SECURITIES AND EXCHANGE COMMISSION

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

For the Fiscal Year Ended June 30, 2004
Commission File No. 0-5214

2819 Walnut Hill Lane, Dallas, Texas 75229
(Address of principal executive offices)

Registrant’s telephone number, including area code: (214) 357-6181

Securities registered pursuant to Section 12(b) of the Act:
None

Securities Registered Pursuant to Section 12(g) of the Act:

     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. [X]

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

     The aggregate value of the voting stock held by non-affiliates of the Registrant as of December 31, 2003 was approximately $ 31.1 million. Shares of voting stock held by executive officers, directors and holders of more than 10% of the outstanding voting stock have been excluded from this calculation because such persons may be deemed to be affiliates. Exclusion of such shares should not be construed to indicate that any of such persons possesses the power, direct or indirect, to control the Registrant, or that any such person is controlled by or under common control with the Registrant.

     Number of shares outstanding of the Registrant’s Common Stock, $1.00 par value, as of September 22, 2004 was 3,024,184.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the 2004 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

1

TABLE OF CONTENTS

2

PART I

ITEM 1. BUSINESS

     Peerless Mfg. Co. (the “Company,” “Registrant,” “Peerless” or “we,” “us” or “our”) was organized in 1933 as a proprietorship and was incorporated as a Texas corporation in 1946. We have three wholly owned subsidiaries incorporated in Texas, the United Kingdom, and Barbados, respectively. Our executive offices are located at 2819 Walnut Hill Lane, Dallas, TX 75229. Our telephone number at this location is (214) 357-6181, and our website may be accessed at www.peerlessmfg.com. Our fiscal year ends on June 30. References herein to “fiscal 2002,” “fiscal 2003,” and “fiscal 2004” refer to our fiscal years ended June 30, 2002, 2003, and 2004, respectively.

     In connection with the discontinuation of our Boiler operations (see Note D – “Discontinued Operations” in our Notes to Consolidated Financial Statements), the fiscal 2004 financial information has been presented, and the prior years financial information has been restated, to report the discontinued operations in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” In addition, certain fiscal 2003 and fiscal 2002 items have been reclassified to conform to the fiscal 2004 presentation.

Operating Segments and Products

     We operate our business through two primary business segments, the first of which is our Environmental Systems business, which accounted for approximately 47% of our revenues in fiscal 2004. In this segment, we design, engineer, manufacture and sell environmental control systems, which are used for air pollution abatement. Our main product, Selective Catalytic Reduction Systems, referred to as “SCR Systems,” is used to convert nitrogen oxide (NOx) emissions from exhaust gases, caused by burning hydrocarbon fuels, such as coal, gasoline, natural gas and oil, into harmless nitrogen and water vapor. These systems are totally integrated, complete with instruments, controls and related valves and piping. In this segment, we also offer systems to reduce other pollutants, such as carbon monoxide (CO) and particulate matter (PM).

     Our other business segment is our Separation Filtration Systems business, which accounted for approximately 53% of our revenues in fiscal 2004. In this business segment, we design, engineer, manufacture and sell specialized products known as “separators” or “filters” which are used for a variety of purposes in cleaning gases and liquids as they move through piping systems. These products are used primarily to remove solid and liquid contaminants from natural gas, as well as saltwater aerosols from combustion intake air of shipboard gas turbine and diesel engines. Separators are also used in nuclear power plants to remove water from saturated steam.

     Although we manufacture and stock a limited number of products for immediate delivery, the majority of our products are custom designed based on specific customer requirements or specifications, generally pursuant to long-term fixed priced contracts. In certain cases, our products are designed by us but produced by subcontractors or contract vendors under our supervision.

     Please see Note O - “Industry Segment and Geographic Information,” in our Notes to Consolidated Financial Statements and Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report for further disclosure and discussion of financial information with respect to these two segments, Environmental Systems and Separation Filtration Systems.

3

Restructuring and Organizational Realignment

     During fiscal 2002, the demand for electricity declined and the United States economy weakened. As a result, a considerable slowdown in the construction of new power plants occurred. In addition, regulatory uncertainties caused NOx reduction initiatives relating to retrofit projects to be delayed. In July 2002, as a response to these market and economic indicators, we initiated a “restructuring and organizational realignment initiative.” The goal of this initiative was to reduce costs, streamline operations, and identify certain non-critical, marginally performing operating activities, thereby positioning us with a more competitive cost structure for our overall long-term success. In connection therewith, we identified our Boiler business as a non-critical, marginally performing business segment and suspended new orders during fiscal 2003. The assets of this segment were sold during the first part of fiscal 2004, and as a result, our financial information has been restated to present this operation as a discontinued business unit.

     We believe as a result of these initiatives, including the redirection of our resources to focus on our two remaining segments, we are positioned to maximize our current operational efficiencies and have the flexibility to meet our customers’ current and anticipated needs. Even though our restructuring and organizational realignment initiatives are complete, we continue to look for ways to improve our operational efficiencies and performance.

Manufacturing and Outsourcing

     Our products are fabricated utilizing a combination of in-house manufacturing, subcontractors and contract vendors. In both fiscal 2003 and 2004, manufacturing outsourced to subcontractors accounted for a significant percentage of our costs of good sold (approximately 39% in fiscal 2003 and 41% in fiscal 2004). We believe the use of outsourcing relationships provides us with flexibility to rapidly expand our manufacturing capacity without significantly increasing our capital expenditures. Our subcontractors generally manufacture products on a fixed-price basis for each project. We regularly review our subcontractor and contract vendor relationships to ensure competitive pricing , quality and workmanship standards and on-time delivery performance.

     We maintain significant in-house manufacturing capabilities and generally manufacture products whose complexity may preclude their production by our subcontractors and contract vendors and where necessary, to protect our proprietary technology.

Customers

     Our Environmental Systems are sold to power producers, power developers, engineering and construction companies, heat recovery steam generator manufacturers, boiler manufacturers, refineries, petrochemical plants and others who desire or may be required by environmental regulations to reduce NOx emissions and ground level ozone to which NOx is a precursor.

     Gas separators, filters and conditioning systems produced by our Separation Filtration Systems business are sold to gas producers and gas gathering, transmission and distribution companies, chemical manufacturers and oil refineries, either directly or through contractors engaged to build plants and pipelines, and to manufacturers of compressors, turbines, and nuclear and conventional steam generating equipment. Marine separation and filtration systems are sold primarily to shipbuilders.

     We market our products worldwide through independent representatives who sell on a commission basis under the general direction of an officer of Peerless. We also sell products directly to customers through our internal sales force. Our business activity and revenues historically have not been seasonal.

     We are not dependent upon any single customer or group of customers in either of our two business segments. The custom-designed and project-specific nature of our business can cause year-to-year

4

variances in our major customers. During fiscal 2004, one customer accounted for approximately 10% of our revenues, and in fiscal 2003 and 2002, different customers accounted for approximately 16% and 15% of our total revenues, respectively.

     Sales to international customers have been an integral part of our business for more than 40 years. During fiscal 2004, foreign sales amounted to approximately $25.1 million, or 42.0% of our revenues, compared to sales of approximately $25.0 million, or 38.5% of our revenues during fiscal 2003, and $20.6 million, or 21.7% of our revenues in fiscal 2002. Our global offices and worldwide independent sales rep network allows us to sell to most geographic regions. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Factors That May Affect Our Operating Results and Other Risk Factors” and Item 7A - “Quantitative and Qualitative Disclosures About Market Risk” of this Report.

Backlog

     Our backlog of uncompleted orders as of June 30, 2004, was approximately $34 million, compared to $40 million as of June 30, 2003. Backlog has been calculated under our customary practice of including incomplete orders for products that are deliverable in future periods, but that may be changed or cancelled. Approximately 70% of our backlog is scheduled to be completed during our next fiscal year ending June 30, 2005. For further discussion on our backlog, please see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Backlog” of this Report.

Competition

     We have several domestic and international competitors with capital and revenues that are larger and smaller than ours in the manufacturing and selling of Environmental Systems and Separation Filtration Systems. Management believes that experience, performance, reliability and warranty service are the prime competitive factors in our markets. We believe that we strongly compete in all these areas.

Patents, Licenses and Product Development

     We believe that we are an industry leader in designing, engineering and manufacturing efficient, dependable Environmental Systems. We also consider ourselves to be highly skilled in the technology required to design and manufacture high efficiency vapor/liquid separation equipment and systems for the oil and gas industry and filtration equipment for the marine market. Our expenditures for new product development and improvements were approximately $241,000 in fiscal year 2004, $316,000 in fiscal 2003, and $576,000 in fiscal 2002.

