2002, 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
4.26%.

The export sales credit facility provides for aggregate borrowings of $10.0
million, subject to borrowing base limitations, of which $4.3 million was
outstanding as of December 31, 2002. In addition, we had issued letters of
credit totaling $720,000 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.

We borrowed $1.5 million under a long-term promissory note arrangement on
February 6, 2002. 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 our manufacturing facility in Magnolia, Texas that we
purchased in the fourth quarter of 2001.

We had unsecured letters of credit totaling $432,000 at December 31, 2002.

At January 31, 2003, borrowing base limitations reduced our available
borrowing capacity under the revolving credit facilities to $24.3 million. No
borrowing capacity was available under our export sales credit facility.

31

COMMITMENTS AND CONTINGENCIES

The following table summarizes our known contractual obligations as of
December 31, 2002.

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

(1) We have no capital lease arrangements or significant firm purchase
commitments as of December 31, 2002.

(2) Operating lease obligations for periods that exceed five years primarily
include costs associated with the usage of waterways in the United Kingdom,
which have lease terms that extend up to 125 years. If the property were
sold or sublet to a new tenant, these lease arrangements would be fully
transferable.

(3) Other long-term liabilities represent our postretirement benefit obligation
as of December 31, 2002. Benefit payments associated with the obligation
were estimated based upon actual experience for the year ended December 31,
2002. Changes in actuarial assumptions or medical trend rates in subsequent
years could cause our liability under this postretirement benefit plan to
change.

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 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 April 2001, we paid $226,000 under this arrangement related to the
year ended January 23, 2001. In August 2002, the Company paid $197,000 under
this arrangement related to the year ended January 23, 2002, resulting in an
increase in goodwill. No liability was accrued under this arrangement for the
years ended January 23, 2003 and 2002.

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

On March 13, 2003, we executed an agreement to issue 15,000 shares of our
Series B Convertible Preferred Stock along with warrants to purchase 248,800
shares of our common stock to Lime Rock Partners II, L.P., a private investment
fund, for an aggregate purchase price of $15.0 million. Of the aggregate
purchase price, approximately $99,000 will be allocated to the warrants, and we
will amortize this discount over three years. The proceeds from the issuance
will be used to reduce our outstanding revolving debt balances and for general
corporate purposes. This transaction is expected to close prior to the end of
March 2003.

Each share of Series B Convertible Preferred Stock has a face value of
$1,000 and pays a cumulative dividend of 10% per annum of face value, which is
payable semi-annually on June 15 and December 15 of each year. Each share of
Series B Convertible Preferred Stock is convertible, at the option of the holder
thereof, into (i) a number of shares of common stock equal to the face value of
such share divided by the conversion price, which is $7.805, and (ii) a cash
payment equal to the amount of dividends on such share that have accrued since
the prior semi-annual dividend payment date. The warrants that will be issued to
Lime Rock have an exercise price of $10.00 per share of common stock and expire
on the third anniversary of its issuance. We can force exercise of the warrants
if our stock price trades above $13.50 per share for 30 consecutive days. We
estimate that accounting for issuance of the preferred shares will lower our
earnings by $0.05 per diluted share in 2003 relative to what earnings might
otherwise have been.

32

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 opportunity. Although we were in compliance with
existing restrictive loan covenants as of December 31, 2002 and expect to
continue to be in compliance, there can be no assurance we will remain in
compliance in future periods and, therefore, we 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.

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 pay 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 the Managing Partner of
Capricorn Holdings LLC, the general partner of Capricorn Investors II, L.P., a
private investment partnership, 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 of Capricorn Holdings
LLC. Capricorn Investors II, L.P. controls approximately 20% of our common
stock. Fees paid to Capricorn Management totaled $115,000, $85,000 and $75,000
for the years ended December 31, 2002, 2001 and 2000, 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.

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, also pursuant to the terms of that
employment agreement, we 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 us approximately $665,000. 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. The amount of the loan was equal to the cost to exercise the
options plus any personal tax burdens that resulted from the exercise. The
maturity of these loans was July 31, 2003, and interest accrued at rates ranging
from 6% to 7.8% per annum. As of June 30, 2002, these outstanding notes
receivable totaled $3.4 million, including principal and accrued interest.
Effective July 1, 2002, the notes were reviewed by our board and 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. As of December 31, 2002, the balance of the notes
(principal and accrued interest) due from this officer under these loan
arrangements was $3.5 million. These loans to this executive officer, which were
made on a full recourse basis in prior periods to facilitate direct ownership of
our common stock, are currently subject to and in compliance with provisions of
the Sarbanes-Oxley Act of 2002.

