e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended December 31, 2005


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition Period from to

Commission File Number 0-5214

PEERLESS MFG. CO.

(Exact Name of Registrant as Specified in Its Charter)


Texas		75-0724417

(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

2819 Walnut Hill Lane, Dallas, Texas		75229

(Address of Principal Executive Offices)		(Zip code)

(214) 357-6181
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-accelerated filer þ

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

As of February 13, 2006, there were 3,086,434 shares of the Registrant’s common stock outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PEERLESS MFG. CO. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)


	December 31, 2005			June 30, 2005
	(unaudited)
ASSETS
Current assets
Cash and cash equivalents	$	7,521		$	8,277
Accounts receivable — principally trade — net of allowance of uncollectible accounts of $224 at December 31, 2005 and $352 at June 30, 2005		11,729			11,613
Inventories, net		5,338			3,297
Costs and earnings in excess of billings on uncompleted contracts		9,623			10,140
Deferred income taxes		1,163			1,163
Other — net		2,228			1,206

Total current assets		37,602			35,696

Property, plant and equipment — net		3,116			3,315
Other assets		866			784
Other assets of discontinued operations		9			9

	$	41,593		$	39,804


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Account payable — trade	$	9,623		$	8,572
Billings in excess of costs and earnings on uncompleted contracts		3,664			2,081
Commissions payable		882			762
Product warranties		697			845
Accrued liabilities and other		3,341			3,058
Liabilities of discontinued operations		101			106

Total current liabilities		18,308			15,424

Deferred income taxes		90			90

Shareholders’ equity
Common stock		3,086			3,036
Additional paid-in capital		2,705			2,114
Other		(51	)		171
Retained earnings		17,455			18,969

Total shareholders’ equity		23,195			24,290

Total liabilities and shareholders’ equity	$	41,593		$	39,804

See accompanying notes to the consolidated financial statements.

PEERLESS MFG. CO. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)


	Three months ended						Six months ended
	December 31,						December 31,
	2005			2004			2005			2004
Revenues	$	11,534		$	10,844		$	23,176		$	22,062
Cost of goods sold		8,388			7,905			17,677			15,908

Gross profit		3,146			2,939			5,499			6,154
Operating expenses
Sales and marketing		1,565			1,407			3,107			2,882
Engineering and project management		820			881			1,646			1,832
General and administrative		2,087			1,357			3,225			2,412

		4,472			3,645			7,978			7,126

Operating loss		(1,326	)		(706	)		(2,479	)		(972	)

Other income (expense)
Foreign exchange gain		29			4			57			65
Other income (expense) — net		97			(1	)		182			39

		126			3			239			104


Loss from continuing operations before income taxes		(1,200	)		(703	)		(2,240	)		(868	)
Income tax benefit		408			239			759			295

Net loss from continuing operations		(792	)		(464	)		(1,481	)		(573	)

Discontinued operations
Loss from discontinued operations		(50	)		(50	)		(50	)		(80	)
Income tax benefit		17			17			17			27

Net loss from discontinued operations		(33	)		(33	)		(33	)		(53	)

Net loss	$	(825	)	$	(497	)	$	(1,514	)	$	(626	)


BASIC LOSS PER SHARE
Loss from continuing operations	$	(0.26	)	$	(0.15	)	$	(0.49	)	$	(0.19	)
Loss from discontinued operations		(0.01	)		(0.01	)		(0.01	)		(0.02	)

Basic loss per share	$	(0.27	)	$	(0.16	)	$	(0.50	)	$	(0.21	)


DILUTED LOSS PER SHARE
Loss from continuing operations	$	(0.26	)	$	(0.15	)	$	(0.49	)	$	(0.19	)
Loss from discontinued operations		(0.01	)		(0.01	)		(0.01	)		(0.02	)

Diluted loss per share	$	(0.27	)	$	(0.16	)	$	(0.50	)	$	(0.21	)

See accompanying notes to the consolidated financial statements.

PEERLESS MFG. CO. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Six months ended December 31,
	2005			2004
Cash flows from operating activities:
Net loss	$	(1,514	)	$	(626	)
Net loss from discontinued operations		(33	)		(53	)

Net loss from continuing operations		(1,481	)		(573	)
Adjustments to reconcile net loss from continuing operations to net cash provided by (used in) operating activities:
Depreciation and amortization		218			335
Provision for bad debts		144			218
Provision for warranty expense		159			206
Inventory valuation reserve		105			22
Foreign exchange gain		(57	)		(65	)
Gain on sale of property		(22	)		—
Stock based compensation		71			—
Other		8			70

Changes in operating assets and liabilities:
Accounts receivable		(260	)		211
Inventories		(2,146	)		(250	)
Costs and earnings in excess of billings on uncompleted contracts		517			3,802
Other current assets		(887	)		(249	)
Other assets		(82	)		233
Accounts payable		1,051			(1,202	)
Billings in excess of costs and earnings on uncompleted contracts		1,583			1,528
Commissions payable		120			(41	)
Product warranties		(307	)		(204	)
Excess tax benefits from stock-based payment arrangements		(134	)		(37	)
Income taxes payable		—			(525	)
Accrued liabilities and other		283			(230	)

Net cash provided by (used in) operating activities of continuing operations		(1,117	)		3,249

Cash flow from investing activities:
Purchases of property and equipment		(29	)		(231	)
Proceeds from the sale of equipment		32			—

Net cash provided by (used in) investing activities of continuing operations		3			(231	)

Cash flows from financing activities:
Proceeds from sale of common stock		264			118
Excess tax benefits from stock-based payment arrangements		134			37

Net cash provided by financing activities of continuing operations		398			155

Net cash used in discontinued operations		(38	)		(93	)

Effect of exchange rate changes on cash and cash equivalents		(2	)		5


Net increase (decrease) in cash and cash equivalents		(756	)		3,085

Cash and cash equivalents at beginning of period		8,277			4,119


Cash and cash equivalents at end of period	$	7,521		$	7,204

See accompanying notes to consolidated financial statements.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying condensed consolidated financial statements of Peerless Mfg. Co. and Subsidiaries (hereafter referred to as the “Company”, “we”, “us”, “our”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. The condensed consolidated financial statements of the Company as of December 31, 2005, and for the three and six months ended December 31, 2005 and December 31, 2004 are unaudited and, in the opinion of management, contain all adjustments necessary for the fair presentation of the financial position and results of operations of the Company for the interim periods. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2005. The results of operations for the three and six months ended December 31, 2005 are not necessarily indicative of the results to be expected for the entire year (see Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Factors That May Affect Our Operating Results and Other Risk Factors”). The Company’s fiscal year ends on June 30. References herein to fiscal 2005 and fiscal 2006 refer to our fiscal years ended June 30, 2005 and 2006, respectively.

In connection with the discontinuation of our Boiler operations, the financial information has been presented to report the discontinued operations in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” See Note 6 — “Contingencies” and Note 9 — “Discontinued Operations” in our Notes to Consolidated Financial Statements of this Report for additional information on the discontinuance of this business unit.

Certain fiscal 2005 items have been reclassified to conform to the fiscal 2006 presentation. Unless otherwise noted, all dollar and share amounts are in thousands, except per share amounts.

2. Accounts Receivable

The Company’s accounts receivable are due from companies in various industries. Credit is extended based on evaluation of a customer’s financial condition, and collateral is not generally 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.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2. Accounts Receivable — Continued

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


	Three months ended					Six months ended
	December 31,					December 31,
	2005			2004		2005			2004
Balance at beginning of period	$	466		$	231	$	352		$	431
Bad debt expense		30			196		144			218
Accounts written off, net		(272	)		—		(272	)		(222	)

Balance at end of period	$	224		$	427	$	224		$	427

3. 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 excess and potentially obsolete inventories 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.

Principal components of inventories are as follows:


	December 31,			June 30,
	2005			2005
Material and component parts	$	4,665		$	3,027
Work in progress		779			232
Finished goods		317			356

		5,761			3,615

Reserve for obsolete and slow-moving inventory		(423	)		(318	)

	$	5,338		$	3,297

Changes in the Company’s reserve for obsolete and slow-moving inventory are as follows:


	Three months ended				Six months ended
	December 31,				December 31,
	2005		2004		2005		2004
Balance at beginning of period	$	370	$	202	$	318	$	196
Additions		53		16		105		22
Amounts written off		—		—		—		—

Balance at end of period	$	423	$	218	$	423	$	218

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4. Revenue Recognition and Cost and Earnings on Uncompleted Contracts

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 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (“SOP 81-1”). SOP81-1 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 margin over the life of a contract. 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. 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.

