e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the Quarterly Period Ended December 31, 2006


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 February 9, 2007, there were 3,194,197 shares of the Registrant’s common stock outstanding.

FORWARD-LOOKING STATEMENTS

This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and 21E of the Securities Exchange Act of 1934. You should not place undue reliance on these statements. These forward-looking statements include statements that reflect the current views of our senior management with respect to our financial performance and future events with respect to our business and our industry in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “forecast,” “estimate,” “may,” “should,” “anticipate” and similar statements of a future or forward-looking nature identify forward-looking statements. Forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, the following:

	•		changes in the power generation industry and/or the economy;

	•		changes in the price, supply or demand for natural gas;

	•		changes in current environmental legislation;

	•		increased competition;

	•		changes in our ability to conduct business outside the United States, including changes in foreign laws and regulations;

	•		decreased demand for our products;

	•		the effects of U.S. involvement in hostilities with other countries and large-scale acts of terrorism, or the threat of hostilities or terrorist acts;

	•		the effects of natural disasters; and

	•		loss of the services of any of our senior management or other key employees.

The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this and other reports we file with the Securities and Exchange Commission, including the information in Item 1A. “Risk Factors” of Part I to our Annual Report on Form 10-K for the year ended June 30, 2006. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate.

Page 3

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PEERLESS MFG. CO. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)


	December 31		June 30,
	2006		2006
	(unaudited)

ASSETS
Current assets:
Cash and cash equivalents	$	6,243	$	6,411
Restricted cash		2,741		—
Accounts receivable-principally trade — net of allowance for doubtful accounts of $462 at December 31, 2006 and at June 30, 2006		14,615		16,463
Inventories		5,475		4,871
Costs and earnings in excess of billings on uncompleted contracts		11,265		13,891
Assets held for sale		767		767
Deferred income taxes		1,338		1,338
Other current assets		1,063		1,431

Total current assets		43,507		45,172

Property, plant and equipment — net		1,984		2,140
Other assets		823		845
Deferred income taxes		6		2

Total assets	$	46,320	$	48,159


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	9,942	$	13,860
Billings in excess of costs and earnings on uncompleted contracts		2,816		2,601
Commissions payable		1,012		1,238
Income taxes payable		171		75
Product warranties		658		626
Accrued liabilities and other		3,666		3,842

Total current liabilities		18,265		22,242

Commitments and contingencies

Shareholders’ equity:
Common stock		3,194		3,134
Additional paid-in capital		4,182		3,143
Accumulated other comprehensive income		376		245
Retained earnings		20,303		19,395

Total shareholders’ equity		28,055		25,917

Total liabilities and shareholders’ equity	$	46,320	$	48,159

See accompanying notes to the condensed consolidated financial statements.

Page 4

PEERLESS MFG. CO. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)


	Three months ended						Six months ended
	December 31,						December 31,
	2006			2005			2006			2005

Revenues	$	14,091		$	11,534		$	28,729		$	23,176
Cost of goods sold		9,587			8,388			19,830			17,677

Gross profit		4,504			3,146			8,899			5,499
Operating expenses
Sales and marketing		1,644			1,565			3,366			3,107
Engineering and project management		955			820			1,788			1,646
General and administrative		1,375			2,087			2,563			3,225

		3,974			4,472			7,717			7,978

Operating income (loss)		530			(1,326	)		1,182			(2,479	)

Other income
Interest income		73			50			135			103
Foreign exchange gain		101			29			82			57
Other income		—			47			—			79

		174			126			217			239


Earnings (loss) from continuing operations before income taxes		704			(1,200	)		1,399			(2,240	)
Income tax (expense) benefit		(247	)		408			(491	)		759

Net earnings (loss) from continuing operations		457			(792	)		908			(1,481	)

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

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

Net earnings (loss)	$	457		$	(825	)	$	908		$	(1,514	)


BASIC EARNINGS (LOSS) PER SHARE
Earnings (loss) from continuing operations	$	0.14		$	(0.26	)	$	0.29		$	(0.49	)
Loss from discontinued operations		—			(0.01	)		—			(0.01	)

Basic earnings (loss) per share	$	0.14		$	(0.27	)	$	0.29		$	(0.50	)


DILUTED EARNINGS (LOSS) PER SHARE
Earnings (loss) from continuing operations	$	0.14		$	(0.26	)	$	0.28		$	(0.49	)
Loss from discontinued operations		—			(0.01	)		—			(0.01	)

Diluted earnings (loss) per share	$	0.14		$	(0.27	)	$	0.28		$	(0.50	)

See accompanying notes to the condensed consolidated financial statements.

Page 5

PEERLESS MFG. CO. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)


	Six months ended December 31,
	2006			2005
Cash flows from operating activities:
Net earnings (loss)	$	908		$	(1,514	)
Adjustments to reconcile net earnings (loss) from operations to net cash provided by (used in) operating activities:
Depreciation and amortization		339			218
Deferred income taxes		(4	)		—
Provision for bad debts		—			144
Provision for warranty expense		124			159
Inventory valuation reserve		94			105
Foreign exchange gain		(82	)		(57	)
Gain on sale of equipment		—			(22	)
Stock based compensation		126			79
Excess tax benefits from stock-based payment arrangements		(229	)		(134	)
Changes in operating assets and liabilities of continuing operations:
Accounts receivable		1,850			(260	)
Inventories		(694	)		(2,146	)
Costs and earnings in excess of billings on uncompleted contracts		2,647			517
Other current assets		368			(887	)
Other assets		22			(82	)
Accounts payable		(3,902	)		1,051
Billings in excess of costs and earnings on uncompleted contracts		215			1,583
Commissions payable		(226	)		120
Product warranties		(92	)		(307	)
Income taxes payable		325			—
Accrued liabilities and other		(89	)		283

Net cash provided by (used in) operating activities of continuing operations:		1,700			(1,150	)
Cash flow from investing activities of continuing operations:
Increase in restricted cash		(2,741	)		—
Proceeds from the sale of equipment		—			32
Purchases of property and equipment		(183	)		(29	)

Net cash provided by (used in) investing activities of continuing operations:		(2,924	)		3
Cash flows from financing activities of continuing operations:
Proceeds from exercise of stock options		744			264
Excess tax benefits from stock-based payment arrangements		229			134

Net cash provided by financing activities of continuing operations		973			398
Cash flow from discontinued operations:
Cash used in operating activities		—			(5	)

Net cash used in discontinued operations		—			(5	)
Effect of exchange rate changes on cash and cash equivalents		83			(2	)
Net decrease in cash and cash equivalents		(168	)		(756	)
Cash and cash equivalents at beginning of period		6,411			8,277

Cash and cash equivalents at end of period	$	6,243		$	7,521

See accompanying notes to the condensed consolidated financial statements.

Page 6

PEERLESS MFG. CO. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS)
(In thousands)
(Unaudited)


								Accumulated
					Additional			Other						Total
	No. of		Common		Paid-in			Comprehensive			Retained			Shareholders’
	Shares		Stock		Capital			Income			Earnings			Equity

Balance at July 1, 2006		3,134	$	3,134	$	3,143		$	245		$	19,395		$	25,917
Comprehensive income
Net earnings from continuing operations												908			908
Foreign currency translation adjustment									131						131

Total comprehensive income															1,039

Restricted stock grant amortization						21									21

Stock options expense						105									105
Stock options exercised		60		60		684									744
Income tax benefit related to stock options exercised						229									229

Balance at December 31, 2006		3,194	$	3,194	$	4,182		$	376		$	20,303		$	28,055


Balance at July 1, 2005		3,036	$	3,036	$	2,114		$	171		$	18,969		$	24,290
Comprehensive loss
Net loss from continuing operations												(1,481	)		(1,481	)
Net loss from discontinued operations												(33	)		(33	)
Foreign currency translation adjustment									(58	)					(58	)

Total comprehensive loss															(1,572	)

Issuance of restricted stock		10		10		(10	)								—
Restricted stock grant amortization						8									8

Stock option expense						71									71
Stock options exercised		40		40		224									264
Income tax benefit related to stock options exercised						134									134

Balance at December 31, 2005		3,086	$	3,086	$	2,541		$	113		$	17,455		$	23,195

See accompanying notes to the condensed consolidated financial statements.

Page 7

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(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” and “our”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. The condensed consolidated financial statements of the Company as of December 31, 2006, and for the three and six months ended December 31, 2006 and December 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, 2006. The results of operations for the three and six months ended December 31, 2006 are not necessarily indicative of the results to be expected for the entire fiscal year. The Company’s fiscal year ends on June 30. References herein to fiscal 2006 and fiscal 2007 refer to our fiscal years ended June 30, 2006 and 2007, 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 11 — “Discontinued Operations” in our Notes to the Condensed Consolidated Financial Statements of this Report for additional information on the discontinuance of this business unit.