As previously agreed in 2001, we loaned an employee who is an executive
officer and director $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 the exercise cost and personal 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 December 31, 2002, the balance of the note (principal
and interest) due from this officer under this loan arrangement was
approximately $223,000. This loan to this executive officer, which was made on a
full

33

recourse basis in prior periods to facilitate direct ownership of our common
stock, is currently subject to and in compliance with provisions of the
Sarbanes-Oxley Act of 2002.

During 1997, we loaned $1.5 million (at a rate of 10% per annum) to one of
our directors 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 our common stock to its partners. During 1998, we
acquired an option at a cost of $200,000 to purchase 173,050 shares of our
common stock from the director at a price of $8.81 per share. At our option, the
note could be repaid with shares of our 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 we
exercised an option to purchase 173,050 shares of our common stock from this
director at a cost of $1.5 million. The remaining balance of the note was repaid
during June 2000.

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

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. However, current economic and
political unrest in Venezuela has increased inflation and affected our
operations in that country. Since revenues earned in Venezuela during 2002
represented less than 1% of our total revenues, our exposure to this increase in
inflation was not significant.

RECENT 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. We adopted
this standard on July 1, 2001, with no material effect on our 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 for impairment
on an annual 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 $1.6 million at December 31, 2002, and recorded amortization and
interest expense related to those assets of $840,000 for the year ended December
31, 2002. We ceased periodic amortization of goodwill on the date of adoption.
Net goodwill at December 31, 2002 was $79.0 million. The pro forma impact of
applying SFAS No. 142 to operating results for the years ended December 31, 2001
and 2000, would have been a reduction in amortization expense of $3.7 million
and $1.6 million, respectively, resulting in net income of $9.0 million and $9.3
million, respectively. The pro forma increase in basic and diluted earnings per
share would have been $.23 and $.23, respectively, for 2001, and $.11 and $.10,
respectively, for 2000.

In accordance with SFAS No. 142, we tested goodwill for impairment as of
December 31, 2002. Based upon the testing performed, we determined that goodwill
was not impaired as of December 31, 2002. Therefore, no impairment charge was
recorded under SFAS No. 142 as of December 31, 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 requires us to record the fair value of
an asset retirement obligation as a liability in the period in

34

which we incur a legal obligation associated with the retirement of tangible
long-lived assets that result from acquisition, construction, development and/or
normal use of the assets. In addition, the standard requires us to record a
corresponding asset that will be depreciated over the life of the asset that
gave rise to the liability. Subsequent to the initial measurement of this asset
retirement obligation, we will be required to adjust the liability at the end of
each period to reflect changes in estimated retirement cost and the passage of
time. We are required to adopt this pronouncement on January 1, 2003. The
provisions of this pronouncement will require us to record certain retirement
obligations during the first quarter of 2003. We are currently determining the
impact that this pronouncement will have on our financial condition and 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 became
effective for financial statements issued for fiscal years beginning after
December 15, 2001. We adopted this pronouncement on January 1, 2002, resulting
in an immaterial impact 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 amends existing guidance on reporting gains and losses on
extinguishment of debt, prohibiting the classification of the gain or loss as
extraordinary. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback
accounting for certain lease modifications that have economic effects similar to
sale-leaseback arrangements. The provisions of the Statement related to the
rescission of Statement No. 4 will be applied for the fiscal year beginning
after May 14, 2002, with early adoption encouraged. The provisions of the
Statement related to Statement No. 13 were effective for transactions occurring
after May 15, 2002, with early adoption encouraged. SFAS No. 145 has been
adopted with respects to the revision of Statement No. 13 on May 15, 2002, and
will be adopted on January 1, 2003, with respect to the amendment of SFAS No. 4.
However, the adoption of SFAS No. 145 is not expected to have a material effect
on our financial condition or results of operations.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit or
Disposal Activities," which addresses financial accounting and reporting for
costs 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
exit or disposal activities that are initiated after December 31, 2002, with
early adoption encouraged. The provisions of this pronouncement will be applied
to any exit or disposal activities on or after January 1, 2003. However, we do
not expect this pronouncement to have a material effect on our financial
condition or results of operations.

In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others, an interpretation of FASB Statements No.
5, 57 and 107 and a rescission of FASB Interpretation No. 34." This
interpretation elaborates on the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under guarantees
issued. The interpretation also clarifies that a guarantor is required to
recognize, at the inception of a guarantee, a liability for the fair value of
the obligation taken. The initial recognition and measurement provisions of the
interpretation are applicable to guarantees issued or modified after December
31, 2002. We do not expect this interpretation to have a material impact on our
financial condition or results of operations.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure, an amendment to FASB Statement No.
123." This statement amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation," to provide alternative methods to transition, on a
volunteer-basis, to the fair value method of accounting for stock-based employee
compensation. Additionally, this statement amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements. Certain disclosure modifications are required for fiscal
years ending after December 15, 2002, if a transition to SFAS No. 123 is
elected. We have not yet elected to transition to SFAS No. 123 as of December
31, 2002.

35

ITEM 7A. 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 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, 2002, 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, our working capital
facility for export sales and our long-term facility secured by our Magnolia
manufacturing plant. At December 31, 2002, we had $37.8 million outstanding
under the term loan portion of the revolving credit and term loan facility. At
December 31, 2002, outstanding borrowings under our revolving credit agreement
totaled $9.0 million. Borrowings under our revolving credit agreement bear
interest at floating rates. As of December 31, 2002, the weighted average
interest rate of borrowings under the revolving credit and term loan facility
was 4.26%. Borrowings outstanding under the export sales credit facility were
$4.3 million at December 31, 2002, and bore interest at 4.25%. Borrowing under
the long-term arrangement secured by our Magnolia manufacturing facility totaled
$1.4 million at December 31, 2002, and accrued interest at 4.65%.

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, 2002, a 100 basis point
increase in interest rates under these borrowings would decrease our current
year net income and cash flow from operations by approximately $364,000. 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, 2002, 2001 and 2000, as applicable, along with the Independent
Auditors' report:

36

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, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity and comprehensive
income, and cash flows for each of the three years ended December 31, 2002.
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, 2002 and 2001 and the results of their
operations and their cash flows for each of the three years ended December 31,
2002, in conformity with accounting principles generally accepted in the United
States of America.

As discussed in Note 2 to the consolidated financial statements, effective
January 1, 2002, the Company adopted the provisions of Statement of Financial
Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," as
required. As discussed in Note 14 to the Consolidated Financial Statements, the
Company changed its method of accounting for postretirement benefits in January
2000.

KPMG LLP

Houston, Texas
February 19, 2003

37

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes to consolidated financial statements.

38

NATCO GROUP INC. AND SUBSIDIARIES

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

See accompanying notes to consolidated financial statements.

39

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
COMPREHENSIVE INCOME
(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes to consolidated financial statements.

40

NATCO GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

See accompanying notes to consolidated financial statements.
41

NATCO GROUP INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) ORGANIZATION

NATCO Group Inc. 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"). In June 1989, the
Company acquired from C-E all of the outstanding common stock of National Tank
Company and certain other businesses that were subsequently divested or
distributed to shareholders.

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
wholly-owned subsidiaries for the years ended December 31, 2002, 2001 and 2000.
Furthermore, certain reclassifications have been made to fiscal 2001 and fiscal
2000 amounts in order to present these results on a comparable basis with
amounts for fiscal 2002.

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 wholly-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 year ended
December 31, 2002, one customer, ExxonMobil Corporation and affiliates, through
its general contractor, Hyundai Heavy Industries, Co., provided 10% of the
Company's consolidated revenues. No customer provided more than 10% of
consolidated revenues for the year ended December 31, 2001. 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.

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.

42

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. Prior to the adoption on January 1, 2002, of Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets", goodwill was being amortized on a straight-line basis over periods of
20 to 40 years. In accordance with SFAS No. 142, the Company ceased amortization
of goodwill and began to evaluate goodwill on an impairment basis. Based on this
testing, the Company's management believes that no impairment of goodwill exists
at December 31, 2002. See Note 23, Goodwill Impairment Testing. Amortization
expense for the years ended December 31, 2001 and 2000 was $3.7 million and $1.6
million, respectively. Accumulated amortization at December 31, 2002 and 2001
was $6.4 million.

Other Assets, Net. Other assets include prepaid pension assets, patents,
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 and interest expense was
$840,000, $932,000 and $554,000, for the years ended December 31, 2002, 2001 and
2000, 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 certain 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. 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. In December 2002, SFAS No. 148 "Accounting for Stock-Based
Compensation -- Transition and Disclosure, an amendment to FASB Statement No.
123" was issued and provides alternative methods to transition to the fair value
method of accounting for stock based compensation, on a volunteer basis, and
requires additional disclosures at both annual and interim periods. 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.