The components of uncompleted contracts are as follows:


	December 31,			June 30,
	2005			2005
Costs incurred on uncompleted contracts and estimated earnings	$	32,144		$	34,978
Less billings to date		(26,185	)		(26,919	)

	$	5,959		$	8,059

The components of uncompleted contracts are reflected in the balance sheets as follows:


	December 31,			June 30,
	2005			2005
Costs and earnings in excess of billings on uncompleted contracts	$	9,623		$	10,140
Billings in excess of costs and earnings on uncompleted contracts		(3,664	)		(2,081	)

	$	5,959		$	8,059

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

5. Product Warranties

The Company warrants that its products will be free from defects in materials and workmanship and will conform to agreed upon specifications at the time of delivery and typically for a period of 12 to 18 months from the date of customer acceptance, depending upon the specific product and terms of the customer agreement. Typical warranties require the Company to repair or replace defective products during the warranty period at no cost to the customer. The Company attempts to obtain back-up concurrent warranties for major component parts from its suppliers. The Company provides for the estimated cost of product warranties, based on historical experience by product type, expectation of future conditions and the extent of back-up concurrent supplier warranties in place, at the time the product revenue is recognized. Revision to the estimated product warranties is made when necessary, based on changes in these factors. Product warranty activity is as follows:


	Three months ended						Six months ended
	December 31,						December 31,
	2005			2004			2005			2004
Balance at beginning of period	$	916		$	980		$	845		$	982
Provision for warranty expenses		17			47			159			206
Warranty charges		(236	)		(43	)		(307	)		(204	)

Balance at end of period	$	697		$	984		$	697		$	984

6. Contingencies

On March 19, 2004, we 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 our discontinued Boiler business 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. We believe that all, or at least a majority, of the payments may fail to meet the applicable standards for avoidance under the Bankruptcy Code and other applicable law, or that a number of defenses may be able to be asserted that may negate any recovery by the plaintiffs. We intend to defend vigorously against the lawsuit and we believe the likelihood of a material loss, at this time, is not probable.

On April 25, 2005, we received notice that we may have received preferential transfers amounting to approximately $900,000 in connection with the Chapter 11 filing by Erie Power Technologies, Inc. Based on our preliminary investigation, we believe that all, or at least a majority, of the payments received may fail to meet the applicable standards for avoidance under the Bankruptcy Code and other applicable law, or that a number of defenses may be able to be asserted that may negate any recovery by the plaintiffs. We intend to defend vigorously against the lawsuit and we believe the likelihood of a material loss, at this time, is not probable.

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 its results of operations.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7. Accrued Liabilities

The components of accrued liabilities and other are as follows:


	December 31,		June 30,
	2005		2005
Accrued start-up expense	$	1,070	$	974
Accrued compensation		634		691
Sales and use tax payable		711		523
Accrued property tax expense		209		111
Other		717		759

	$	3,341	$	3,058

8. Stock Based Compensation

The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), effective July 1, 2005. SFAS 123R requires the recognition of the fair value of stock-based compensation in net earnings.

The Company has two stock option and restricted stock plans. In December 1995, the Company adopted a stock option and restricted stock plan (the “1995 Plan”), which provides for a maximum of 240,000 shares of common stock to be issued. Stock options are granted at market value, generally vest ratably over four years, and expire ten years from date of grant. In January 2002, the Company adopted a stock option and restricted stock plan (the “2001 Plan”), which provides for a maximum of 250,000 shares of common stock to be issued. Stock options are granted at market value, generally vest ratably over four years, and expire ten years from date of grant. Under both plans, stock options are granted to employees at exercise prices equal to the fair market value of the Company’s stock at the dates of grant. Stock options granted to non-employee directors are generally exercisable on the date of grant which is generally at the annual shareholders’ meeting. The Company issues new shares of common stock to satisfy option exercises. The Company recognizes stock-based compensation expense over the requisite service period of the individual grants, which generally equals the vesting period.

Prior to July 1, 2005, the Company accounted for these plans under the intrinsic value method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. The Company, applying the intrinsic value method, did not record stock-based compensation cost in net earnings because the exercise price of its stock options equaled the market price of the underlying stock on the date of grant. The Company has elected to utilize the modified prospective transition method for adopting SFAS 123R. Under this method, the provisions of SFAS 123R apply to all awards granted or modified after the date of adoption. In addition, the unrecognized expense of awards not yet vested at the date of adoption, determined under the original provisions of SFAS 123, shall be recognized in net earnings in the periods after the date of adoption. The Company recognized stock-based compensation cost in the amount of $49 in the three months ended December 31, 2005 as well as related tax-benefits of $17. The Company recognized stock-based compensation cost in the amount of $71 in the six months ended December 31, 2005 as well as related tax-benefits of $24.

SFAS 123R requires the Company to present pro forma information for periods prior to the adoption as if it had accounted for all stock-based compensation under the fair value method of that statement.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

8. Stock Based Compensation — Continued

For purposes of pro forma disclosure, the estimated fair value of the options at the date of grant is amortized to expense over the requisite service period, which generally equals the vesting period. The following table illustrates the effect on net earnings and earnings per share as if the Company had applied the fair value recognition provisions of SFAS 123R to its stock-based employee compensation.


	Three months ended			Six months ended
	December 31, 2004			December 31, 2004
Net loss, as reported	$	(497	)	$	(626	)
Deduct: Total stock-based employee compensation expense determined using the fair value based method for all awards, net of tax		(46	)		(70	)

Pro forma net loss	$	(543	)	$	(696	)


Loss per share:
Basic — as reported	$	(0.16	)	$	(0.21	)

Basic — pro forma	$	(0.18	)	$	(0.23	)

Diluted — as reported	$	(0.16	)	$	(0.21	)

Diluted — pro forma	$	(0.18	)	$	(0.23	)

A summary of the option activity under the plans for the three and six months ended December 31, 2005 is as follows:


						Weighted		Aggregate
				Weighted		Average		Grant Date
				Average		Remaining		Fair
	# of Options			Exercise		Term		Value
	(exact quantity)			Price		(in years)		(in thousands)
Balance at July 1, 2005		237,950		$	11.22
Granted		—		$	—
Exercised		(250	)	$	12.64
Canceled		(2,800	)	$	14.02
Forfeited		—		$	—

Balance at September 30, 2005		234,900		$	11.18		6.03	$	1,259
Granted		4,000		$	16.95
Exercised		(39,750	)	$	6.56
Canceled		(25,000	)	$	12.94
Forfeited		(500	)	$	19.50

Balance at December 31, 2005		173,650		$	12.10		6.27	$	993
Exercisable at December 31, 2005		140,600		$	11.69		5.71	$	797

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

8. Stock Based Compensation — Continued

For all of the Company’s stock-based compensation plans, the fair value of each grant was estimated at the date of grant using the Black-Scholes option pricing model. Black-Scholes utilizes assumptions related to volatility, the risk-free interest rate, the dividend yield (which is assumed to be zero, as the Company has not paid, nor anticipates paying any, cash dividends) and employee exercise behavior. Expected volatilities utilized in the model are based mainly on the historical volatility of the Company’s stock price and other factors.