     To protect our intellectual property rights, we depend upon a combination of patents, trademarks, internal controls and non-disclosure and confidentiality agreements with our employees, subcontractors, contract vendors, customers and others having business dealings with the Company. We have existing patents and patent applications pending on certain products and processes that are important to our business. These include patents on vane designs, separator profiles, environmental controls equipment, marine/separator filtration systems and pressure testing capabilities. In addition, most of our products are proprietary and are sold utilizing our proven technology and knowledge of the applications.

5

Employees

     At June 30, 2004, we had 181 employees (196 employees at June 30, 2003). Our employees by location is as follows:

     None of our employees are represented by a labor union or are subject to a collective bargaining agreement. We have not experienced any material labor difficulties during the past year and we believe our employee relations are good.

Raw Materials

     We purchase raw materials and component parts essential to our business from established sources and have not experienced any unusual problems in purchasing required materials and parts. We believe that raw materials and component parts will be available in sufficient quantities to meet our anticipated demand. However, there can be no assurance that we will continue to find our raw materials in quantities or at prices satisfactory to us.

Environmental Regulation

     We do not believe that our compliance with federal, state or local statutes or regulations relating to the protection of the environment has had any material effect upon capital expenditures, earnings or our competitive position. Our manufacturing processes do not emit substantial foreign substances into the environment.

     Environmental regulations related to NOx and ozone emissions have a significant impact on the demand for our Environmental Systems. See also Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Statements and Factors That May Affect Our Operating Results and Other Risk Factors” of this Report. For geographic information see Note O – “Industry Segment and Geographic Information,” of our Notes to Consolidated Financial Statements attached to this Report.

Available Information

     Our Internet website is http://www.peerlessmfg.com. Peerless makes available free of charge through its Internet website (under “Investor Relations”) the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and Proxy Statements and all amendments to those reports as soon as reasonable practicable after they are electronically filed with (or furnished to) the Securities and Exchange Commission (SEC). Reports, Proxy Statements and other information regarding the Company also are contained on the SEC’s Internet website, http://www.sec.gov.

     Peerless has posted its Code of Conduct for Directors and Employees and other corporate governance related policies, and charters for its Audit, Compensation and Nomination Committees on its website, http://www.peerlessmfg.com. This information is available in print to any shareholder who

6

requests it by writing to the Company at 2819 Walnut Hill Lane, Dallas, Texas 75229, attention: Ms. Susan Banner.

ITEM 2. PROPERTIES.

     Our executive offices and research and development facilities are owned, and are located in Dallas, Texas. We own and operate manufacturing and warehousing facilities in Abilene, Denton and Dallas, Texas. We also lease sales and marketing facilities in Dallas, Texas, Halstead – Essex, England and Singapore. See table below for additional details on our locations.

     During fiscal year 2003, in connection with restructuring initiatives, we consolidated our Dallas manufacturing operations into our Abilene manufacturing facility.

     While we believe our office and manufacturing facilities are adequate and suitable for our present and future requirements, we will continue to periodically review our space requirements and consolidate and dispose, lease or sublet facilities we no longer require and acquire new space, if our needs dictate.

     Pursuant to the terms of our revolving credit facility, we have agreed not to pledge as collateral our facilities for any obligations . Please see Item 7 - - “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” of this Report.

ITEM 3. LEGAL PROCEEDINGS

     From time to time we are involved in various litigation matters arising in the ordinary course of our business. We do not believe the disposition of any current matter will have a material adverse effect on our consolidated financial position or results of operations. For further discussion on various litigation matters, please see Note J – “Contingencies,” of our Notes to Consolidated Financial Statements of this Report.

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

     No matters require disclosure.

7

PART II

Unless otherwise indicated, the share, per share and dividend per share information reflected in this report have been adjusted to reflect the Registrant’s two-for-one stock split in the form of a stock dividend effected on October 18, 2001.

     Our common stock, par value $1.00 per share, is listed on the Nasdaq National Market under the symbol “PMFG.” The following table sets forth, for the periods indicated, the range of the daily high and low closing bid prices for our common stock as reported by Nasdaq.

     The last reported sale price of our common stock on NASDAQ on September 22, 2004 was $14.45 per share. As of that date, there were approximately 125 record holders of common stock. Cash dividends may be paid, from time to time, on our common stock as our Board of Directors deems appropriate after consideration of our continued growth rate, operating results, financial condition, cash requirements, compliance with the financial and other restrictive covenants of our bank credit facility, and such other factors as the Board of Directors deems appropriate. The Company did not pay cash dividends in either fiscal year 2004 or 2003. The Company did not repurchase any of its common stock during fiscal 2004, nor does the Company have an approved repurchase program.

     See Item 12 – Security Ownership of Beneficial Owners and Management and Related Shareholder Matters section of this Report for information relating to our equity compensation plans.

8

ITEM 6. SELECTED FINANCIAL DATA

     The following table sets forth selected financial data regarding our results of operations and financial position as of and for each of the years in the five-year period ended June 30, 2004, which are derived from our audited consolidated financial statements. Our consolidated financial statements and notes thereto as of June 30, 2004 and 2003, and for the years ended June 30, 2004, 2003 and 2002, and the report of Grant Thornton LLP thereon, are included in Item 8 of this Report. The selected financial data should be read in conjunction with Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto included in Item 8 of this Report. The share, earnings (loss) per share, dividends per share, and book value per share amounts have been adjusted to give effect to the two-for-one stock split effected on October 18, 2001. Certain earnings per share amounts may not total due to rounding.

9

ITEM 6. SELECTED FINANCIAL DATA — CONTINUED

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

Overview

     We are a global company providing environmental and separation filtration products for the abatement of air pollution and the removal of contaminants from gases and liquids through our two principal business segments – Environmental Systems and Separation Filtration Systems. During fiscal year 2004, we discontinued the operations of our Boiler business. See Item 1 – “Business – Restructuring and Organizational Realignment” and Note D – “Discontinued Operations” in our Notes to Consolidated Financial Statements of this Report for additional discussion on the discontinuance of this business unit.

     Environmental Systems. This business segment represented approximately 47%, 58%, and 69% of our fiscal 2004, 2003, and 2002 revenues, respectively. The main product of the Environmental Systems segment is Selective Catalytic Reduction Systems, referred to as “SCR Systems”. These environmental control systems are used for air pollution abatement and convert NOx emissions from exhaust gases caused by burning hydrocarbon fuels such as coal, gasoline, natural gas and oil, into harmless nitrogen and water vapor. Along with the SCR Systems, this segment also offers systems to reduce other pollutants such as CO and particulate matter. These systems are totally integrated, complete with instruments, controls and related valves and piping.

     Separation Filtration Systems. This business segment represented approximately 53%, 42%, and 31% of our fiscal 2004, 2003, and 2002 revenues, respectively. The Separation Filtration Systems segment produces specialized products known as “separators” or “filters” which are used for a variety of purposes in cleaning gases and liquids as they move through piping systems. These products are used primarily to remove solid and liquid contaminants from natural gas as well as saltwater aerosols from combustion intake air of shipboard gas turbine and diesel engines. In addition, separators are also used in nuclear power plants to remove water from saturated steam.

     Boilers. In this discontinued business segment, we designed, engineered, manufactured and sold packaged boilers and other steam generating equipment. This equipment is used to produce steam, which is used for heating, drying, driving steam engines and a variety of other applications. See also Item 1 – “Business – Restructuring and Organizational Realignment” of this Report for additional discussion on the discontinuance of this business unit during fiscal 2004.

10

Forward-Looking Statements

     From time to time, we make oral and written statements that may constitute “forward-looking statements” (rather than historical facts) as defined in the Private Securities Litigation Reform Act of 1996 or by the Securities and Exchange Commission in its rules, regulations and releases, including statements regarding our expectations, hopes, beliefs, intentions, projections or strategies regarding the future. We desire to avail ourselves of the “safe harbor” provisions in the Private Securities Litigation Reform Act of 1996 for forward-looking statements made from time to time, including, but not limited to, the forward-looking statements made in this Report, as well as those made in our other filings with the SEC. Forward-looking statements contained in this Report are based on management’s current plans and expectations and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. In the preparation of this Report, where such forward-looking statements appear, we have sought to accompany such statements with meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those described in the forward-looking statements. Such factors include, but are not limited to, the “Factors That May Affect Our Operating Results and Other Risk Factors,” as set forth starting on page 21 of this Report.

     All forward-looking statements included in this Report are based on information available to us on the date hereof, and we expressly disclaim any obligation to release publicly any updates or changes in the forward-looking statements, whether as a result of changes in events, conditions, or circumstances on which any forward-looking statement is based.