Certain prior year amounts have been reclassified to conform to the current year presentation, specifically the reclassification of liquidated damages from product warranties to accrued liabilities and other.

2. New Accounting Standards

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 clarifies the accounting for uncertainty in tax positions. The interpretation prescribes a recognition threshold and measurement attribute to the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 is effective for the Company beginning July 1, 2007. The Company is currently assessing the potential impact of the adoption of FIN No. 48 on its financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value in accordance with generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company has not yet completed its evaluation of the impact of adopting SFAS No. 157.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for the first annual period ending after November 15, 2006. The Company does not expect that the adoption of SAB No. 108 will have an impact on its results of operations or financial position or that any adjustment will be made.

Page 8

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

3. 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 extended to customers outside the United States. Accounts receivable are generally due within 30 to 45 days and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts receivable 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 economy generally 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 receivable are credited back to bad debt expense in the period the payment is received.

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


	Three months ended						Six months ended
	December 31,						December 31,
	2006			2005			2006		2005
Balance at beginning of period	$	518		$	466		$	462	$	352
Bad debt expense		(56	)		30			—		144
Accounts written off, net		—			(272	)		—		(272	)

Balance at end of period	$	462		$	224		$	462	$	224

4. 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 the value of inventory on hand, using specific aging categories, and records a provision for excess and potentially obsolete inventories based on historical usage and estimated future usage. In assessing the ultimate realization of its inventory, the Company is required to make judgments as to future demand requirements. As actual future demand or market conditions may vary from those projected by the Company, adjustments to inventory valuations may be required.

Principal components of inventories are as follows:


	December 31,			June 30,
	2006			2006

Material and component parts	$	5,130		$	4,417
Work in progress		615			626
Finished goods		258			262

		6,003			5,305

Reserve for obsolete and slow-moving inventory		(528	)		(434	)

	$	5,475		$	4,871

Page 9

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

4. Inventories — Continued

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


	Three months ended				Six months ended
	December 31,				December, 31
	2006		2005		2006		2005
Balance at beginning of period	$	490	$	370	$	434	$	318
Additions		38		53		94		105
Amounts written off		—		—		—		—

Balance at end of period	$	528	$	423	$	528	$	423

5. 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 margins 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 in the period in which it is determined a loss will result. 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:


	December 31,			June 30,
	2006			2006
Costs incurred on uncompleted contracts and estimated earnings	$	50,673		$	43,448
Less billings to date		(42,224	)		(32,158	)

	$	8,449		$	11,290

Page 10

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

5. Revenue Recognition and Cost and Earnings on Uncompleted Contracts — Continued

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


	December 31,			June 30,
	2006			2006
Costs and earnings in excess of billings on uncompleted contracts	$	11,265		$	13,891
Billings in excess of costs and earnings on uncompleted contracts		(2,816	)		(2,601	)

	$	8,449		$	11,290

6. Assets Held for Sale

The Company has agreed to sell its headquarters facility located in Dallas, Texas to the Dallas Area Rapid Transit Authority for $4,424. The property is approximately 12 acres and contains the Company’s administrative offices, research & development laboratory and manufacturing and storage operations. The Company expects to relocate all of the operations currently performed at this facility no later than May 1, 2007. At December 31, 2006 and June 30, 2006, the book value of the facility was $767. The Company ceased depreciating these assets as of June 30, 2006.

The assets held for sale are summarized as follows:


	December 31,			June 30,
	2006			2006

Buildings & improvements	$	2,768		$	2,768
Equipment		152			152
Furniture and fixtures		13			13

		2,933			2,933
Less accumulated depreciation		(2,794	)		(2,794	)

		139			139
Land		628			628

	$	767		$	767

7. 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.

Page 11

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

7. Product Warranties — Continued

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 are made when necessary based on changes in these factors. Product warranty activity is as follows:


	Three months ended						Six months ended
	December 31,						December 31,
	2006			2005			2006			2005

Balance at beginning of period	$	639		$	916		$	626		$	845
Provision for warranty expenses		55			17			124			159
Warranty charges		(36	)		(236	)		(92	)		(307	)

Balance at end of period	$	658		$	697		$	658		$	697

8. Contingencies

On April 25, 2006, the Company received notice that it allegedly received $900 of preferential transfers in connection with the Chapter 11 filing by Erie Power Technologies, Inc. Based on preliminary investigation, the Company believes that a majority of the payments received may not meet the applicable standards for avoidance under the Bankruptcy Code and other applicable laws, or that a number of defenses may be asserted that would negate any recovery by the plaintiffs. The Company intends to vigorously defend against the lawsuit and believes the likelihood of a material loss is not probable.

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

9. Accrued Liabilities and Other

The components of accrued liabilities and other are as follows:


	December 31,		June 30,
	2006		2006

Accrued start-up expense	$	1,846	$	1,717
Accrued compensation		667		1,094
Accrued professional, legal and other expenses		496		531
Sales and use taxes payable		25		3
Other		632		497

	$	3,666	$	3,842

Page 12

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except share and per share amounts)

10. 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.

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. The 1995 Plan expired on November 21, 2006. Therefore, no additional awards may be granted under the 1995 Plan. In January 2002, the Company adopted another 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 generally vest ratably over four years and expire ten years from the date of grant. Under both plans, stock options are or were granted to employees at exercise prices equal to the fair market value of the Company’s stock at the date 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.

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 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 fair value of each award granted under the plans 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 13

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except share and per share amounts)

10. Stock Based Compensation — Continued

The following is a summary of the assumptions used and the weighted average grant-date fair value of the stock options granted during the three and six months ended December 31, 2006 and 2005:


	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005
Expected volatility		44.5	%		52.6	%		44.5	%		52.6	%
Expected term (years)		4.92			5.66			4.92			5.66
Risk free interest rate		5.11	%		4.12	%		5.11	%		4.12	%
Dividend yield		0.00	%		0.00	%		0.00	%		0.00	%

Weighted average grant date fair value	$	10.89		$	8.99		$	10.89		$	8.99

As a result of the adoption of SFAS 123R, the financial results were lower than under the previous accounting method for share based compensation by the following amounts:


	Three months ended				Six months ended
	December 31,				December 31,
	2006		2005		2006		2005

Earnings from continuing operations before income taxes	$	79	$	49	$	105	$	71
Earnings from continuing operations		51		32		68		47
Net earnings		51		32		68		47
Basic and diluted net earnings per common share	$	0.02	$	0.01	$	0.02	$	0.02

Page 14

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except share and per share amounts)

10. Stock Based Compensation — Continued

A summary of the option activity under the plans for the three and six months ended December 31, 2006 and 2005 is as follows:


	2006					2005
				Weighted					Weighted
				Average					Average
				Exercise					Exercise
	No. of Options			Price		No. of Options			Price
Balance at July 1,		143,650		$	14.02		237,950		$	11.22
Granted		—		$	—		—		$	—
Exercised		(32,400	)	$	13.77		(250	)	$	12.64
Forfeited before vesting		—		$	—		(2,800	)	$	14.02
Forfeited after vesting		—		$	—		—		$	—

Balance at September 30,		111,250		$	14.09		234,900		$	11.18
Granted		5,000		$	23.80		4,000		$	16.95
Exercised		(27,488	)	$	10.83		(39,750	)	$	6.56
Forfeited before vesting		—		$	—		(25,000	)	$	12.94
Forfeited after vesting		—		$	—		(500	)	$	19.50

Balance at December 31,		88,762		$	15.64		173,650		$	12.10
Exercisable at end of period		49,601		$	15.36		140,600		$	11.69

The total options outstanding at December 31, 2006 had a weighted average remaining term of 7.21 years and an aggregate intrinsic value of $802, based upon the closing price of the Company’s common stock on December 29, 2006. The options exercisable at December 31, 2006 had a weighted average remaining term of 6.32 years and an aggregate intrinsic value of $462, based upon the closing price of the Company’s common stock on December 29, 2006.

Prior to the adoption of SFAS 123R, all tax benefits resulting from the exercise of stock options were presented as operating cash flows in the Consolidated Statements of Cash Flows. SFAS 123R requires that cash flows from the exercise of stock options resulting from tax benefits in excess of recognized cumulative compensation cost (excess tax benefits) be classified as financing cash flows. For the three and six months ended December 31, 2006 and 2005 such excess tax benefits were classified as financing cash flows.