43

The Company's pro forma net earnings and earnings per share for the years
ended December 31, 2002, 2001 and 2000 as per SFAS No. 123 were as follows:

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 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 $2.0
million, $2.1 million and $1.8 million for the years ended December 31, 2002,
2001 and 2000, 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, 2002 and
2001, the Company had $6.0 million and $5.4 million, 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,
2002, 2001 or 2000.

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.

44

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
potential common share are computed by dividing net income by the weighted
average number of common and potential common shares outstanding. For the
purposes of this calculation, outstanding employee stock options are considered
potential common shares. In conformity with Securities and Exchange Commission
requirements, common stock, options and warrants, or other potentially dilutive
instruments are reflected in earnings per share calculations for all periods
presented. Anti-dilutive stock options were excluded from the calculation of
potential common shares. The impact of these anti-dilutive shares would have
been a reduction of 314,000 shares, 145,000 shares and 36,000 shares for the
years ended December 31, 2002, 2001 and 2000, respectively.

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

(3) CAPITAL STOCK

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 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.

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

45

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 automatically
converted 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.

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 $7.32 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 $7.16 per share. The cost to
reacquire these shares was recorded as treasury stock at December 31, 2002 and
2001, respectively.

In February 2001 and June 2000, the Company issued 8,520 Class B shares and
418,145 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 and
$4.1 million in 2000, as a result of these transactions.

(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 418,145 Class B
shares and 8,520 Class B shares in 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. In accordance
with SFAS No. 142, "Goodwill and Other Intangible Assets," the Company ceased
amortizing goodwill associated with the Cynara acquisition on January 1, 2002.
Goodwill and accumulated amortization was $17.6 million and $2.3 million,
respectively, at December 31, 2002.

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 was being amortized over a twenty-year period
prior to the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets,"
on January 1, 2002. Goodwill and accumulated amortization related to the
Porta-Test acquisition were $5.4 million and $532,000, respectively, at December
31, 2002.

46

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 was being
amortized over a twenty-year period prior to the adoption of SFAS No. 142,
"Goodwill and Other Intangible Assets," on January 1, 2002. Goodwill and
accumulated amortization related to the MPE acquisition were $3.4 million and
$338,000, respectively, at December 31, 2002.

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 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 was being amortized over a twenty-year period prior to the
adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," on January 1,
2002. Goodwill and accumulated amortization related to the ESI acquisition were
$6.0 million and $510,000, respectively, at December 31, 2002.

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 re-injection systems for oil and
gas fields, oily water treatment, oil separation, hydro-cyclone 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 was being amortized over a twenty-year period, prior to the
adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," on January 1,
2002. Goodwill and accumulated amortization expense related to the Axsia
acquisition were $47.4 million and $1.9 million, respectively, at December 31,
2002.

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.

47

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) CLOSURE AND OTHER

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 27 employees including 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 began implementing this plan in November 2002,
and incurred approximately $548,000 of costs under this plan, including
severance related costs of $123,000, asset impairment charges of $121,000, and
other costs totaling $304,000, primarily related to lease obligations. At
December 31, 2002, the Company's remaining accrued liability related to this
restructuring was $304,000, and additional relocation and shop moving costs
which will be expensed as incurred are expected through the second quarter of
2003.

In June 2001, the Company recorded a charge of $1.6 million that 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 a 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 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. See Note 17, Related Parties.

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, 2002 and 2001, inventories valued using the LIFO method and
included above amounted to $26.3 million and $29.5 million, respectively.
Reductions in LIFO layers resulted in a $59,000

48

decrease in net income for the year ended December 31, 2002. There were no
reductions in 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:

(8) PROPERTY, PLANT AND EQUIPMENT, NET

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

Depreciation expense was $4.9 million, $4.1 million and $3.1 million,
respectively, for the years ended December 31, 2002, 2001 and 2000. 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 $5.0
million and $5.3 million, and the related accumulated depreciation was $3.3
million and $3.5 million, at December 31, 2002 and 2001, respectively. Lease and
rental income of $1.3 million, $1.2 million and $581,000 for the years ended
December 31, 2002, 2001 and 2000, respectively, was included in revenues.

49

(9) ACCRUED EXPENSES AND OTHER

Accrued expense and other consisted of the following:

(10) 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.