Results of Operations – Consolidated

     Revenues. For fiscal 2004, revenues decreased approximately $5.1 million, or 7.9% to $59.8 million from $64.9 million in fiscal 2003. Domestic revenues decreased approximately $5.2 million, or 13.0%, from $39.9 million in fiscal 2003 to $34.7 million in fiscal 2004. Foreign revenues increased approximately $100,000, or 0.4%, from $25.0 million in fiscal 2003 to $25.1 million in fiscal 2004. The decline in domestic revenues was mainly attributable to the decline in our Environmental Systems sales, which continues to be impacted by the slow-down in new merchant power construction and regulatory uncertainties. The increase in our foreign revenues related primarily to the increase in our Separation Filtration Systems sales in Europe and the Middle East through our UK subsidiary, partially offset by a decrease in these systems sales in Latin America. See Item 7 – “Results of Operations – Segments” of this Report for further discussion of revenues.

     For fiscal 2003, revenues decreased approximately $30.0 million, or 31.6%, to $64.9 million from $94.9 million in fiscal 2002. Domestic revenues decreased approximately $34.4 million, or 46.3%, from $74.3 million in fiscal 2002 to $39.9 million in fiscal 2003. Foreign revenues increased approximately $4.4 million, or 21.4%, from $20.6 million in fiscal 2002 to $25.0 million in fiscal 2003. The decline in domestic revenues was mainly attributable to the decline in our Environmental Systems sales. The increase in foreign revenues related primarily to the increase in our Separation Filtration Systems sales through our UK subsidiary. We believe the decline in the construction of new power plants, regulatory uncertainties, and the economic climate all contributed to the significant decline in our domestic revenues during the period. See Item 7 – “Results of Operations – Segments” of this Report for further discussion of revenues.

     Gross Profit Margin. Our margins, during a particular period, may be impacted by three primary factors: (1) sales volume, (2) shifts in our product mix and, (3) start-up and warranty costs. Certain products have higher margins than others; as a result, shifts in the composition of our sales can have a significant impact on our margins either at the selling margin level or through a negative or positive impact on our manufacturing absorption. For fiscal 2004, our gross profit margin increased $1.8 million, or 10.6%, from $17.0 million in fiscal 2003 to $18.8 million in fiscal 2004. Gross profit margin, as a percentage of sales, increased from 26.2% for fiscal 2003 to 31.5% for fiscal 2004. Our margins during

11

the fiscal 2004 were favorably impacted by a significant reduction in our start-up and warranty costs, which decreased $2.5 million, or 71.4%, from $3.5 million in fiscal 2003 to $1.0 million in fiscal 2004, which resulted from our project execution quality control program. This improvement was offset by a higher unabsorbed manufacturing factor during the period due to our decreased sales volume. In addition to the foregoing, our margins were negatively impacted by shifts in our product mix, as our Environmental Systems revenues declined from 58% of our total revenues in fiscal 2003 to 47% in fiscal 2004. The negative impact associated with the decline in our Environmental Systems revenue during fiscal 2004, was partially offset by the 103% increase in our nuclear/marine revenues.

     For fiscal 2003, our gross profit margins decreased $13.0 million, or 43.3%, from $30.0 million in fiscal 2002 to $17.0 million in fiscal 2003. Gross profit margins, as a percentage of sales, decreased from 31.6% for fiscal 2002 to 26.2% for fiscal 2003. Our reported margins during fiscal year 2003 were impacted primarily by two factors, our manufacturing absorption factor, which was impacted by the 46.3% decrease in our domestic revenues, and a shift in our product sales mix, as our Environmental Systems revenues, which historically have higher gross profit margins, represented only 57.8% of our total revenues compared to 69.1% for fiscal 2002. In addition to the two primary factors, our margins during fiscal 2003 were also impacted by start-up costs on several SCR system projects being higher than we initially budgeted and increased competition in the marketplace.

     Operating Expenses. For fiscal 2004, operating expenses from continuing operations decreased by approximately $1.5 million or 9.1%, from $16.4 million for fiscal 2003 to approximately $14.9 million for fiscal 2004. Operating expenses, as a percentage of sales, were 25.0% for fiscal 2004, compared to 25.3% for fiscal 2003. On a comparative basis, and as a percentage of revenues, our sales and marketing expenses increased from 9.1% to 10.3%, our engineering and project management expenses decreased from 8.0% to 6.9%, and our general and administrative expenses (including restructuring expenses in fiscal 2003) decreased from 8.2% to 7.8%. The increase in our sales and marketing expenses, as a percentage of revenues, related primarily to an increase in our commission expense during the period, which is directly related to the increase in our Separation Filtration Systems revenues, which generally tends to have a higher commission rate than our Environmental Systems revenues. The decrease in engineering and project management expenses is attributed to our restructuring and realignment initiative started last year and due to the decline in our Environmental Systems revenues, which generally are more engineering intensive than our Separation Filtration Systems sales. The decrease in general and administrative expenses related primarily to the costs in fiscal 2003 associated with our restructuring, which savings were partially offset by the higher public company related expenses in fiscal 2004. The higher public company related expenses are expected to continue as the Company continues to manage the increased expense of compliance with corporate governance requirements enacted by the SEC, as well as the Nasdaq stock market.

     For fiscal 2003, operational expenses decreased $4.6 million, or 21.9%, from $21.0 million for fiscal 2002 to $16.4 million for fiscal 2003. Operating expenses as a percentage of revenue were 25.3% for fiscal 2003 and 22.2% for fiscal 2002. On a comparative basis, and as a percentage of revenues, our sales and marketing expenses increased from 7.8% to 9.1%, our engineering and project management expenses increased from 7.8% to 8.0%, and our general and administrative expenses increased from 6.6% to 8.2%. The decrease in the amount of total operating expenses during fiscal 2003 was due to the implementation of our restructuring and organizational realignment initiative. As the steps in this initiative were phased-in over the year, we did not realize the full benefit of this initiative until the second half of the fiscal year. In connection with this initiative, we incurred approximately $500,000 in severance payments and related costs. In addition, included in our operating expenses in fiscal 2003 was an additional provision for doubtful accounts of approximately $650,000, which related primarily to a customer that had declared bankruptcy (see Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Contingencies,” of this Report for further discussion).

12

     Other Income and Expense. For fiscal 2004, other income and expense items changed by approximately $751,000, from income of approximately $727,000 for the fiscal 2003 to expense of $24,000 for fiscal 2004. During fiscal 2003, we recognized a gain of approximately $473,000 on the sale of our Wylie, Texas real property and other assets. We also realized foreign currency exchange losses associated with our UK operations of approximately $101,000 during fiscal 2004 compared to exchange gains of approximately $146,000 in fiscal 2003.

     For fiscal 2003, other income and expense items changed by approximately $317,000 from an addition to income of approximately $410,000 for fiscal 2002 to an addition to income of $727,000 for fiscal 2003. During fiscal 2003, we recognized a gain of approximately $473,000 on the sale of our Wylie, Texas real property and other assets and recognized a gain of approximately $267,000 in fiscal 2002 on the sale of our Carrollton, Texas real property and other assets. We also realized foreign currency exchange gains of approximately $146,000 during fiscal 2003 compared to exchange gains of approximately $84,000 in fiscal 2002.

     Income Taxes. The Company’s effective income tax rate for continuing operations was approximately 37.6%, 30.5% and 34.9% in fiscal 2004, 2003 and 2002, respectively. The increased rate in fiscal 2004 is due primarily to our increased state income tax expense during the year and reduced foreign tax related benefits. The decrease in our expense during fiscal 2003 related primarily to our lower effective foreign tax rate. The increased foreign tax related benefits during fiscal 2002, were offset by a higher state income tax burden during that year. For further discussion related to our income taxes, please see Note M – “Income Taxes,” to our Notes to Consolidated Financial Statements attached to this Report.

     Net Earnings from Continuing Operations. As a result of the above factors, our net earnings from continuing operations increased by approximately $1.5 million, or 166.7%, from approximately $911,000, or 1.4% of sales, for fiscal 2003, to approximately $2.4 million, or 4.0% of sales, for fiscal 2004. Basic earnings per share increased from $0.30 per share for fiscal 2003, to $0.80 per share for fiscal 2004. Diluted earnings per share increased from $0.30 per share for fiscal 2003, to $0.79 per share for fiscal 2004.

     For fiscal year 2003, net earnings from continuing operations decreased $5.2 million, or 85.2%, from $6.1 million for fiscal year 2002 to $911,000 in fiscal 2003. Basic earnings per share decreased from $2.04 per share for fiscal 2002, to $.30 per share for fiscal 2003. Diluted earnings per share decreased from $1.97 per share for fiscal 2002, to $.30 per share for fiscal 2003.