Page 15

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except share and per share amounts)

10. Stock Based Compensation — Continued

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


	Three months ended				Six months ended
	December 31,				December 31,
	2006		2005		2006		2005
Total cash received	$	298	$	261	$	744	$	264
Income tax benefits	$	120	$	134	$	229	$	134
Total intrinsic value of options exercised	$	385	$	148	$	707	$	150

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


	Three months ended					Six months ended
	December 31, 2006					December 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		45,286		$	6.75		45,286		$	6.75
New Grants		—		$	—		—		$	—
Vested		(6,125	)	$	6.44		(6,125	)	$	6.44
Forfeited		—		$	—		—		$	—

Unvested at end of period		39,161		$	6.80		39,161		$	6.80

The total fair value of stock options vested during the three months ended December 31, 2006 and 2005 was $39 and $40, respectively. The total fair value of stock options vested during the six months ended December 31, 2006 and 2005 was $39 and $57, respectively.

As of December 31, 2006, the total remaining unrecognized compensation cost related to unvested stock options was $201. The weighted average remaining requisite service period of the unvested stock options was 1.26 years.

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PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except share and per share amounts)

10. Stock Based Compensation — Continued

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


	Three months ended					Six months ended
	December 31, 2006					December 31, 2006
				Weighted					Weighted
				Average					Average
				Grant Date					Grant Date
	No. of Shares			Fair Value		No. of Shares			Fair Value
Balance at beginning of period		10,000		$	17.06		10,000		$	17.06
New Grants		—		$	—		—		$	—
Vested		(2,500	)	$	17.06		(2,500	)	$	17.06
Forfeited		—		$	—		—		$	—

Balance at end of period		7,500		$	17.06		7,500		$	17.06

As of December 31, 2006, the total remaining unrecognized compensation cost related to unvested restricted stock awards was $121. The weighted average remaining requisite service period of the unvested restricted stock awards was 1.85 years.

11. Discontinued Operations

During the first quarter of the Company’s fiscal year ended June 30, 2004, the Board of Directors authorized the divestiture, and the Company sold certain assets of its Boiler business segment. During the fourth quarter of the Company’s fiscal year ended June 30, 2006, all remaining Boiler related assets were disposed of and all liabilities satisfied. Discontinued operations activity is as follows for the three and six months ended December 31, 2006 and 2005:


	Three months ended					Six months ended
	December 31,					December 31,
	2006		2005			2006		2005

Revenues	$	—	$	—		$	—	$	—
Cost of goods sold		—		—			—		—

Gross loss		—		—			—		—
Operating expenses		—		50			—		50

Operating loss		—		(50	)		—		(50	)
Income tax benefit		—		17			—		17

Net loss from operations	$	—	$	(33	)	$	—	$	(33	)


Basic and diluted loss per share	$	—	$	(0.01	)	$	—	$	(0.01	)

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PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

12. 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 earnings (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 earnings (loss) per share for the periods indicated.


	Three months ended					Six months ended
	December 31,					December 31,
	2006		2005			2006		2005
Net earnings (loss) from continuing operations	$	457	$	(792	)	$	908	$	(1,481	)
Loss from discontinued operations		—		(33	)		—		(33	)

Net earnings (loss)	$	457	$	(825	)	$	908	$	(1,514	)


Basic weighted average common shares outstanding		3,170		3,045			3,149		3,041
Effect of dilutive options		32		—			47		—

Diluted weighted average common shares outstanding		3,202		3,045			3,196		3,041


BASIC EARNINGS (LOSS) PER SHARE
Earnings (loss) from continuing operations	$	0.14	$	(0.26	)	$	0.29	$	(0.49	)
Loss from discontinued operations		—		(0.01	)		—		(0.01	)

Net earnings (loss) per share	$	0.14	$	(0.27	)	$	0.29	$	(0.50	)


DILUTED LOSS PER SHARE
Earnings (loss) from continuing operations	$	0.14	$	(0.26	)	$	0.28	$	(0.49	)
Loss from discontinued operations		—		(0.01	)		—		(0.01	)

Net earnings (loss) per share	$	0.14	$	(0.27	)	$	0.28	$	(0.50	)

Diluted weighted average common shares outstanding excluded outstanding stock options to purchase 211 and 208 shares of common stock, respectively, for the three and six months ended December 31, 2005 because their impact would have been anti-dilutive. No stock options were excluded in the three and six months ended December 31, 2006.

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PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

13. 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, valves and piping, to offer its customers a totally integrated system.

Segment profit and loss is based on revenue less direct expenses of the segment before allocation of general, administrative, research and development costs. All inter-company transfers between segments have been eliminated. Segment information and reconciliation to operating profit for the three and six months ended December 31, 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,						Six months ended,
	December 31,						December 31,
	2006			2005			2006			2005

Revenues
Environmental	$	2,550		$	3,629		$	7,164		$	6,895
Separation / Filtration		11,541			7,905			21,565			16,281

Consolidated	$	14,091		$	11,534		$	28,729		$	23,176


Operating income (loss)
Environmental	$	(138	)	$	272		$	794		$	(9	)
Separation / Filtration		2,043			489			2,951			755
Reconciling items		(1,375	)		(2,087	)		(2,563	)		(3,225	)

Consolidated	$	530		$	(1,326	)	$	1,182		$	(2,479	)

Page 19

PEERLESS MFG. CO. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

14. Lines of Credit

On September 30, 2006, the Company entered into a revolving credit facility for working capital requirements that expires on September 30, 2008 and has a maximum borrowing availability equal to the lesser of (i) $9,000 or (ii) 70% of eligible accounts receivable and 40% of eligible inventory. 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 December 31, 2006, the applicable rate was the Euro rate plus 2.0% (7.32%). At December 31, 2006, the Company had $2,411 outstanding under stand-by letters of credit and no borrowings outstanding, leaving a maximum availability under the credit facility of $6,589 (actual availability at December 31, 2006 of $2,824 based on the borrowing base calculation). The facility contains financial covenants, certain restrictions on capital expenditures, acquisitions, asset dispositions, dividends and additional debt, as well as other customary covenants. As of December 31, 2006, the Company was in compliance with all financial and other covenants under this credit facility.

In addition, the Company’s UK subsidiary had a £2,600 ($5,091) debenture agreement used to facilitate the issuances of bank guarantees. At December 31, 2006, this facility was secured by substantially all of the UK subsidiary’s assets, and was backed by a cash deposit of £1,400 ($2,741), which is recorded as restricted cash on the Company’s balance sheet. At December 31, 2006, there was £2,069 ($4,051) outstanding under this credit facility. As of December 31, 2006, the Company was in compliance with all financial and other covenants under this credit facility.

15. Supplemental Cash Flow Information

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


	Three months ended						Six months ended
	December 31,						December 31,
	2006			2005			2006			2005
Income tax paid	$	150		$	—		$	460		$	—
Income tax refunds received	$	(297	)	$	(150	)	$	(297	)	$	(150	)

Page 20

PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

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

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 24.9% and 29.8% of our revenues in the first six months of fiscal 2007 and 2006, respectively. In this segment, we design, engineer, manufacture and sell environmental control systems, which are used for air pollution abatement. Our main product, Selective Catalytic Reduction Systems, referred to as “SCR Systems,” is used to convert nitrogen oxide (NOx) emissions into nitrogen and water vapor. Nitrogen oxide (NOx) emissions are generated by exhaust gases caused by burning hydrocarbon fuels, such as coal, gasoline, natural gas and oil, as well as organic bio-fuels such as wood products, grasses and grains. In this segment, we also offer systems to reduce other pollutants, such as carbon monoxide (CO) and particulate matter (PM). These systems are totally integrated, complete with instruments, controls and related valves and piping.

Separation / Filtration Systems. This reporting segment represented 75.1% and 70.2% of our revenues in the first six months of fiscal 2007 and 2006, respectively. In this segment, we design, engineer, manufacture and sell specialized products known as “separators” or “filters” which are used for a variety of purposes in cleaning gases and liquids as they move through piping systems. These products are used primarily to remove solid and liquid contaminants from natural gas, as well as saltwater aerosols from combustion intake air of shipboard gas turbine and diesel engines. Separators are also used in nuclear power plants to remove water from saturated steam.

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, reserve for obsolete and slow moving inventory, and valuation allowance related to the deferred tax asset. 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 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (“SOP 81-1”). SOP 81-1 requires the use

Page 21

PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

of percentage-of-completion accounting for long-term contracts that contain enforceable rights regarding services to be provided and received by the contracting parties, consideration to be exchanged, and the manner and terms of settlement, assuming reasonably dependable estimates of revenues and expenses can be made. The percentage-of-completion methodology generally results in the recognition of reasonably consistent profit margins over the life of a contract. Amounts recognized in revenue are calculated using the percentage of construction cost completed, generally on a cumulative cost to total cost basis. Cumulative revenues recognized may be less or greater than cumulative costs and profits billed at any point in time during a contract’s term. The resulting difference is recognized as “costs and earnings in excess of billings on uncompleted contracts” or “billings in excess of costs and earnings on uncompleted contracts.”

