Perma-Pipe International Holdings, Inc. - Quarter Report: 2005 October (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

PART I – FINANCIAL INFORMATION

The accompanying interim condensed consolidated financial statements of MFRI, Inc. and subsidiaries (the “Company”) are unaudited, but include all adjustments which the Company’s management considers necessary to present fairly the financial position and results of operations for the periods presented. These adjustments consist of normal recurring adjustments. Certain information and footnote disclosures have been condensed or omitted pursuant to Securities and Exchange Commission rules and regulations. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended January 31, 2005. Reclassifications have been made in prior year financial statements to conform to the current year presentation. The results of operations for the quarter ended October 31, 2005 are not necessarily indicative of the results to be expected for the full year ending January 31, 2006. One of the reasons for this is that, generally, sales of the Company’s piping systems have had a tendency to be lower during the winter months, due to weather constraints over much of the northern hemisphere.

MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands except per share information)

See notes to condensed consolidated financial statements.

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MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

See notes to condensed consolidated financial statements.

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MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See notes to condensed consolidated financial statements.

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MFRI, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

OCTOBER 31, 2005

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Employer contributions remaining for fiscal year ending January 31, 2006 are expected to be $23,693. In August 2005 a $23,693 contribution was made, and in October 2005 a $45,584 contribution was made.

As of December 9, 2005 a total of 36,576 stock options were exercised since February 1, 2005.

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Accumulated other comprehensive income presented on the accompanying condensed consolidated balance sheets consists of the following:

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10.   In May 2005, SFAS No. 154, “Accounting Changes and Error Corrections” (a replacement of APB Opinion No. 20 and SFAS No. 3) was issued. Statement 154 requires that all voluntary changes in accounting principles and changes required by a new accounting pronouncement that do not include specific transition provisions be applied retrospectively to prior periods’ financial statements, unless it is impracticable to do so. Opinion 20 required that most voluntary changes in accounting principle be recognized by including the cumulative effect of changing to the new accounting principle as a component of net income in the period of change. Statement 154 is effective prospectively for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with earlier application encouraged. Earlier application is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date the Statement was issued (May 2005). Statement 154 does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of the Statement. Accordingly, the Company will implement the provisions of this accounting pronouncement in the fiscal reporting period ending January 31, 2007. The impact on the Company is not expected to be material.

In April 2005, the SEC announced the adoption of a new rule that amends the compliance dates for Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (Statement No. 123R). Under Statement No. 123R, the Company would have been required to implement the standard as of the beginning of the first interim or annual period that begins after June 15, 2005, or in the interim reporting period ending October 31, 2005. The SEC’s new rule allows the Company to implement Statement No. 123R at the beginning of its next fiscal year, and accordingly, the Company will begin to reflect the adjustment to earnings for the impact of this accounting pronouncement in the interim reporting period ending April 30, 2006. The impact on the Company in the future is not expected to be material.

On December 5, 2005, the Board of Directors of MFRI, Inc. (the “Company”) approved the acceleration of the vesting requirements for “out-of-the-money” stock options previously granted to employees, including its officers, pursuant to the 2004 Stock Incentive Plan, and “out-of-the-money” stock options previously granted to independent directors pursuant to the 2001 Independent Directors Stock Option Plan. The primary purpose of the acceleration is to eliminate reportable compensation expense the Company would recognize in future periods in its statements of operations upon its adoption of FASB Statement No. 123R (“Share-Based Payments”) in the year beginning February 1, 2006. The Company anticipates that such acceleration of vesting will reduce its pre-tax stock option compensation expense in each of the years 2006 through 2009 by approximately $109,000, or $.02 per share. A Form 8-K was filed on December 9, 2005.

On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (“the Act”). The Act provides a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010. In return, the Act also provides for a two-year phase-out (except for certain pre-existing binding contracts) of the existing Extraterritorial Income (“ETI”) exclusion tax benefit for foreign sales which the World Trade Organization (“WTO”) ruled was an illegal export subsidy. The European Union (“EU”) believes that the Act fails to adequately repeal the illegal export subsidies because of the transitional provisions and has asked the WTO to review whether these transitional provisions are in compliance with their prior ruling. This will have no material impact on the Company. Additionally, the Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividend received deduction for certain dividends from controlled foreign corporations. The impact on the Company is not expected to be material.