     Discontinued Operations. Our net loss from discontinued operations for the year ended June 30, 2004 was approximately $364,000 compared to a net loss of $1.3 million for the year ended June 30, 2003. The expense in the 2004 fiscal year related primarily to costs associated with the start-up and commissioning of projects that were not commissioned by June 30, 2003. The Company has established a reserve (approximately $300,000 at June 30, 2004), based on its estimate of these costs given the most current information available and historical experience. While we believe our reserve is adequate and the judgment applied is appropriate, due to a number of factors, our estimated liability could differ from our actual costs incurred (see “Critical Accounting Policies – Product Warranties” of this Report). Also included in our net loss for the year ended June 30, 2004 was a net gain related to the disposal of our Boiler operation of approximately $92,000 ($140,000 gain less taxes of $48,000). Basic and diluted loss per share from discontinued operations was ($0.12) per share for fiscal 2004, compared to a loss of ($0.43) per share for fiscal 2003.

     Our net loss from discontinued operations for fiscal 2002 was approximately $1.7 million. Our basic loss per share from discontinued operation in fiscal 2002 was ($0.57) per share. Our diluted loss per share from discontinued operations in fiscal 2002 was ($0.55) per share. See also Note D – “Discontinued Operations” to our Notes to Consolidated Financial Statements of this Report for further discussion of discontinued operations.

13

     Net Earnings (Loss). As a result of the above factors, our net earnings increased approximately $2.4 million from a net loss of $379,000, or (0.6)% of sales, for fiscal 2003, to approximately $2.0 million, or 3.4% of sales, for fiscal 2004. Basic earnings per share increased from a loss of ($0.13) per share for fiscal 2003, to earnings of $0.68 per share for fiscal 2004. Diluted earnings per share increased from a loss of ($0.13) per share for fiscal 2003, to earnings of $0.67 per share for fiscal 2004.

     Our net loss was approximately $379,000, or (0.6)% of sales, for fiscal 2003, compared to net earnings of approximately $4.4 million, or 4.6% of sales for fiscal 2002. Basic earnings per share decreased from $1.47 per share for fiscal 2002, to a loss of ($0.13) per share for fiscal 2003. Diluted earnings per share decreased from $1.43 per share for fiscal 2002, to a loss of ($0.13) per share for fiscal 2003.

Results of Operations – Segments

     Currently we are organized along two lines of business: Environmental Systems, and Separation Filtration Systems. The Company had three reportable segments – Environmental Systems, Separation Filtration Systems, and Boilers in fiscal 2003 and 2002. The Boiler segment was discontinued and its assets sold during the first quarter of fiscal 2004. See Note D – “Discontinued Operations” in the Notes to our Consolidated Financial Statements for further discussion on the Boiler segment. Segment information for fiscal 2002 has been restated on a comparable basis with fiscal 2003 and 2004.

     Revenues. The following table displays revenues by reportable segment (dollars in thousands).

     Revenues from our Environmental Systems decreased $9.4 million, or 25.1%, in fiscal 2004, and decreased $28.0 million, or 42.7%, in fiscal 2003. Our Environmental Systems segment continues to be impacted by the slow-down in new power plant construction and regulatory uncertainties. We expect that spending for NOx reduction systems will increase in 2005 – 2008 as regulatory compliance deadlines come into effect over the next 5 years. We have experienced and continue to expect an increase in request for proposals, as users begin to implement their compliance plans. In addition, while the construction of new power plants has significantly declined over the past several years, we believe this portion of the Environmental Systems business will show improvement in 2006 – 2007, as older plants are retired/or modified and new plants are built to meet the growing demand for electricity both domestically and internationally.

     Separation Filtration Systems revenues increased by approximately $4.3 million, or 15.8% in fiscal 2004 and decreased by approximately $2.0 million, or 6.8% in fiscal 2003. We saw our domestic Separation Filtration Systems revenues increase by approximately $4.2 million, or 84.5% in fiscal 2004, compared to a decrease of $6.7 million, or 57.7% for fiscal 2003. The increase in our domestic revenues during fiscal 2004 can be attributed primarily to an increase in our nuclear/marine sales, which increased by $3.6 million, or 102.9%. The increase related primarily to life extension projects at several nuclear power plants and increased military spending. The decline in our domestic sales during fiscal 2003 related primarily to the economic weakness in the US economy. Our international revenues increased $100,000, or 0.6% in fiscal 2004, compared to an increase of $4.7 million, or 26.8% in fiscal 2003. The

14

increase in our international revenues during fiscal 2004 can be attributed to an increase in our UK sales of approximately $2.5 million, which was offset by a decline in our Latin American sales of approximately $2.4 million, due to the economic and political uncertainties surrounding this area. The increase in international revenues during fiscal 2003, related primarily to the increase in sales through our UK subsidiary of $1.4 million, and an increase in international sales through our domestic operation of approximately $3.3 million.

     Segment Profit. The following table displays segment profit by reportable segment (dollars in thousands):

     To measure segment profit, management uses segment revenues, less segment costs and expenses, before allocation of general and administrative costs. In the past, the Company did not allocate its manufacturing costs that were not fully absorbed to each individual segment. Starting in fiscal 2003, the Company began allocating all costs associated with the manufacture, sale and design of its products to each segment. The Company does not allocate its general and administrative expenses to individual segments. Fiscal 2002 segment profit information has been restated to conform to the fiscal 2004 and 2003 presentation.

     Environmental Systems profit in fiscal 2004 increased $942,000, or 29.5% over fiscal 2003. Profit in fiscal 2003 decreased $10.4 million, or 76.5% over fiscal 2002. As a percentage of Environmental Systems revenue, profit in Environmental Systems was 14.7%, 8.5% and 20.7%, in fiscal 2004, 2003 and 2002, respectively. The increase in our Environmental Systems profit margin during the fiscal 2004 related primarily to the decrease in start-up and commissioning costs of SCR projects, resulting from the Company’s project execution quality control program, and a reduction of operational expenses in connection with our organizational realignment and restructuring. The decline in our Environmental System profit margin during fiscal 2003 related primarily to the 42.7% drop in this segment’s revenues and the resulting impact on its operational overhead as a percentage of sales. In addition, start-up costs on several jobs were higher than initially budgeted which impacted this segment’s reported profits by approximately 4% (as a percentage of sales).

     Separation Filtration Systems profit in fiscal 2004 increased $1.7 million, or 61.4% over fiscal 2003. Profit in fiscal 2003 increased $1.1 million, or 63.7% over fiscal 2002. As a percentage of Separation Filtration Systems revenue, profit in Separation Filtration Systems was 13.8%, 9.9%, and 5.6%, in fiscal 2004, 2003 and 2002, respectively. The increase in the Separation Filtration Systems profit margins relates primarily to the changes in our sales mix during these periods.

     Market Outlook

     Environmental Systems. We expect that the spending for NOx reduction systems will increase in 2005 – 2008 as users implement their compliance plans as regulatory compliance deadlines come in to effect over the next 5 years. In addition, while the construction of new power plants has significantly declined over the last several years, we expect this market to improve in 2006 – 2007, as older plants are retired/or modified and new plants are built to meet the growing demand for electricity both domestically and internationally.

15

Separation Filtration Systems. The market for nuclear/marine products remains strong, and is expected to continue at such levels for at least the next 5 years, as nuclear power plants continue to invest in life extension projects and increased military spending occurs. The Nuclear Regulatory Commission estimates that by 2010, nearly 80% of nuclear power plants in the United States will be in the license renewal process. In addition, the increased demand for natural gas, both domestically and internationally, should also create new opportunities for our separator and filter products. One such opportunity is Liquified Natural Gas (LNG) and its associated gas processing facilities, which are currently being proposed in a number of areas to facilitate the transportation of LNG to the United States and other markets.

Contingencies

     The Company previously disclosed that a $2.2 million receivable (before allowance for doubtful accounts) due from a customer that had filed a plan of reorganization under Chapter 11 of the United States Bankruptcy Code was included in its discontinued operations. The Company obtained outside counsel to assist with the collection of this receivable and filed a statutory lien on the refinery where its equipment was installed. During the 2004 fiscal year, the Company and the project owner reached a settlement agreement whereby the parties agreed to release each other from any outstanding claims, the Company agreed to release its lien, and the project owner paid the outstanding unreserved balance due on the receivable.

     On March 19, 2004, the Company received notice that an adversary proceeding was initiated by Enron Corp. and National Energy Production Corporation in the United States Bankruptcy Court for the Southern District of New York against PMC Acquisition, Inc., a subsidiary that operated the discontinued Boiler business of the Company under the name ABCO Industries. The plaintiffs allege that certain accounts receivable payments paid to ABCO were avoidable transfers under the Bankruptcy Code and are seeking to recover approximately $1 million from ABCO. The Company has engaged outside counsel and believes that all, or a majority of the payments, fail to meet the applicable standards for avoidance under the Bankruptcy Code and otherwise applicable law, and that a number of defenses can be asserted that will negate any recovery by the plaintiffs. The Company intends to vigorously defend against the lawsuit and management believes the likelihood of loss in not probable.