When using the percentage-of-completion method, we must be able to accurately estimate the total costs we expect to incur on a project in order to record the proper amount of revenues for that period. We update our estimates of costs and the status of each project with our subcontractors and our manufacturing plant personnel. If it is determined that a loss will result from the performance of a contract, the entire amount of the loss is recognized 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 related to revenue and cost estimates in percentage-of-completion models through corporate policy and approval and monitoring processes, any estimation process, including that used in preparing contract accounting models, involves inherent risk.

Product Warranties. We offer warranty periods of various lengths to our customers depending upon the specific product and terms of the customer agreement. We typically negotiate varying terms regarding warranty coverage and length of warranty depending upon the product involved and customary practices. In general, our warranties require us to repair or replace defective products during the warranty period at no cost to the customer. We attempt to obtain back-up concurrent 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 receivable using a combination of factors, including the age of the outstanding balances, evaluation of customers’ current and past financial condition and credit scores, recent payment history, current economic environment, discussions with our project managers, and discussions with the customers directly, and record a provision for doubtful accounts based on historical collections and estimated future collections. As actual collections or market conditions may vary from those projected, adjustments to our allowance for doubtful accounts may be required.

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 the value of inventory on hand, using specific aging categories, and record a provision for

Page 22

PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

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, adjustments to our inventory reserve may be required.

Deferred Tax Asset — Valuation Allowance. We have a significant amount of net deferred tax assets, which consisted of a subsidiary state net operating loss carry-forward and temporary differences resulting from differences in the tax and book basis of certain assets and liabilities. The state net operating loss carry-forward expires, if unused, as follows: $3,300 in 2007; $2,100 in 2008; $1,900 in 2009; and, $210 in 2010. Based on evaluations performed, 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 its expirations, and accordingly we have recorded a valuation allowance to reduce the corresponding deferred tax asset to its anticipated net realizable value (see Note O in the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended June 30, 2006.). As actual results in future periods and projections of future results may vary from those projected, adjustments to our valuation allowance may be required.

Page 23

PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 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						Six months ended
	December 31,						December 31,
	2006			2005			2006			2005
Net revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold		68.0			72.7			69.0			76.3

Gross profit		32.0			27.3			31.0			23.7
Operating expenses		28.2			38.8			26.9			34.4

Operating earnings (loss)		3.8			(11.5	)		4.1			(10.7	)
Other income		1.2			1.1			0.8			1.0

Net earnings (loss) from continuing operations before income taxes		5.0			(10.4	)		4.9			(9.7	)
Income tax benefit (expense)		(1.8	)		3.5			(1.7	)		3.3

Net earnings (loss) from continuing operations		3.2			(6.9	)		3.2			(6.4	)
Loss from discontinued operations, net of tax		—			(0.3	)		—			(0.1	)

Net earnings (loss)		3.2	%		(7.2	)%		3.2	%		(6.5	)%

Cost of goods sold includes manufacturing and distribution costs for products sold. Manufacturing and distribution costs include material, direct and indirect labor, manufacturing overhead, sub-contract work, inbound and 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 expenses, 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, sales incentives 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 24

PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

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

Results of Operations — Consolidated

Revenues

The following table summarizes consolidated revenues for the three months ended December 31, 2006 and 2005:


	Three months ended December 31,
	2006		% of Total			2005		% of Total

Domestic	$	7,826		55.5	%	$	4,962		43.0	%
International		6,265		44.5	%		6,572		57.0	%

Total revenues	$	14,091		100.0	%	$	11,534		100.0	%

For the second quarter of fiscal 2007, total revenues increased $2,557, or 22.2%, when compared to the second quarter of fiscal 2006. Domestic revenues increased $2,864, or 57.7%, in the second quarter of fiscal 2007 when compared to the second quarter of fiscal 2006. International revenues decreased $307, or 4.7%, in the second quarter of fiscal 2007 when compared to the second quarter of fiscal 2006. Amounts are classified as domestic or international based upon the location of our customer. The increase in our domestic revenues relates primarily to an increase of separation and filtration equipment sales attributable to an increased demand for natural gas.

Gross Profit

The following table summarizes revenues, cost of goods sold, and gross profit for the three months ended December 31, 2006 and 2005:


	Three months ended December 31,
	2006		% of Revenue			2005		% of Revenue

Revenues	$	14,091		100.0	%	$	11,534		100.0	%
Cost of goods sold		9,587		68.0	%		8,388		72.7	%

Gross profit	$	4,504		32.0	%	$	3,146		27.3	%

For the second quarter of fiscal 2007, our gross profit increased $1,358, or 43.2%, when compared to the second quarter of fiscal 2006. Our gross profit, as a percentage of revenues, increased to 32.0% for the second quarter of fiscal 2007 compared to 27.3% for the second quarter of fiscal 2006. The improved gross profit is primarily attributable to shifts in the product mix of our sales in the second quarter of fiscal 2007 when compared to the second quarter of fiscal 2006.

Page 25

PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

Operating Expenses

The following table summarizes operating expenses for the three months ended December 31, 2006 and 2005:


	Three months ended December 31,
	2006		% of Sales			2005		% of Sales

Sales and marketing	$	1,644		11.7	%	$	1,565		13.6	%
Engineering & project management		955		6.8	%		820		7.1	%
General and administrative		1,375		9.7	%		2,087		18.1	%

Total operating expenses	$	3,974		28.2	%	$	4,472		38.8	%

For the second quarter of fiscal 2007, our operating expenses from continuing operations decreased by $498, or 11.1 % when compared to the second quarter of fiscal 2006. As a percentage of revenue, these expenses decreased to 28.2% in the second quarter of fiscal 2007 from 38.8% in the second quarter of fiscal 2006. Our sales and marketing expenses were $1,644 in the second quarter of fiscal 2007 compared to $1,565 in the second quarter of fiscal 2006. Selling and marketing expenses in the second quarter of fiscal 2007 increased over the second quarter of fiscal 2006 primarily due to the increased revenues. Our engineering and project management expense increased to $955 in the second quarter of fiscal 2007 from $820 in the second quarter of fiscal 2006. The increase in our engineering and project management expense related primarily to our increased revenues in the second quarter of fiscal 2007 over the second quarter of fiscal 2006. Our general and administrative expenses decreased $712 in the second quarter of fiscal 2007, compared to the second quarter of fiscal 2006. The general and administrative expenses in the second quarter of fiscal 2006 included expenses associated with a one time charge incurred in connection with a special project and severance paid to a former officer.

Other Income

The following table summarizes other income for the three months ended December 31, 2006 and 2005:


	Three months ended December 31,
	2006		% of Sales			2005		% of Sales

Interest income	$	73		0.5	%	$	50		0.4	%
Foreign exchange gain		101		0.7	%		29		0.3	%
Other income		—		0.0	%		47		0.4	%

Total other income	$	174		1.2	%	$	126		1.1	%

For the second quarter of fiscal 2007 other income items increased by $48, from income of $126 for the second quarter of fiscal 2006 to income of $174 for the second quarter of fiscal 2007. This change was primarily due to increased foreign currency exchange gains during the second quarter of fiscal 2007 over the second quarter of fiscal 2006. The increased foreign currency exchange gains were partially offset by a decrease in other income in the second quarter of fiscal 2007 compared

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

to the second quarter of fiscal 2006, primarily due to the loss of rental income from an inactive warehouse that was sublet in fiscal 2006.

Income Taxes

Our effective income tax rate for continuing operations was 35% and 34%, for the second quarter of fiscal years 2007 and 2006, respectively.

Net Earnings (Loss) from Continuing Operations

Our net earnings from continuing operations increased by $1,249, from a net loss of $792, or 6.9% of revenues, for the second quarter of fiscal 2006, to net earnings of $457, or 3.2% of revenues, for the second quarter of fiscal 2007 and related primarily to our increased revenues and gross profit. Basic and diluted earnings (loss) per share increased from a net of loss of $0.26 per share for the second quarter of fiscal 2006, to net earnings of $0.14 per share for the second quarter of fiscal 2007.

Discontinued Operations

There was no operating income or loss generated by the discontinued Boiler segment during the three months ended December 31, 2006. Our net loss during the three months ended December 31, 2005 related primarily to legal expenses associated with adversary proceedings initiated by Enron Corporation and National Energy Production Corporation. An agreement to settle this litigation was consummated and the litigation was dismissed in the fourth quarter of fiscal 2006. Basic and diluted earnings (loss) per share from discontinued operations were a net of loss of $0.01 per share for the second quarter of fiscal 2006. No operating income or loss was generated by our discontinued operations for the three months ended December 31, 2006. See Note 11, Discontinued Operations, to our Condensed Consolidated Financial Statements included in this report for additional information.