The following is a summary of the assumptions used and the weighted average grant-date fair value of the stock options granted during the three and six months ended December 31, 2005 and 2004:


	Three Months Ended		Six Months Ended
	December 31,		December 31,
	2005	2004	2005	2004
Expected volatility	52.6%	46.4%	52.6%	46.4%
Expected term (years)	5.66	5.00	5.66	5.00
Risk free interest rate	4.12%	4.00%	4.12%	4.00%
Dividend yield	0.00%	0.00%	0.00%	0.00%

Weighted average grant date fair value	$8.99	$6.78	$8.99	$6.78

A summary of the status of the Company’s non-vested stock options at December 31, 2005, and changes during the three and six months ended December 31, 2005 is presented below:


	Three months ended		Six months ended
	December 31, 2005		December 31, 2005
		Weighted		Weighted
		Average		Average
	# of Options	Grant Date	# of Options	Grant Date
	(exact quantity)	Fair Value	(exact quantity)	Fair Value
Non vested at beginning of period	64,300	$6.00	70,100	$5.98
New Grants	—	—	—	—
Vested	(6,250)	$6.44	(9,250)	$6.20
Canceled	(25,000)	$5.95	(27,800)	$5.94

Non vested at end of period	33,050	$5.95	33,050	$5.95

As of December 31, 2005, the total remaining unrecognized compensation cost related to non-vested stock options was $166. The weighted average remaining requisite service period of the non-vested stock options was 1.52 years.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. Comprehensive Loss

Comprehensive loss is defined as all changes in equity during a period, except those resulting from investments by owners and distributions to owners. The components of comprehensive loss were as follows:


	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2005			2004			2005			2004
Net loss from continuing operations	$	(792	)	$	(464	)	$	(1,481	)	$	(573	)
Net loss from discontinued operations		(33	)		(33	)		(33	)		(53	)
Foreign currency translation adjustment		(21	)		129			(59	)		120

Comprehensive loss	$	(846	)	$	(368	)	$	(1,573	)	$	(506	)

11. Loss Per Share

Basic loss per share has been computed by dividing net loss by the weighted average number of common shares outstanding during the applicable period. Diluted loss per share reflects the potential dilution that could occur if options or other contracts to issue common shares were exercised or converted into common stock. The following table sets forth the computation for basic and diluted loss per share for the periods indicated. Certain loss per share amounts may not total due to rounding.


	Three months ended						Six months ended
	December 31,						December 31,
	2005			2004			2005			2004
Net loss from continuing operations	$	(792	)	$	(464	)	$	(1,481	)	$	(573	)
Loss from discontinued operations		(33	)		(33	)		(33	)		(53	)

Net loss	$	(825	)	$	(497	)	$	(1,514	)	$	(626	)


Basic weighted average common shares outstanding		3,045			3,030			3,041			3,022
Effect of dilutive options		—			—			—			—

Diluted weighted average common shares outstanding		3,045			3,030			3,041			3,022


BASIC LOSS PER SHARE
Loss from continuing operations	$	(0.26	)	$	(0.15	)	$	(0.49	)	$	(0.19	)
Loss from discontinued operations		(0.01	)		(0.01	)		(0.01	)		(0.02	)

Net loss per share	$	(0.27	)	$	(0.16	)	$	(0.50	)	$	(0.21	)


DILUTED LOSS PER SHARE
Loss from continuing operations	$	(0.26	)	$	(0.15	)	$	(0.49	)	$	(0.19	)
Loss from discontinued operations		(0.01	)		(0.01	)		(0.01	)		(0.02	)

Net loss per share	$	(0.27	)	$	(0.16	)	$	(0.50	)	$	(0.21	)

Diluted weighted average common shares outstanding excluded 211 and 208 outstanding stock options for the three and six months ended December 31, 2005 and 2004, respectively, because their impact would be anti-dilutive.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12. Segment Information

The Company identifies reportable segments based on management responsibility within the corporate structure. The Company has two reportable industry segments: Environmental Systems and Separation Filtration Systems. The main product of its Environmental Systems segment is its Selective Catalytic Reduction Systems, referred to as “SCR Systems”. The Separation Filtration Systems segment produces various types of separators and filters used for removing liquids and solids from gases and air. The Company combines these systems with other components, such as instruments, controls and related valves and piping to offer its customers a totally integrated system.

Segment profit and loss is based on revenue less direct expenses of the segment before allocation of general, administrative, research and development costs. All inter-company transfers between segments have been eliminated. Segment information and reconciliation to operating profit for the three and six months ended December 31, 2005 and 2004 are presented below. Note that the Company does not allocate general and administrative expenses (“unallocated overhead”), assets, expenditures for assets or depreciation expense on a segment basis for internal management reporting, and therefore such information is not presented.


				Separation			General &
	Environmental			Filtration			Administrative
	Systems			Systems			Expenses			Consolidated
Three months ended December 31, 2005

Net revenues from customers	$	3,629		$	7,905					$	11,534
Segment profit (loss)		272			489			(2,087	)		(1,326	)

Three months ended December 31, 2004

Net revenues from customers	$	4,987		$	5,857					$	10,844
Segment profit (loss)		1,210			(559	)		(1,357	)		(706	)

Six months ended December 31, 2005

Net revenues from customers	$	6,895		$	16,281					$	23,176
Segment profit (loss)		(9	)		755			(3,225	)		(2,479	)

Six months ended December 31, 2004

Net revenues from customers	$	8,977		$	13,085					$	22,062
Segment profit (loss)		1,274			166			(2,412	)		(972	)

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

13. Industry Segment and Geographic Information

The Company attributes revenues from external customers to individual geographic sales offices based on the country where the sale originated. Information about the Company’s operations in different geographic offices as of and for the three and six months ended December 31, 2005 and December 31, 2004 is as follows:


	United			United
	States			Kingdom		Eliminations			Consolidated
Three months ended December 31, 2005

Net sales to unaffiliated customers	$	8,537		$	2,997	$	—		$	11,534
Transfers between geographic areas		179			—		(179	)		—

Total	$	8,716		$	2,997	$	(179	)	$	11,534

Identifiable long-lived assets	$	3,062		$	54	$	—		$	3,116


Three months ended December 31, 2004

Net sales to unaffiliated customers	$	9,619		$	1,225	$	—		$	10,844
Transfers between geographic areas		(79	)		—		79			—

Total	$	9,540		$	1,225	$	79		$	10,844

Identifiable long-lived assets	$	2,866		$	83	$	—		$	2,949


Six months ended December 31, 2005

Net sales to unaffiliated customers	$	17,881		$	5,295	$	—		$	23,176
Transfers between geographic areas		210			—		(210	)		—

Total	$	18,091		$	5,295	$	(210	)	$	23,176

Identifiable long-lived assets	$	3,062		$	54	$	—		$	3,116


Six months ended December 31, 2004

Net sales to unaffiliated customers	$	18,600		$	3,462	$	—		$	22,062
Transfers between geographic areas		681			—		(681	)		—

Total	$	19,281		$	3,462	$	(681	)	$	22,062

Identifiable long-lived assets	$	2,866		$	83	$	—		$	2,949

Transfers between the geographic offices primarily represent inter-company export sales and are accounted for based on established sales prices between the related companies.

Identifiable long-lived assets of geographic offices are those assets related to the Company’s operations in each office.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

14. Lines of Credit

On October 31, 2003, the Company 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, and is secured by substantially all of the Company’s domestic assets. At December 31, 2005, the applicable rate was Euro plus 1.75% (6.22%).

At December 31, 2005, the Company had approximately $3.9 million outstanding under stand-by letters of credit and no loans outstanding, leaving a maximum availability under the credit facility of approximately $8.6 million (actual availability at December 31, 2005 approximately $5.4 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 December 31, 2005, the Company was in compliance with all financial and other covenants under the credit facility.

In addition, the Company’s UK subsidiary had a £2.6 million (approximately $4.5 million) debenture agreement used to facilitate the issuances of bank guarantees. At December 31, 2005, this facility was secured by substantially all of the UK subsidiary assets, and was backed by a Peerless stand-by letter of credit of £1.4 million (approximately $2.5 million, which is included in the $3.9 million outstanding under the Company’s $12.5 million revolving credit facility described above). At December 31, 2005, there was approximately £2.4 million (approximately $4.2 million) outstanding under this facility, leaving approximately £200,000 availability.

15. Supplemental cash flow Information

Net cash flows from operating activities reflect cash payments for income taxes as follows:


	Three months ended					Six months ended
	December 31.					December 31.
	2005			2004		2005			2004
Income taxes paid (received)	$	(150	)	$	150	$	(150	)	$	660

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 35 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.

Overview

We are a global company providing environmental, separation and 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.

Environmental Systems. This business segment represented approximately 40.7% and 29.8% of our first six months fiscal 2005 and 2006 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 instrumentation, controls and related valves and piping.

Separation Filtration Systems. This business segment represented approximately 59.3% and 70.2% of our first six months fiscal 2005 and 2006 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.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

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, allowance for doubtful accounts, and reserve for obsolete and slow moving inventory. Our policies and related procedures for these items 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 margin 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 our costs are subcontracted under fixed-priced 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, changes in customer 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.

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 depending 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 obtain back-up concurrent

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

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 collectability of accounts receivable based upon historical collection trends, current economic factors, and the assessment of the collectability of specific accounts. We evaluate the collectability 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, discussions with our project managers, and discussions 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. We regularly review inventory values on hand, using specific aging categories, and record a reserve 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 us, adjustments to our inventory valuations may be required.