     From time to time the Company is involved in various litigation matters arising in the ordinary course of its business. The Company does not believe the disposition of any current matter will have a material adverse effect on its consolidated financial position or its results of operations.

Backlog

     The Company’s backlog of unfilled orders was approximately $34 million at June 30, 2004, compared to $40 million at June 30, 2003. Our backlog at June 30, 2004, when compared to our backlog at June 30, 2003, has been impacted by the completion of a substantial contract of approximately $6 million (original value of contract - $14 million), during the first part of fiscal 2004. Our Environmental Systems segment continues to be impacted by the effects of the slow down in new power plant construction. We expect that spending for NOx reduction systems will increase in 2005 – 2008 as users implement their compliance plans as regulatory deadlines approach, and we are continuing to see an increase request for proposals relating to such initiatives. In addition, while the construction of new power plants has seen a decline over the past several years, we believe this portion of the Environmental Systems business will improve in 2006 – 2007. The market for Peerless nuclear and marine products remains strong as nuclear power plants continue to invest in life extension projects and increased military spending occurs. The shortage of natural gas supplies is creating new opportunities for Peerless separators and filters, such as the production of LNG and the associated gas processing facilities.

16

Financial Position

     Assets. Total assets decreased by approximately $4.3 million, or 9.8%, from $43.8 million at June 30, 2003 to $39.5 million at June 30, 2004. The decrease in our assets during the fiscal year resulted primarily from the downturn in our business. At June 30, 2004, we held cash and cash equivalents of $4.1 million, had working capital of $20.7 million, and a current ratio of 2.4-to-1.0 This compares with cash and cash equivalents of $6.7 million, $17.8 million in working capital, and a current ratio of 1.8 to-1.0 at June 30, 2003.

     Liabilities and Shareholders’ Equity. Total liabilities decreased by approximately $6.7 million, or 31.2%, from $21.5 million at June 30, 2003 to $14.8 million at June 30, 2004. The decrease in liabilities related primarily to a decrease in our accounts payable of approximately $4.0 million and a decrease in our billings in excess of costs and earnings on uncompleted contracts of approximately $1.6 million see “Liquidity and Capital Resources” of Item 7). The increase in our equity of approximately $2.4 million, or 10.8%, from $22.3 million at June 30, 2003 to $24.7 million at June 30, 2004 resulted primarily from our earnings during the period. Our debt (total liabilities)-to-equity ratio improved from .96-to-1.0 at June 30, 2003 to .60-to-1.0 at June 30, 2004, reflecting the 31.2% reduction in our liabilities and the 10.8% increase in our equity during the period.

Liquidity and Capital Resources

     Our cash and cash equivalents were $4.1 million as of June 30, 2004, compared to $6.7 million at June 30, 2003. Cash used in operating activities during fiscal year 2004 was $4.3 million, compared to $5.7 million and $4.6 million being provided by operations during fiscal 2003 and fiscal 2002, respectively.

     Because we are engaged in the business of manufacturing custom systems, our progress billing practices are event-oriented rather than date-oriented, and vary from contract to contract. We customarily bill our customers after the occurrence of project milestones. Billings to customers affect the balance of billings in excess of costs and earnings or the balance of cost and earnings in excess of billings, as well as the balance of accounts receivable. Consequently, we focus on the net amount of these accounts along with accounts payable, to determine our management of working capital. At June 30, 2004, the balance of these working capital accounts was $15.9 million compared to $7.9 million at June 30, 2003, reflecting an increase of our investment in these working capital items of $8.0 million. Generally, a contract will either allow for amounts to be billed upon shipment or on a progress basis based on the attainment of certain milestones. During the 2004 fiscal year, a greater percentage of the Company’s contracts in progress called for billings upon project shipment versus the attainment of certain milestones, which resulted in the increase in our investment in these working capital accounts. In addition, during fiscal year 2004, funds were provided by our operating profit and used to reduce our accrued expenses.

     Cash used in investing activities was approximately $98,000 for fiscal year 2004, compared to cash provided by investing activities of approximately $423,000 for fiscal 2003, and cash used of approximately $1.2 million in fiscal 2002. The use of cash during fiscal 2004 related primarily to capital refurbishments of our Denton and Abilene, Texas manufacturing facilities, offset by the redemption of a short-term investment. The cash provided during the 2003 fiscal year related primarily to the sale of 32 acres of undeveloped land in Wylie, Texas. The use of cash during fiscal 2002 related primarily to the refurbishment of our Abilene, Texas manufacturing facility and new technology equipment purchased during the year, offset by the proceeds from the sale of our Carrollton, Texas facility.

     Cash provided by financing activities was approximately $130,000 and $64,000 during fiscal 2004 and 2003, respectively, and related to the proceeds from the issuance of common stock, pursuant to employee stock options. Cash used during fiscal 2002 was approximately $1.4 million, and related to the

17

payment of a $1.6 million note on our Abilene, Texas facility, offset by the proceeds from the issuance of common stock, pursuant to employee stock options, of approximately $236,000.

     Cash provided from our discontinued operations during the current period was approximately $1.8 million, compared to a use of cash from discontinued operations of approximately $900,000 and $3.1 million for fiscal 2003 and 2002, respectively. The cash provided during the current period can be attributed to the collection of a significant receivable due from a customer that had filed for a plan of reorganization under Chapter 11 of the United States Bankruptcy Code (see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Contingencies,” of this Report).

     As a result of the above factors, during fiscal year 2004, our cash and cash equivalents decreased by approximately $2.6 million, compared to an increase of approximately $5.3 million and a decrease of $1.2 million during fiscal 2003 and 2002, respectively.

     On October 31, 2003, we entered into a $12.5 million revolving credit facility for working capital requirements that expires on October 31, 2006. The facility carries a floating interest rate based on the prime or Euro rate plus or minus an applicable margin (Euro plus 1.75% at June 30, 2004), and is secured by substantially all our domestic assets. At June 30, 2004, we had $3.5 million outstanding under stand-by letters of credit and no loans outstanding, leaving us availability under our credit facility of $9.0 million. The facility contains financial covenants, certain restrictions on capital expenditures, acquisitions, asset dispositions, dividends and additional debt, as well as other customary covenants. As of June 30, 2004, the Company was in compliance with all financial and other covenants under the credit facility.

     In addition, our UK subsidiary has a £2.0 million (approximately $3.6 million) debenture agreement used to facilitate the issuances of bank guarantees. This facility is secured by substantially all of the UK subsidiary assets, and is backed by a Peerless stand-by letter of credit of £1.3 million (approximately $2.3 million, which is included in the $3.5 million outstanding above) and expires on October 31, 2004. At June 30, 2004, there was approximately £1.44 million outstanding under this facility, leaving availability of approximately £560,000 (approximately $1 million).

     We believe we maintain adequate liquidity to support existing operations and planned growth, as well as to continue operations during reasonable periods of unanticipated adversity.

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

     The following table summarizes the indicated contractual obligations and other commitments of the Company as of June 30, 2004. The Company has no off-balance-sheet arrangements in place as of June 30, 2004.

(1)

Purchase obligations in the table above represent the value of open purchase orders as of June 30, 2004. We believe that some of these obligations could be canceled for payment of a nominal penalty, or no penalty; however, the amount of open purchase orders that could be canceled

18

		under such terms is difficult to quantify. In addition, the Company generally has contracts with its customers that minimize its exposure to losses for materials purchased within lead-times necessary to meet customer forecasts.
(2)		Included in the amount of stand-by letters of credit is an approximately $2.3 million stand-by letter of credit issued on the behalf of Peerless to guarantee the debenture agreement of its subsidiary, Peerless Europe Limited.

Critical Accounting Policies

     The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates.

     Certain of our accounting policies require a higher degree of judgment than others in their application. These include revenue recognition on long-term contracts, accrual for estimated warranty costs and allowance for doubtful accounts. Our policies and related procedures for revenue recognition on long-term contracts, accrual of warranty costs and allowance for doubtful accounts are summarized below.

     Revenue Recognition. We provide products under long-term, generally fixed-priced, contracts that may extend up to 18 months, or longer, in duration. In connection with these contracts, we follow the guidance contained in AICPA Statement of Position (“SOP”) 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 81-1 requires the use of percentage-of-completion accounting for long-term contracts that contain enforceable rights regarding services to be provided and received by the contracting parties, consideration to be exchanged, and the manner and terms of settlement, assuming reasonably dependable estimates of revenues and expenses can be made. The percentage-of-completion methodology generally results in the recognition of reasonably consistent profit margins over the life of a contract. Amounts recognized in revenue are calculated using the percentage of construction cost completed, generally on a cumulative cost to total cost basis. Cumulative revenues recognized may be less or greater than cumulative costs and profits billed at any point in time during a contract’s term. The resulting difference is recognized as “costs and earnings in excess of billings on uncompleted contracts” or “billings in excess of costs and earnings on uncompleted contracts.”