(11) LONG-TERM DEBT

The consolidated borrowings of the Company were as follows:

The aggregate future maturities of long-term debt for the next five years
ended December 31 are as follows: 2003--$7.1 million; 2004--$20.3 million;
2005--$7.1 million; 2006--$16.8 million; and 2007--$1.0 million.

50

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 its borrowing capacity in the
U.K. from $5.0 million to $10.0 million. No other material modifications were
made to the agreement at that time.

Amounts borrowed under the term loan bear interest at a rate of 4.21% per
annum as of December 31, 2002. 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 ("EBITDA"), 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%.

NATCO paid commitment fees of 0.50% per year until April 1, 2002, and will
pay 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.

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 allowed for future capital investment in our CO(2) gas-processing
facility at Sacroc in west Texas, and revised certain debt covenants, modified
certain defined terms, 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 exceeds 3 to 1.

The revolving credit and term loan facility is guaranteed by all of 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. In addition, the Company has pledged 65% of the voting stock of its
active foreign subsidiaries. The revolving credit and term loan facility
contains restrictive covenants which, among other things, limit the amount of
funded debt to EBITDA, imposes a minimum fixed charge coverage ratio, a minimum
asset coverage ratio and a minimum net worth requirement. As of December 31,
2002, the Company was in compliance with all restrictive debt covenants. NATCO
had letters of credit outstanding under the revolving credit facilities totaling
$17.4 million at December 31, 2002. These letters of credit constitute contract
performance and warranty collateral and expire at various dates through
September 2005.

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.

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 $4.3 million were outstanding at December
31, 2002. Letters of credit outstanding under the export sales credit facility
as of December 31, 2002 totaled $720,000. 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 $432,000 at December
31, 2002.

The Company borrowed $1.5 million under a long-term promissory note
arrangement on February 6, 2002. 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.
51

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, 2002, 2001 and 2000.

(12) 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, 2002 and 2001, the Company recorded a valuation allowance
of $258,000 and $1.3 million, related to certain deferred tax assets acquired
with the purchase of Axsia in March 2001. The Company had net operating loss
carry-forwards for federal income tax purposes of $7.6 million as of December
31, 2002, that were available to offset future federal income tax through 2022.

52

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:

Cumulative undistributed earnings of foreign subsidiaries totaled $10.4
million as of December 31, 2002. The Company considers earnings from these
foreign subsidiaries to be indefinitely reinvested and accordingly, no provision
for U.S. foreign or state income taxes has been made for these earnings. Upon
distribution of foreign subsidiary earnings in the form of dividends or
otherwise, such distributed earnings would be reportable for U.S. income tax
purposes (subject to adjustment for foreign tax credits.)

Federal income tax returns for fiscal years beginning with 1999 are open
for review by the Internal Revenue Service.

(13) STOCKHOLDERS' EQUITY

CEO Stock Options. In connection with the engagement of the Chief
Executive Officer of the Company, the Company granted him options to purchase
common shares of National Tank Company that were subsequently converted to
options to purchase common stock of the Company. As of December 31, 2002 and
2001, stock options granted to the Chief Executive Officer under all stock
option plans related to 346,113 shares 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, 2002, 2001 and 2000, options
relating to an aggregate of 527,701 shares, 527,701 shares and 764,204 shares,
respectively, remained outstanding under this plan.

53

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 the Company's common stock. The options vest over periods of
up to four years. The maximum term under these options is ten years. At December
31, 2002, 2001 and 2000, options relating to an aggregate of 731,587 shares,
743,920 shares, and 743,953 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, 2002
and 2001, options relating to an aggregate of 807,326 shares and 795,826 shares,
respectively, were outstanding under this plan. No options were outstanding
under this plan as of December 31, 2000.

Transactions pursuant to the Company's stock option plans for the years
ended December 31, 2002, 2001 and 2000, include:

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

54

common stock, the expected term of outstanding stock options, the Company's
risk-free interest rate and expected dividend payments during the contractual
life of the options. 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, 2003. Volatility was
calculated at 52% as of December 31, 2002, but was stepped-down by 10% per year
for the next three 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, 2002:

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, 2002.

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. For the
Company's pro forma net earnings and earnings per share for the years ended
December 31, 2002, 2001 and 2000, See Note 2, Summary of Significant Accounting
Policies.

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 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.

(14) 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

55

statement of income as of December 31, 2000, as a result of this change in
accounting principle. See Note 15, Pension and Other Postretirement Benefits.