Net Earnings (Loss)

Our net earnings increased by $1,282, from a net loss of $825, or 7.2% of revenues, for the second quarter of fiscal 2006, to net earnings of $457, or 3.2% of revenues, for the second quarter of fiscal 2007. Basic and diluted earnings (loss) per share increased from a net of loss of $0.27 per share for the second quarter of fiscal 2006, to net earnings of $0.14 per share for the second quarter of fiscal 2007.

Results of Operations — Segments

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 accounting principles generally accepted in the United States of America (“GAAP”). Certain corporate level expenses have been excluded from our segment operating results and are analyzed separately.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

Environmental Systems

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. This reporting segment represented 18.1% and 31.5% of our revenues for the second quarter of fiscal 2007 and fiscal 2006, respectively.

The following table summarizes Environmental Systems’ revenues and operating income during the three months ended December 31, 2006 and 2005:


	Three months ended December 31,
	2006			2005

Revenue	$	2,550		$	3,629
Operating income (loss)	$	(138	)	$	272

Operating income (loss) as % of revenue		(5.4	)%		7.5	%

Revenues from Environmental Systems decreased in the second quarter of fiscal 2007 when compared to the second quarter of fiscal 2006, primarily due to the timing of awards of new gas power plant construction projects and increased competition.

Environmental Systems’ operating income in the second quarter of fiscal 2007 decreased $410 compared to the second quarter of fiscal 2006. As a percentage of Environmental Systems’ revenue, the operating loss was 5.4% in the second quarter of fiscal 2007 compared to operating income of 7.5% in the second quarter of fiscal 2006. The decrease in operating income in fiscal 2007 compared to fiscal 2006 is primarily related to the decrease in revenue. Additionally, this business segment incurred increased expense associated with the installation and commissioning of certain product installed during the second quarter of fiscal 2007.

Our Environmental Systems business has been impacted by the timing of the awards of new gas power plant construction. We would expect that as compliance deadlines for air regulations come into effect and the demand for power increases in the short term as well as over the next three to five years, facilities will have to implement their compliance plans, resulting in increased spending for environmental reduction systems. State Implementation Plans, the Clean Air Interstate Rule, and consent decrees all create a favorable market environment for our Environmental Systems. Increasing energy demand is beginning to necessitate the construction of new power plants, which would require systems to reduce NOx emissions. Domestically, new gas-fired plants are anticipated to be constructed to meet peak power demands. In addition, new coal-fired power plants, applied to base-load operations, have been announced for construction over the next several years.

Separation / Filtration Systems

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. This reporting segment represented 81.9% and 68.5% of our revenues for the second quarter of fiscal 2007 and fiscal 2006, respectively.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

The following table summarizes Separation / Filtration Systems’ revenues and operating income during the three months ended December 31, 2006 and 2005:


	Three months ended December 31,
	2006			2005

Revenue	$	11,541		$	7,905
Operating income	$	2,043		$	489

Operating income as % of revenue		17.7	%		6.2	%

Separation / Filtration Systems’ revenues increased by $3,636, or 46.0%, in the second quarter of fiscal 2007 when compared to the second quarter of fiscal 2006. Our revenues increased during the second quarter of fiscal 2007 when compared to the same period in the prior year both domestically and internationally. This increase in revenues is attributed primarily to an increase in natural gas transmission projects as a result of strong energy demand.

Separation / Filtration Systems’ operating income in the second quarter of fiscal 2007 increased $1,554 compared to the second quarter of fiscal 2006. As a percentage of Separation / Filtration Systems’ revenue, operating income was 17.7% in the second quarter of fiscal 2007 and 6.2% in the second quarter of fiscal 2006. The increased operating income is primarily attributable to the increased gross profit associated with the growth in revenues and mix of product sold.

Strong energy demand is creating opportunities for our separation and filtration products. New pipelines, gas processing facilities, chemical and petrochemical processing plants, and LNG plants and terminals are driving the growth of this business segment. We believe the domestic and international markets for our separation products will continue to remain strong as nuclear power plants continue to invest in life extension and power up-rate projects, in connection with the license renewals for these facilities. The construction of new nuclear power plants internationally is also expected to provide revenue opportunities.

Corporate Level Expenses

The corporate level expenses excluded from our segment operating results are corporate level general and administrative expenses. See “Results of Operations — Consolidated — Operating Expenses” above for additional discussion on these expenses.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

Six Months Ended December 31, 2006 Compared to Six Months Ended December 31, 2005

Results of Operations — Consolidated

Revenues

The following table summarizes consolidated revenues for the six months ended December 31, 2006 and 2005:


	Six months ended December 31
	2006		% of Total			2005		% of Total

Domestic	$	15,431		53.7	%	$	11,533		49.8	%
International		13,298		46.3	%		11,643		50.2	%

Total revenues	$	28,729		100.0	%	$	23,176		100.0	%

For the first six months of fiscal 2007, total revenues increased $5,553, or 24.0%, when compared to the first six months of fiscal 2006. Domestic revenues increased $3,898, or 33.8%, in the first six months of fiscal 2007 when compared to the first six months of fiscal 2006. International revenues increased $1,655, or 14.2%, in the first six months of fiscal 2007 when compared to the first six months of fiscal 2006. Amounts are classified as domestic or international based upon the location of our customer. The increase in our domestic and international revenues relates primarily to an increase of separation and filtration equipment sales attributable to an increased demand for natural gas, in addition to increased international revenues of our Environmental Systems.

Gross Profit

The following table summarizes revenues, cost of goods sold, and gross profit for the six months ended December 31, 2006 and 2005:


	Six months ended December 31,
	2006		% of Revenue			2005		% of Revenue

Revenues	$	28,729		100.0	%	$	23,176		100.0	%
Cost of goods sold		19,830		69.0	%		17,677		76.3	%

Gross profit	$	8,899		31.0	%	$	5,499		23.7	%

For the first six months of fiscal 2007, our gross profit increased $3,400, or 61.8%, when compared to the first six months of fiscal 2006. Our gross profit, as a percentage of revenues, increased to 31.0% for the first six months of fiscal 2007 compared to 23.7% for the first six months of fiscal 2006. The improved gross profit is primarily attributable to shifts in the product mix of our sales in the first six months of fiscal 2007 when compared to the first six months of fiscal 2006.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

Operating Expenses

The following table summarizes operating expenses for the six months ended December 31, 2006 and 2005:


	Six months ended December 31,
	2006		% of Sales			2005		% of Sales

Sales and marketing	$	3,366		11.7	%	$	3,107		13.4	%
Engineering & project management		1,788		6.3	%		1,646		7.1	%
General and administrative		2,563		8.9	%		3,225		13.9	%

Total operating expenses	$	7,717		26.9	%	$	7,978		34.4	%

For the first six months of fiscal 2007, our operating expenses from continuing operations decreased by $261 or 3.2% when compared to the first six months of fiscal 2006. As a percentage of revenue, these expenses decreased to 26.9% in the first six months of fiscal 2007 from 34.4% in the first six months of fiscal 2006, primarily as a result of the increased revenue in the current quarter compared to the same prior year period. Our sales and marketing expenses were $3,366 in the first six months of fiscal 2007 compared to $3,107 in the first six months of fiscal 2006. Selling and marketing expenses in the first six months of fiscal 2007 increased over the first six months of fiscal 2006 primarily due to the increased revenues. Our engineering and project management expense increased to $1,788 in the first six months of fiscal 2007 from $1,646 in the first six months of fiscal 2006. The increase in our engineering and project management expense related primarily to our increased revenues in the first six months of fiscal 2007 over the first six months of fiscal 2006. Our general and administrative expenses decreased $662 in the first six months of fiscal 2007, compared to the first six months of fiscal 2006. The general and administrative expenses in the first six months of fiscal 2006 included expenses associated with a one time charge incurred in connection with a special project and severance paid to a former officer.

Other Income

The following table summarizes other income for the six months ended December 31, 2006 and 2005:


	Six months ended December 31,
	2006		% of Sales			2005		% of Sales

Interest income	$	135		0.5	%	$	103		0.4	%
Foreign exchange gain		82		0.3	%		57		0.2	%
Other income		—		0.0	%		79		0.4	%

Total other income	$	217		0.8	%	$	239		1.0	%

For the first six months of fiscal 2007, other income items decreased by $22, from income of $239 for the first six months of fiscal 2006 to income of $217 for the first six months of fiscal 2007. This change was primarily due to the loss of rental income from an inactive warehouse that was sublet in fiscal 2006. The lost income was partially offset by increased interest income and

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

foreign currency exchange gains in the first six month of fiscal 2007 over the first six months of fiscal 2006.