     When using the percentage-of-completion method, we must be able to accurately estimate the total costs we expect to incur on a project in order to record the proper amount of revenues for that period. We continually update our estimates of costs and status of each project with our subcontractors and our manufacturing plants. If it is determined that a loss will result from the performance of a contract, the entire amount of the loss is charged against income when it is determined. The impact of revisions in contract estimates are recognized on a cumulative basis in the period in which the revisions are made. In addition, significant portions of the our costs are subcontracted under fixed-price arrangements, thereby reducing the risk of significant cost overruns on any given project. However, a number of internal and external factors, including labor rates, plant utilization factors, future material prices, customer change specifications, and other factors can affect our cost estimates. While we attempt to reduce the risk relating to revenue and cost estimates in percentage-of-completion models through corporate policy and approval and monitoring processes, any estimation process, including that used in preparing contract accounting models, involves inherent risk.

19

     Product Warranties. We offer warranty periods of various lengths to our customers depending upon the specific product and terms of the customer agreement. We typically negotiate varying terms regarding warranty coverage and length of warranty dependent upon the product involved and customary practices. In general, our warranties require us to repair or replace defective products during the warranty period at no cost to the customer. We attempt to back-up concurrent warranties for major component parts from our suppliers. As of each balance sheet date, we record an estimate for warranty related costs for products sold based on historical experience, expectation of future conditions and the extent of back-up concurrent supplier warranties in place. While we believe that our estimated warranty reserve is adequate and the judgment applied is appropriate, due to a number of factors our estimated liability for product warranties could differ from actual warranty costs incurred in the future.

     Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts to reflect estimated losses resulting from the inability of customers to make required payments. On an on-going basis, we evaluate the collectibility of accounts receivable based upon historical collection trends, current economic factors, and the assessment of the collectibility of specific accounts. We evaluate the collectibility of specific accounts using a combination of factors, including the age of the outstanding balances, evaluation of customers’ current and past financial condition and credit scores, recent payment history, current economic environment, and discussions with our project managers and with the customers directly.

     Reserve for Obsolete and Slow-Moving Inventory. Inventories are valued at the lower of cost or market and are reduced by a reserve for excess and potentially obsolete inventories. The Company regularly reviews inventory values on hand, using specific aging categories, and records a provision for obsolete and slow-moving inventory based on historical usage and estimated future usage. As actual future demand or market conditions may vary from those projected by management, adjustments to inventory valuations may be required.

New Accounting Standards

     In November 2002, Financial Accounting Standards Board (“FASB”) reached a consensus on Emerging Issues Task Force (“EITF”) Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The guidance in this Issue was effective for revenue arrangements entered into in fiscal years beginning after June 15, 2003. The Issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities and whether, as a result, there is embedded more than one earnings process for revenue recognition purposes. The adoption of this pronouncement did not have a material impact on our financial condition or results of our operations.

     In April 2003, FASB issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” Statement No. 149 requires that contracts with comparable characteristics be accounted for similarly. The Statement clarifies the circumstances in which a contract with an initial net investment meets the characteristics of a derivative, and when a derivative contains a financing component and amends certain other existing pronouncements. This Statement was effective for contracts entered into or modified after June 30, 2003. The adoption of this pronouncement did not have a material impact on our financial condition or results of our operations.

     In May 2003, the FASB issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” Statement No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Many of these instruments were previously classified as equity. Statement No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability, or as an asset in some circumstances. This Statement applies to three types of freestanding financial instruments, other than outstanding shares. One type is mandatory redeemable shares, which the issuing company is obligated to buy back in exchange for cash or assets; a second type includes put options and forward purchase

20

contracts that require or may require the issuer to buy back some of its shares in exchange for cash or other assets; and the third type is obligations that can be settled with shares, the monetary value of which is fixed, ties solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuer’s shares. This Statement does not apply to features embedded in a financial instrument that is not a derivative in its entirety. Statement No. 150 was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this pronouncement did not have a material impact on our financial statements.

     In December 2003, the FASB revised FIN No. 46 (FIN 46R), “Consolidation of Variable Interest Entities.” FIN 46R clarifies the application of Accounting Research Bulletin No. 51 for certain entities for which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Company would currently be required to adopt FIN 46R for any variable interest entities it had and would be required to meet the disclosure requirements of this pronouncement. However, the Company has determined that it does not have an interest in such entities based on its analysis and assessment.

Factors That May Affect Our Operating Results and Other Risk Factors

     Investing in our common stock involves a high degree of risk. Any of the following risks could have a material adverse effect on our financial condition, liquidity, and results of operations or prospects, financial or otherwise. Reference to these factors in the context of a forward-looking statement or statements will be deemed to be a statement that any one or more of the following factors may cause actual results to differ materially from those in such forward-looking statement or statements. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward-Looking Statements” of this Report.

     Changes in the power generation industry and/or the economy could have an adverse impact on sales of our Environmental Systems and our operating results.

     The demand for our Environmental Systems depends to an extent on the continued construction of power generation plants and the upgrade of existing power plants. In fiscal 2004, approximately 47% of our consolidated revenues were derived from sales of Environmental Systems for new and refurbished power plants compared to approximately 58% for fiscal 2003. The power generation industry has experienced cyclical periods of slow growth or decline. Any change in the power plant industry that results in a decline in the construction of new power plants or a decline in the refurbishing of existing power plants could have a materially adverse impact on our Environmental Systems revenues and our results of operations. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

     Changes in the price, supply or demand for natural gas could have an adverse impact on our sales of Separation Systems and our operating results.

     A large portion of our separation filtration business is driven by the construction of natural gas production and transportation infrastructure. Increasing demand for natural gas may result in the construction of natural gas production facilities and facilities to transport the gas to its end destination (i.e., pipelines and LNG processing plants). Increasing prices of natural gas, while beneficial to exploration activities and the financing of new projects, can adversely impact demand. Excessive supply could also negatively impact the price of natural gas, which could discourage spending on new projects.

21

     Changes in current environmental legislation could have an adverse impact on the sale of our Environmental Systems and on our operating results.

     Our Environmental Systems business is primarily regulatory driven. Laws and regulations governing the discharge of pollutants into the environment or otherwise relating to the protection of the environment or human health have played a significant part in the increase use of Environmental Systems in the United States. These laws include U.S. federal statutes such as the Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), the Clean Water Act and the Clean Air Act, and the regulations implementing them, as well as similar laws and regulations at state and local levels and in other countries. These laws and regulations may change or other jurisdictions may not adopt similar laws and regulations. This business segment will be adversely impacted to the extent that current regulations requiring the reduction of NOx emissions are repealed, amended or implementation dates delayed or to the extent that regulatory authorities minimize enforcement. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

     Competition could result in lower sales and decreased margins.

     We operate in highly competitive markets worldwide. Competition could result in not only a reduction in our sales, but also a reduction in the prices we charge for our products. To remain competitive we must be able to not only anticipate or respond quickly to our customers’ needs and enhance and upgrade our existing products and services to meet those needs, but also continue to price our products competitively. Our competitors may develop cheaper, more efficient products or may be willing to charge lower prices for strategic marketing or to increase market share. Some of our competitors have more capital and resources than we do and may be better able to take advantage of acquisition opportunities or adapt more quickly to changes in customer requirements. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

     We enter into fixed-priced contracts. If our actual costs exceed our original estimates, our profits will be reduced.

     The majority of our contracts are on a fixed-price basis. Although we benefit from cost savings, we have limited ability to recover cost overruns. Because of the large scale and long duration of our contracts, unanticipated cost increases may occur as a result of several factors, including, but not limited to, (1) increases in the cost, or shortages of components, materials or labor; (2) unanticipated technical problems; (3) required project modifications not initiated by the customer; and (4) suppliers’ or subcontractors’ failure to perform. These factors could delay delivery of our products and our contracts often provide for liquidated damages for late delivery. Unanticipated costs that we cannot pass on to our customers or the payment of liquidated damages under fixed contracts would negatively impact our profits.

     Our backlog may not be indicative of our future revenue.

     Customers may cancel or delay projects for reasons beyond our control. Our orders normally contain cancellation provisions, which permit us to recover only our costs and a portion of our anticipated profit in the event a customer cancels an order. If a customer elects to cancel, we may not realize the full amount of revenues included in our backlog. If projects are delayed, the timing of our revenues could be affected and projects may remain in our backlog for extended periods of time. Revenue recognition occurs over long periods of time and is subject to unanticipated delays. If we receive relatively large orders in any given quarter, fluctuations in the levels of our quarterly backlog can result because the backlog in that quarter may reach levels that may not be sustained in subsequent quarters. Our backlog may not be indicative of our future revenues. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

22

     Our ability to conduct business outside the United States may be adversely affected by factors outside of our control and our revenues and profits from international sales could be adversely impacted.

     For fiscal 2004, revenue outside the United States represented approximately 42% of our consolidated revenues. In fiscal 2003, approximately 39% of our revenue was derived from sales outside the United States. Our operations and earnings throughout the world have been, and may in the future be, affected from time to time in varying degrees by war, political developments and foreign laws and regulations, such as regional economic uncertainty, political instability, restrictions, customs and tariffs, changing regulatory environments, fluctuations in foreign currency exchange rates and adverse tax consequences. The likelihood of such occurrences and their overall effect upon us vary greatly from country to country and are not predictable. These factors may result in a decline in revenues or profitability and could adversely affect our ability to expand our business outside of the United States.

     Our financial performance may vary significantly from period to period, making it difficult to estimate future revenue.

     Our annual revenues and earnings have varied in the past and are likely to vary in the future. Our Environmental Systems contracts generally stipulate customer specific delivery terms and may have contract cycles of a year or more, which subjects them to many factors beyond our control. In addition, these contracts are significantly larger in size than our typical Separation Filtration Systems contracts, which tend to intensify their impact on our annual operating results. Furthermore, as a significant portion of our operating costs are fixed, an unanticipated decrease in our revenues, a delay or cancellation of orders in backlog, or a decrease in the demand for our products, may have a significant impact on our annual operating results. Therefore, our annual operating results may be subject to significant variations and our operating performance in one period may not be indicative of our future performance.

     Our margins are affected by shifts in our product mix.

     Certain of our products have higher margins than others. Consequently, changes in the composition of our sales between products from quarter-to-quarter or from period-to-period can have a significant impact on our reported margins. Certain of our products also have a much higher internally manufactured cost component; and therefore, changes from quarter-to-quarter or from period-to-period can have a significant impact on our reported margins through a negative or positive impact on our manufacturing absorption. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

     Our products are covered by warranties. Unanticipated warranty costs for defective products could adversely affect our financial condition and results of operations and reputation.

     We provide warranties on our products generally for terms of three years or less. These warranties require us to repair or replace faulty products and meet certain performance standards, among other customary warranty provisions. While we continually monitor our warranty claims and provide a reserve for estimated warranty issues on an on-going basis, an unanticipated claim could have a material adverse impact on our operations. In some cases, we may be able to subrogate a claim back to a subcontractor, if the subcontractor supplied the defective product or performed the service, but this may not always be possible. The need to repair or replace products with design or manufacturing defects could temporarily delay the sale of new products, reduce our profits and could adversely affect our reputation. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operation” of this Report.

23

     Product liability claims not covered by insurance could adversely affect our financial condition and results of operations.

     We may be subject to product liability claims involving claims of personal injury or property damage. While we maintain product liability insurance coverage to protect us in the event of such a claim, our coverage may not be adequate to cover the cost of defense and the potential award in the event of a claim. Also, a well-publicized actual or perceived problem could adversely affect our reputation and reduce the demand for our products.

     Large contracts represent a significant portion of our accounts receivable, which increases our exposure to credit risk.

     We closely monitor the credit worthiness of our customers. Significant portions of our sales are to customers who place large orders for custom products and whose activities are related to the power and oil/gas industries. As such, our exposure to credit risk is affected to some degree by conditions within these industries and governmental and/or political conditions. We mitigate our exposure to credit risk, to some extent, by requiring progress payments and letters of credit. However, as some of our exposure is outside of our control, unanticipated events could have a materially adverse impact on our operating results. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources” of this Report.

     Changes in billing terms can increase our exposure to working capital and credit risk.

     Our products are generally sold under contracts that allow us to either bill upon the completion of certain agreed upon milestones, or upon the actual shipment of the product. The Company attempts to negotiate progress-billing milestones on all large contracts to help the Company manage the working capital and credit risk associated with these large contracts. Consequently, shifts in the billing terms of the contracts in the Company’s backlog from period to period can increase the Company’s requirement for working capital and can increase the Company’s exposure to credit risk. See Item 7 – “Management’s Discussion and Analysis and Results of Operations – Liquidity and Capital Resources” of this Report.

     The terms and conditions of our credit facility impose restrictions on our operations. We may not be able to raise additional capital, if needed.

     The terms and conditions of our current $12.5 million revolving credit facility impose restrictions that affect, among other things, our ability to incur debt, make capital expenditures, merge, sell assets, make distributions, or create or incur liens. The availability of our credit facility is also subject to certain financial covenants, including a prohibition against consecutive quarterly losses. Our ability to comply with the covenants may be affected by events beyond our control and we cannot assure that we will achieve operating results meeting the requirements of the credit agreement. A breach of any of these covenants could result in a default under our credit facility. In the event of a default, the bank could elect to declare the outstanding principal amount of our credit facility, all interest thereon, and all other amounts payable under our credit facility to be immediately due and payable. As of June 30, 2004 we were in compliance with all financial and other covenants of our credit facility.

     Our ability to satisfy any debt obligations will depend upon our future operating performance, which will be affected by prevailing economic, financial and business conditions and other factors, some of which are beyond our control. We anticipate that borrowings from our existing revolving credit facility, or the refinancing of our revolving credit facility, and cash provided by operating activities, should provide sufficient funds to finance capital expenditures, working capital and otherwise meet our operating expenses and service our debt requirements as they become due. However, in the event that we require additional capital, there can be no assurance that we will be able to raise such capital when needed or on satisfactory terms, if at all.

24

     Our business is subject to risks of terrorist acts and acts of war.

     Terrorist acts and acts of war may disrupt our operations, as well as our customers’ operations. Such acts have created, and continue to create, economic and political uncertainties and have contributed to global economic instability. Any future terrorist activities, and any continued military or security operations could further weaken the global economy and create additional uncertainties forcing our customers to further reduce their capital spending, or cancel or delay already planned construction projects, which could have a material adverse impact on our business, operating results and financial condition.

     Our common stock is thinly traded, which may result in low liquidity.

     The daily trading volume of our common stock is relatively low and therefore the liquidity and appreciation in our stock may not meet our shareholders’ expectations. The market price of our common stock could be adversely impacted as a result of sales by our existing shareholders of a large number of shares of our common stock in the market, or the perception that such sales could occur.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

     Our primary market risk exposures are in the areas of interest rate risk and foreign currency exchange rate risk. We feel our risk to interest rate fluctuations is nominal, as our investments are short-term in nature and we are currently not borrowing under our bank credit facility. Our exposure to currency exchange rate fluctuations has been, and is expected to continue to be, modest as foreign contracts payable in currencies other than United Stated dollars are performed, for the most part, in the local currency and therefore provide a “natural hedge” against currency fluctuations. We, on occasion, will purchase derivative transactions with respect to foreign contracts that do not contain a “natural hedge,” but the impact of any fluctuation in the exchange rates in these hedged currencies, would be expected to have an immaterial impact on our financial operations. The impact of currency exchange rate movements on inter-company transactions has been, and is expected to continue to be, immaterial. We did not have any derivative transactions outstanding as of June 30, 2004.

25

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors
Peerless Mfg. Co.

We have audited the accompanying consolidated balance sheets of Peerless Mfg. Co. and subsidiaries as of June 30, 2004 and 2003, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended June 30, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above, present fairly, in all material respects, the consolidated financial position of Peerless Mfg. Co. and subsidiaries as of June 30, 2004 and 2003, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended June 30, 2004, in conformity with accounting principles generally accepted in the United States of America.

/s/ GRANT THORNTON LLP                                      
Grant Thornton LLP

Dallas, Texas
September 15, 2004

26

PEERLESS MFG. CO. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)

ASSETS

See accompanying notes to consolidated financial statements.

27

PEERLESS MFG. CO. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

LIABILITIES AND SHAREHOLDERS’ EQUITY

See accompanying notes to consolidated financial statements.

28

PEERLESS MFG. CO. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements

29

PEERLESS MFG. CO. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

See accompanying notes to consolidated financial statements

30

PEERLESS MFG. CO. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements.

31

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE A. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Peerless Mfg. Co. designs, engineers, and manufactures specialized products for the removal of contaminants from gases and liquids and for air pollution abatement. The Company’s products are manufactured principally at plants located in Texas and are sold worldwide with the principal markets located in North America and Europe. Primary customers are equipment manufacturers, engineering contractors and operators of power plants.

A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows.

