The unaudited Condensed Consolidated Financial Statements include the accounts of Hurco Companies, Inc. and its consolidated subsidiaries. We design and produce computerized machine tools, interactive computer control systems and software for sale through our distribution network to the worldwide metal cutting market. We also provide software options, computer control upgrades, accessories and replacement parts for our products, as well as customer service and training support.

The condensed financial information as of April 30,July 31, 2005 and for the three and sixnine months ended April 30,July 31, 2005 and April 30,July 31, 2004 is unaudited; however, in our opinion, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results and financial position for the interim periods. We suggest that you read these condensed consolidated financial statements in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended October 31, 2004.

We enter into foreign currency forward exchange contracts periodically to hedge certain forecast inter-company product sales and inter-company and third party product purchases that will be denominated in foreign currencies (primarily the Pound Sterling, Euro and New Taiwan Dollar). The purpose of these instruments is to mitigate the risk that the U.S. dollar net cash inflows and outflows resulting from sales and purchases denominated in foreign currencies will be adversely affected by changes in exchange rates. These forward contracts have been designated as cash flow hedge instruments, and are recorded in the Condensed Consolidated Balance Sheet at fair value in Other Current Assets and Accrued Expenses. Gains and losses resulting from changes in the fair value of these hedge instruments are deferred in Accumulated Other Comprehensive Income and recognized as an adjustment to Cost of Sales in the period that the sale or purchase of the product that was the subject of the hedged transaction is recognized, thereby providing an offsetting economic impact against the corresponding change in the U.S. dollar value of the inter-company sale or purchase being hedged.

At April 30,July 31, 2005, we had $607,000$2,278,000 of net gains related to cash flow hedges deferred in Accumulated Other Comprehensive Income. Of this amount, $829,000$2,025,000 represents unrealized gains related to future cash flow hedge instruments that remain subject to currency fluctuation risk. These deferred gains will be recorded as an adjustment to Cost of Sales in the periods through October 2006, in which the sale or purchase of the related hedged item is recognized, as described above. Net losses on cash flow hedge instruments which we reclassified from Other Comprehensive Income to Cost of Sales in the quarters ended April 30,July 31, 2005 and 2004 were $212,000$5,000 and $598,000,$726,000, respectively.

We also enter into foreign currency forward exchange contracts to protect against the effects of foreign currency fluctuations on receivables and payables denominated in foreign currencies. These derivative instruments are not designated as hedges under Statement of Financial Accounting Standards No. 133, “Accounting Standards for Derivative Instruments and Hedging Activities” (SFAS 133), and, as a result, changes in fair value are reported currently as Other Income (Expense), Net in the Consolidated Statement of Operations consistent with the transaction gain or loss on the related foreign denominated receivable or payable. Such net transaction losses were $334,000$114,000 and $21,000$12,000 for the quarters ended April 30,July 31, 2005 and 2004, respectively.

At April 30,July 31, 2005, we had two stock-based compensation plans for employees and non-employee directors, which are described more fully in the notes to the consolidated financial statements included in our 2004 annual report on Form 10-K. We account for those plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. No stock based compensation cost is reflected in net earnings related to those plans, except for certain non-qualified options subject to variable plan accounting, as all stock options granted had exercise prices equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net earnings and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock Based Compensation,” to the above plans.

Basic and diluted earnings per common share are based on the weighted average number of our shares of common stock outstanding. Diluted earnings per common share give effect to outstanding stock options using the treasury method. The impact of stock options for the three months ended April 30,July 31, 2005 and 2004 was 177,000173,000 and 281,000,322,000, respectively.

The allowance for doubtful accounts was $755,000$790,000 as of April 30,July 31, 2005 and $723,000 as of October 31, 2004.

Inventories, priced at the lower of cost (first-in, first-out method) or market, are summarized below (in thousands):

We operate in a single segment: industrial automation systems.Wesystems. We design and produce computerized machine tools, interactive computer control systems and software for sale through our distribution network to the worldwide metal working market. We also provide software options, computer control upgrades, accessories and replacement parts for our products, as well as customer service and training support.

On November 23, 2004, we entered into a separation and release agreement with Roger J. Wolf, who retired from his position as Senior Vice President and as Chief Financial Officer. Under the agreement, we will pay Mr. Wolf severance compensation totaling $465,000.

A rollforward of the severance accrual follows (in thousands):

From time to time, our European subsidiaries guarantee third party lease financing residuals in connection with the sale of certain machines in Europe. At April 30,July 31, 2005 there were 3436 third party guarantees totaling approximately $1.8$1.6 million. A retention of title clause allows us to obtain the machine if the customer defaults on its lease. We believe that the proceeds obtained from liquidation of the machine would exceed our exposure.

We provide warranties on our products with respect to defects in material and workmanship. The terms of these warranties are generally one year for machines and shorter periods for service parts. We recognize a reserve with respect to this obligation at the time of product sale, with subsequent warranty claims recorded against the reserve. The amount of the warranty reserve is determined based on historical trend experience and any known warranty issues that could cause future warranty costs to differ from historical experience.

A reconciliation of the changes in our warranty reserve is as follows (in thousands):

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto appearing elsewhere herein. Certain statements made in this report, including our expectations regarding capital expenditures working capital and expected cash flows, may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These factors include, among others, changes in general economic and business conditions that affect market demand for machines tools, and related computer control systems, software products, and replacement parts, changes in manufacturing markets, adverse currency movements, innovations by competitors, quality and delivery performance by our contract manufacturersforeign subsidiaries and affiliates and component suppliers, and governmental actions and initiatives including import and export restrictions and tariffs.

Hurco Companies, Inc. is an industrial technology company. We design and produce computerized machine tools, featuring our proprietary computer control systems and software, for sale through our own distribution network to the worldwide metal working market. We also provide software options, control upgrades, accessories and replacement parts for our products, as well as customer service and training support.