Income Taxes

Our effective income tax rate for continuing operations was 35% and 34%, for the first six months of fiscal years 2007 and 2006, respectively.

Net Earnings (Loss) from Continuing Operations

Our net earnings from continuing operations increased by $2,389, from a net loss of $1,481, or 6.4% of revenues, for the first six months of fiscal 2006, to net earnings of $908, or 3.2% of revenues, for the first six months of fiscal 2007 and related primarily to our increased revenues and gross profit. Basic earnings (loss) per share increased from a net of loss of $0.49 per share for the first six months of fiscal 2006, to net earnings of $0.29 per share for the first six months of fiscal 2007. Diluted earnings (loss) per share increased from a net of loss of $0.49 per share for the first six months of fiscal 2006, to net earnings of $0.28 per share for the first six months of fiscal 2007.

Discontinued Operations

There was no operating income or loss generated by the discontinued Boiler segment during the six months ended December 31, 2006. Our net loss during the six months ended December 31, 2005 related primarily to legal expenses associated with adversary proceedings initiated by Enron Corporation and National Energy Production Corporation. An agreement to settle this litigation was consummated and the litigation was dismissed in the fourth quarter of fiscal 2006. Basic and diluted earnings (loss) per share from discontinued operations were a net of loss of ($0.01) per share for the first six months of fiscal 2006. No operating income or loss was generated by our discontinued operations for the six months ended December 31, 2006. See Note 11, Discontinued Operations, to our Condensed Consolidated Financial Statements included in this report for additional information.

Net Earnings (Loss)

Our net earnings increased by $2,422, from a net loss of $1,514, or 6.5% of revenues, for the first six months of fiscal 2006, to net earnings of $908, or 3.2% of revenues, for the first six months of fiscal 2007. Basic earnings (loss) per share increased from a net of loss of $0.50 per share for the first six months of fiscal 2006, to net earnings of $0.29 per share for the first six months of fiscal 2007. Diluted earnings (loss) per share increased from a net of loss of $0.50 per share for the first six months of fiscal 2006, to net earnings of $0.28 per share for the first six months of fiscal 2007.

Results of Operations — Segments

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

Environmental Systems

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. This reporting segment represented 24.9% and 29.8% of our revenues for the first six months of fiscal 2007 and fiscal 2006, respectively.

The following table summarizes Environmental Systems’ revenues and operating income for the six months ended December 31, 2006 and 2005:


	Six months ended December 31,
	2006			2005

Revenue	$	7,164		$	6,895
Operating income (loss)	$	794		$	(9	)

Operating income (loss) as % of revenue		11.1	%		(0.1	)%

Revenues from Environmental Systems increased $269 in the first six months of fiscal 2007 when compared to the first six months of fiscal 2006.

Environmental Systems’ operating income in the first six months of fiscal 2007 increased $803 compared to the first six months of fiscal 2006. As a percentage of Environmental Systems revenue, operating income was 11.1% in the first six months of fiscal 2007 compared to an operating loss of 0.1% in the first six months of fiscal 2006. When compared to the first six months of fiscal 2006, gross profit for the first six months of fiscal 2007 improved primarily due to a change in market conditions and product mix. Operating expenses continued to decline primarily due to product standardization activities and cost control measures.

Separation / Filtration Systems

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. This reporting segment represented 75.1% and 70.2% of our revenues for the first six months of fiscal 2007 and fiscal 2006, respectively.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

The following table summarizes Separation / Filtration Systems revenues and operating income for the six months ended December 31, 2006 and 2005:


	Six months ended December 31,
	2006			2005

Revenue	$	21,565		$	16,281
Operating income	$	2,951		$	755

Operating income as % of revenue		13.7	%		4.6	%

Separation / Filtration Systems’ revenues increased by $5,284, or 32.5%, in the first six months of fiscal 2007 when compared to the first six months of fiscal 2006. Our revenues increased during the first six months of fiscal 2007 when compared to the same period in the prior year both domestically and internationally, primarily due to an increase in natural gas transmission projects.

Separation / Filtration Systems’ operating income in the first six months of fiscal 2007 increased $2,196 compared to the first six months of fiscal 2006. As a percentage of Separation / Filtration Systems’ revenue, operating income was 13.7% in the first six months of fiscal 2007 and 4.6% in the first six months of fiscal 2006. Gross profit improved during the second quarter of fiscal 2007 primarily due to reduced warranty and start-up costs and shifts in product mix and market segments.

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

Corporate Level Expenses

Contingencies

On April 25, 2006, we received notice that we allegedly received $900 of preferential transfers 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 not meet the applicable standards for avoidance under the Bankruptcy Code and other applicable laws, or that a number of defenses may be asserted that would negate any recovery by the plaintiffs. We intend to vigorously defend against the lawsuit and we believe the likelihood of a material loss is not probable.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 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 results of operations.

Backlog

The Company’s backlog of orders was $37,000 at December 31, 2006 and $40,000 at June 30, 2006. The timing of our larger contracts can have a notable impact upon our backlog from period to period.

Financial Position

Assets. Total assets decreased by $1,839, or 3.8%, from $48,159 at June 30, 2006, to $46,320 at December 31, 2006. We held cash and cash equivalents of $6,243, had working capital of $25,242 and a current liquidity ratio of 2.4-to-1.0 at December 31, 2006. This compares with cash and cash equivalents of $6,411, $22,930 in working capital, and a current liquidity ratio of 2.0-to-1.0 at June 30, 2006.

Liabilities and Shareholders’ Equity. Total liabilities decreased by $3,977, or 17.9%, from $22,242 at June 30, 2006 to $18,265 at December 31, 2006. This decrease in liabilities related primarily to the decrease in our accounts payable of $3,918. The increase in shareholder’s equity of $2,138 or 8.2%, from $25,917 at June 30, 2006 to $28,055 at December 31, 2006 was primarily a result of our net earnings and an increase in capital from the exercise of stock options during the first six months of fiscal 2007. The ratio of total liabilities-to-equity decreased from ..86-to-1.0 at June 30, 2006 to .65-to-1.0 at December 31, 2006, reflecting a 17.9% decrease in liabilities and an 8.2% increase in shareholder’s equity during the period.

Liquidity and Capital Resources

Our cash and cash equivalents were $6,243 at December 31, 2006, compared to $6,411 at June 30, 2006. Cash provided by operating activities during the first six months of fiscal year 2007 was $1,700 compared to cash used in operating activities during the first six months of fiscal 2006 of $1,150.

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 typically 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 receivable along with accounts payable, to determine our management of working capital. At December 31, 2006, the balance of these working capital accounts was $13,122 compared to $13,893 at June 30, 2006, reflecting a decrease of our investment in these working capital items of $771. Generally, a contract will either allow for amounts to be billed upon shipment or on a progress basis based on the attainment of certain milestones. During the first six months of fiscal 2007, several large projects were in the early stages of production and the milestones for billing had not been achieved. Additionally, several large projects were finalized and shipped, which resulted in a decrease in our investment in these working capital accounts. During the first six months of fiscal 2007, funds were primarily provided by a decrease in our accounts receivable.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

Cash used by investing activities was $2,924 for the first six months of fiscal year 2007, compared to cash provided by investing activities of $3 for the first six months of fiscal 2006. Cash used during the first six months of fiscal 2007 related primarily to an increase in restricted cash to support a debenture agreement used by our UK subsidiary to facilitate the issuances of bank guarantees.

Cash provided by financing activities was $973 and $398 during the first six months of fiscal 2007 and 2006, respectively, and related to the proceeds from the issuance of common stock and the corresponding excess tax benefits associated with the exercise of employee stock options.

No cash was provided by or used in our discontinued operations during the first six months of fiscal 2007, compared to cash used by our discontinued operations of $5 in the first six months of fiscal 2006.

As a result of the above factors, our cash and cash equivalents during the first six months of fiscal year 2007 decreased by $168, compared to a decrease of $756 in the first six months of fiscal 2006.

On September 30, 2006, we entered into a revolving credit facility for working capital requirements that expires on September 30, 2008 and has a maximum borrowing availability equal to the lesser of (i) $9,000 or (ii) 70% of eligible accounts receivable and 40% of eligible inventory. 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 our assets in the United States. At December 31, 2006, the applicable rate was the Euro rate plus 2.0% (7.32%). At December 31, 2006, we had $2,411 outstanding under stand-by letters of credit and no borrowings outstanding, leaving a maximum availability under the credit facility of $6,589 (actual availability at December 31, 2006 of $2,824 based on our borrowing base calculation). The facility contains financial covenants, certain restrictions on capital expenditures, acquisitions, asset dispositions, dividends and additional debt, as well as other customary covenants. As of December 31, 2006, we were in compliance with all financial and other covenants under this credit facility.

In addition, our UK subsidiary had a £2,600 ($5,091) debenture agreement used to facilitate the issuances of bank guarantees. At December 31, 2006, this facility was secured by substantially all of the UK subsidiary’s assets, and was backed by a cash deposit of £1,400 ($2,741), which is recorded as restricted cash on the balance sheet. At December 31, 2006, there was £2,069 ($4,051) outstanding under this credit facility. As of December 31, 2006, we were in compliance with all financial and other covenants under this credit facility.

We believe we maintain adequate liquidity to support existing operations and planned growth.

New Accounting Standards

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 clarifies the accounting for uncertainty in tax positions. The interpretation prescribes a recognition threshold and measurement attribute to the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 is effective for the Company beginning July 1, 2007. We are currently assessing the potential impact of the adoption of FIN No. 48 will have on our financial statements.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value in accordance with generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We have not yet completed our evaluation of the impact of adopting SFAS No. 157.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for the first annual period ending after November 15, 2006. We do not expect that the adoption of SAB No. 108 will have an impact on our results of operations or financial position or that any adjustment will be made.


Item 3.		Quantitative and Qualitative Disclosures About Market Risk

Our primary market risk exposures are interest rate risk and currency exchange rate risk. We currently believe 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 States dollars are performed, for the most part, in the same currency and therefore provide a “natural hedge” against currency fluctuations. On occasion, we engage in 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 results of operations. The impact of currency exchange rate movements on inter-company transactions has been, and is expected to continue to be, immaterial. We did not have any derivatives outstanding as of December 31, 2006.

Since June 30, 2006, 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, 2006 as filed with the Securities and Exchange Commission.


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

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except per share amounts)

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 Company’s controls and procedures can only provide reasonable, not absolute, assurance that the above objectives have been met.

During the quarter ended December 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, 2007 because the market value of the Company’s common stock held by non-affiliates exceeded $75,000 at December 31, 2006. That report is to include an assessment by the Company’s management of the effectiveness of its internal control over financial reporting for the fiscal year ending June 30, 2007 along with an attestation report from the Company’s independent auditors regarding that assessment. Accordingly, the Company is undertaking a comprehensive effort to assess its system of internal control over financial reporting. Using internal resources and external consulting assistance, the Company will review its internal control over financial reporting to assess its adequacy and, as necessary, to address identified issues or inadequacies.

PART II. OTHER INFORMATION


Item 1.		Legal Proceedings


Item 1A.		Risk Factors

There have been no material changes in the risk factors set forth under Part I, Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2006 filed with the Securities and Exchange Commission.

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PEERLESS MFG. CO. AND SUBSIDIARIES
DECEMBER 31, 2006
(Amounts in thousands, except share and per share amounts)

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


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

Our 2006 Annual Meeting of shareholders was held on November 16, 2006. A total of 3,119,559 shares of our common stock, or approximately 98.5% of all shares of our common stock entitled to vote at the meeting, were represented by proxy or ballot. At the Annual Meeting, four Directors were elected to the Board of Directors, each to serve until his term expires or until his successor is elected and qualified. The vote with respect to the election of these Directors was a follows:

Total Vote

Annual

Total Vote

Withheld

Meeting

for Each

from Each

Class of

when Term

Director

Expires

Kenneth R. Hanks

3,114,201

5,358

Class I

2007

Howard G. Westerman, Jr.

3,114,201

5,358

Class II

2008

Peter J. Burlage

3,114,103

5,456

Class III

2009

Sherrill Stone

3,114,103

5,456

Class III

2009

R. Clayton Mulford will continue to serve a Director.

At the same meeting, the appointment by the Audit Committee of Grant Thornton LLP as our independent registered public accounting firm for fiscal 2007 was ratified by shareholders in a non-binding vote as follows:


For			3,075,394
Against			40,391
Abstain			3,774

Item 5 is not applicable and has been omitted.

Page 39


	Page
	Number
PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheets at December 31, 2006 (unaudited) and June 30, 2006		4

Unaudited Condensed Consolidated Statements of Operations for the three and six months ended December 31, 2006 and 2005		5

Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended December 31, 2006 and 2005		6

Unaudited Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss) for the six months ended December 31, 2006 and 2005		7

Notes to the Condensed Consolidated Financial Statements		8

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		21

Item 3. Quantitative and Qualitative Disclosures About Market Risk		37

Item 4. Controls and Procedures		37

PART II: OTHER INFORMATION

Item 1. Legal Proceedings		38

Item 1A. Risk Factors		38

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		39

Item 3. Defaults Upon Senior Securities		39

Item 4. Submission of Matters to a Vote of Security Holders		39

Item 5. Other Information		39

Item 6. Exhibits		40

SIGNATURES		41
Agreement for Purchase
Rule 13a-14(a)/15(d)-14(a) Certification of CEO
Rule 13a-14(a)/15(d)-14(a) Certification of CFO
Section 1350 Certification of CEO
Section 1350 Certification of CFO


Exhibit
Number		Exhibit

10 (a)		Agreement for Purchase between Peerless Mfg. Co. and Dallas Rapid Area Transit.

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.


	PEERLESS MFG. CO.
Date: February 13, 2007	/s/ Peter J. Burlage
	Peter J. Burlage
	President and Chief Executive Officer (Principal Executive Officer)


Date: February 13, 2007	/s/ Henry G. Schopfer, III
	Henry G. Schopfer, III
	Chief Financial Officer (Principal Financial and Accounting Officer)

	(A)		Real estate or interest therein, identified as Parcel NW3-18 and described in attached Exhibit “1” incorporated herein by reference, provided, however, that notwithstanding the foregoing, upon receipt of a survey of the Property, which survey Seller will obtain at Seller’s sole cost and expense and which survey will be certified to Seller (the “Seller Survey”), the legal description of the Property as set forth on the Seller Survey will be used by Seller and Purchaser for all purposes under this Contract, including for purposes of Exhibit 1 and the Deed.

	(B)		The Property interest being acquired herein is Fee Simple.


(A) Amount to be paid by DART to Seller at closing (“Closing”):	$	4,424,000.00

TOTAL PURCHASE PRICE	$	4,424,000.00

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	(A)		It is mutually understood by Seller and DART that this Agreement is subject to approval of the Federal Transit Administration and the DART Board, and final DART acceptance. Such approvals and final DART acceptance shall be evidenced by the execution of this Agreement by DART and delivery of said executed Agreement to Seller.

	(B)		The Effective Date of this Agreement shall be the date this Agreement is executed by DART. References to the date of execution of this Agreement are to the Effective Date.

	(C)		Seller is responsible for all taxes due or delinquent on the Property as of the date of Closing. Seller shall pay only all taxes for all years up to and including the year preceding the year of Closing and taxes for the year of Closing shall be prorated to the date of Closing. If the Closing occurs before the tax rate is fixed for the year of Closing, the apportionment of taxes shall be based on the previous years’ tax rate applied to the latest assessed valuation, but any difference in estimated and actual taxes shall be adjusted between the parties upon the written request of either party when the actual tax rate and assessed valuation for the year of Closing are available. It is further understood that BUYER IS A PUBLIC BODY AND EXEMPT FROM PAYMENT OF TAXES OF PROPERTY OWNED BY IT FROM AND AFTER THE DATE OF ITS ACQUISITION.

	(D)		At the Closing, DART shall deliver the Purchase Price to the title company (“Title Company”) selected by the parties, for disbursement and shall pay (a) all costs of the survey; (b) the premium for the Owner’s Policy of Title Insurance; (c) all costs involved in preparation and recording all documents required for Closing; (d) all Title Company escrow fees; and (e) prepayment penalties and/or charges required to be paid by Seller on a preexisting mortgage entered into by Seller in good faith.

			At the Closing, Seller shall deliver a Special Warranty Deed, in the form attached as Exhibit 2, conveying good and indefeasible title to the Property, subject only to the permitted exceptions as set out in the Special Warranty Deed, and any other documents reasonably required to complete the Closing in accordance with the usual practices for Closing real estate transactions in Dallas County, Texas.

			Subject to the permitted exceptions, Seller is responsible for delivering unencumbered title to DART at Closing. Except as otherwise provided in this Agreement, Seller shall be liable for any encumbrances arising after Closing as a result of the actions of the Seller. The terms of this sub-section shall survive the Closing.

			Within ten (10) days of the Effective Date, DART will request a current title commitment for the Property. DART shall, after receipt of the title commitment and in no event less than sixty (60) days prior to the Closing, give written notice to Seller of any objections DART has to the title as disclosed by the commitment. Any matters shown on the title commitment to which DART does not object timely shall become permitted exceptions.