Consolidation

The Company consolidates the accounts of its subsidiaries, all of which are wholly-owned. All significant inter-company accounts and transactions have been eliminated in consolidation.

Cash Equivalents

For purposes of the statement of cash flows, the Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

Accounts Receivable

The Company’s accounts receivable are due from companies in various industries. Credit is extended based on evaluation of the customer’s financial condition and, generally collateral is not required except on credit extension to international customers. Accounts receivable are generally due within 30 days and are stated at amounts due from customers net of an allowance for uncollectible accounts. Accounts outstanding longer than contractual payment terms are considered past due. The Company records an allowance on a specific basis by considering a number of factors, including the length of time the trade accounts receivable are past due, the Company’s previous loss history, the customer’s current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited back to bad debt expense in the period the payment is received.

Changes in the Company’s allowance for uncollectible accounts are as follows:

32

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE A. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

Inventories

Inventories are valued at the lower of cost or market. Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead. The Company regularly reviews inventory values on hand, using specific aging categories, and records a provision for obsolete and slow-moving inventory based on historical usage and estimated future usage. In assessing the ultimate realization of its inventory, the Company is required to make judgments as to future demand requirements. As actual future demand or market conditions may vary from those projected by the Company, adjustments to inventory valuations may be required.

Depreciable Assets

Depreciation is provided for in amounts sufficient to relate the cost of depreciable assets to operations over their estimated service lives (generally 3 to 7 years), principally by the straight-line method. Routine maintenance costs are expensed as incurred. Major improvements that extend the life, increase the capacity or improve the safety or the efficiency of property owned are capitalized. Major improvements to leased buildings are capitalized as leasehold improvements and amortized over the shorter of the estimated life or the lease term.

Warranty Costs

The Company provides product warranties for specific product lines and accrues for estimated future warranty costs in the period in which the revenue is recognized based on historical experience, expectation of future conditions, and the extent of backup concurrent supplier warranties in place.

Revenue Recognition

The Company provides products under long-term, generally fixed-priced, contracts that may extend up to 18 months, or longer, in duration. In connection with these contracts, the Company follows the guidance contained in AICPA Statement of Position (“SOP”) 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 81-1 requires the use of percentage-of-completion accounting for long-term contracts that contain enforceable rights regarding services to be provided and received by the contracting parties, consideration to be exchanged, and the manner and terms of settlement, assuming reasonably dependable estimates of revenues and expenses can be made. The percentage-of-completion methodology generally results in the recognition of reasonably consistent profit margins over the life of a contract. Amounts recognized in revenue are calculated using the percentage of construction cost completed, generally on a cumulative cost to total cost basis. Cumulative revenues recognized may be less or greater than cumulative costs and profits billed at any point in time during a contract’s term. The resulting difference is recognized as “costs and earnings in excess of billings on uncompleted contracts” or “billings in excess of costs and earnings on uncompleted contracts.”

The completed contract method is applied to relatively short-term contracts where the financial statement presentation does not vary materially from the presentation under the percentage-of-completion method. Revenues under the completed contract method are recognized upon shipment of the product.

33

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE A. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

Shipping and Handling Policy

Shipping and handling fees charged to customers are reported as revenue. Shipping and handling costs that are incurred that related to products sold are reported as cost of goods sold.

Earnings (Loss) Per Common Share

Basic earnings (loss) per common share are computed by dividing net earnings (loss) by the weighted average number of common shares outstanding during each year presented. Diluted earnings (loss) per common share give effect to the assumed issuance of shares pursuant to outstanding stock option plans, when dilutive.

Stock Based Compensation

In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (SFAS 148) which amends Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and requires disclosures in annual and interim financial statements of the effects of stock-based compensation as reflected below.

At June 30, 2004, the Company has two stock-based employee compensation plans, which are described more fully in Note K. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market price of the underlying common stock on the date of grant. The following table illustrates the effect on net earnings (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

34

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE A. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

Foreign Currency

All balance sheet accounts of foreign operations are translated into U.S. dollars at the year-end rate of exchange and statements of operations items are translated at the weighted average exchange rates for the year. The resulting translations adjustments are made directly to a separate component of stockholders’ equity, gains and losses from foreign currency transactions, such as those resulting from the settlement of foreign receivables or payables, are included in the consolidated statements of operations.

Financial Instruments

The carrying amounts of cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses approximate fair value because of the short-term nature of these items.

Long-Lived Assets

In accordance with statement on Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviews it long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable and exceeds its fair value. If conditions indicate an asset might be impaired, the Company estimates the future cash flows expected to result from the use of the asset and its eventual disposition. The impairment would be measured by the amount by which the asset exceeds its fair value typically represented by the discounted cash flows associated with the asset.

Stock Split

In September 2001 the board of directors approved a two-for-one stock split of the Company’s common stock effected in the form of a 100% stock dividend, which was distributed on October 18, 2001, to shareholders of record on October 8, 2001. All share and per share amounts have been restated to give retroactive effect to the stock split. In addition, all references in the Consolidated Financial Statements and Notes to Consolidated Financial Statements, to weighted average number of shares, per share amounts, cash dividends, and market prices of the Company’s common stock have been restated to give retroactive recognition to the stock split.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

35

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE A. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

Reclassification

Certain reclassifications of prior year amounts have been made to conform to the current year presentation.

NOTE B. NEW ACCOUNTING PRONOUNCEMENTS

     In November 2002, Financial Accounting Standards Board (“FASB’) reached a consensus on Emerging Issues Task Force (“EITF”) Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The guidance in this Issue was effective for revenue arrangements entered into in fiscal years beginning after June 15, 2003. The Issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities and whether, as a result, there is embedded more than one earnings process for revenue recognition purposes. The adoption of this pronouncement did not have a material impact on our financial condition or results of our operations.

     In April 2003, FASB issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” Statement No. 149 requires that contracts with comparable characteristics be accounted for similarly. The Statement clarifies the circumstances in which a contract with an initial net investment meets the characteristics of a derivative, and when a derivative contains a financing component and amends certain other existing pronouncements. This Statement was effective for contracts entered into or modified after June 30, 2003. The adoption of this pronouncement did not have a material impact on our financial condition or results of our operations.

     In May 2003, the FASB issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” Statement No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Many of these instruments were previously classified as equity. Statement No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability, or as an asset in some circumstances. This Statement applies to three types of freestanding financial instruments, other than outstanding shares. One type is mandatory redeemable shares, which the issuing company is obligated to buy back in exchange for cash or assets; a second type includes put options and forward purchase contracts that require or may require the issuer to buy back some of its shares in exchange for cash or other assets; and the third type is obligations that can be settled with shares, the monetary value of which is fixed, ties solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuer’s shares. This Statement does not apply to features embedded in a financial instrument that is not a derivative in its entirety. Statement No. 150 was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this pronouncement did not have a material impact on our financial statements.

36

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE B. NEW ACCOUNTING PRONOUNCEMENTS - CONTINUED

In December 2003, the FASB revised FIN No. 46 (FIN 46R), “Consolidation of Variable Interest Entities.” FIN 46R clarifies the application of Accounting Research Bulletin No. 51 for certain entities for which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Company would currently be required to adopt FIN 46R for any variable interest entities it had and would be required to meet the disclosure requirements of this pronouncement. However, the Company has determined that it does not have an interest in such entities based on its analysis and assessment.

NOTE C. CONCENTRATIONS OF CREDIT RISK

The Company closely monitors the creditworthiness of its customers. Significant portions of the Company’s sales are to customers who place large orders for custom systems and customers whose activities are related to the electrical generation and oil and gas industries, including some who are located in other countries. The Company generally requires progress payments, but may extend credit to some of its customers. The Company’s exposure to credit risk is also affected to some degree by conditions within the electrical generation and oil and gas industries. When sales are made to smaller international enterprises, the Company generally requires progress payments or an appropriate guarantee of payment, such as a letter of credit from a financial institution.

The Company is not dependent upon any single customer or group of customers in either of our two primary business segments. The custom-designed and project-specific nature of its business can cause year-to-year variance in its major customers. During fiscal 2004, one customer accounted for approximately 10% of its consolidated revenues, and in fiscal years 2003 and 2002, different customers accounted for approximately 16% and 15% of its total consolidated revenues, respectively.

37

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE D. DISCONTINUED OPERATIONS

During the first quarter of fiscal 2004, the Board of Directors authorized the divestiture, and the Company sold certain assets of its Boiler business segment with a net book value of approximately $110, for $250, resulting in a gain on disposal of $140.

The following represents a summary of operating results and the gain on disposition of the Boiler segment presented as discontinued operations:

     The current and non-current assets and liabilities of the discontinued boiler segment are as follows:

38

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

NOTE E. INVENTORIES

     Principal components of inventories are as follows: