10-Q

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 March 31, 2006

OR

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 a shell company (as defined in Rule 12b-2 of the Exchange Act).

          Yes o  No þ

As of May 12, 2006, there were 3,101,809 shares of the Registrant’s common stock outstanding.

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006

TABLE OF CONTENTS

	Page
	Number
PART I:FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at March 31, 2006 (unaudited) and June 30, 2005		3
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended March 31, 2006 and 2005		4
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended March 31, 2006 and 2005.		5
Notes to the Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 3. Quantitative and Qualitative Disclosures About Market Risk		38
Item 4. Controls and Procedures		39
PART II: OTHER INFORMATION
Item 1. Legal Proceedings		40
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		40
Item 3. Defaults Upon Senior Securities		40
Item 4. Submission of Matters to a Vote of Security Holders		40
Item 5. Other Information		40
Item 6. Exhibits		41
SIGNATURES		42
Employment Agreement - Sean P. McMenamin
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)
Certification of Chief Executive Officer Pursuant to Section 1350
Certification of Chief Financial Officer Pursuant to Section 1350

Page 2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PEERLESS MFG. CO. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

	March 31, 2006			June 30, 2005
	(unaudited)
ASSETS
Current assets
Cash and cash equivalents	$	6,343		$	8,277
Accounts receivable — principally trade — net of allowance for uncollectible accounts of $262 at March 31, 2006 and $352 at June 30, 2005		13,260			11,613
Inventories, net		5,704			3,297
Costs and earnings in excess of billings on uncompleted contracts		10,709			10,140
Deferred income taxes		1,163			1,163
Other — net		1,949			1,206
Total current assets		39,128			35,696
Property, plant and equipment — net		3,018			3,315
Other assets		876			784
Other assets of discontinued operations		9			9
	$	43,031		$	39,804
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Account payable — trade	$	11,648		$	8,572
Billings in excess of costs and earnings on uncompleted contracts		2,395			2,081
Commissions payable		1,023			762
Product warranties		742			845
Accrued liabilities and other		2,544			3,058
Liabilities of discontinued operations		220			106
Total current liabilities		18,572			15,424
Deferred income taxes		90			90
Shareholders’ equity
Common stock		3,102			3,036
Additional paid-in capital		2,945			2,114
Other		(48	)		171
Retained earnings		18,370			18,969
Total shareholders’ equity		24,369			24,290
Total liabilities and shareholders’ equity	$	43,031		$	39,804

See accompanying notes to the consolidated financial statements.

Page 3

PEERLESS MFG. CO. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

	Three months ended						Nine months ended
	March 31,						March 31,
	2006			2005			2006			2005
Revenues	$	18,121		$	12,999		$	41,297		$	35,061
Cost of goods sold		12,778			9,155			30,455			25,063
Gross profit		5,343			3,844			10,842			9,998
Operating expenses
Sales and marketing		1,662			1,558			4,769			4,440
Engineering and project management		914			892			2,560			2,724
General and administrative		1,314			1,200			4,539			3,612
		3,890			3,650			11,868			10,776
Operating income (loss)		1,453			194			(1,026	)		(778	)
Other income (expense)
Foreign exchange gain (loss)		(24	)		3			33			68
Other income — net		87			53			269			92
		63			56			302			160
Earnings (loss) from continuing operations before income taxes		1,516			250			(724	)		(618	)
Income tax benefit (expense)		(513	)		(45	)		246			250
Net earnings (loss) from continuing operations		1,003			205			(478	)		(368	)
Discontinued operations
Loss from discontinued operations		(133	)		—			(183	)		(80	)
Income tax benefit		45			—			62			27
Net loss from discontinued operations		(88	)		—			(121	)		(53	)
Net earnings (loss)	$	915		$	205		$	(599	)	$	(421	)
BASIC EARNINGS (LOSS) PER SHARE *
Earnings (loss) from continuing operations	$	0.32		$	0.07		$	(0.16	)	$	(0.12	)
Loss from discontinued operations		(0.03	)	$	—			(0.04	)		(0.02	)
Basic earnings (loss) per share	$	0.30		$	0.07		$	(0.20	)	$	(0.14	)
DILUTED EARNINGS (LOSS) PER SHARE *
Earnings (loss) from continuing operations	$	0.32		$	0.07		$	(0.16	)	$	(0.12	)
Loss from discontinued operations		(0.03	)	$	—			(0.04	)		(0.02	)
Diluted earnings (loss) per share	$	0.29		$	0.07		$	(0.20	)	$	(0.14	)

* Certain earnings (loss) per share amounts may not total due to rounding

See accompanying notes to the consolidated financial statements.

Page 4

PEERLESS MFG. CO. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands — Unaudited)

	Nine months ended March 31,
	2006			2005
				(Revised)
Cash flows from operating activities:
Net loss	$	(599	)	$	(421	)
Adjustments to reconcile net loss from operations to net cash provided by (used in) operating activities:
Depreciation and amortization		496			487
Provision for bad debts		218			268
Provision for warranty expense		216			419
Inventory valuation reserve		130			37
Foreign exchange gain		(33	)		(68	)
Gain on sale of property		(22	)		—
Stock based compensation		94			—
Other		19			70
Changes in operating assets and liabilities:
Accounts receivable		(1,879	)		4,003
Inventories		(2,539	)		(1,010	)
Costs and earnings in excess of billings on uncompleted contracts		(572	)		2,094
Other current assets		(596	)		(488	)
Other assets		(92	)		62
Accounts payable		3,067			(795	)
Billings in excess of costs and earnings on uncompleted contracts		314			2,124
Commissions payable		261			(107	)
Product warranties		(319	)		(359	)
Excess tax benefits from stock-based payment arrangements		(145	)		(43	)
Income taxes payable		—			(524	)
Accrued liabilities and other		(521	)		(178	)
Net cash provided by (used in) operating activities:		(2,502	)		5,571
Cash flow from investing activities:
Purchases of property and equipment		(209	)		(347	)
Proceeds from the sale of equipment		32			—
Net cash used in investing activities of continuing operations		(177	)		(347	)
Cash flows from financing activities:
Proceeds from sale of common stock		485			140
Excess tax benefits from stock-based payment arrangements		145			43
Net cash provided by financing activities of continuing operations		630			183
Cash flow from discontinued operations — revised:
Cash provided by (used in) operating activities		114			(73	)
Cash provided by (used in) investing activities		—			—
Cash provided by (used in) financing activities		—			—
Net cash provided by (used in) discontinued operations		114			(73	)
Effect of exchange rate changes on cash and cash equivalents		1			5
Net increase (decrease) in cash and cash equivalents		(1,934	)		5,339
Cash and cash equivalents at beginning of period		8,277			4,119
Cash and cash equivalents at end of period	$	6,343		$	9,458

See accompanying notes to consolidated financial statements.

Page 5

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands, except per share amounts)

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 March 31, 2006, and for the three and nine months ended March 31, 2006 and March 31, 2005 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 nine months ended March 31, 2006 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.

Starting with the period ended March 31, 2006, the Company has separately disclosed the operating, investing, and financing portions of cash flows attributable to discontinued operations, which in prior periods, were reported on a combined basis as a single amount.

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 it is determined that the receivable has become uncollectible, and payments subsequently received on such receivables are credited back to bad debt expense in the period the payment is received.

Page 6

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

2. Accounts Receivable — Continued

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

	Three months ended					Nine months ended
	March 31,					March 31,
	2006			2005		2006			2005
Balance at beginning of period	$	224		$	427	$	352		$	431
Bad debt expense		74			51		218			268
Accounts written off, net		(36	)		—		(308	)		(221	)
Balance at end of period	$	262		$	478	$	262		$	478

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:

	March 31,			June 30,
	2006			2005
Material and component parts	$	4,989		$	3,027
Work in progress		873			232
Finished goods		290			356
		6,152			3,615
Reserve for obsolete and slow-moving inventory		(448	)		(318	)
	$	5,704		$	3,297

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

	Three months ended				Nine months ended
	March 31,				March 31,
	2006		2005		2006		2005
Balance at beginning of period	$	423	$	218	$	318	$	196
Additions		25		15		130		37
Amounts written off		—		—		—		—
Balance at end of period	$	448	$	233	$	448	$	233

Page 7

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

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”). 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. 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. The Company does not assume any profit component for change orders prior to the change order being approved by the customer. Cumulative revenues recognized may be more or less 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 and invoicing of the product.

     The components of uncompleted contracts are as follows:

	March 31,			June 30,
	2006			2005
Costs incurred on uncompleted contracts and estimated earnings	$	33,106		$	34,978
Less billings to date		(24,792	)		(26,919	)
	$	8,314		$	8,059

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

	March 31,			June 30,
	2006			2005
Costs and earnings in excess of billings on uncompleted contracts	$	10,709		$	10,140
Billings in excess of costs and earnings on uncompleted contracts		(2,395	)		(2,081	)
	$	8,314		$	8,059

Page 8

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

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 shipment, 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 concurrent warranties for major component parts produced by third party 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 concurrent supplier warranties in place, at the time the product revenue is recognized. Revisions to the estimated product warranties is made when necessary, based on changes in these factors. Product warranty activity is as follows:

	Three months ended						Nine months ended
	March 31,						March 31,
	2006			2005			2006			2005
Balance at beginning of period	$	697		$	984		$	845		$	982
Provision for warranty expenses		57			213			216			419
Warranty charges		(12	)		(155	)		(319	)		(359	)
Balance at end of period	$	742		$	1,042		$	742		$	1,042

6. Contingencies

On March 19, 2004, the Company received notice that an adversary proceeding was initiated by Enron Corp. (“Enron”) and National Energy Production Corporation (“NEPCO”) in the United States Bankruptcy Court for the Southern District of New York against PMC Acquisition, Inc., a subsidiary that operated the Company’s discontinued Boiler business under the name ABCO. The plaintiffs alleged that certain accounts receivable payments paid to ABCO were avoidable transfers under the Bankruptcy Code and sought to recover approximately $1,000. The Company reached an agreement with the bankruptcy estates of Enron and NEPCO to settle and resolve the litigation for $175. On May 4, 2006, the United States Bankruptcy Court for the Southern District of New York, where Enron and NEPCO’s bankruptcy cases are pending, approved the settlement agreement among the Company, Enron and NEPCO. The Company expects that the settlement will be fully consummated and the litigation dismissed in the quarter ending June 30, 2006.

     On April 25, 2005, the Company received notice that it allegedly received preferential transfers amounting to approximately $900 in connection with the Chapter 11 filing by Erie Power Technologies, Inc. Based on preliminary investigation, the Company believes that a majority of the

Page 9

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

6. Contingencies — Continued

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. The Company intends to defend vigorously against the lawsuit and believes the likelihood of a material loss, at this time, is not probable.

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

7. Accrued Liabilities

The components of accrued liabilities and other are as follows:

	March 31,		June 30,
	2006		2005
Accrued start-up expense	$	1,111	$	974
Accrued compensation		528		691
Sales and use tax payable		54		523
Accrued property tax expense		59		111
Other		792		759
	$	2,544	$	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. 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. Under both plans, 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 recognizes stock-based compensation expense over the requisite service period of the individual grants, which generally equals the vesting period. Under both plans, restricted stock awards entitle the holder to shares of common stock when the award vests. Awards generally vest ratably over four years. The fair value of the restricted stock awards is based upon the market price of the underlying common stock as of the date of the grant and is amortized over their applicable vesting period using the straight-line method. The Company uses newly issued shares of common stock to satisfy option exercises and restricted stock awards.

Page 10

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

8. Stock Based Compensation – Continued

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 $23 in the three months ended March 31, 2006 and related tax-benefits of $8. The Company recognized stock based compensation cost in the amount of $94 in the nine months ended March 31, 2006 and related tax-benefits of $32.

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.

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			Nine months ended
	March 31, 2005			March 31, 2005
Net earnings (loss), as reported	$	205		$	(421	)
Deduct: Total stock-based employee compensation expense determined using the fair value based method for all awards, net of tax		(48	)		(118	)
Pro forma net earnings (loss)	$	157		$	(539	)
Earnings (loss) per share:
Basic — as reported	$	0.07		$	(0.14	)
Basic — pro forma	$	0.05		$	(0.18	)
Diluted — as reported	$	0.07		$	(0.14	)
Diluted — pro forma	$	0.05		$	(0.18	)

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.

Page 11

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except share and per share amounts)

8. Stock Based Compensation – Continued

A summary of the option activity under the plans for the three and nine months ended March 31, 2006 is as follows:

						Weighted		Aggregate
				Weighted		Average		Grant Date
				Average		Remaining		Fair
	No. 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
Forfeited before vesting		(2,800	)	$	14.02
Forfeited after vesting		—		$	—
Balance at September 30, 2005		234,900		$	11.18		6.03	$	1,259
Granted		4,000		$	16.95
Exercised		(39,750	)	$	6.56
Forfeited before vesting		(25,000	)	$	12.94
Forfeited after vesting		(500	)	$	19.50
Balance at December 31, 2005		173,650		$	12.10		6.27	$	993
Granted		18,000		$	18.39
Exercised		(15,375	)	$	14.36
Forfeited before vesting		—
Forfeited after vesting		—
Balance at March 31, 2006		176,275		$	12.54		6.33	$	1,026
Exercisable at March 31, 2006		130,364		$	11.49		5.42	$	716

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 nine months ended March 31, 2006 and 2005:

	Three Months Ended						Nine Months Ended
	March 31,						March 31,
	2006			2005			2006			2005
Expected volatility		47.7	%		36.8	%		47.7 % - 52.6	%		36.8% - 46.4	%
Expected term (years)		4.05			5.00			4.05 - 5.66			5.00
Risk free interest rate		4.63	%		4.00	%		4.12% - 4.63	%		4.00	%
Dividend yield		0.00	%		0.00	%		0.00	%		0.00	%
Weighted average grant date fair value	$	7.88		$	5.65		$	8.08		$	5.76

A summary of the stock options exercised during the three and nine months ended March 31, 2006 and 2005 is presented below:

	Three months ended				Nine months ended
	March 31,				March 31,
	2006		2005		2006		2005
Total cash received	$	221	$	22	$	485	$	140
Income tax benefits	$	11	$	6	$	145	$	43
Total grant-date fair value	$	109	$	12	$	259	$	78

Page 12

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except share and per share amounts)

8. Stock Based Compensation – Continued

A summary of the status of the Company’s unvested stock options at March 31, 2006, and changes during the three and nine months ended March 31, 2006 is presented below:

	Three months ended					Nine months ended
	March 31, 2006					March 31, 2006
				Weighted					Weighted
				Average					Average
				Grant Date					Grant Date
	No. of Options			Fair Value		No. of Options			Fair Value
Unvested at beginning of period		33,050		$	5.95		70,100		$	5.98
New Grants		18,000		$	7.88		18,000		$	7.88
Vested		(5,139	)	$	5.95		(14,389	)	$	6.00
Forfeited		—		$	—		(27,800	)	$	5.94
Unvested at end of period		45,911		$	6.74		45,911		$	6.74

As of March 31, 2006, the total remaining unrecognized compensation cost related to unvested stock options was $282. The weighted average remaining requisite service period of the unvested stock options was 1.83 years.

A summary of the restricted stock award activity under the plans for the three and nine months ended March 31, 2006 is as follows:

			Weighted
			Average
			Grant Date
	No. of Shares		Fair Value
Balance at July 1, 2005		—	$	—
Granted		—	$	—
Vested		—	$	—
Forfeited		—	$	—
Balance at September 30, 2005		—	$	—
Granted		10,000	$	17.06
Vested		—	$	—
Forfeited		—	$	—
Balance at December 31, 2005		10,000	$	17.06
Granted		—	$	—
Vested		—	$	—
Forfeited		—	$	—
Balance at March 31, 2006		10,000	$	17.06

Page 13

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

9. Discontinued Operations

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

The following represents a summary of operating results of the discontinued Boiler segment:

	Three months ended					Nine months ended
	March 31,					March 31,
	2006			2005		2006			2005
Revenues	$	—		$	—	$	—		$	—
Cost of goods sold		—			—		—			75
Gross loss		—			—		—			(75	)
Operating expenses		133			—		183			5
Operating loss		(133	)		—		(183	)		(80	)
Income tax benefit		45			—		62			27
Net loss from operations	$	(88	)	$	—	$	(121	)	$	(53	)
Diluted loss per share	$	(0.03	)	$	—	$	(0.04	)	$	(0.02	)

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

	March 31,		June 30,
	2006		2005
Assets
Equipment — net of accumulated depreciation of $11 at March 31, 2006 and June 30, 2005	$	9	$	9
Total assets of discontinued operations	$	9	$	9
Liabilities
Product warranties and other reserves	$	220	$	106
Total current liabilities of discontinued operations	$	220	$	106

Page 14

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

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						Nine Months Ended
	March 31,						March 31,
	2006			2005			2006			2005
Net earnings (loss) from continuing operations	$	1,003		$	205		$	(478	)	$	(368	)
Net loss from discontinued operations		(88	)		—			(121	)		(53	)
Foreign currency translation adjustment		(8	)		(42	)		(67	)		78
Comprehensive earnings (loss)	$	907		$	163		$	(666	)	$	(343	)

11. Earnings (Loss) Per Share

Basic earnings (loss) per share has been computed by dividing net earnings (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					Nine months ended
	March 31,					March 31,
	2006			2005		2006			2005
Net earnings (loss) from continuing operations	$	1,003		$	205	$	(478	)	$	(368	)
Loss from discontinued operations		(88	)		—		(121	)		(53	)
Net earnings (loss)	$	915		$	205	$	(599	)	$	(421	)
Basic weighted average common shares outstanding		3,088			3,032		3,056			3,026
Effect of dilutive options		48			43		—			—
Diluted weighted average common shares outstanding		3,136			3,075		3,056			3,026
BASIC EARNINGS (LOSS) PER SHARE
Earnings (loss) from continuing operations	$	0.32		$	0.07	$	(0.16	)	$	(0.12	)
Loss from discontinued operations		(0.03	)		—		(0.04	)		(0.02	)
Net earnings (loss) per share	$	0.30		$	0.07	$	(0.20	)	$	(0.14	)
DILUTED LOSS PER SHARE
Earnings (loss) from continuing operations	$	0.32		$	0.07	$	(0.16	)	$	(0.12	)
Loss from discontinued operations		(0.03	)		—		(0.04	)		(0.02	)
Net earnings (loss) per share	$	0.29		$	0.07	$	(0.20	)	$	(0.14	)

Diluted weighted average common shares outstanding excluded 31 and 81 outstanding stock options for the three months ended March 31, 2006 and 2005, respectively, and diluted weighted average common shares outstanding excluded 203 and 167 outstanding stock options for the nine months ended March 31, 2006 and 2005, respectively, because their impact would be anti-dilutive.