			Seller shall have a reasonable time, not to exceed thirty (30) days after receipt of DART’s title objections to cure such objections, and Seller covenants and agrees to make a reasonable effort to eliminate the objected to exceptions, PROVIDED, HOWEVER, that in no instance shall Seller be obligated to expend funds or undertake litigation to remove such objections. In the event Seller is unable to remove such title objections within the time provided, DART may either (a) waive the objections and accept such title as Seller is able to convey and proceed to close the sale with no abatement or reduction in the Purchase Price, or (b) institute eminent domain proceedings for the acquisition of the Property. The foregoing shall be the sole and exclusive remedies available to DART in the event Seller is unable to remove DART’S title objections. IN THE EVENT SELLER IS UNABLE TO PROVIDE TITLE AS REQUIRED HEREIN, AND DART IS COMPELLED TO INITIATE EMINENT DOMAIN PROCEEDINGS TO CURE THE TITLE, THE PURCHASE PRICE STATED IN THE CONTRACT SHALL NOT BE ADMISSIBLE IN SUBSEQUENT EMINENT DOMAIN PROCEEDINGS AND THIS AGREEMENT AND ALL NEGOTIATIONS ASSOCIATED WITH THIS AGREEMENT SHALL BE INADMISSIBLE UNDER RULE 408 OF THE TEXAS RULES OF EVIDENCE. In addition to the matters set out above, DART has the right to accept the Property with specific exceptions. The terms of this paragraph shall survive the closing or earlier termination of this Agreement.

			The Closing of this contract shall take place on May 1, 2007; provided, however, Seller and Buyer may agree to an earlier date for the Closing by a written amendment to this Agreement.

	(E)		Possession of the Property shall be delivered to DART at Closing. Any extension of occupancy beyond the date of Closing must be authorized by DART in writing. During the period from the date of Closing until the Seller surrenders possession to DART, the Seller shall exercise ordinary care in protecting the Property from theft and vandalism. All Property, whether real or personal, included in this agreement shall be delivered to DART in the same condition existing as of the effective date of this agreement, less any reasonable wear and tear.

	(F)		If DART desires a survey and/or hazardous materials study of the Property, it shall be at DART’s expense; PROVIDED, HOWEVER, that Seller shall permit DART’s hazardous

			materials inspectors and surveyor access to the Property for the purpose of making such survey and study, and DART indemnifies Seller against any liens or damage to the Property or injuries to persons arising out of the performance of such work on the Property by DART’s hazardous materials inspectors and surveyor. The terms of this sub-section shall survive the closing or earlier termination of this Agreement.

	(G)		All risk of loss to the Property shall remain upon Seller prior to Closing. If, prior to Closing, the Property shall be damaged or destroyed by any casualty loss, such as fire, tornado, flood or the like, DART may either terminate this contract by written notice to Seller within ten (10) business days after receipt of notice of said casualty loss, or proceed to Closing. If DART elects to proceed with Closing irrespective of such casualty loss, there shall be no reduction in the Purchase Price, but Seller shall assign to DART Seller’s interest in any insurance proceeds due to Seller as a result of such casualty up to and including the Purchase Price. Any insurance proceeds in excess of the Purchase Price shall remain the property of Seller.

	(H)		It is understood by Seller and DART that the Property is being sold to DART under the threat of eminent domain and that Seller’s legal responsibility for any Environmental Condition (as defined below) with respect to the Property shall be determined as if DART had acquired the Property from Seller through an eminent domain proceeding. The terms of this sub-section shall survive Closing.

	(I)		DART acknowledges that in connection with the sale of the Property under this Agreement, Seller has offered DART the opportunity to conduct whatever testing DART deems appropriate with respect to the environmental condition of the Property. DART further acknowledges that in the event DART discovers or otherwise learns of any Environmental Condition (as defined below) related to the Property for which DART might or will seek a recovery from Seller, that Seller requests that DART promptly give Seller written notice of such Environmental Condition and promptly provide Seller with copies of all data, reports and other information regarding the Environmental Condition (the “Environmental Condition Notice”). Seller acknowledges that whether DART gives or does not give Seller the Environmental Condition Notice is solely within DART’s discretion and that this Agreement does not obligate DART to give such notice. “Environmental Condition” shall mean the presence of any Regulated Substances (defined below) at, in, on, or under the Property, in excess of TCEQ cleanup standards for commercial/industrial land uses as defined in 30 TAC Sec. 350.4(a)(13) (“Commercial Standards”). “Regulated Substances” shall mean any substances whether solid, liquid or gaseous, which are regulated by the TCEQ as a “hazardous substance,” “hazardous material,” “hazardous waste,” “toxic substance,” or “solid waste.” The terms of this sub-section shall survive Closing.

	(J)		In the event DART determines that an Environmental Condition exists that requires disclosure to the TCEQ and for which DART might or will seek a recovery from Seller, Seller requests that (i) all activities be performed in a least-cost manner and only to the extent necessary to obtain a voluntary cleanup program (“VCP”) conditional Certificate of Completion, or such other similar closure document from TCEQ to the effect that the Environmental Condition meets Commercial Standards and (ii) that DART keep Seller informed of the remediation efforts and DART’s communications with the TCEQ (collectively the “Seller’s Remediation Request”). Seller acknowledges that whether DART gives or does not comply with Seller’s Remediation Request is solely within DART’s discretion and that this Agreement does not obligate DART to comply with such request. The terms of this sub-section shall survive Closing.

	(K)		DART warrants to Seller that no real estate broker or salesman has performed services on behalf of DART such as to warrant payment of a commission by reason of the Closing of this contract. Seller has been represented by CB Richard Ellis in connection with the Property and will be solely responsible for any commission or other compensation that may be due to CB Richard Ellis in connection with the Closing. Under no circumstances

			will DART pay for or be responsible for a real estate commission to a broker or a sales person.

	(L)		All notices provided herein to be given to Sellers shall be in writing and shall be given to Seller at 2819 Walnut Hill Lane, Dallas, Texas 75229 Attention: Peter J. Burlage, Chief Executive Officer or to such other address as Seller shall hereafter designate to DART by notice. All notices provided herein to be given to DART shall be in writing and shall be given to Buyer at P.O. Box 660163, Dallas, Texas 75266-7230, Attention: Assistant Vice President of Real Estate, or to such other address or individual as DART shall hereafter designate to Seller by notice. Any and all notices required or provided for herein shall be deemed to be effectively given when delivered in person or when mailed by United States Registered or Certified Mail with postage prepaid and addressed as herein above set forth.

	(M)		The parties have chosen to defer discussion of the appropriate relocation costs and other relocation benefits that will be paid by DART to Seller. These issues will be addressed under a separate agreement between DART and Seller.

	(N)		Miscellaneous:

	a.		This contract shall be construed under and in accordance with the laws of The State of Texas, and is entirely performable in Dallas County, Texas.

	b.		This contract embodies the entire Agreement between the parties and supersedes all prior Agreements and understandings, if any, relating to the Property and may be amended or supplemented only by a written instrument executed by both parties.

	c.		If any provision of this contract is held to be illegal, invalid or unenforceable under present or future laws, such provisions shall be fully severable and the contract shall be construed and enforced as if such illegal, invalid or unenforceable provision had never comprised a part of the contract. The remaining provisions of the contract shall be and remain in full force and effect and shall not be affected by the illegal, invalid or unenforceable provision or by its severance from this contract. Furthermore, in lieu of such illegal, invalid or unenforceable provision, there shall be added, automatically as a part of this contract, a provision as similar in terms to such illegal, invalid or unenforceable provision as may be possible and be legal, valid or enforceable.

	d.		This contract shall be binding and inure to the benefit of DART and Seller and their respective heirs, personal representatives, successors and assigns.

	e.		Words of any gender used in this contract shall be held and construed to include any other gender and words in the singular shall include the plural, and vice versa, unless the context clearly requires otherwise.

	f.		Neither party may assign its interest in this Agreement without the prior consent of the other party.


Peerless Mfg. Co.
/s/ Peter J. Burlage
By: Peter J. Burlage, Chief Executive Officer

75-0724417
Tax I.D. Number

Peerless Mfg. Co.
2819 Walnut Hill Lane
Dallas. Texas 75229


DALLAS AREA RAPID TRANSIT

By:		/s/ Cleo Grounds

		Cleo Grounds
		Assistant Vice-President, Real Estate

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)		[Not Applicable]

	(c)		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

	(d)		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.

	(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/ Peter J. Burlage
	Peter J. Burlage
	President and Chief Executive Officer
	Date: February 13, 2007



	/s/ Henry G. Schopfer, III
	Henry G. Schopfer, III
	Chief Financial Officer
	Date: February 13, 2007

(1)		The Quarterly Report on Form 10-Q of the Company for the period ended December 31, 2006, as filed with the Securities and 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.