(15) PENSION AND OTHER POSTRETIREMENT BENEFITS

The Company has adopted SFAS 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 W.S. Tyler
Incorporated ("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 14, 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 each year as
reimbursement of postretirement benefit expenses for 2002 and 2001, and recorded
a receivable for the present value of the future benefits of $217,000.

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, 2002, the Company had formally terminated the
pension plan and benefit payments were distributed, except amounts due to
certain retirees, who had not yet replied to notification of pending
distributions. The Company intends to purchase an annuity contract for
approximately $234,000, to fund any remaining liability under this plan
arrangement.

56

The following table sets forth the plan's benefit obligation, fair value of
plan assets, and funded status at December 31, 2002 and 2001.

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

58

Company may make discretionary contributions as profit sharing contributions.
Company contributions to the plan totaled $1.4 million, $1.8 million and $1.4
million for the years ended December 31, 2002, 2001 and 2000, respectively.

(16) 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, 2002,
were as follows: 2003--$4.0 million, 2004--$3.0 million, 2005--$1.2 million,
2006--$1.0 and 2007--$915,000. Total expense for operating leases for the years
ended December 31, 2002, 2001 and 2000 was $5.8 million, $5.3 million and $4.4
million, respectively.

For a discussion of lease and rental income, see Note 8, Property, Plant
and Equipment, net.

(17) RELATED PARTIES

The Company pays 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 the
Managing Partner of Capricorn Holdings LLC, the general partner of Capricorn
Investors II, L.P., a private investment partnership, and directly or indirectly
controls approximately 31% of the Company's outstanding common stock. In
addition, the Company's Chief Executive Officer, Mr. Gregory, is a non-salaried
member of Capricorn Holdings LLC. Capricorn Investors II, L.P. controls
approximately 20% of the Company's common stock. Fees paid to Capricorn
Management totaled $115,000, $85,000 and $75,000 for the years ended December
31, 2002, 2001 and 2000, 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.

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 the initial public offering of its Class A common stock, also pursuant
to the terms of that employment agreement, the Company 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. 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. The amount of the loan was
equal to the cost to exercise the options plus any personal tax burdens that
resulted from the exercise. The maturity of these loans was July 31, 2003, and
interest accrued at rates ranging from 6% to 7.8% per annum. As of June 30,
2002, these outstanding notes receivable totaled $3.4 million, including
principal and accrued interest. Effective July 1, 2002, the notes were reviewed
by the Company's board and 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. As of December 31, 2002,
the balance of the notes (principal and accrued interest) due from this officer
under these loan arrangements was $3.5 million. These loans to this executive
officer, which were made on a full recourse basis in prior periods to facilitate
direct ownership in the Company's common stock, are currently subject to and in
compliance with provisions of the Sarbanes-Oxley Act of 2002.

As previously agreed in 2001, the Company loaned an employee who is an
executive officer and director $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 the exercise cost and personal tax burdens

59

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 December 31, 2002, the balance of
the note (principal and interest) due from this officer under this loan
arrangement was approximately $223,000. This loan to this executive officer,
which was made on a full recourse basis from time to time in prior periods to
facilitate direct ownership in the Company's common stock, is currently subject
to and in compliance with provisions of the Sarbanes-Oxley Act of 2002.

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.

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 15, Pension and Other Postretirement Benefits.

(18) 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 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 April 2001, the Company paid $226,000 under this arrangement
related to the year ended January 23, 2001. In August 2002, the Company paid
$197,000 under this arrangement related to the year ended January 23, 2002,
resulting in an increase in goodwill. No liability was accrued pursuant to this
arrangement as of December 31, 2002.

(19) 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.

(20) LITIGATION

The Company is a party to various routine legal proceedings. These
primarily involve commercial claims, products liability claims and workers'
compensation claims. The Company cannot predict the outcome of these lawsuits,
legal proceedings and claims with certainty. Nevertheless, the Company's
management believes that the outcome of all of these proceedings, even if
determined adversely, would not have a material adverse effect on its business
or financial condition.

60

(21) 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.

North American Operations: This segment consists of the U.S. Sales and
Service business unit, the Company's Canadian and Venezuelan subsidiaries, Latin
American operations and CO2 gas-processing operations. The U.S. Sales and
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. NATCO Venezuela and
Latin American operations generally provide replacement parts to service
customers in South America and Mexico, respectively. The CO2 gas-processing
operations include on-going service at two gas-processing plants in the United
States. The principal market for the U.S. Sales and 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 four business units; U.S.
Engineered Systems, NTC Technical Services, NATCO Japan 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.

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, 2002, 2001 and 2000 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.

62

(22) QUARTERLY DATA

The following tables summarize unaudited quarterly information for the
years ended December 31, 2002, 2001 and 2000:

(23) GOODWILL IMPAIRMENT TESTING

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 for impairment on an annual 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 December 31, 2002 and 2001
were summarized in the following table:

Amortization and interest expense of $840,000, $932,000 and $554,000 were
recognized related to these assets for the years ended December 31, 2002, 2001
and 2000, respectively. The estimated aggregate amortization and interest
expense for these assets for each of the following five fiscal years is:
2003--$625,000; 2004--$383,000; 2005--$341,000; 2006--$152,000; and
2007--$27,000. For segment reporting purposes, these intangible assets and the
related amortization expense were recorded under "Corporate and Eliminations."

63

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
December 31, 2002 was $79.0 million. The pro forma impact of applying SFAS No.
142 to operating results for years ended December 31, 2001 and 2000, would have
been a reduction of amortization expense of $3.7 million and $1.6 million,
respectively, resulting in net income of $9.0 million and $9.3 million,
respectively. The pro forma increase in basic and diluted earnings per share
would have been $.23 and $.23, respectively, for 2001, and $.11 and $.10,
respectively, for 2000.

In accordance with SFAS No. 142, the Company tested impairment of goodwill
by comparing the fair value of operating assets to the carrying value of those
assets, including any related goodwill. As required in the pronouncement, the
Company identified separate reportable units for purposes of this evaluation. In
determining carrying value, the Company segregated assets and liabilities that,
to the extent possible, were clearly identifiable by specific reporting unit.
All inter-company receivables/payables were excluded. Certain corporate and
other assets and liabilities, that were not clearly identifiable by specific
reporting unit, were allocated based on the ratio of each reporting unit's net
assets relative to total net assets. The resulting fair value was then compared
to the carrying value of the reportable unit to determine whether or not an
impairment had occurred at the reportable unit level. No impairment was
indicated and, in accordance with the pronouncement, no additional tests were
required.

Since no impairment of goodwill was indicated based upon the testing
performed, no impairment charge was recorded under SFAS No. 142 as of December
31, 2002. Goodwill will be tested for impairment annually on December 31.

(24) 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, and had no
material effect on the Company's 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. See discussion and results of impairment testing at Note 23,
Goodwill Impairment Testing.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This standard requires the Company to record the fair
value of an asset retirement obligation as a liability in the period in which a
legal obligation associated with the retirement of tangible long-lived assets
that result from acquisition, construction, development and/or normal use of the
assets, is incurred. In addition, the standard requires the Company to record a
corresponding asset that will be depreciated over the life of the asset that
gave rise to the liability. Subsequent to the initial measurement of this asset
retirement obligation, the Company will be required to adjust the liability at
the end of each period to reflect changes in estimated retirement cost and the
passage of time. The Company will adopt this pronouncement on January 1, 2003,
which will require certain liabilities to be recorded in the first quarter of
2003. The Company is currently determining the effect that this pronouncement
will have on its financial condition and 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 became
effective for financial statements issued for fiscal years beginning after
December 15, 2001. The Company adopted this pronouncement on January 1, 2002,
resulting in no material effect on 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 amends existing guidance on reporting gains and losses on
extinguishment of debt, prohibiting the classification of the gain or loss as
extraordinary. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback
accounting for

64

certain lease modifications that have economic effects similar to sale-leaseback
arrangements. The provisions of the statement related to the rescission of
Statement No. 4 will be applied for the fiscal year beginning after May 14,
2002, with early adoption encouraged. The provisions of the statement related to
Statement No. 13 were effective for transactions occurring after May 15, 2002,
with early adoption encouraged. SFAS No. 145 has been adopted with respects to
the revision of Statement No. 13 on May 15, 2002, and will be adopted on January
1, 2003, with respect to the amendment of SFAS No. 4. However, the adoption of
SFAS No. 145 is not expected to have a material effect on the Company's
financial condition or results of operations.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit or
Disposal Activities," which addresses financial accounting and reporting for
costs 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
exit or disposal activities that are initiated after December 31, 2002, with
early adoption encouraged. The provisions of this pronouncement will be applied
to any exit or disposal activities on or after January 1, 2003. However, the
Company does not expect this pronouncement to have a material effect on its
financial condition or results of operations.

In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others, an interpretation of FASB Statements No.
5, 57 and 107 and a rescission of FASB Interpretation No. 34." This
interpretation elaborates on the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under guarantees
issued. The interpretation also clarifies that a guarantor is required to
recognize, at the inception of a guarantee, a liability for the fair value of
the obligation taken. The initial recognition and measurement provisions of the
Interpretation are applicable to guarantees issued or modified after December
31, 2002. The Company does not expect this Interpretation to have a material
effect on its financial condition or results of operations.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure, an amendment to FASB Statement No.
123." This statement amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation," to provide alternative methods to transition, on a
volunteer-basis, to the fair value method of accounting for stock-based employee
compensation. Additionally, this statement amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements. Certain disclosure modifications are required for fiscal
years ending after December 15, 2002, if a transition to SFAS No. 123 is
elected. The Company has not elected to transition to SFAS No. 123 as of
December 31, 2002. See Note 13, Stockholders' Equity.

(25) SUBSEQUENT EVENTS

On March 13, 2003, the Company executed an agreement to issue 15,000 shares
of its Series B Convertible Preferred Stock along with warrants to purchase
248,800 shares of the Company's common stock to Lime Rock Partners II, L.P., a
private investment fund, for an aggregate purchase price of $15.0 million. Of
the aggregate purchase price, approximately $99,000 will be allocated to the
warrant, and the Company will amortize this discount over three years. The
proceeds from the issuance will be used to reduce the Company's outstanding
revolving debt balances and for general corporate purposes. This transaction is
expected to close prior to the end of March 2003.

Each share of Series B Convertible Preferred Stock has a face value of
$1,000 and pays a cumulative dividend of 10% per annum of face value, which is
payable semi-annually on June 15 and December 15 of each year. Each share of
Series B Convertible Preferred Stock is convertible, at the option of the holder
thereof, into (i) a number of shares of common stock equal to the face value of
such share divided by the conversion price, which is $7.805, and (ii) a cash
payment equal to the amount of dividends on such share that have accrued since
the prior semi-annual dividend payment date. The warrants that will be issued to
Lime Rock have an exercise price of $10.00 per share of common stock and expire
on the third anniversary of its issuance. The Company can force exercise of the
warrants if the Company's stock price trades above $13.50 per share for 30
consecutive days.

65

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 22, 2003, 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 22, 2003, which section is
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

The information concerning security ownership of certain beneficial owners
and management and related stockholder matters is set forth in the sections
entitled "Voting Securities and Principal Holders Thereof," "Security Ownership
of Management," and "Equity Compensation Plans" in the Proxy Statement for the
Annual Meeting of Stockholders to be held on May 22, 2003, which sections are
incorporated by reference.

Equity compensation plan information at December 31, 2002 was as follows:

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 22,
2003, which sections are incorporated by reference.

ITEM 14. CONTROLS AND PROCEDURES

CONTROLS AND PROCEDURES

On March 17, 2003 and on various dates throughout 2002 and 2003, members of
our management team, including our Chief Executive Officer and Chief Financial
Officer, 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, to evaluate and continually improve the effectiveness of the design
and operation of these controls. Based upon this review, our management has
determined that disclosure controls and
66

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 December 31, 2002, and no corrective actions are
anticipated as we noted no significant deficiencies or material weaknesses in
our control structure. Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, our Chief Executive Officer and Chief Financial Officer have provided
certain certifications to the SEC. These certifications accompanied this report
when filed with the SEC, but are not set forth herein.

PART IV

ITEM 15. 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.

70

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 21st day of March 2003.

NATCO GROUP INC.
(Registrant)

By: /s/ NATHANIEL A. GREGORY
------------------------------------
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
21st, 2003.

72

CERTIFICATIONS

I, Nathaniel A. Gregory, certify that:

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

2. Based on my knowledge, this annual 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 annual report;

3. Based on my knowledge, the financial statements, and other
financial information included in this annual 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
annual 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
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 annual 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 annual report (the "Evaluation Date"); and

c. presented in this annual 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 functions):

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 annual report whether 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: March 21, 2003

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

73

CERTIFICATIONS

I, J. Michael Mayer, certify that:

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

2. Based on my knowledge, this annual 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 annual report;

3. Based on my knowledge, the financial statements, and other
financial information included in this annual 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
annual 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
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 annual 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 annual report (the "Evaluation Date"); and

c. presented in this annual 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 functions):

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 annual report whether 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: March 21, 2003

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

74

EXHIBIT INDEX

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* Included herewith.

** Management contracts or compensatory plans or arrangements.