Page 15

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

12. Segment Information

The Company identifies reportable segments based on management responsibility within the corporate structure. The Company has two reporting 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 nine months ended March 31, 2006 and 2005 are presented below. The Company does not allocate general and administrative expenses (“reconciling items”), assets, expenditures for assets or depreciation expense on a segment basis for internal management reporting, and therefore such information is not presented.

	Three months ended						Nine months ended
	March 31,						March 31,
	2006			2005			2006			2005
Revenues
Environmental	$	6,490		$	6,549		$	13,385		$	15,526
Separation Filtration		11,631			6,450			27,912			19,535
Consolidated	$	18,121		$	12,999		$	41,297		$	35,061
Operating income (loss)
Environmental	$	1,384		$	645		$	1,375		$	1,919
Separation Filtration		1,383			749			2,138			915
Reconciling items		(1,314	)		(1,200	)		(4,539	)		(3,612	)
Consolidated	$	1,453		$	194		$	(1,026	)	$	(778	)

Page 16

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

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 nine months ended March 31, 2006 and March 31, 2005 is as follows:

	United		United
	States		Kingdom		Eliminations			Consolidated
Three months ended March 31, 2006
Net sales to unaffiliated customers	$	15,214	$	2,907	$	—		$	18,121
Transfers between geographic areas		267				(267	)		—
Total	$	15,481	$	2,907	$	(267	)	$	18,121
Identifiable long-lived assets	$	2,971	$	47	$	—		$	3,018
Three months ended March 31, 2005
Net sales to unaffiliated customers	$	10,242	$	2,757	$	—		$	12,999
Transfers between geographic areas		1,128		—		(1,128	)		—
Total	$	11,370	$	2,757	$	(1,128	)	$	12,999
Identifiable long-lived assets	$	2,829	$	84	$	—		$	2,913
Nine months ended March 31, 2006
Net sales to unaffiliated customers	$	33,095	$	8,202	$	—		$	41,297
Transfers between geographic areas		477				(477	)		—
Total	$	33,572	$	8,202	$	(477	)	$	41,297
Identifiable long-lived assets	$	2,971	$	47	$	—		$	3,018
Nine months ended March 31, 2005
Net sales to unaffiliated customers	$	28,842	$	6,219	$	—		$	35,061
Transfers between geographic areas		1,809		—		(1,809	)		—
Total	$	30,651	$	6,219	$	(1,809	)	$	35,061
Identifiable long-lived assets	$	2,829	$	84	$	—		$	2,913

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

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

Page 17

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

14. Lines of Credit

On October 31, 2003, the Company entered into a $12,500 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 assets in the United States. At March 31, 2006, the applicable rate was Euro plus 1.75% (6.57%). At March 31, 2006, the Company had approximately $6,200 outstanding under stand-by letters of credit and no loans outstanding, leaving a maximum availability under the credit facility of approximately $6,300 (actual availability at March 31, 2006 of approximately $1,800). 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 March 31, 2006, the Company was in compliance with all financial and other covenants under the credit facility.

In addition, the Company’s UK subsidiary had a £2,600 (approximately $4,500) debenture agreement used to facilitate the issuances of bank guarantees. At March 31, 2006, this facility was secured by substantially all of the UK subsidiary assets, and was backed by a stand-by letter of credit of £1,400 (approximately $2,500, which is included in the $6,200 outstanding under the Company’s $12,500 revolving credit facility described above). At March 31, 2006, there was approximately £2,600 (approximately $4,500) outstanding under this facility, the maximum amount under this facility. As of March 31, 2006, the Company was in compliance with all financial and other covenants under the credit facility.

15. Supplemental cash flow Information

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

	Three months ended				Nine months ended
	March 31,				March 31,
	2006		2005		2006			2005
Income taxes paid (received)	$	—	$	—	$	(150	)	$	660

Page 18

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

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. Such factors include, but are not limited to, the factors in Item 2 — “Factors That May Affect Our Operating Results and Other Risk Factors,” as set forth starting on page 34 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 reporting segment represented approximately 32.4% and 44.3% of our first nine months fiscal 2006 and 2005 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 reporting segment represented approximately 67.6% and 55.7% of our first nine months fiscal 2006 and 2005 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.

Page 19

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)

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 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

Page 20

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

products during the warranty period at no cost to the customer. We attempt to obtain back-up concurrent warranties for major component parts from our suppliers. As of each balance sheet date, we record an estimate for warranty related costs for products sold based on historical experience, expectation of future conditions and the extent of back-up concurrent supplier warranties in place. While we believe that our estimated warranty reserve is adequate and the judgment applied is appropriate, due to a number of factors our estimated liability for product warranties could differ from actual warranty costs incurred in the future.

     Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts to reflect estimated losses resulting from the inability of customers to make required payments. On an on-going basis, we evaluate the 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.

     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 in 2006; $3,300 in 2007; $2,100 in 2008; $1,900 in 2009; and, $210 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.

Page 21

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

Results of Operations

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

	Three Months Ended						Nine Months Ended
	March 31,						March 31,
	2006			2005			2006			2005
Net revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold		70.5			70.4			73.7			71.5
Gross profit		29.5			29.6			26.3			28.5
Operating expenses		21.5			28.1			28.8			30.7
Operating earnings (loss)		8.0			1.5			(2.5	)		(2.2	)
Other income		0.3			0.4			0.7			0.5
Net earnings (loss) from continuing operations before income taxes		8.3			1.9			(1.8	)		(1.7	)
Income tax benefit (expense)		(2.8	)		(0.3	)		0.6			0.7
Net earnings (loss) from continuing operations		5.5			1.6			(1.2	)		(1.0	)
Loss from discontinued operations, net of tax		(0.5	)		—			(0.3	)		(0.2	)
Net earnings (loss)		5.0	%		1.6	%		(1.5)	%		(1.2)	%

     Cost of goods sold includes manufacturing and distribution costs for products sold. The manufacturing and distribution costs include material, direct labor, indirect labor, manufacturing overhead, sub-contract work, inbound freight, outbound freight, purchasing, receiving, inspection, warehousing, internal transfer costs, and other costs of our manufacturing and distribution processes. Additionally, cost of goods sold includes the costs of commissioning the equipment and warranty related costs.

     Operating expenses include sales and marketing expenses; engineering and project management expense; and general and administrative expenses.

     Sales and marketing expenses include payroll, employee benefits, stock-based compensation and other employee-related costs associated with sales and marketing personnel. Additionally, sales and marketing expenses include travel and entertainment, advertising, promotions, trade shows, seminars, and other programs.

     Engineering and project management expenses include payroll, employee benefits, stock-based compensation and other employee-related costs associated with engineering, project management and field service personnel. Additionally, engineering and project management expenses include the cost of sub-contracted engineering services.

     General and administrative costs include payroll, employee benefits, stock-based compensation and other employee-related costs and departmental functional costs associated with executive management, finance, accounting, human resources, information systems, and other administrative employees. Additionally, general and administrative costs include facility costs, insurance, audit fees, legal fees, reporting expense, professional services, and other administrative fees.

Page 22

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

Three Months Ended March 31, 2006 Compared to Three Months Ended March 31, 2005

Results of Operations — Consolidated

     Revenues

     The following table summarizes consolidated revenues:

	Three months ended March 31,
	2006		% of Total			2005		% of Total
Domestic	$	11,365		62.7	%	$	7,827		60.2	%
International	$	6,756		37.3	%	$	5,172		39.8	%
Total revenues	$	18,121		100.0	%	$	12,999		100.0	%

     For the third quarter of fiscal 2006, revenues increased $5,122, or 39.4%, when compared to the third quarter of fiscal 2005. Domestic revenues increased $3,538, or 45.2%, in the third quarter of fiscal 2006 when compared to the third quarter of fiscal 2005. International revenues increased $1,584, or 30.6%, in the third quarter of fiscal 2006 when compared to the third quarter of fiscal 2005. The increase in our domestic and international revenues relates primarily to an increase of gas separation and filtration equipment sales attributable to an increased demand for natural gas. See Item 2 — “Results of Operations — Segments” of this Report for further discussion.

     Gross Profit

     The following table summarizes revenues, cost of goods sold, and gross profit:

	Three months ended March 31,
	2006		% of Revenue			2005		% of Revenue
Revenues	$	18,121		100.0	%	$	12,999		100.0	%
Cost of goods sold		12,778		70.5	%		9,155		70.4	%
Gross profit	$	5,343		29.5	%	$	3,844		29.6	%

     For the third quarter of fiscal 2006, our gross profit increased $1,499, or 39.0%, when compared to the third quarter of fiscal 2005. Our gross profit, as a percentage of revenues, remained relatively constant in the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005. See Item 2 — “Results of Operations — Segments” of this Report for further discussion.

Page 23

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

     Operating Expenses

          The following table summarizes operating expenses:

	Three months ended March 31,
	2006		% of Sales			2005		% of Sales
Sales and marketing	$	1,662		9.2	%	$	1,558		12.0	%
Engineering & project management		914		5.0	%		892		6.9	%
General and administrative		1,314		7.3	%		1,200		9.2	%
Total operating expenses	$	3,890		21.5	%	$	3,650		28.1	%

     For the third quarter of fiscal 2006, our operating expenses from continuing operations increased by $240, or 6.6% when compared to the third quarter of fiscal 2005. These expenses as a percentage of revenue decreased to 21.5% in the third quarter of fiscal 2006 from 28.1% in the third quarter of fiscal 2005, which is primarily related to the increased revenue in the current quarter compared to the same period in the prior year. On a comparative basis, our sales and marketing expenses were $1,662 in the third quarter of fiscal 2006 compared to $1,558 in the third quarter of fiscal 2005. Selling commissions in the third quarter of fiscal 2006 increased over the third quarter of fiscal 2005 due to the increased revenues, while other selling expenses decreased as a result of improved cost control. Our engineering and project management expense increased to $914 in the third quarter of fiscal 2006 from $892 in the third quarter of fiscal 2005 and primarily relates to the increased activity associated with the increased revenues. Our general and administrative expenses increased $114 in the third quarter of fiscal 2006, compared to the third quarter of fiscal 2005, due primarily to increased legal expenses associated with the defense of adversary proceedings. See Item 2 — “Contingencies” of this Report for further discussion.

     Other Income and Expense

     The following table summarizes other income and expenses:

	Three months ended March 31,
	2006			% of Sales			2005		% of Sales
Foreign exchange gain (loss)	$	(24	)		-0.1	%	$	3		0.0	%
Other income, net		87			0.4	%		53		0.4	%
Total other income	$	63			0.3	%	$	56		0.4	%

     For the third quarter of fiscal 2006, other income and expense items increased by $7, from income of $56 for the third quarter of fiscal 2005 to income of $63 for the third quarter of fiscal 2006. This change was primarily due to increased interest income partially offset by our foreign currency exchange losses during the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005.

     Income Taxes

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

Page 24

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

     Net Earnings from Continuing Operations

     Our net earnings from continuing operations increased by $798, from net earnings of $205, or 1.6% of revenues, for the third quarter of fiscal 2005, to $1,003, or 5.5% of revenues, for the third quarter of fiscal 2006 and related primarily to our increased revenues and gross profit. Basic and diluted earnings per share increased from $0.07 per share for the third quarter of fiscal 2005, to $0.32 per share for the third quarter of fiscal 2006.

     Discontinued Operations

     We had a net loss of $88 from discontinued operations during the third quarter of fiscal 2006 and no earnings or loss during the third quarter of fiscal 2005. Our net loss in fiscal 2006 related primarily to legal and settlement expenses associated with adversary proceedings initiated by Enron. See Note 6 – “Contingencies” to our Notes to Consolidated Financial Statements of this Report. Basic and diluted loss per share from discontinued operations was $0.03 per share for the third quarter of fiscal 2006 and $0.00 per share for the third quarter of fiscal 2005.

     Net Earnings

     Our net earnings increased $710 from net earnings of $205, or 1.6% of revenues, for the third quarter of fiscal 2005, to net earnings of $915, or 5.0% of revenues, for the third quarter of fiscal 2006. Basic earnings per share increased from $0.07 per share for the third quarter of fiscal 2005, to $0.30 per share for the third quarter of fiscal 2006. Diluted earnings per share increased from $0.07 per share for the third quarter of fiscal 2005, to $0.29 per share for the third quarter of fiscal 2006.

Nine months Ended March 31, 2006 Compared to Nine months Ended March 31, 2005

Results of Operations – Consolidated

     Revenues

     The following table summarizes consolidated revenues:

	Nine months ended March 31,
	2006		% of Total			2005		% of Total
Domestic	$	22,898		55.4	%	$	21,224		60.5	%
International		18,399		44.6	%		13,837		39.5	%
Total revenues	$	41,297		100.0	%	$	35,061		100.0	%

     For the first nine months of fiscal 2006, revenues increased $6,236, or 17.8%, when compared to the first nine months of fiscal 2005. Domestic revenues during the first nine months of fiscal 2006 increased approximately $1,674, or 7.9%, when compared to the first nine months of fiscal 2005. International revenues increased $4,562, or 33.0%, during the first nine months of fiscal 2006 when compared to the first nine months of fiscal 2005. The increase in our domestic and international revenues relates primarily to an increase of gas separation and filtration equipment sales attributable to an increased demand for natural gas. See Item 2 – “Results of Operations – Segments” of this Report for further discussion.

Page 25

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

     Gross Profit

          The following table summarizes revenue, cost of goods sold and gross profit (dollars in thousands):

	Nine months ended March 31,
	2006		% of Revenue			2005		% of Revenue
Revenues	$	41,297		100.0	%	$	35,061		100.0	%
Cost of goods sold		30,455		73.7	%		25,063		71.5	%
Gross profit	$	10,842		26.3	%	$	9,998		28.5	%

     For the first nine months of fiscal 2006, our gross profit increased $844, or 8.4%, when compared to the first nine months of fiscal 2005. Our gross profit, as a percentage of revenues, decreased from 28.5% in the first nine months of fiscal 2005 to 26.3% in the first nine months of fiscal 2006.

     Our gross profit during any particular period may be impacted by four primary factors: 1) sales volume, 2) shifts in our product mix, 3) material cost changes, and 4) start-up and warranty costs. The increased gross profit during the first nine months of fiscal 2006 compared to the first nine months of fiscal 2005 was favorably impacted by our increased revenues. However, gross profit, as a percentage of revenues, during the first nine months of fiscal 2006 compared to the first nine months of fiscal 2005 was unfavorably impacted by shifts in product mix and increased cost of material. Our warranty and start-up costs, as a percentage of revenues, remained relatively constant for both periods. See Item 2 – “Results of Operations – Segments” of this Report for further discussion.

     Operating Expenses

     The following table summarizes operating expenses:

	Nine months ended March 31,
	2006		% of Sales			2005		% of Sales
Sales and marketing	$	4,769		11.5	%	$	4,440		12.6	%
Engineering & project management		2,560		6.2	%		2,724		7.8	%
General and administrative		4,539		11.0	%		3,612		10.3	%
Total operating expenses	$	11,868		28.7	%	$	10,776		30.7	%

     For the first nine months of fiscal 2006, our operating expenses from continuing operations increased by $1,092, or 10.1% when compared to the first nine months of fiscal 2005. These expenses as a percentage of revenue decreased to 28.7% in the first nine months of fiscal 2006 from 30.7% in the first nine months of fiscal 2005. On a comparative basis, our sales and marketing expenses were $4,769 in the first nine months of fiscal 2006 compared to $4,440 in the first nine months of fiscal 2005. Selling commissions in the first nine months of fiscal 2006 increased over the first nine months of fiscal 2005 due to the increased revenues, while other selling expenses decreased as a result of improved cost control. Our engineering and project management expense decreased to $2,560 in the

Page 26

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

first nine months of fiscal 2006 from $2,724 in the first nine months of fiscal 2005 and primarily as a result of improved cost control. Our general and administrative expenses increased $927 in the first nine months of fiscal 2006, compared to the first nine months of fiscal 2005, due primarily to a one time charge during the second quarter of fiscal 2006 incurred in connection with a special project and the separation of a former officer. Additionally, our general and administrative expenses increased in the first nine months of fiscal 2006, compared to the first nine months of fiscal 2005 due to legal expenses associated with the defense of adversary proceedings. See Item 2 — “Contingencies” of this Report for further discussion.

     Other Income and Expense

     The following table summarizes other income and expenses:

	Nine months ended March 31,
	2006		% of Sales			2005		% of Sales
Foreign exchange gain (loss)	$	33		0.1	%	$	68		0.2	%
Other income, net		269		0.6	%		92		0.3	%
Total other income	$	302		0.7	%	$	160		0.5	%

     For the first nine months of fiscal 2006, other income and expense items increased by $142, from income of $160 for the first nine months of fiscal 2005 to income of $302 for the first nine months of fiscal 2006. This change was primarily due to increased interest income and increased rental income associated with the lease of an inactive warehouse, partially offset by reduced foreign currency exchange gains during the first nine months of fiscal 2006 compared to the first nine months of fiscal 2005.

     Income Taxes

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

     Net Loss from Continuing Operations

     Our net loss from continuing operations increased by $110, from a net loss of $368, or 1.0% of revenues, for the first nine months of fiscal 2005, to $478, or 1.2% of revenues, for the first nine months of fiscal 2006 and related primarily to our decreased gross profit associated with the shift in product mix and increased cost of materials, combined with the increased general and administrative costs incurred in connection with a special project and the separation of a former officer. Basic and diluted loss per share increased from a net loss of $0.12 per share for the first nine months of fiscal 2005, to a net loss of $0.16 per share for the first nine months of fiscal 2006.

     Discontinued Operations

     We had a net loss of $53 from discontinued operations during the first nine months of fiscal 2005 and $121 during the first nine months 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 $220 at March 31, 2006, which was

Page 27

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

established based on the most current information available. 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 nine months of fiscal 2005 and $0.04 for the first nine months of fiscal 2006.

     Net Loss

     Our net loss increased $178 from a net loss of $421 or 1.2% of revenues, for the first nine months of fiscal 2005, to a net loss of $599, or 1.5% of revenues, for the first nine months of fiscal 2006. Basic and diluted loss per share increased from a net loss of $0.14 per share for the first nine months of fiscal 2005, to a net loss of $0.20 per share for the first nine months of fiscal 2006.

Results of Operations – Segments

     Currently we are organized along two lines of business: Environmental Systems and Separation Filtration Systems. Revenue and operating income in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles (“GAAP”). Certain corporate level expenses have been excluded from our segment operating results and are analyzed separately.

     Environmental Systems

     This reporting segment represented approximately 50.4% and 35.8% of our revenues for the third quarter of fiscal 2005 and fiscal 2006, respectively. This business segment represented approximately 44.3% and 32.4% of our revenues for the first nine 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 are integrated systems, with instruments, controls and related valves and piping.

     The following table summarizes Environmental Systems revenues and operating income:

	Three months ended March 31,
	2006			2005			% Change
Revenue	$	6,490		$	6,549			-0.9	%
Operating income	$	1,384		$	645			114.6	%
Operating income as % of revenue		21.3	%		9.8	%

	Nine months ended March 31,
	2006			2005			% Change
Revenue	$	13,385		$	15,526			-13.8	%
Operating income	$	1,375		$	1,919			-28.3	%
Operating income as % of revenue		10.3	%		12.4	%

Page 28

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

     Revenues from Environmental Systems remained relatively constant in the third quarter of fiscal 2006 when compared to the third quarter of fiscal 2005. Revenues from Environmental Systems decreased by approximately $2,141, or 13.8%, in the first nine months of fiscal 2006 when compared to the first nine months of fiscal 2005. Our Environmental Systems segment continues to be impacted by the lack of new power plant construction, uncertainties regarding compliance strategies at existing facilities, and increased competition. While we have seen a decline in our Environmental Systems sales over the past several years, we presently 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 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.

     Environmental Systems operating income in the third quarter of fiscal 2006 increased approximately $739 compared to the third quarter of fiscal 2005. As a percentage of Environmental Systems revenue, operating income was approximately 21.3% in the third quarter of fiscal 2006 and approximately 9.8% in the third quarter of fiscal 2005. Environmental Systems operating income in the first nine months of fiscal 2006 decreased approximately $544 compared to the first nine months of fiscal 2005. As a percentage of Environmental Systems revenue, operating income was approximately 10.3% in the first nine months of fiscal 2006 and approximately 12.4% in the first nine months of fiscal 2005. During the third quarter of fiscal 2006 when compared to the third quarter of fiscal 2005, gross profit improved primarily due to reduced warranty and start-up costs, and operating expenses continued to decline primarily due to product standardization activities and cost control measures. During the first nine months of fiscal 2006 when compared to the first nine months of fiscal 2005, operating expenses continued to decline from the reasons noted above while the gross profit declined.

     This decrease in gross profit 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 gross profit is also attributable to increased competitive market conditions, combined with increased cost of component parts.

     Although our Environmental Systems business has been impacted by the lack of new gas 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 Environmental 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.

     Separation Filtration Systems

     This reporting segment represented approximately 49.6% and 64.2% of our revenues for the third quarter of fiscal 2005 and fiscal 2006, respectively. This business segment represented approximately 55.7% and 67.6% of our revenues for the first nine months of fiscal 2005 and fiscal 2006, respectively. The Separation Filtration Systems segment produces specialized products known

Page 29

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

as “separators” or “filters” which are used for a variety of purposes in cleaning gases and liquids as they move through piping systems.

     The following table summarizes Separation Filtration Systems revenues and operating income:

	Three months ended March 31,
	2006			2005			% Change
Revenue	$	11,631		$	6,450			80.3	%
Operating income	$	1,383		$	749			84.6	%
Operating income as % of revenue		11.9	%		11.6	%

	Nine months ended March 31,
	2006			2005			% Change
Revenue	$	27,912		$	19,535			42.9	%
Operating income	$	2,138		$	915			133.7	%
Operating income as % of revenue		7.7	%		4.7	%

     Separation Filtration Systems revenues increased by approximately $5,181, or 80.3%, in the third quarter of fiscal 2006 when compared to the third quarter of fiscal 2005. Revenues from Separation Filtration Systems increased by approximately $8,377, or 42.9%, in the first nine months of fiscal 2006 when compared to the first nine months of fiscal 2005. We saw our revenues increase during the third quarter of fiscal 2006 and the first nine months of fiscal 2006 when compared to the same periods in the prior year both domestically and internationally. The increase in our revenues in fiscal 2006 related primarily to increased sales of our gas separation and filtration products globally.

     Separation Filtration Systems operating income in the third quarter of fiscal 2006 increased approximately $634 compared to the third quarter of fiscal 2005. As a percentage of Separation Filtration Systems revenue, operating income was approximately 11.6% in the third quarter of fiscal 2005 and approximately 11.9% in the third quarter of fiscal 2006. Separation Filtration Systems operating income in the first nine months of fiscal 2006 increased approximately $1,223 compared to the first nine months of fiscal 2005. As a percentage of Separation Filtration Systems revenue, operating income was approximately 4.7%, in the first nine months of fiscal 2005 and approximately 7.7% in the first nine months of fiscal 2006. During the third quarter of fiscal 2006 when compared to the third quarter of fiscal 2005, although there was increased revenues, gross profit as a percentage of revenue declined primarily due to increased cost of material, while operating expenses increased primarily due to the increased revenue activities. During the first nine months of fiscal 2006 when compared to the first nine months of fiscal 2005, although there was increased revenues, operating expenses also increased primarily due to the increased commissions, and gross profit as a percentage of revenue declined. The decline in gross profit is attributable to increased warranty and start-up costs predominantly attributable to a specific mechanical component failure.

     The strong energy demand is creating 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

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PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

continue to invest in life extension and power up-rate projects, in connection with their license renewals. The construction of new nuclear power plants internationally is also creating opportunities.

Corporate Level Expenses

     The following table summarizes corporate level expenses excluded from our segment operating results (dollars in thousands):

	Three months ended March 31,
	2006		2005		% Change
Corporate level expenses	$	1,314	$	1,200		9.5	%

	Nine months ended March 31,
	2006		2005		% Change
Corporate level expenses	$	4,539	$	3,612		25.7	%

     The corporate level expense excluded from our segment operating results are corporate level general and administrative expenses. See Item 2 – “Management’s Discussion and Analysis of Financial and Results of Operations – Consolidated” for additional discussion on these expenses.

Contingencies

     On March 19, 2004, we received notice that an adversary proceeding was initiated by Enron Corp. (“Enron”) and National Energy Production Corporation (“NEPCO”) 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. The plaintiffs alleged that certain accounts receivable payments paid to ABCO were avoidable transfers under the Bankruptcy Code and sought to recover approximately $1,000. We reached an agreement with the bankruptcy estates of Enron and NEPCO to settle and resolve the litigation for $175. On May 4, 2006, the United States Bankruptcy Court for the Southern District of New York, where Enron and NEPCO’s bankruptcy cases are pending, approved the settlement agreement among the Company, Enron and NEPCO. We expect that the settlement will be fully consummated and the litigation dismissed in the quarter ending June 30, 2006.

     On April 25, 2005, we received notice that we allegedly received preferential transfers amounting to approximately $900 in connection with the Chapter 11 filing by Erie Power Technologies, Inc. Based on our preliminary investigation, we believe that 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.

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PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

     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.

Backlog

     The Company’s backlog of orders was approximately $47,000 at March 31, 2006, approximately $34,000 at June 30, 2005 and, approximately $36,000 at March 31, 2005. We have received significant contract 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 – Segments” in this Report for additional discussion on factors affecting our backlog and our future expectations.

Financial Position

     Assets. Total assets increased by approximately $3,227, or 8.1%, from $39,804 at June 30, 2005, to approximately $43,031 at March 31, 2006. We held cash and cash equivalents of approximately $6,343, had working capital of approximately $20,556 and a current liquidity ratio of approximately 2.1-to-1.0 at March 31, 2006. This compares with cash and cash equivalents of $8,277, $20,272 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 nine months of fiscal 2006 resulted primarily from the Company’s ability to 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 $3,148, or 20.3%, from $15,514 at June 30, 2005 to $18,662 at March 31, 2006. This increase in liabilities related primarily to an increase in our accounts payable of approximately $3,076. See Item 2 - “Liquidity and Capital Resources” of this Report for further discussion. The increase in our equity of approximately $79 or 0.3%, from $24,290 at June 30, 2005 to $24,369 at March 31, 2006 resulted primarily from increase in capital from the exercise of stock options during the first nine months of fiscal 2006, partially offset by our net loss from operations. Our debt (total liabilities)-to-equity ratio increased from .64-to-1.0 at June 30, 2005 to .77-to-1.0 at March 31, 2006, reflecting a 20.3% increase in our liabilities and a 0.3% increase in our equity during the period.

Liquidity and Capital Resources

     Our cash and cash equivalents were $6,343 as of March 31, 2006, compared to $8,277 at June 30, 2005. Cash used in operating activities during the first nine months of fiscal year 2006 was approximately $2,502, compared to cash provided by operating activities during the first nine months of fiscal 2005 of approximately $5,571.

     Because we are engaged in the business of manufacturing 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

Page 32

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

March 31, 2006, the balance of these working capital accounts was approximately $9,926 compared to approximately $11,100 at June 30, 2005, reflecting a decrease of our investment in these working capital items of approximately $1,174. 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 nine 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 nine 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 other payables.

     Cash used by investing activities was approximately $177 for the first nine months of fiscal year 2006, compared to cash used by investing activities of approximately $347 for the first nine months of fiscal 2005. Cash used during the first nine months of fiscal 2006 related primarily office and equipment upgrades, partially offset by the net cash from the sale of company vehicles. The use of cash during the first nine months of fiscal 2005 related primarily to capital refurbishments of our Denton and Abilene, Texas manufacturing facilities.

     Cash provided by financing activities was approximately $630 and $183 during the first nine 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 provided by our discontinued operations during the first nine months of fiscal 2006 was approximately $114, compared to cash used from discontinued operations of approximately $73 in the first nine months of fiscal 2005.

     As a result of the above factors, our cash and cash equivalents during the first nine months of fiscal year 2006 decreased by approximately $1,934, compared to an increase of approximately $5,339 in the first nine months of fiscal 2005.

     On October 31, 2003, the Company entered into a $12,500 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 assets in the United States. At March 31, 2006, the applicable rate was Euro plus 1.75% (6.57%). At March 31, 2006, the Company had approximately $6,200 outstanding under stand-by letters of credit and no loans outstanding, leaving a maximum availability under the credit facility of approximately $6,300 (actual availability at March 31, 2006 of approximately $1,800). 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 March 31, 2006, the Company was in compliance with all financial and other covenants under the credit facility.

     In addition, the Company’s UK subsidiary had a £2,600 (approximately $4,500) debenture agreement used to facilitate the issuances of bank guarantees. At March 31, 2006, this facility was secured by substantially all of the UK subsidiary assets, and was backed by a stand-by letter of credit of £1,400 (approximately $2,500, which is included in the $6,200 outstanding under the Company’s $12,500 revolving credit facility described above). At March 31, 2006, there was approximately £2,600 (approximately $4,500) outstanding under this facility, the maximum under the facility. As of

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PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

March 31, 2006, 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.

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” 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.

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,

Page 34

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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.

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 profits.

Our backlog may not be indicative of our future revenue.

     Customers may cancel or delay projects for reasons beyond our control. Our orders normally contain cancellation provisions which permit us to recover only our costs and a portion of our anticipated profit in the event a customer cancels an order. If a customer elects to cancel 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.

Page 35

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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 nine months of fiscal 2005 and fiscal 2006 revenue outside the United States represented approximately 39.5% and 44.6% 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.

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 can have a significant impact on our reported margin through a negative or positive impact on our manufacturing absorption.

     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

Page 36

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

defects could temporarily delay the sale of new products, reduce our profits and could adversely affect our reputation.

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.

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 $12,500 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. 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 March 31, 2006 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

Page 37

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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.

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. These requirements may negatively impact our profit margins and result in 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

Page 38

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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 March 31, 2006.

     Since June 30, 2005, there have been no material changes in the quantitative or qualitative aspects of our market risk profile. For information regarding our exposure to certain market risks, see Item 7A “-Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended June 30, 2005 as filed with the SEC.

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 defined in Rules 13a-15(e) and 15d-15(e) promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934) 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 the Company’s disclosure controls and procedures were effective in ensuring that all information required to be disclosed in this Report has been recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. Additionally, based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this Report, the Company’s disclosure controls and procedures were effective in ensuring that all material information required to be filed in this Report has been accumulated and communicated to the Company’s management, including its principle executive and principal financial officers, in a timely fashion to allow decisions regarding required disclosures.

     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 March 31, 2006, 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 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 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

Page 39

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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

     From time to time we are involved in various litigation matters arising in the ordinary course of our business. We do not believe the disposition of any current matter will have a material adverse effect on our consolidated financial position or results of operations.

Items 2, 3, 4, and 5 are not applicable and have been omitted.

Page 40

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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 January 11, 2006, by and between Peerless Mfg. Co. and Sean P. McMenamin. *
	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

Page 41

PEERLESS MFG. CO. AND SUBSIDIARIES
FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 2006
(Amounts in thousands, except per share amounts)

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: May 15, 2006	/s/ Sherrill Stone
	Sherrill Stone
	Chairman and Chief Executive Officer
Date: May 15, 2006	/s/ Henry G. Schopfer, III
	Henry G. Schopfer, III
	Chief Financial Officer
	(Principal Financial and Accounting Officer)

Page 42

EX-10.(A)

EXHIBIT 10(a)

EMPLOYMENT AGREEMENT

     THIS EMPLOYMENT AGREEMENT (this “Agreement”) is entered into to be effective as of January 11, 2006 (the “Effective Date”), between PEERLESS MFG. CO. (“Employer”), and SEAN MCMENAMIN (“Employee”).

Section 1. Employment.

     1.1 Employment and Term. Subject to the terms and conditions of this Agreement, Employer agrees to employ Employee pursuant to this Agreement for a term beginning on the Effective Date and ending on the third anniversary date of the Effective Date, unless Employee’s employment is terminated earlier as provided in Section 4 below. Notwithstanding the foregoing, in no event will the term of Employee’s employment hereunder be less than 90 days from the Effective Date. Sections 2, 3, and 5 of this Agreement shall survive any termination of Employee’s employment with Employer.

     1.2 Duties. At all times during the course of Employee’s employment with Employer, Employee agrees to perform the duties associated with his position diligently and to devote all of his business time, attention and efforts to the business of Employer. Employee agrees to comply with the policies, procedures and guidelines established by Employer from time to time. Employee agrees to perform his duties faithfully and loyally and to the best of his abilities, and shall use his best efforts to promote the business of Employer. Employee understands and agrees that both the business and personal standards and ethics of Employer’s employees must at all times be above reproach. Employee agrees to act at all times so as to reflect this high standard. Employee further agrees to abide by all rules, policies, or procedures established by Employer from time to time.

Section 2. Non-Competition.

     2.1 Non Competition.

     (a) Employee agrees that during the term of his employment and for a period of one (1) year following termination of his employment (regardless of whether Employee is terminated without Cause (as defined in Section 4.1(c) below), for Cause, voluntarily resigns or otherwise), neither Employee nor any person or entity directly or indirectly controlling, controlled by or under common control with Employee, shall directly or indirectly, on his own behalf or as an employee or other agent of or an investor in another person:

     (i) engage in any business conducted by Employer during Employee’s term of employment with Employer (collectively, the “Business”);

     (ii) influence or attempt to influence any customer or supplier of Employer or any affiliate of Employer to purchase goods or services related to the Business from any person other than Employer or such affiliate; or

     (iii) employ or attempt to employ any individuals who are then or have been employees of Employer or any affiliate of Employer during the preceding 12 months, or influence or seek to influence any such employees to leave Employer’s or such affiliate’s employment.