On December 21, 2004, the Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” was issued. FSP FAS 109-1 clarifies that this tax deduction should be accounted for as a special deduction in accordance with Statement 109. As such, the special deduction has no effect on deferred tax assets and liabilities existing at the date of enactment. Rather, the impact of this deduction would be reported in the period in which the deduction is claimed on the Company’s tax return beginning in 2005. As regulations are still

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pending, the Company has not been able to quantify the impact, however, but believes that the impact is not expected to be material.

On July 11, 2002, the Company entered into a secured loan and security agreement with a financial institution (“Loan Agreement”). Under the terms of the Loan Agreement as amended through March 31, 2005, which matures on November 30, 2007, the Company can borrow under a revolving line of credit $27,000,000, subject to borrowing base and other requirements. Interest rates generally are based on options selected by the Company as follows: (a) a margin in effect plus a prime rate; or (b) a margin in effect plus the LIBOR rate (“LIBOR Margin”) for the corresponding interest period. At October 31, 2005, the prime rate was 6.75%, and the margin added to the LIBOR rate, which is determined each quarter based on the applicable financial statement ratio, was 2.00 percentage points. Monthly interest payments were made. As of October 31, 2005, the Company had borrowed $12,348,000 and had $3,948,000 available to it under the revolving line of credit. In addition, $3,796,600 of availability was used under the Loan Agreement primarily to support letters of credit to guarantee amounts owed for an Industrial Revenue Bond borrowing. The Loan Agreement provides that all payments by the Company’s customers are deposited in a bank account from which all funds may only be used to pay the debt under the Loan Agreement. At October 31, 2005, the amount of restricted cash was $749,000. Cash required for operations is provided by draw-downs on the line of credit.

At September 12, 2005 the Company entered into an interest rate swap agreement through November 28, 2008 under which the interest rate on $8,000,000 is fixed at 4.72% plus LIBOR Margin.

The statements contained under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and certain other information contained elsewhere in this report, which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “continue,” “remains,” “intend,” “aim,” “should,” “prospects,” “could,” “future,” “potential,” “believes,” “plans,” “likely,” and “probable,” or the negative thereof or other variations thereon or comparable terminology, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the safe harbors created thereby. These statements should be considered as subject to the many risks and uncertainties that exist in the Company’s operations and business environment. Such risks and uncertainties could cause actual results to differ materially from those projected. These uncertainties include, but are not limited to, economic conditions, market demand and pricing, competitive and cost factors, raw material availability and prices, global interest rates, currency exchange rates, labor relations and other risk factors.

RESULTS OF OPERATIONS

MFRI, Inc.

Generally, sales of the Company’s piping systems have had a tendency to be lower during the winter months, due to weather constraints over much of the northern hemisphere.

Three months ended October 31

Net sales of $39,384,000 for the quarter decreased 0.8% from $39,708,000 for the comparable quarter in the prior year. (See following discussion of each business segment.)

Gross profit of $9,263,000 increased 1.1% from $9,164,000 in the prior year quarter, and gross margin increased to 23.5% of net sales in the current year quarter from 23.1% of net sales in the prior year quarter. (See following discussion of each business segment.)

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Net income declined to $857,000 in the current quarter from $1,614,000 in the prior year quarter. The decrease in net income was due to increased selling expense and general administrative expense. Selling expense increased for additional headcount. General administrative expense increased primarily due to start up costs described in the Piping Systems Business section of this report, and costs and operations interruption related to Hurricane Rita. The plant located in New Iberia, LA suffered damage of $143,000 and was not operational for most of October. Other general administrative expense increases included professional services expenses, use of consultants, and SOX404 compliance related spending of $250,000. (See following discussion of each business segment.)

Nine months ended October 31

Net sales of $116,277,000 for the nine months increased 5.8% from $109,904,000 for the comparable period in the prior year. (See following discussion of each business segment.)

Gross profit of $26,447,000 increased 10.1% from $24,022,000 for the comparable period in the prior year, and gross margin increased to 22.7% of net sales in the current year from 21.9% of net sales in the prior year. (See following discussion of each business segment.)

Net income declined to $1,862,000 for the nine months from $2,653,000 for the comparable period in the prior year. The decrease in net income was due to increased general administrative expense primarily due to increased professional services expenses, use of consultants, start up costs described in the Piping Systems Business section of this report, and costs and operational interruption related to Hurricane Rita. (See following discussion of each business segment.)

Filtration Products Business

Three months ended October 31

Net sales for the quarter increased 12.5% to $15,832,000 from $14,067,000 for the comparable quarter in the prior year. This increase was primarily due to higher sales of filter elements.

Gross profit as a percent of net sales decreased to 20.7% in the current year from 23.0% in the prior year primarily as a result of product mix.

Selling expense increased to $1,682,000 or 10.6% of net sales from $1,377,000 or 9.8% of net sales for the comparable quarter last year. The increase is primarily due to additional headcount and increased travel.

General and administrative expenses decreased to $736,000 or 4.6% of net sales in the current year quarter from $801,000 or 5.7% of net sales in the prior year quarter. The decrease is primarily due to a decrease in bank fees due to the redemption of the Industrial Revenue Bonds in September 2004, and decrease in professional services expenses.

Nine months ended October 31

Net sales for the nine months increased 4.5% to $47,789,000 from $45,733,000 for the comparable period in the prior year. This increase is primarily due to improved conditions in the markets.

Gross profit as a percent of net sales remained at 20.5%, primarily as a result of improved manufacturing efficiency on slightly higher unit volume partially offsetting increased raw material costs.

Selling expense for the nine months increased to $4,613,000 or 9.7% of net sales from $4,171,000 or 9.1% of net sales for the comparable period in the prior year. The increase is primarily due to additional headcount and increased travel.

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General and administrative expenses increased to $2,447,000 or 5.1% of net sales in the current year period from $2,361,000 or 5.2% of net sales in the prior year. This dollar increase is primarily due to increased professional services expenses.

Piping Systems Business

Generally, sales of the Company’s piping systems have had a tendency to be lower during the winter months, due to weather constraints over much of the northern hemisphere.

Three months ended October 31

Net sales decreased 26.1% to $13,704,000 in the current quarter from $18,544,000 in the prior year quarter. This decrease was primarily due to the installation season ending earlier than in the prior year. In addition, the Oil & Gas operation in Louisiana was disrupted for most of October due to Hurricane Rita

Gross profit as a percent of net sales increased to 22.7% from 20.3% due to improvements in product mix.

Selling expense decreased to $299,000 or 2.2% of net sales in the current year quarter from $333,000 or 1.8% of net sales for the prior year quarter. The dollar decrease was primarily due to lower headcount in the quarter.

General and administrative expense increased to $1,235,000 or 9.0% of net sales in the current year quarter from $1,024,000 or 5.5% of net sales for the prior year quarter. In September, 2005 the Company announced that its Piping Systems Business had established a new company, Perma-Pipe Middle East, FZE, (PPME), in the United Arab Emirates. The company will manufacture specialty pre-insulated piping systems for Dubai, other parts of the United Arab Emirates, and other markets in the region. The increase in general and administrative expense was primarily due to $292,000 in start up costs related to PPME. The plant located in New Iberia, LA suffered damage of $143,000 and was not operational for most of October.

Nine months ended October 31

Net sales of $42,738,000 for the nine months increased 0.5% from $42,531,000 for the comparable period in the prior year.

Gross profit as a percent of net sales increased to 21.8% from 19.8%, mainly due to higher margin jobs and managing the price of steel in contracts.

Selling expense increased to $1,028,000 or 2.4% of net sales in the current year period from $932,000 or 2.2% of net sales in the prior year period. The increase is primarily due to additional headcount early in the year.

General and administrative expense increased to $3,458,000 or 8.1% of net sales in the current year period, compared with $2,829,000 or 6.7% of net sales in the prior year period. The increase in general and administrative expense was primarily due to start up costs of $385,000 related to PPME. The plant located in New Iberia, LA suffered damage of $143,000 and was not operational for most of October.

Industrial Process Cooling Equipment Business

Three months ended October 31

Net sales of $9,848,000 for the quarter increased 38.8% from $7,097,000 for the comparable quarter in the prior year. The increase was due primarily to improved conditions in domestic plastic molding and printing markets.

Gross profit decreased to 29.2% of net sales from 30.3% of net sales in the prior year quarter, primarily due to pricing pressure in international markets and material cost increases.

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Selling expense increased to $1,172,000 or 11.9% of net sales in the current year quarter from $874,000 or 12.3% of net sales in the prior year quarter. The dollar increase was due to additional headcount and higher commissions due to increased sales.

General and administrative expense increased to $1,029,000 or 10.5% of net sales from $828,000 or 11.7% of net sales in the prior year quarter. This dollar increase was primarily due to increased professional services expenses and use of consultants to implement production planning systems.

Nine months ended October 31

Net sales of $25,750,000 for the nine months increased 19.0% from $21,640,000 for the comparable period in the prior year, mainly due to improved conditions in all domestic markets.

Gross margin decreased to 28.6% of net sales from 28.9% of net sales in the prior year, primarily due to pricing pressure in international markets and material cost increases.

Selling expense increased to $3,145,000 or 12.2% of net sales in the current year period from $2,586,000 or 12.0% of net sales in the prior year. The increase is primarily due to additional headcount and higher commissions associated with increased sales.

General and administrative expense increased to $2,976,000 or 11.6% of net sales in the current year period from $2,431,000 or 11.2% of net sales in the prior year. This increase is due to increased professional services expenses and use of consultants to implement production planning systems.

General Corporate Expense

General corporate expense included interest expense and general and administrative expenses that were not allocated to the business segments.

Three months ended October 31

General and administrative expense decreased to $1,417,000 or 3.6% of net sales in the current year quarter from $1,446,000 or 3.6% of net sales in the prior year quarter. The dollar decrease was mainly due to decrease in group insurance expense.

Interest expense increased to $496,000 for the current year quarter from $456,000 in the prior year quarter. The increase was primarily due to the increase in interest rates.

Nine months ended October 31

General and administrative expense increased to $4,894,000 in the current year nine-month period from $3,879,000 in the prior year period, and increased as a percentage of net sales to 4.2% in the current year period from 3.5% in the prior year period. The increase is mainly due to expenses incurred to comply with Sarbanes-Oxley including consulting fees and additional headcount.

Interest expense increased to $1,360,000 for the current year period from $1,331,000 for the comparable period in the prior year. The increase is primarily due to the increase in interest rates.

Taxes on earnings reflected the estimated annual effective rates for the period ended October 31, 2005. The 31% effective tax rate for the nine months ended October 31 was less than the statutory U.S. federal income tax rate principally due to a research and development tax credit, state net operating losses not previously benefited, and the benefit of lower statutory tax rates in foreign jurisdictions.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents as of October 31, 2005 were $753,000 as compared to $723,000 at January 31, 2005. The Company used $2,305,000 from operations during the first nine months. Operating cash flows increased by

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$3,683,000 from the same period in the prior year. A cash distribution of $270,000 was received from the Company’s investment in a joint venture. Net borrowings of $1,572,000 from the Company’s credit facility, and operating cashflow were used to support $3,936,000 in capital spending. Exercise of stock options resulted in $106,000 of cash inflow.

Trade receivables increased $1,735,000 and inventories increased $671,000 from January 31, 2005 due to increased production and sales. Other operating assets and liabilities decreased $1,356,000 from January 31, 2005.

Net cash used for investing activities for the nine months ended October 31, 2005 was $3,602,000. Current year capital expenditures included construction of a warehouse and equipment purchases. Capital expenditures increased $2,924,000 from the prior year period. Proceeds from sale of property and equipment decreased $1,747,000 from the prior year. On June 17, 2004, the Company sold one of its buildings located in Winchester, Virginia. The building sold consisted of 66,998 square feet on 10 acres. The Company is leasing from the Buyer approximately 12,000 square feet of the building. There was not a material gain or loss on the sale.

Debt totaled $28,799,000, an increase of $1,260,000 since the beginning of the year. Net cash inflows from financing activities were $1,678,000, primarily as a result of borrowings of $37,015,000 and payments of $35,429,000. Exercise of stock options resulted in $106,000 of cash inflow.

The Company’s working capital was approximately $28,815,000 at October 31, 2005 compared to approximately $26,332,000 at January 31, 2005. The change was primarily due to the increase in accounts receivable and the decrease in accounts payable.

The Company’s current ratio was 2.2 to 1 for October 31, 2005 and 2.0 to 1 for January 31, 2005, respectively. Debt to total capitalization at October 31, 2005 and January 31, 2005 was 46.8%.

At October 31, 2005, the Company was in compliance with covenants under the Loan Agreement as defined below.

On July 11, 2002, the Company entered into a secured loan and security agreement with a financial institution (“Loan Agreement”). Under the terms of the Loan Agreement as amended through March 31, 2005, which matures on November 30, 2007, the Company can borrow under a revolving line of credit $27,000,000, subject to borrowing base and other requirements. Interest rates generally are based on options selected by the Company as follows: (a) a margin in effect plus a prime rate; or (b) a margin in effect plus the LIBOR rate (“LIBOR Margin”) for the corresponding interest period. At October 31, 2005, the prime rate was 6.75%, and the margin added to the LIBOR rate, which is determined each quarter based on the applicable financial statement ratio, was 2.00 percentage points. Monthly interest payments were made. As of October 31, 2005, the Company had borrowed $12,348,000 and had $3,948,000 available to it under the revolving line of credit. In addition, $3,796,600 of availability was used under the Loan Agreement primarily to support letters of credit to guarantee amounts owed for an Industrial Revenue Bond borrowing. The Loan Agreement provides that all payments by the Company’s customers are deposited in a bank account from which all funds may only be used to pay the debt under the Loan Agreement. At October 31, 2005, the amount of restricted cash was $749,000. Cash required for operations is provided by draw-downs on the line of credit.

At September 12, 2005 the Company entered into an interest rate swap agreement through November 28, 2008 under which the interest rate on $8,000,000 is fixed at 4.72% plus LIBOR Margin.

ACCOUNTING PRONOUNCEMENTS

In May 2005, SFAS No. 154, “Accounting Changes and Error Corrections” (a replacement of APB Opinion No. 20 and SFAS No. 3) was issued. Statement 154 requires that all voluntary changes in accounting principles and changes required by a new accounting pronouncement that do not include specific transition provisions be applied retrospectively to prior periods’ financial statements, unless it is impracticable to do so. Opinion 20 required that most voluntary changes in accounting principle be recognized by including the cumulative effect

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of changing to the new accounting principle as a component of net income in the period of change. Statement 154 is effective prospectively for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with earlier application encouraged. Earlier application is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date the Statement was issued (May 2005). Statement 154 does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of the Statement. Accordingly, the Company will implement the provisions of this accounting pronouncement in the fiscal reporting period ending January 31, 2007. The impact on the Company is not expected to be material.

In April 2005, the SEC announced the adoption of a new rule that amends the compliance dates for Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (Statement No. 123R). Under Statement No. 123R, the Company would have been required to implement the standard as of the beginning of the first interim or annual period that begins after June 15, 2005, or in the interim reporting period ending October 31, 2005. The SEC’s new rule allows the Company to implement Statement No. 123R at the beginning of its next fiscal year, and accordingly, the Company will begin to reflect the adjustment to earnings for the impact of this accounting pronouncement in the interim reporting period ending April 30, 2006. The impact on the Company is not expected to be material.

On December 5, 2005, the Board of Directors of MFRI, Inc. (the “Company”) approved the acceleration of the vesting requirements for “out-of-the-money” stock options previously granted to employees, including its officers, pursuant to the 2004 Stock Incentive Plan, and “out-of-the-money” stock options previously granted to independent directors pursuant to the 2001 Independent Directors Stock Option Plan. The primary purpose of the acceleration is to eliminate reportable compensation expense the Company would recognize in future periods in its statements of operations upon its adoption of FASB Statement No. 123R (“Share-Based Payments”) in the year beginning February 1, 2006. The Company anticipates that such acceleration of vesting will reduce its pre-tax stock option compensation expense in each of the years 2006 through 2009 by approximately $109,000, or $.02 per share. A Form 8-K was filed on December 9, 2005.

On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (“the Act”). The Act provides a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010. In return, the Act also provides for a two-year phase-out (except for certain pre-existing binding contracts) of the existing Extraterritorial Income (“ETI”) exclusion tax benefit for foreign sales which the World Trade Organization (“WTO”) ruled was an illegal export subsidy. The European Union (“EU”) believes that the Act fails to adequately repeal the illegal export subsidies because of the transitional provisions and has asked the WTO to review whether these transitional provisions are in compliance with their prior ruling. This will have no material impact on the Company. Additionally, the Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividend received deduction for certain dividends from controlled foreign corporations. The impact on the Company is not expected to be material.

The Company was subject to market risk associated with changes in foreign currency exchange rates and interest rates. Foreign currency exchange rate risk was mitigated through maintenance of local production facilities in the markets served, invoicing of customers in the same currency as the source of the products and use of foreign currency denominated debt in Denmark. The Company also utilized foreign currency forward contracts to reduce exposure to exchange rate risks. The forward contracts were short-term in duration, generally one year or less. The major currency exposure hedged by the Company was the Canadian dollar. The contract amounts, carrying amounts and fair values of these contracts were not significant at October 31, 2005 or January 31, 2005.

The changeover from national currencies to the Euro began on January 1, 2002 and has not materially affected, the Company’s foreign currency exchange risk profile, although some customers may require the Company to invoice or pay in Euros rather than the functional currency of the manufacturing entity.

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The Company entered into an interest rate swap agreement to reduce its exposure to market risks from changing interest rates under the revolving credit agreement. Under the terms of the swap agreement, the Company agreed to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to the notional principal amount. Any differences paid or received on the interest rate swap agreements are recognized as adjustments to interest expense over the life of the swap, thereby adjusting the effective interest rate on the underlying obligation. Financial instruments are not held or issued for trading purposes. In order to obtain hedge accounting treatment, any derivatives used for hedging purposes must be designated as, and effective as, a hedge of an identified risk exposure at the inception of the contract. Accordingly, changes in the fair value of the derivative contract must be highly correlated with changes in the fair value of the underlying hedged item at inception of the hedge and over the life of the hedge contract.

At October 31, 2005 one interest rate swap agreement was in effect with a notional value of $8,000,000 maturing in 2008. The swap agreement exchanges the variable rate to fixed interest rate payments of 4.72% plus LIBOR margin. The interest rate swap was effective as a cash flow hedge and no charge to earnings was required during the quarter ended October 31, 2005. The fair value of the derivative financial instrument was $6,536 at October 31, 2005. At October 31, 2005 $4,300, net of deferred tax benefits of $2,200, was recorded in other assets and accumulated other comprehensive income associated with the cash flow hedge.

Commodity price risk is the possibility of higher or lower costs due to changes in the prices of commodities, such as ferrous alloys (e.g., steel) which are used in the production of the piping systems. The Company attempted to mitigate such risks by obtaining price commitments from its commodity suppliers and, when it appeared appropriate, purchasing quantities in advance of likely price increases.

As of October 31, 2005, the Company carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed in the Company’s periodic SEC filings. There have been no changes in the Company’s internal controls over financial reporting during the fiscal quarter to which this report relates that have materially affected or are reasonably likely to affect the Company’s internal controls over financial reporting.

PART II – OTHER INFORMATION

Item 6. Exhibits.

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SIGNATURES

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

MFRI, INC.

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