Deferred Tax Asset – Valuation Allowance. We have a significant amount of net deferred tax assets, which consist principally of (1) a subsidiary State net operating loss carry-forward and (2) temporary differences in the tax and book basis of certain assets and liabilities. The State net operating loss carry-forward expires, if unused, as follows: $365,000 in 2006; $3.3 million in 2007; $2.1 million in 2008; $1.9 million in 2009; and, $210,000 in 2010. Based on evaluations performed by us in the quarter ended June 30, 2005, we determined that it is more likely than not, that insufficient taxable income will be generated by the subsidiary to fully utilize the state operating loss carry-forward prior to expiration, and we have accordingly recorded a valuation allowance to reduce the corresponding deferred tax asset to its anticipated net realizable value (see Note M of the Notes to Consolidated Financial Statements of our Annual Report on Form 10-K for the year ended June 30, 2005). As actual future factors or conditions may vary from those projected by us, adjustments to our valuation allowance may be required.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Results of Operations

The following table displays our statements of operations as a percentage of net revenues:


	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2005			2004			2005			2004
Net revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold		72.7			72.9			76.3			72.1

Gross profit		27.3			27.1			23.7			27.9
Operating expenses		38.8			33.6			34.4			32.3

Operating loss		(11.5	)		(6.5	)		(10.7	)		(4.4	)
Other income		1.1			—			1.0			0.5

Net loss from continuing operations before income taxes		(10.4	)		(6.5	)		(9.7	)		(3.9	)
Income tax benefit		3.5			2.2			3.3			1.3

Net loss from continuing operations		(6.9	)		(4.3	)		(6.4	)		(2.6	)

Loss from discontinued operations, net of tax		(0.3	)		(0.3	)		(0.1	)		(0.2	)

Net loss		(7.2	)%		(4.6	)%		(6.5	)%		(2.8	)%

Three Months Ended December 31, 2005 Compared to Three Months Ended December 31, 2004

Results of Operations — Consolidated

Revenues. The following table displays consolidated revenues (dollars in thousands):


	Three months ended
	December 31,
	2005		% of Total			2004		% of Total
Domestic	$	4,962		43.0	%	$	6,024		55.6	%
International	$	6,572		57.0	%	$	4,820		44.4	%

Total	$	11,534		100.0	%	$	10,844		100.0	%

For the second quarter of fiscal 2006, revenues increased approximately $690,000, or 6.4%, from approximately $10.8 million in the second quarter of fiscal 2005 to $11.5 million in the second quarter of fiscal 2006. Domestic revenues decreased approximately $1.1 million, or 17.6%, from approximately $6.0 million in the second quarter of fiscal 2005 to $4.9 million in the second quarter of fiscal 2006. International revenues increased approximately $1.8 million, or 36.3%, from $4.8 million in the second quarter of fiscal 2005 to $6.6 million in the second quarter of fiscal 2006. The decline in our domestic revenues is principally related to the decline in our environmental systems equipment sales impacted by customer requested delays in the timing of projects and their subsequent delivery. The increase in our international revenues relates primarily to an increase of gas separation and filtration equipment sales in Canada and Latin America and sales through our European subsidiary,

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

due to an increased demand for natural gas. See Item 2 — “Results of Operations — Segments” of this Report for further discussion.

Gross Profit Margin. The following table displays gross profit margin (dollars in thousands):


	Three months ended
	December 31,
	2005			% of Sales			2004			% of Sales
Selling margin	$	3,876			33.6	%	$	3,358			31.0	%
Unabsorbed manufacturing	$	(587	)		-5.1	%	$	(467	)		-4.3	%
Warranty and start up costs	$	(143	)		-1.2	%	$	48			0.4	%

Gross profit margin	$	3,146			27.3	%	$	2,939			27.1	%

Our gross profit margin during any particular period may be impacted by four primary factors: 1) sales volume, 2) unanticipated material cost increases, 3) shifts in our product mix, and 4) start-up and warranty costs. Shifts in our product mix can impact our reported margin in three ways: 1) certain of our products have higher selling margin than others, 2) certain of our products have a higher manufactured cost component than others, and 3) certain markets are more competitive than others. Consequently, shifts in the geographic or product composition of our sales can have a significant impact on our reported margin either at the selling margin level, or through a negative or positive impact on our manufacturing absorption.

For the second quarter of fiscal 2006, our gross profit margin increased approximately $207,000, or 7.0%, from $2.9 million in the second quarter of fiscal 2005 to $3.1 million in the second quarter of fiscal 2006. Our gross profit, as a percentage of sales, increased from 27.1% in the second quarter of fiscal 2005 to 27.3% in the second quarter of fiscal 2006. Our selling margin (our margin before the allocation of our unabsorbed manufacturing overhead and start-up and warranty costs), as a percentage of sales, increased from 31.0% in the second quarter of fiscal 2005 to 33.6% in the second quarter of fiscal 2006. The increase in our selling margin during the period can be attributed to a continued shift in the composition of our sales (see Segment Profit — following for further discussion). In addition, our gross profit margin during the period was impacted by an increase in our unabsorbed manufacturing costs, which increased, as a percentage of sales, from 4.3% in the second quarter of fiscal 2005 to 5.1% in the second quarter of fiscal 2006, and an increase in our start-up and warranty costs, which increased, as a percentage of sales approximately 1.6% in the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005. The increase in our unabsorbed manufacturing costs was related to the decrease in our domestic sales volume that is produced in our plants. The increase in our start-up and warranty costs was related to higher than anticipated start-up costs associated with commissioning certain Environmental Systems projects and certain Separation Filtration Systems (see Segment Profit — following for further discussion).

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Operating Expenses. The following table displays operating expenses (dollars in thousands):


			Three months ended
			December 31,
	2005		% of Sales			2004		% of Sales
Sales and marketing	$	1,565		13.6	%	$	1,407		13.0	%
Engineering & project management		820		7.1	%		881		8.1	%
General and administrative		2,087		18.1	%		1,357		12.5	%

Total operating expenses	$	4,472		38.8	%	$	3,645		33.6	%

For the second quarter of fiscal 2006, our operating expenses from continuing operations increased by approximately $827,000, or 22.7% when compared to the second quarter of fiscal 2005. These expenses as a percentage of sales increased to 38.8% in the second quarter of fiscal 2006 from 33.6% in the second quarter of fiscal 2005. On a comparative basis, our sales and marketing expenses were approximately $1.5 million in the second quarter of fiscal 2006 compared to approximately $1.4 million in the second quarter of fiscal 2005. Selling commissions in the second quarter of fiscal 2006 increased over the second quarter of fiscal 2005 due to the increased revenues, while selling expenses decreased as a result of cost control monitoring. Our engineering and project management expense decreased to approximately $820,000 in the second quarter of fiscal 2006 from approximately $881,000 in the second quarter of fiscal 2005 and continues to relate to our cost control measures and product standardization activities. Our general and administrative expenses increased approximately $730,000 in the second quarter of fiscal 2006, compared to the second quarter of fiscal 2005, due primarily to a one time charge incurred in connection with a special project and the separation of a former Chief Operating Officer, which expenses, were partially offset by a reduction in the cost of general insurance and a reduction in the provision for bad debt.

Other Income and Expense. The following table displays other income and expenses (dollars in thousands):


			Three months ended
			December 31,
	2005		% of Sales			2004			% of Sales
Foreign exchange gain	$	29		0.3	%	$	4			0.0	%
Other income (expense), net		97		0.8	%		(1	)		0.0	%

Total other income	$	126		1.1	%	$	3			0.0	%

For the second quarter of fiscal 2006, other income and expense items increased by approximately $123,000, from income of approximately $3,000 for the second quarter of fiscal 2005 to income of approximately $126,000 for the second quarter of fiscal 2006. This change was primarily due to increased rental income associated with the lease of an inactive warehouse, increased interest income, and a gain on the sale of equipment in the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005. Additionally, our foreign currency exchange gains during the second quarter of fiscal 2006 increased approximately $25,000 compared to the second quarter of fiscal 2005.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Income Taxes.

Our effective income tax rate for continuing operations was approximately 34% for the second quarter of fiscal years 2005 and 2006.

Net Loss from Continuing Operations. The following table displays net loss from continuing operations (dollars in thousands):


	Three months ended
	December 31,
	2005			% of Sales			2004			% of Sales
Loss from continuing operations	$	(792	)		-6.9	%	$	(464	)		-4.3	%

Basic loss per share	$	(0.26	)				$	(0.15	)
Diluted loss per share	$	(0.26	)				$	(0.15	)

Our net loss from continuing operations increased by approximately $328,000, from a loss of approximately $464,000, or (4.3%) of sales, for the second quarter of fiscal 2005, to a loss of $792,000, or (6.9%) of sales, for the second quarter of fiscal 2006 and related primarily to an increase in operating expenses from a one time charge incurred in connection with a special project and the separation of a former Chief Operating Officer, in addition to increased commission expense associated with increased revenues. Basic and diluted loss per share increased from a loss of ($0.15) per share for the second quarter of fiscal 2005, to a loss of ($0.26) per share for the second quarter of fiscal 2006

Discontinued Operations.

We had a net loss of approximately $33,000 from discontinued operations during the second quarter of fiscal 2005 and the second quarter of fiscal 2006. Our net loss in fiscal 2005 related primarily to costs associated with the start-up and warranty costs of certain boiler projects, while our net loss in fiscal 2006 related primarily to legal expenses associated with adversary proceedings initiated by Enron. The Company has a remaining reserve of approximately $101,000 at December 31, 2005, which reserve was established based on 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” and Note 6 — “Contingencies” to our Notes to Consolidated Financial Statements of this Report). Basic and diluted loss per share from discontinued operations was ($0.01) per share for the second quarter of fiscal 2005 and the second quarter of fiscal 2006.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Net Loss. The following table displays net loss (dollars in thousands):


	Three months ended
	December 31,
	2005			% of Sales			2004			% of Sales
Net loss	$	(825	)		-7.2	%	$	(497	)		-4.6	%

Basic loss per share	$	(0.27	)				$	(0.16	)
Diluted loss per share	$	(0.27	)				$	(0.16	)

Our net loss increased approximately $328,000 from a net loss of $497,000, or (4.6%) of sales, for the second quarter of fiscal 2005, to a net loss of approximately $825,000, or (7.2%) of sales, for the second quarter of fiscal 2006. Basic and diluted loss per share increased from a net loss of ($0.16) per share for the second quarter of fiscal 2005, to a net loss of ($0.27) per share for the second quarter of fiscal 2006.

Six Months Ended December 31, 2005 Compared to Six Months Ended December 31, 2004

Results of Operations — Consolidated

Revenues. The following table displays consolidated revenues (dollars in thousands):


	Six months ended
	December 31,
	2005		% of Total			2004		% of Total
Domestic	$	11,533		49.8	%	$	13,397		60.7	%
International	$	11,643		50.2	%	$	8,665		39.3	%

Total	$	23,176		100.0	%	$	22,062		100.0	%

For the first six months of fiscal 2006, revenues increased approximately $1.1 million, or 5.0%, from approximately $22.1 million in the first six months of fiscal 2005 to $23.2 million in the first six months of fiscal 2006. Domestic revenues decreased approximately $1.8 million, or 13.9%, from approximately $13.4 million in the first six months of fiscal 2005 to $11.6 million in the first six months of fiscal 2006. International revenues increased approximately $2.9 million, or 34.4%, from $8.7 million in the first six months of fiscal 2005 to $11.6 million in the first six months of fiscal 2006. The decline in our domestic revenues is principally related to the decline in our separation and filtration equipment and environmental system sales impacted by customer requested delays in the timing of projects and their subsequent delivery, combined with increased market challenges. The increase in our international revenues relates primarily to an increase of gas separation and filtration equipment sales in Canada and Latin American, and sales through our European subsidiary, due to an increased demand for natural gas. See Item 2 — “Results of Operations — Segments” of this Report for further discussion.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Gross Profit Margin. The following table displays gross profit margin (dollars in thousands):


	Six months ended
	December 31,
	2005			% of Sales			2004			% of Sales
Selling margin	$	7,498			32.3	%	$	7,154			32.4	%
Unabsorbed manufacturing	$	(1,233	)		-5.3	%	$	(808	)		-3.6	%
Warranty and start up costs	$	(766	)		-3.3	%	$	(192	)		-0.9	%

Gross profit margin	$	5,499			23.7	%	$	6,154			27.9	%

For the first six months of fiscal 2006, our gross profit margin decreased approximately $655,000, or 10.6%, from $6.2 million in the first six months of fiscal 2005 to $5.5 million in the first six months of fiscal 2006. Our gross profit, as a percentage of sales, decreased from 27.9% in the first six months of fiscal 2005 to 23.7% in the first six months of fiscal 2006. Our selling margin (our margin before the allocation of our unabsorbed manufacturing overhead and start-up and warranty costs), as a percentage of sales, remained relatively constant at 32.3% during the first six months of fiscal 2006, compared to 32.4% during the first six months of fiscal 2005. Our gross profit margin during the period was impacted by an increase in our unabsorbed manufacturing costs, which increased, as a percentage of sales, from 3.6% in the first six months of fiscal 2005 to 5.3% in the first six months of fiscal 2006, and an increase in our start-up and warranty costs, which increased, as a percentage of sales, from 0.9% in the first six months of fiscal 2005 to 3.3% in the first six months of fiscal 2006. The increase in our unabsorbed manufacturing costs was related to the decrease in our domestic sales volume that is produced in our plants.. The increase in our start-up and warranty costs was related to higher than anticipated start-up costs associated with commissioning certain Environmental Systems projects and certain Separation Filtration Systems (see Segment Profit — following for further discussion).

Operating Expenses. The following table displays operating expenses (dollars in thousands):


	Six months ended
	December 31,
	2005		% of Sales			2004		% of Sales
Sales and marketing	$	3,107		13.4	%	$	2,882		13.1	%
Engineering & project management		1,646		7.1	%		1,832		8.3	%
General and administrative		3,225		13.9	%		2,412		10.9	%

Total operating expenses	$	7,978		34.4	%	$	7,126		32.3	%

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

For the first six months of fiscal 2006, our operating expenses from continuing operations increased by approximately $852,000, or 12.0%, when compared to the first six months of fiscal 2005. These expenses as a percentage of sales increased from 32.3% in the first six months of fiscal 2005 to 34.4% in the first six months of fiscal 2006. On a comparative basis, our sales and marketing expenses were approximately $2.9 million during the first six months of fiscal 2005 and approximately $3.1 million the first six months of fiscal 2006. Selling commissions in the first six months of fiscal 2006 increased over the first six months of fiscal 2005 due to the increased revenues, while selling expenses decreased as a result of cost control monitoring. Our engineering and project management expense decreased from $1.8 million in the first six months of fiscal 2005 to $1.6 million in the first six months of fiscal 2006 due primarily to our cost control measures and product standardization activities. Our general and administrative expenses increased approximately $813,000 in the first six months of fiscal 2006, compared to the first six months of fiscal 2005, due primarily to a one time charge incurred in connection with a special project and the separation of a former Chief Operating Officer, which expenses, were partially offset by a reduction in our cost of general insurance and a reduction in our provision for bad debt.

Other Income. The following table displays other income (dollars in thousands):


	Six months ended
	December 31,
	2005		% of Sales			2004		% of Sales
Foreign exchange gain	$	57		0.2	%	$	65		0.3	%
Other income, net		182		0.8	%		39		0.2	%

Total other income	$	239		1.0	%	$	104		0.5	%

For the first six months of fiscal 2006, other income and expense items increased by approximately $135,000, from income of approximately $104,000 for the first six months of fiscal 2005 to income of approximately $239,000 for the first six months of fiscal 2006. This change was primarily due to increased rental income associated with the lease of an inactive warehouse and increased interest income in the first six months of fiscal 2006 compared to the first six months of fiscal 2005, which increase, was partially offset by a decrease in our foreign currency exchange gains during the first six months of fiscal 2006 compared to the first six months of fiscal 2005.

Income Taxes.

Our effective income tax rate for continuing operations was approximately 34% for the first six months of fiscal years 2005 and 2006.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Net Loss from Continuing Operations. The following table displays net loss from continuing operations (dollars in thousands):


	Six months ended
	December 31,
	2005			% of Sales			2004			% of Sales
Loss from continuing operations	$	(1,481	)		-6.4	%	$	(573	)		-2.6	%

Basic loss per share	$	(0.49	)				$	(0.19	)
Diluted loss per share	$	(0.49	)				$	(0.19	)

Our net loss from continuing operations increased by approximately $908,000, from a loss of approximately $573,000, or (2.6%) of sales, for the first six months of fiscal 2005, to a loss of $1.5 million, or (6.4%) of sales, for the first six months of fiscal 2006 and related primarily to an increase in operating expenses from a one time charge incurred in connection with a special project and the separation of a former Chief Operating Officer, in addition to increased commission expense associated with increased revenues. Basic and diluted loss per share increased from a loss of ($0.19) per share for the first six months of fiscal 2005, to a loss of ($0.49) per share for the first six months of fiscal 2006.

Discontinued Operations.

We had a net loss of approximately $53,000 from discontinued operations during the first six months of fiscal 2005 compared to a net loss of approximately $33,000 from discontinued operations for the first six months of fiscal 2006. Our net loss in fiscal 2006 related primarily to legal expenses associated with adversary proceedings initiated by Enron, while our net loss in fiscal 2005 related primarily to costs associated with the start-up and warranty costs of certain boiler projects. The Company has a remaining reserve of approximately $101,000 at December 31, 2005, which reserve was established based on 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” and Note 6 — “Contingencies” to our Notes to Consolidated Financial Statements of this Report). Basic and diluted loss per share from discontinued operations was ($0.02) per share for the first six months of fiscal 2005, compared to a loss of ($0.01) per share for the first six months of fiscal 2006.

Net Loss. The following table displays net loss (dollars in thousands):


	Six months ended
	December 31,
	2005			% of Sales			2004			% of Sales
Net loss	$	(1,514	)		-6.5	%	$	(626	)		-2.8	%

Basic loss per share	$	(0.50	)				$	(0.21	)
Diluted loss per share	$	(0.50	)				$	(0.21	)

Our net loss increased approximately $888,000 from a net loss of $626,000, or (2.8%) of sales, for the first six months of fiscal 2005, to a net loss of approximately $1.5 million, or (6.5%) of sales, for the first six months of fiscal 2006. Basic and diluted loss per share increased from a net loss of ($0.21) per share for the first six months of fiscal 2005, to a net loss of ($0.50) per share for the first six months of fiscal 2006.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Results of Operations — Segments

Currently we are organized along two lines of business: Environmental Systems and Separation Filtration Systems.

Environmental Systems. This business segment represented approximately 46.0% and 31.5% of our revenues for the second quarter of fiscal 2005 and fiscal 2006, respectively. This business segment represented approximately 40.7% and 29.8% of our revenues for the first six months of fiscal 2005 and fiscal 2006, respectively. The primary product of the Environmental Systems segment is Selective Catalytic Reduction Systems, referred to as “SCR Systems”. These systems are totally integrated, complete with instruments, controls and related valves and piping.

Separation Filtration Systems. This business segment represented approximately 54.0% and 68.5% of our revenues for the second quarter of fiscal 2005 and fiscal 2006, respectively. This business segment represented approximately 59.3% and 70.2% of our revenues for the first six months of fiscal 2005 and fiscal 2006, 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.

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


	Three months ended										Six months ended
	December 31,										December 31,
	2005		%			2004		%			2005		%			2004		%
Environmental Systems	$	3,629		31.5	%	$	4,987		46.0	%	$	6,895		29.8	%	$	8,977		40.7	%
Separation Filtration Systems		7,905		68.5	%		5,857		54.0	%		16,281		70.2	%		13,085		59.3	%

Total	$	11,534		100.0	%	$	10,844		100.0	%	$	23,176		100.0	%	$	22,062		100.0	%

Revenues from Environmental Systems decreased by approximately $1.4 million, or 27.2%, in the second quarter of fiscal 2006, from approximately $5.0 million in the second quarter of fiscal 2005 to $3.6 million in the second quarter of fiscal 2006. Revenues from Environmental Systems decreased by approximately $2.1 million, or 23.2%, in the first six months of fiscal 2006, from approximately $9.0 million in the first six months of fiscal 2005 to $6.9 million in the first six months of fiscal 2006. Our Environmental Systems segment continues to be impacted by the lack of new power plant construction, compliance strategy uncertainties at existing facilities, and competition. While we have seen a decline in our Environmental Systems sales over the past several years, we expect the increasing demand for energy and shrinking electricity generation reserves to result in new power plant construction which will likely require NOx reduction equipment. In addition, as compliance deadlines to air regulations come into effect over the next three to five years, we would expect that spending for NOx reduction systems will increase as compliance strategies at existing facilities

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

become more certain. We continue to see a steady increase to our proposal levels, particularly for our products in new power related projects in selected domestic regions, as well as international regions, and anticipated compliance projects (see Market Outlook following for further discussion).

Separation Filtration Systems revenues increased by approximately $2.0 million, or 35.0%, in the second quarter of fiscal 2006, from approximately $5.9 million in the second quarter of fiscal 2005 to $7.9 million in the second quarter of fiscal 2006. Revenues from Separation Filtration Systems increased by approximately $3.2 million, or 24.4%, in the first six months of fiscal 2006, from approximately $13.1 million in the first six months of fiscal 2005 to $16.3 million in the first six months of fiscal 2006. We saw our domestic Separation Filtration Systems revenues decrease by approximately $333,000 or 14.1% in the second quarter of fiscal 2006 when compared to the second quarter of fiscal 2005. Our international revenues increased approximately $2.4 million, or 68.0% in the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005. We saw our domestic Separation Filtration Systems revenues decrease by approximately $910,000 or 14.6% in the first six months of fiscal 2006 when compared to the first six months of fiscal 2005. Our international revenues increased approximately $4.1 million, or 60.1% in the first six months of fiscal 2006 compared to the first six months of fiscal 2005. The decrease in our domestic revenues, during fiscal 2006, is attributed primarily to a decrease in the sales of our gas separation and filtration products, which we believe is due to a decline in domestic fuel gas conditioning system projects that are used in new gas-fired power plants. The increase in our international revenues in fiscal 2006 related primarily to increased sales of our gas separation and filtration products into Canada and Latin America and sales by our European subsidiary.

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


	Three months ended						Six months ended
	December 31,						December 31,
	2005			2004			2005			2004
Environmental Systems	$	272		$	1,210		$	(9	)	$	1,274
Separation Filtration Systems		489			(559	)		755			166

Total		761			651			746			1,440
General and administrative expenses		(2,087	)		(1,357	)		(3,225	)		(2,412	)

Operating loss	$	(1,326	)	$	(706	)	$	(2,479	)	$	(972	)

Segment profit and loss is based on revenue less direct expenses of the segment before allocation of general, administrative costs. All inter-company transfers between segments have been eliminated. The Company allocates all costs associated with the design, manufacture, and sale of its products to each segment. The Company does not allocate general and administrative expenses on a segment basis for internal management reporting.

Environmental Systems. Environmental Systems segment profit in the second quarter of fiscal 2006 decreased approximately $938,000 compared to the second quarter of fiscal 2005. As a percentage of Environmental Systems revenue, segment profit in Environmental Systems was approximately 7.5% in the second quarter of fiscal 2006 and approximately 24.3% in the second quarter of fiscal 2005. Environmental Systems segment profit in the first six months of fiscal 2006 decreased approximately $1.3 million compared to the first six months of fiscal 2005. As a percentage of Environmental Systems revenue, segment profit in Environmental Systems was approximately

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

(0.1%) in the first six months of fiscal 2006 and approximately 14.2% in the first six months of fiscal 2005.The major impacts to Environmental Systems segment profit related primarily to the following:

	1.		Decrease in selling margin. Our selling margin decreased by approximately 5.0% of sales in the first six months of fiscal 2006, compared to the first six months of fiscal 2005. This decrease is primarily attributable to an adjustment in the second quarter of fiscal 2005 related primarily to certain control deficiencies discovered by management. See Part II, Item 9A – “Controls and Procedures” of our Annual Report on Form 10-K for the year ended June 30, 2005 for further discussion regarding the control deficiency. The decrease in selling margin is also attributable to increased competitive market conditions, combined with increased cost of component parts.

	2.		Start-up and warranty expenses, as percentage of sales. Actual start-up and warranty expenses were approximately $429,000, or 6.2% of revenue in the first six months of fiscal 2006 compared to $146,000, or 1.6% of revenue in the first six months of fiscal 2005. The increase in expense during fiscal 2006 relates predominately to the operation of mechanical equipment outside the customary operating parameters. The solution required changes to the operating procedures to ensure the problem does not recur. Although not all of the units installed in these unique operating conditions have failed, the modified operating procedures will be circulated to all installed systems to ensure the project owners are aware of the potential risk of future claims that may not fall within our warranty period.

	3.		Operational expenses, as a percentage of sales. As part of our on-going cost control monitoring, our operational expenses have continued to decline from approximately $1.8 million in the first six months of fiscal 2005, to $1.5 million in the first six months of fiscal 2006. However, due to declines in this segment’s revenue that exceeded its expense reductions over these periods, expenses, as a percentage of sales, have actually increased from 20.1% in the first six months of fiscal 2005, to 22.3% in the first six months of fiscal 2006.

Separation Filtration Systems. Separation Filtration Systems segment profit in the second quarter of fiscal 2006 increased approximately $1.0 million compared to the second quarter of fiscal 2005. As a percentage of Separation Filtration Systems revenue, segment profit in Separation Filtration Systems was approximately (9.5%) in the second quarter of fiscal 2005 and approximately 6.2% in the second quarter of fiscal 2006. Separation Filtration Systems segment profit in the first six months of fiscal 2006 increased approximately $589,000 compared to the first six months of fiscal 2005. As a percentage of Separation Filtration Systems revenue, segment profit in Separation Filtration Systems was approximately 1.3%, in the first six months of fiscal 2005 and approximately 4.6% in the first six months of fiscal 2006.The changes in the Separation Filtration Systems segment profit related primarily to the following:

Increase in selling margin. Our selling margin increased by approximately 3.4% of sales in the first six months of fiscal 2006, compared to the first six months of fiscal 2005. This increase is primarily attributable to an adjustment in the second quarter of fiscal 2005 related to certain control deficiencies discovered by management. See Part II, Item 9A – “Controls and Procedures” of our Annual Report on Form 10-K for the year ended June 30, 2005 for further discussion regarding the control deficiency.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005


	2.		Operational expenses, as a percentage of sales. As part of our on-going cost control monitoring, our operational expenses, as a percentage of sales, have continued to decline. As a percentage of sales, operational expenses have decreased from 22.2% in the first six months of fiscal 2005, to 19.7% in the first six months of fiscal 2006.

	3.		Start-up and warranty expenses, as a percentage of sales. Actual start-up and warranty expenses were approximately $337,000, or 2.1% of revenue in the first six months of fiscal 2006 compared to approximately $46,000, or 0.4% of revenue in the first six months of fiscal 2005. The increase in expense during the first six months of fiscal 2006 is predominantly attributable to a specific mechanical component failure supplied to operate in high temperature conditions.

Market Outlook

Environmental Systems. Although our Environmental Systems business has been impacted by the lack of new power plant construction and compliance strategy uncertainties at existing facilities, we would expect that as compliance deadlines to air regulations come into effect over the next three to five years and users implement their compliance plans, spending for NOx reduction systems will increase. State Implementation Plans, the Clean Air Interstate Rule, and consent decrees, all create a potentially positive environment for our Environmental Systems. In addition, increasing energy demand is beginning to require the construction of new power plants, which would require some type of a NOx reduction system. Domestically, new gas-fired plants will likely be constructed to meet peak electricity demand. New coal-fired power plants, applied to base-load operations, are planned for construction over the next several years. The increasing demand for natural gas is creating potential opportunities at LNG receiving terminals, as new on-site power plants may need to be built to provide the extensive energy needed for the re-gasification process. We are also seeing an increase in international opportunities for NOx reduction systems.

Separation Filtration Systems. The strong worldwide energy demand is creating renewed opportunities for our separation and filtration products around the world. New pipelines, gas processing facilities, chemical and petrochemical processing plants, and LNG plants and terminals are driving growth of this business segment. The domestic and international markets for our separation products continues to remain strong, as nuclear power plants continue to invest in life extension and power up-rate projects, in connection with their license renewals. The construction of new nuclear power plants in China, Europe and South Korea are also creating opportunities for our nuclear steam dryers.

Contingencies

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

that may negate any recovery by the plaintiffs. We intend to defend vigorously against the lawsuit and we believe the likelihood of a material loss, at this time, is not probable.

Backlog

The Company’s backlog of unfilled orders was approximately $47 million at December 31, 2005 and approximately $34 million at both June 30, 2005 and December 31, 2004. Of the backlog at December 31, 2005, a significant percentage is anticipated to be completed during fiscal 2006. We have received significant awards in each of our business segments. Domestic and international market demand for our separation and filtration products continues to improve. The slow growth in gas turbine-based power plant construction within the United States together with intensified competition continues to create challenges for our Environmental Systems business. See Item 2 — “Management’s Discussion and Analysis of Financial and Results of Operations — Market Outlook” for additional discussion on factors affecting our backlog and our future expectations.

Financial Position

Assets. Total assets increased by approximately $1.8 million, or 4.5%, from $39.8 million at June 30, 2005, to approximately $41.6 million at December 31, 2005. We held cash and cash equivalents of approximately $7.5 million, had working capital of approximately $19.3 million, and a current liquidity ratio of approximately 2.1-to-1.0 at December 31, 2005. This compares with cash and cash equivalents of $8.3 million, $20.3 million in working capital, and a current liquidity ratio of 2.3-to-1.0 at June 30, 2005. The relative stability of our assets and our liquidity ratio during the first six months of fiscal 2006 resulted primarily from the Company’s ability to properly manage short-term assets while experiencing a net loss, combined with our increased backlog and demand for material purchases.

Liabilities and Shareholders’ Equity. Total liabilities increased by approximately $2.9 million, or 18.7%, from $15.4 million at June 30, 2005 to $18.3 million at December 31, 2005. This increase in liabilities related primarily to an increase in our accounts payable of approximately $1.0 million, an increase in our billings in excess of costs and earnings on uncompleted contracts of approximately $1.6 million, and an increase in other accrued liabilities of approximately $283,000. See “Liquidity and Capital Resources” of Item 2 of this Report for further discussion. The decrease in our equity of approximately $1.1 million, or 4.5%, from $24.3 million at June 30, 2005 to $23.2 million at December 31, 2005 resulted primarily from our loss during the period, partially offset by increase in capital from the exercise of stock options during the second quarter of fiscal 2006. Our debt (total liabilities)-to-equity ratio increased from .64-to-1.0 at June 30, 2005 to .79-to-1.0 at

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

December 31, 2005, reflecting a 18.7% increase in our liabilities and a 4.5% decrease in our equity during the period.

Liquidity and Capital Resources

Our cash and cash equivalents were $7.5 million as of December 31, 2005, compared to $8.3 million at June 30, 2005. Cash used in operating activities during the first six months of fiscal year 2006 was approximately $1.1 million, compared to cash provided by operating activities during the first six months of fiscal 2005 of approximately $3.3 million.

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 upon 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 December 31, 2005, the balance of these working capital accounts was approximately $8.1 million compared to approximately $11.1 million at June 30, 2005, reflecting a decrease of our investment in these working capital items of approximately $3.0 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 first six months of fiscal 2006, several large projects were in the early stages of production and the milestones for billing had not been achieved. Additionally, several large projects were finalized and shipped, which resulted in a decrease in our investment in these working capital accounts. During the first six months of fiscal 2006, funds were consumed by our operating loss and consumed by an increase in material purchases, while funds were provided by an overall increase in our accrued expenses and other payables.

Cash provided investing activities was approximately $3,000 for the first six months of fiscal year 2006, compared to cash used by investing activities of approximately $231,000 for the first six months of fiscal 2005. Cash provided during the first six months of fiscal 2006 related primarily to net cash from the sale and purchase of company vehicles. The use of cash during the first six months of fiscal 2005 related primarily to capital refurbishments of our Denton and Abilene, Texas manufacturing facilities.

Cash provided by financing activities was approximately $398,000 and $155,000 during the first six months of fiscal 2006 and 2005, respectively, and related to the proceeds from the issuance of common stock pursuant to employee stock options and the corresponding excess tax benefits associated with the stock option transactions.

Cash used by our discontinued operations during the first six months of fiscal 2006 was approximately $38,000, compared to cash used from discontinued operations of approximately $93,000 in the first six months of fiscal 2005.

As a result of the above factors, our cash and cash equivalents during the first six months of fiscal year 2006 decreased by approximately $756,000, compared to an increase of approximately $3.1 million in the first six months of fiscal 2005.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

substantially all of the Company’s domestic assets. At December 31, 2005, the applicable rate was Euro plus 1.75% (6.22%). At December 31, 2005, the Company had approximately $3.9 million outstanding under stand-by letters of credit and no loans outstanding, leaving a maximum availability under the credit facility of approximately $8.6 million (actual availability at December 31, 2005 approximately $5.4 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 December 31, 2005, the Company was in compliance with all financial and other covenants under the credit facility.

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

We have no off-balance sheet arrangements that have, or are reasonable likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.

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 2 — “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 and process plants. 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 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

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

A large portion of our separation and 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.

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 driven by regulatory compliance. 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 increased 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, the Clean Air Act, and the Clean Air Interstate Rule (CAIR), 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 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

Competition could result in lower sales and decreased margin.

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 to 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.

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-priced 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 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. Examples of unanticipated costs that we cannot pass on to our customers include costs associated with the volatile nature of steel prices and the payment of liquidated damages under fixed contracts. Such costs would negatively impact our

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

profits. See Item 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

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 an order, 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. Therefore, our backlog may not be indicative of our future revenues.

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.

During the first six months of fiscal 2005 and fiscal 2006 revenue outside the United States represented approximately 39.3% and 50.2% of our consolidated revenues, respectively. 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, government sanctions, 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 and from time-to-time may impact our ability to ship our products and collect our receivables.

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 and Marine/Nuclear 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 tends 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. See Item 2 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report.

Our gross profit margin is affected by shifts in our product mix.

Certain of our products have higher margin 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 margin. 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

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

can have a significant impact on our reported margin through a negative or positive impact on our manufacturing absorption. See Item 2 — “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 contracted performance requirements, 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 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 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operation” of this Report.

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 frequently 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.

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 2 — “Management’s Discussion and Analysis and Results of Operations — Liquidity and Capital Resources” of this Report.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

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 December 31, 2005 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.

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

Terrorist acts, acts of war, or national disasters 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. Future terrorist activities, military or security operations, or natural disasters could further weaken the domestic/global economies and create additional uncertainties, thus 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.

The inability of our engineering and/or manufacturing operations to sufficiently scale up operations in the short term, in response to unexpected spikes in orders with short cycle times, directly impacts our ability to optimize absorption of our manufacturing overhead expense.

Our engineering and manufacturing operations require a highly skilled workforce for which there is increasing demand and short supply in a very competitive environment. Consequently, unexpected spikes of demand to produce sales orders that require short order cycle times, may require that we, in many cases, outsource the engineering and/or manufacturing of these orders. While our ability to do this is one of our perceived strengths, such practice could negatively affect our margin, through higher unabsorbed manufacturing costs.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Our customers may require us to execute portions of our projects in their local countries.

Certain countries have regulations, or in some cases, customer preferences, requiring that a certain degree of local content be included in projects destined for installation in their country. Such requirements may negatively impact our margin and present project management issues.

Item 3. 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 December 31, 2005.

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information related to the Company (including its consolidated subsidiaries) that is required to be disclosed in the reports it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.

The Company’s management has evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of these disclosure controls and procedures as of the end of the period covered by this Report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2005, the Company’s disclosure controls and procedures were effective in ensuring that all material information required to be filed in this Report has been made known to them in a timely fashion. Due to the inherent limitations of control systems, not all misstatements may be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls could be circumvented by the individual acts of some persons or by collusion of two or more people. The Registrant’s controls and procedures can only provide reasonable, not absolute, assurance that the above objectives have been met.

During the quarter ended December 31, 2005, there have been no changes in the Company’s internal control over financial reporting, or in other factors, that have materially affected or are reasonably likely to materially affect our internal controls over financial reporting.

Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”) requires the Company to include a report regarding the effectiveness of its internal control over financial reporting, beginning with its Annual Report on Form 10-K for the year ending June 30, 2008. That report is to include an

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

assessment by the Company’s management of the effectiveness of its internal control over financial reporting as of the end of the fiscal year along with an attestation report from the Company’s independent auditors regarding that assessment. Accordingly, the Company will undertake a comprehensive effort to assess its system of internal controls over financial reporting. Using internal resources and external consulting assistance, the Company will review its internal controls over financial reporting to assess their adequacy and, as necessary, to address identified issues or inadequacies.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Items 2, 3, and 5 are not applicable and have been omitted.

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

The following matters were submitted to a vote of securities holders at the Annual Meeting of Shareholders held on December 8, 2005. A total of 2,934,888 shares (approximately 96.7% of all shares entitled to vote) were represented by proxy or ballot at the meeting.

The shareholders’ elected Bernard S. Lee and Joseph V. Mariner, Jr. as Class II Directors for a three-year term expiring at the annual meeting of shareholders in 2008, or until their successors are elected and qualified, with 2,929,676 votes for, no votes against, and with 5,212 votes abstaining. Additional directors, whose term of office as directors continued after the meeting were, R. Clayton Mulford, Donald A. Sillers, Jr. and Sherrill Stone.

In addition, the shareholders’ ratified the selection of Grant Thornton LLP to serve as the Company’s independent accountants for the fiscal year ending June 30, 2006 with 2,928,476 votes for, 3,090 votes against, and with 3,322 votes abstaining.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Item 6. Exhibits

(a) Exhibits

The following exhibits are filed as part of this report.


Exhibit
Number		Exhibit
3(a)		Articles of Incorporation, as amended to date (filed as Exhibit 3(a) to our Quarterly Report on Form 10-Q (file No. 0-5214) for the fiscal quarter ended December 31, 1997, and incorporated herein by reference).

3(b)		Bylaws, as amended to date (filed as Exhibit 3(b) to our Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2004, and incorporated herein by reference).

4(a)		Rights Agreement dated May 22, 1997 between Peerless Mfg. Co. and Mellon Investor Services, LLC (formerly ChaseMellon Shareholder Services, L.L.C.), as Rights Agent (filed as Exhibit 1 to our Registration Statement on Form 8-A (file No. 0-5214), dated May 22, 1997, and incorporated herein by reference).

4(b)		Amendment to Rights Agreement dated August 23, 2001, between Peerless Mfg. Co. and Mellon Investor Services, LLC, as Rights Agent (filed as Exhibit 2 to our Registration Statement on Form 8-A dated August 30, 2001, and incorporated herein by reference).

10(a)		Employment Agreement dated October 31, 2005, by and between Peerless Mfg. Co. and Peter J. Burlage. *

10(b)		Agreement dated October 18, 2005, by and between Peerless Mfg. Co. and Henry G. Schopfer, III. *

31(a)		Rule 13a – 14(a)/15d – 14(a) Certification of Chief Executive Officer. *

31(b)		Rule 13a – 14(a)/15d – 14(a) Certification of Chief Financial Officer. *

32(a)		Section 1350 Certification of Chief Executive Officer. **

32(b)		Section 1350 Certification of Chief Financial Officer. **


*		Filed herewith

**		Furnished herewith

Signatures

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


	PEERLESS MFG. CO.
Date: February 14, 2006	/s/ Sherrill Stone
	Sherrill Stone
	Chairman and Chief Executive Officer


Date: February 14, 2006	/s/ Henry G. Schopfer, III
	Henry G. Schopfer, III
	Chief Financial Officer (Principal Financial and Accounting Officer)


	Page
	Number
PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheets at December 31, 2005 (unaudited) and June 30, 2005		3

Unaudited Condensed Consolidated Statements of Operations for the three and six months ended December 31, 2005 and 2004		4

Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended December 31, 2005 and 2004		5

Notes to the Condensed Consolidated Financial Statements		6

Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations		18

Item 3. Quantitative and Qualitative Disclosures About Market Risk		40

Item 4. Controls and Procedures		40

PART II: OTHER INFORMATION

Item 1. Legal Proceedings		41

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		41

Item 3. Defaults Upon Senior Securities		41

Item 4. Submission of Matters to a Vote of Security Holders		41

Item 5. Other Information		41

Item 6. Exhibits		42

SIGNATURES		43
Employment Agreement
Agreement
Rule 13a-14(a)/15d-14(a) Certification of CEO
Rule 13a-14(a)/15d-14(a) Certification of CFO
Section 1350 Certification of CEO
Section 1350 Certification of CFO


	Three months ended		Six months ended
	December 31,		December 31,
	2005	2004	2005	2004
Total cash received	$261	$53	$264	$118
Income tax benefits	$134	$5	$134	$37
Total grant-date fair value	$148	$30	$150	$66