     (b) Employee specifically acknowledges that Employer’s products are sold in a world market and that Employee has been engaged with regard to Employer’s products and Employer’s customers throughout the world without geographic limitation, and accordingly that the restrictive covenant regarding competition contained in this Section 2.1 shall apply without geographic limitation.

     (c) Employee acknowledges that his obligations under this Section 2.1 are a material inducement and condition to Employer’s entering into this Agreement and a material inducement and condition to Employee receiving or having access to Confidential Information (as defined in Section 3.1). Employee acknowledges and agrees that the terms and provisions of this Agreement (including the severance provisions of Section 4.1) and Employee’s receipt and access to Confidential Information are sufficient consideration for the restrictions set forth in this Section 2.1. Employee acknowledges and agrees further that such restrictions are reasonable as to time, geographic area and scope of activity and do not impose a greater restraint than is necessary to protect the goodwill and other business interests of Employer, and Employee agrees that Employer is justified in believing the foregoing.

     (d) If any provision of this Section 2.1 should be found by any court of competent jurisdiction to be unenforceable by reason of its being too broad as to the period of time, territory, and/or scope, then, and in that event, such provision shall nevertheless remain valid and fully effective, but shall be considered to be amended so that the period of time, territory, and/or scope set forth shall be changed to be the maximum period of time, the largest territory, and/or the broadest scope, as the case may be, which would be found enforceable by such court.

     (e) Employee acknowledges that Employee’s violation or attempted violation of this Section 2.1 will cause irreparable damage to Employer or its affiliates, and Employee therefore agrees that Employer shall be entitled as a matter of right to an injunction, out of any court of competent jurisdiction, restraining any violation or further violation of such agreements by Employee or others acting on his behalf. Employer’s right to injunctive relief will be cumulative and in addition to any other remedies provided by law or equity.

Section 3. Confidentiality; Non-disparagement; Conflict of Interest.

     3.1 Confidentiality.

     (a) In the course of his employment with Employer, Employee will receive and have access to commercially valuable, confidential or proprietary information (“Confidential Information”). Confidential Information means all information, whether oral or written, previously or hereafter developed, acquired or used by Employer and relating to the business of Employer that is not generally known to others in Employer’s area of business, including without limitation (i) any trade secrets, work product, processes, analyses or know-how of Employer; (ii) Employer’s advertising, product development, strategic and business plans and information, including customer and prospect lists; (iii) the prices at which Employer has sold or offered to sell its products or services; and (iv) Employer’s financial statements and other financial information.

     (b) Employee acknowledges and agrees that the Confidential Information is and shall be the sole and exclusive property of Employer. Employee shall not use any Confidential Information for his own benefit or disclose any Confidential Information to any third party

(except in the course of performing his authorized duties for Employer under this Agreement), either during or subsequent to his employment with Employer.

     (c) Specifically, Employee agrees that, except as expressly authorized in writing by Employer, or as may be required by law or court order, Employee shall (i) not disclose Confidential Information to any third party, (ii) not copy Confidential Information for any reason, and (iii) not remove Confidential Information from Employer’s premises. Upon termination of his employment with Employer, Employee shall promptly deliver to the Employer all Confidential Information, including documents, computer disks and other computer storage devices and other papers and materials (including all copies thereof in whatever form) containing or incorporating any Confidential Information or otherwise relating in any way to the Employer’s business that are in his possession or under his control.

     (d) Employee acknowledges that Employee’s violation or attempted violation of this Section 3.1 will cause irreparable damage to Employer or its affiliates, and Employee therefore agrees that Employer shall be entitled as a matter of right to an injunction, out of any court of competent jurisdiction, restraining any violation or further violation of such agreements by Employee or others acting on his behalf. Employer’s right to injunctive relief will be cumulative and in addition to any other remedies provided by law or equity.

     3.2. Covenant of Non disparagement. In consideration of this Agreement, Employee agrees and promises that, during the term of and at all times after the termination of this Agreement (regardless of whether Employee is terminated without Cause, for Cause, voluntarily resigns or otherwise), not to make any libelous, disparaging or otherwise injurious statements about or concerning Employer or any of its affiliates, their officers, employees or representatives. Such prohibited statements include any statement that is injurious to the business or business reputation of any of Employer, its affiliates or their employees or representatives, but does not include reasonable statements of disagreement that Employee makes for the purpose of protecting or enforcing any of his rights or interests hereunder or defending against any claim or claims of Employer, so long as such statements are not slanderous or libelous and are delivered in terms as would ordinarily be considered customary and appropriate.

     3.3. Conflict of Interest. Employee agrees that during the term of this Agreement without the prior approval of the Board of Directors of Employer, Employee shall not engage, either directly or indirectly, in any activity which may involve a conflict of interest with Employer or its affiliates (a “Conflict of Interest”), including ownership in any supplier, contractor, subcontractor, customer or other entity with which Employer does business (other than as a shareholder of less than one percent of a publicly traded class of securities) or accept any material payment, service, loan, gift, trip, entertainment or other favor from a supplier, contractor, subcontractor, customer or other entity with which Employer does business and that Employee shall promptly inform the Chief Executive Officer or the Board of Directors of Employer as to each offer received by Employee to engage in any such activity. Employee further agrees to disclose to Employer any other facts of which Employee becomes aware which might involve or give rise to a Conflict of Interest or potential Conflict of Interest.

Section 4. Termination.

     4.1 Termination by Employer.

     (a) Employer may terminate Employee’s employment without Cause upon no less than 30 days prior notice of termination to Employee. In the event of any such termination without Cause, on the effective date of such termination Employer shall pay Employee as

severance compensation, a lump sum payment in an amount equal to the difference of (i) 75% of Employee’s then current base salary annualized less (ii) the amount of base salary paid to Employee from the date of Employer’s notice of termination to the effective date of such termination. In the event of any such termination without Cause, except as aforesaid, Employer shall have no other obligations to pay any base salary, incentive compensation or bonus or provide for any benefits to Employee after the effective date of such termination. As used herein, “base salary” excludes any bonus or incentive compensation.

     (b) Employer may discharge Employee for Cause at any time without prior notice. In the event of any such termination for Cause, Employer’s obligations to pay any base salary, incentive compensation or bonus or provide for any benefits to Employee shall terminate immediately upon the effective date of such termination.

     (c) As used herein, “Cause” shall mean any of the following:

     (i) the conviction of Employee by a court of competent jurisdiction of any felony or crime involving moral turpitude;

     (ii) commission by Employee of an act of fraud or other act reflecting unfavorably upon the public image of Employer as reasonably determined by Employer’s Board of Directors;

     (iii) the continued failure by Employee to substantially perform his duties hereunder, or the intentional wrongdoing by Employee resulting in material injury to Employer, in each case as reasonably determined by Employer’s Board of Directors;

     (iv) the failure by Employee to follow a reasonable directive of the Board of Directors or the Chief Executive Officer of Employer; or

     (v) violation of any policies or procedures of Employer, including without limitation, any human relations policy resulting in material injury to Employer, in each case as reasonably determined by Employer’s Board of Directors.

     4.2 Termination by Employee.

     (a) Employee may resign from Employee’s employment hereunder (whether for voluntary retirement or otherwise) upon no less than 30 days prior notice of resignation to Employer, unless such prior notice is otherwise waived by Employer in its absolute and sole discretion. The effective date of Employee’s resignation shall be as stated in Employee’s notice of resignation or at the sole option of Employer, such earlier date as determined by Employer in its sole discretion. If Employee voluntarily resigns from his employment with Employer during the term hereof (whether for voluntary retirement or otherwise), except as expressly set forth in Section 4.2(b) below, Employer’s obligations to pay any base salary, incentive compensation or bonus or provide for any benefits shall terminate immediately upon the effective date of such resignation. Upon retirement, Employee shall be entitled to all benefits (if any) provided by Employer in the ordinary course to other Employee officers of Employer at comparable retirement age.

     (b) If Employee resigns from Employee’s employment hereunder in accordance with Section 4.2(a) above and at the time of such resignation at least one of the following events has continued for at least 30 consecutive days after Employee has notified Employer in writing of the occurrence of such event, Employer shall pay Employee an amount equal to a lump sum payment in

the amount of 25% of Employee’s then current base salary annualized, less the amount of base salary paid to Employee from the date of notice of resignation to the effective date of such resignation. Such payment to be made on the effective date of resignation. In addition, the Employer will pay the pro rata portion of the annual bonus Employee would have earned pursuant to Employer’s written bonus incentive plan (if any) if Employee had remained employed by Employer for the remainder of the applicable calendar year, with such pro rata amount being determined in equal amounts over the course of the calendar year (for example, 1/12 of the bonus for each month Employee was employed during the applicable bonus year) and such amount being paid in the ordinary course consistent with Employer’s practice. Such events include:

(i)	a material adverse change in the nature or scope of the authorities, functions or duties that Employee had as of the Effective Date;
(ii)	a material adverse change in the calculation (but not the amount) of any annual bonus or a significant reduction in scope or value in the aggregate of other monetary or non-monetary benefits to which Employee was entitled as of the Effective Date;
(iii)	a determination by Employee made in good faith that as a result of a change in circumstances significantly affecting his position, changes in the composition or policies of Employer’s Board of Directors, or of other events of material effect, he has been rendered substantially unable to carry out, or has been substantially hindered in the performance of, the authorities, functions or duties attached to his position asa of the Effective Date, or
(iv)	the requirements by Employer that Employee have as his principal location of work any location not within the greater Dallas – Fort Worth, Texas metropolitan area.

     4.3 Termination on Death of Employee. This Agreement shall terminate automatically upon the death of Employee and all rights of Employee, his heirs, executors and administrators to salary, bonus, incentive compensation or benefits shall terminate immediately, except as otherwise provided in Employer’s benefit plans in effect at such time.

     4.4 Termination by Disability. Employer may terminate Employee’s employment hereunder upon Employee becoming Disabled (as defined below). Upon such termination, Employer shall pay Employee an amount equal to his then current monthly base salary for a period of six months, which payment amounts will be reduced by any disability payments Employee receives during such period from the disability insurance provided through Employer, if any. Employee shall be entitled to all other disability benefits then in effect (if any) provided by Employer to all other executive officers of Employer. In the event of termination due to Employee being Disabled, except as aforesaid, Employer shall have no other obligation to pay any base salary, incentive compensation or bonus or provide for any benefits to Employee after the effective date of termination. For purposes of this Agreement, “Disabled” means any mental or physical impairment lasting (or that will last) more than 180 consecutive or non-consecutive calendar days that prevents Employee from performing the essential functions of his position with or without reasonable accommodation as determined by a competent physician chosen by Employer and consented to by Employee or his legal representatives, which consent will not be unreasonably withheld or delayed. Employee agrees to submit to appropriate medical examinations and authorize his physicians to release medical information necessary to determine whether Employee is Disabled for purposes of this Agreement.

Section 5. Miscellaneous.

     5.1 Notice. Except as set forth below in this Section 5.1, any notice under this Agreement must be in writing and shall be deemed to have been given when delivered personally or by overnight courier service or three days after being sent by mail, postage prepaid, at the address indicated below or to such changed address as such person may subsequently give such notice of:

if to Employer:
	Peerless Mfg. Co. 2819 Walnut Hill Lane Dallas, Texas 75229 Attn: Chairman, Board of Directors
if to Employee:
	Sean McMenamin 8705 Mandevilla Drive Plano, Texas 75024

Notwithstanding the foregoing, the party receiving notice may waive any provisions of this Section 5.1 in its sole and absolute discretion.

     5.2 Assignment. This Agreement shall inure to the benefit of and be binding upon the parties hereto and their respective heirs, personal representatives, successors, and assigns. Except as otherwise provided herein, this Agreement may not be assigned by any party hereto without the prior written consent of the other party hereto. Employer shall require any successor, and any corporation or other person which is in control of such successor, to all or substantially all of the business and/or assets of Employer (by purchase, merger, consolidation or otherwise), by agreement in form and substance reasonably satisfactory to Employee, to expressly assume and agree to perform this Agreement in the same manner and to the same extent that Employer would be required to perform it if no such succession had taken place. Failure of Employer to obtain such agreement prior to the effectiveness of any such succession shall be a material breach of this Agreement by Employer. As used in this Agreement, “Employer” shall mean Employer as herein before defined and any successor to its business and/or all or part of its assets as aforesaid which executes and delivers the assumption agreement provided for in this Section 5.2 or which otherwise becomes bound by all the terms and provisions of this Agreement by operation of law.

     5.3 Headings. The section headings used herein are for reference and convenience only and shall not enter into the interpretation hereof.

     5.4 Counterparts. This Agreement may be executed in one or more counterparts for the convenience of the parties hereto, all of which together shall constitute one and the same instrument.

     5.5 Amendment and Waiver. The provisions of this Agreement may be amended or waived only by written agreement of Employer and Employee, and no course of conduct, failure or delay in enforcing the provisions of this Agreement shall effect the validity, binding effect or enforceability of this Agreement.

     5.6 Severability. Any provision or portion of a provision of this Agreement that is held to be invalid or unenforceable will be severable, and this Agreement will be construed and enforced as if such provision, or portion thereof, did not comprise a part hereof, and the remaining provisions or portions of provisions will remain in full force and effect. In lieu of each invalid or unenforceable provision there will

be added automatically as part of this Agreement a provision as similar in terms to such invalid or unenforceable provision as may be possible and be legal, valid, and enforceable.

     5.7 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas, without giving effect to any conflicts of law rule or principle that might require the application of the laws of another jurisdiction.

     5.8 Disputes. The parties to this Agreement agree that in the event there is a dispute or controversy between them that cannot be settled through direct discussions, it is in the best interests of all for such dispute or controversy to be resolved in the shortest time and with the lowest cost of resolution as practicable. Consequently, any such dispute, controversy or claim between the parties to this Agreement will not be litigated, but instead will be resolved by arbitration in accordance with Title 9 of the U.S. Code (United States Arbitration Act) and the Commercial Arbitration Rules of the American Arbitration Association (the “Rules”), and judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. The arbitration will be before one neutral arbitrator and will proceed under the Expedited Procedures of said Rules. The arbitration will be held in Dallas, Texas, or such other place as may be selected by mutual agreement. The arbitrator will have the discretion to order a pre-hearing exchange of information by the parties, and to set limits for both the scope and time period of such exchange. All issues regarding exchange requests will be decided by the arbitrator. Neither party nor the arbitrator may disclose the existence, content or results of any arbitration hereunder, unless required to do so by court or regulatory order, without the prior written consent of both parties. Administrative fees and expenses of the arbitration itself will be borne by the parties equally unless otherwise required by law, a court of competent jurisdiction or the Rules; provided, that, in no event will Employee be required to pay in excess of $1,000 of such fees and expenses. The arbitrator will also be authorized to award to the prevailing party all or that fraction of its reasonable costs and fees as is deemed equitable. Costs of a party’s representation by counsel or preparation costs for hearing are not considered administrative fees and expenses for purposes hereof. This provision will not apply to any injunctive relief sought by the Company or any of its affiliate under Section 2 or 3 of this Agreement.

     5.9 Entire Agreement. This Agreement embodies the complete agreement between Employer and Employee regarding the subject matter hereof and the same supersede all prior agreements or understandings, whether oral, written or otherwise, between the parties hereto that may have related in any way to the subject matter hereof.

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EMPLOYER:

PEERLESS MFG. CO.

/s/ Sherrill Stone

Sherrill Stone,

Chairman of the Board and
Chief Executive Officer

EMPLOYEE:

/s/ Sean McMenamin

Sean McMenamin

EX-31.(A)

EXHIBIT 31(a)

RULE 13a – 14(a)/15d – 14(a) CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, Sherrill Stone, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of Peerless Mfg. Co.;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(c)	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

/s/ Sherrill Stone

Sherrill Stone
Chairman of the Board and Chief Executive Officer

Date: May 15, 2006

EX-31.(B)

EXHIBIT 31(b)

RULE 13a – 14(a)/15d – 14(a) CERTIFICATION OF CHIEF FINANCIAL OFFICER

I, Henry G. Schopher, III, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of Peerless Mfg. Co.;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(c)	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

/s/ Henry G. Schopfer, III

Henry G. Schopfer, III

Chief Financial Officer
Date: May 15, 2006

EX-32.(A)

EXHIBIT 32(a)

SECTION 1350 CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, Sherrill Stone, Chairman of the Board and Chief Executive Officer of Peerless Mfg. Co. (the “Company”), certify, that pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code:

(1)	The Quarterly Report on Form 10-Q of the Company for the period ended March 31, 2006, as filed with the Securities Exchange Commission on the date hereof (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of the dates and for the periods expressed in the Report.

/s/ Sherrill Stone

Sherrill Stone
Chairman of the Board and Chief Executive Officer

Date: May 15, 2006

The foregoing Certification is being furnished solely pursuant to 18 U.S.C. Section 1350; it is not being filed for purposes of Section 18 of the Securities Exchange Act, and is not to be incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

EX-32.(B)

EXHIBIT 32(b)

SECTION 1350 CERTIFICATION OF CHIEF FINANCIAL OFFICER

I, Henry G. Schopfer, III, Chief Financial Officer of Peerless Mfg. Co. (the “Company”), certify, that pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code:

(1)	The Quarterly Report on Form 10-Q of the Company for the period ended March 31, 2006, as filed with the Securities Exchange Commission on the date hereof (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of the dates and for the periods expressed in the Report.

/s/ Henry G. Schopfer, III

Henry G. Schopfer, III
Chief Financial Officer

Date: May 15, 2006

The foregoing Certification is being furnished solely pursuant to 18 U.S.C. Section 1350; it is not being filed for purposes of Section 18 of the Securities Exchange Act, and is not to be incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.