Our computerized metal cutting machine tools are manufactured in Taiwan to our specifications by our wholly owned subsidiary, Hurco Manufacturing Limited (HML), and an affiliate. We sell our products through approximately 230 independent agents and distributors in approximately 50 countries throughout North America, Europe and Asia. We also have our own direct sales and service organizations in England, France, Germany, Italy, Singapore and China.

The machine tool industry is highly cyclical and changes in demand can occur abruptly. From 1998 through the third quarter of fiscal 2003, we experienced the adverse effects of a significant decline in global demand. We have introduced new product models beginning in late fiscal 2002 and throughoutcontinuing through fiscal 2003 and 2004. When worldwide manufacturing activity, along with demand for machine tools, increased in late fiscal 2003, our sales increased significantly. Those trends werehave continued through the secondthird quarter of fiscal 2005. As a result, we reported our highest amounts for sales and service fees and new order bookings.

Approximately 80% of worldwide demand for machine tools (measured in U.S. dollars) comes from outside the United States. During the secondthird quarter of fiscal 2005, approximately 68%66% of our sales and service fees were attributable to customers located abroad. Our sales to foreign customers are denominated, and payments by those customers are made, in the prevailing currencies—primarily the Euro and Pound Sterling—in the countries in which those customers are located, and our product costs are incurred and paid primarily in the New Taiwan Dollar and U.S. dollars. Changes in currency exchange rates can have a material effect on our operating results when sales made and expenses incurred in foreign currencies are translated to U.S. dollars for financial reporting purposes. For example, when a foreign currency increases in value relative to the U.S. dollar, sales made (and expenses incurred) in that currency, when translated to U.S. dollars for reporting in our financial statements, arewould be higher than would be the case when that currency has a lower value relative to the U.S. dollar. For this reason, in our comparison of period-to-period results, we customarily set forth not only the increases or decrease in those results as reported in our financial statements (which reflect translation to U.S. dollars at actual prevailing exchange rates), but also the impact of foreign currency-denominated revenue or expense translated to U.S. dollars at the same rate of exchange in both periods. Foreign currency translation had no impact on the third quarter results compared to the prior year, as exchange rates were not significantly different during the period. Foreign currency translation did have a significant impact on the nine months year to date results because there was a material difference in exchange rates during the first six months of fiscal 2005 compared to the prior year.

Although ourOur high levels of foreign manufacturing and sales also subject us to cash flow risks due to fluctuating currency exchange rates, werates. We mitigate those risks through the use of various hedging instruments - principally foreign currency forward exchange contracts.

The volatility of demand for machine tools can significantly impact our working capital requirements and, therefore, our cash flow from operations and operating profits. Because our products are manufactured in Taiwan, manufacturing and ocean transportation lead times require that we schedule machine tool production based on forecasts of customer orders for a future period of four or five months. We monitor market and order activity levels and rebalance our future production schedules to changes in demand. Nevertheless a significant unexpected decline in customer orders from forecasted levels would temporarily increase finished goods inventories and our need for working capital.

We monitor the U.S. machine tool market activity as reported by the Association of Manufacturing Technology (AMT), the primary industry group for U.S. machine tool consumption. We also monitor the PMI (formerly called the Purchasing Manager’s Index), as reported by the Institute for Supply Management. Our European and Asian subsidiaries monitor machine tool consumption through various government and trade publications.

We monitor key performance indicators such as days sales outstanding for accounts receivable and inventory turns for the trailing twelve months. We calculate net assets per dollar of revenue to assess our working capital levels. We also monitor operating income and selling, general and administrative expenses as a percentage of sales and service fees.

For the secondthird quarter of fiscal 2005, we reported net income of $3.3$2.9 million, or $.52$.45 per share, compared to $1.7$1.6 million, or $.29$.25 per share, for the corresponding period one year ago.

As noted below, approximately 62%56% of our sales and service fees in the secondthird quarter of fiscal 2005 were derived from European markets. The weighted average exchange rate between the Euro and the U.S. dollar during the secondthird quarter of fiscal 2005 was $1.30 per €1.00, as compared to $1.22 per €1.00 fornot significantly different than in the secondthird quarter of fiscal 2004 an increaseand as a result, the impact of 7%. Approximately $1.2 million (18%) of the increase in totalforeign currency translation on sales and service feesduring this period was attributable to changes in foreign currency exchange rates when sales denominated in foreign currencies are translated to U.S. dollars for financial reporting purposes.not significant.

The following tables set forth sales and service fees by geographic region and product category for the secondthird quarter of 2005 and 2004:

The 27% increase in sales and service fees in EuropeAsia Pacific reflected an 18%a 44% increase in unit sales. The increase was fueled by sales and the previously discussed impact of stronger European currencies relative to the U.S. Approximately $1.1 million (27%) of the increase in Europeannew lathe product line and increased sales and service fees was attributable to changes in currency exchange rates.mainland China.

For the first halfnine months of fiscal 2005, we reported net income of $6.3$9.2 million or $1.00$1.46 per share, compared to $2.4$4.0 million, or $.41$.67 per share, for the prior year period.

Approximately 62%60% of our sales and service fees in the first halfnine months of fiscal 2005 were derived from European markets. The weighted average exchange rate between the Euro and the U.S. dollar during the first halfnine-months of fiscal 2005 was $1.31$1.28 per €1.00, as compared to $1.22 per €1.00 for the first halfnine months of fiscal 2004, an increase of 7%6%. Approximately $2.7 million (19%(14%) of the increase in sales and service fees was attributable to changes in currency exchange rates.

The following tables set forth sales and service fees by geographic region and product category for the first halfnine months of 2005 and 2004: