Perma-Pipe International Holdings, Inc. - Quarter Report: 2005 July (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 July 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 country.

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.

2

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)

JULY 31, 2005

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Employer contributions remaining for fiscal year ending January 31, 2006 are expected to be $92,970. In July 2005, a $23,693 contribution was made.

As of September 10, 2005 a total of 36,038 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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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.

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 in the future will not 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 pending, the Company has not been able to quantify the impact, however, but believes that the impact will not be material.

In May 2005, the U.S. Treasury Department and the Internal Revenue Service issued a notice that provides detailed tax guidance for U.S. companies that elect to repatriate earnings from foreign subsidiaries subject to the temporary tax rate available under AJCA. On December 21, 2004, FSP FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” was issued. FSP 109-2 provides companies additional time, beyond the financial reporting period during which the Act took effect, to evaluate the Act’s impact on a company’s plan for reinvestment or repatriation of certain foreign earnings for purposes of applying Statement 109. FSP 109-2 was effective upon issuance. As of July 31, 2005, management had not decided on whether, and to what extent the Company might repatriate foreign earnings, and accordingly, the financial statements do not reflect any provisions for taxes on unremitted foreign earnings.

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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 July 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 for the corresponding interest period. At July 31, 2005, the prime rate was 6.25%, 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 July 31, 2005, the Company had borrowed $14,815,000 and had $2,864,000 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 July 31, 2005, the amount of restricted cash was $880,000. Cash required for operations is provided by draw-downs on the line of credit.

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 country.

Three months ended July 31

Net sales of $40,691,000 for the quarter increased 6.9% from $38,068,000 for the comparable quarter in the prior-year. (See discussion of each business segment below.)

Gross profit of $9,207,000 increased 2.8% from $8,952,000 in the prior-year quarter, and gross margin decreased to 22.6% of net sales in the current year from 23.5% of net sales in the prior-year. (See discussion of each business segment below.)

Net income declined to $711,000 in the current quarter from $1,369,000 in the prior-year quarter. The decrease in net income was due to increased general administrative expense primarily due to increased professional services expenses and use of consultants. (See discussion of each business segment below.)

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Six months ended July 31

Net sales of $76,893,000 for the six months increased 9.5% from $70,196,000 for the comparable period in the prior year. (See discussion of each business segment below.)

Gross profit of $17,184,000 increased 15.7% from $14,858,000 for the comparable period in the prior year, while gross margin increased to 22.3% of net sales in the current year from 21.2% of net sales in the prior year. (See discussion of each business segment below.)

Net income declined to $1,005,000 for the six months from $1,040,000 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 and use of consultants. (See discussion of each business segment below.)

Filtration Products Business

Three months ended July 31

Net sales for the quarter decreased 2.9% to $14,921,000 from $15,370,000 for the comparable quarter in the prior-year. This decrease was primarily due to lower sales in filter bags and related service work.

Gross profit as a percent of net sales increased to 21.9% in the current year from 21.1% in the prior-year primarily as a result of improved manufacturing efficiency and a favorable product mix.

Selling expense increased to $1,474,000 or 9.9% of net sales from $1,363,000 or 8.9% 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 $874,000 or 5.9% of net sales in the current-year quarter from $894,000 or 5.8% of net sales in the prior-year quarter. The decrease is primarily due to a decrease in legal expenses.

Six months ended July 31

Net sales for the six months increased 0.9% to $31,958,000 from $31,666,000 for the comparable period in the prior year. This increase is primarily due to improved conditions in the domestic steel industry during the first quarter.

Gross profit as a percent of net sales increased to 20.3% in the current year from 19.3% in the prior year, primarily as a result of improved manufacturing efficiency on slightly higher unit volume.

Selling expense for the six months increased to $2,931,000 or 9.2% of net sales from $2,795,000 or 8.8% of net sales for the comparable period in the prior year. The increase is primarily due to additional headcount and increased travel.

General and administrative expenses increased to $1,712,000 or 5.4% of net sales in the current year period from $1,561,000 or 4.9% of net sales in the prior-year. This 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 country.

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Three months ended July 31

Net sales increased 18.2% to $17,727,000 in the current quarter from $14,997,000 in the prior-year quarter. This increase was primarily due to high unit volumes.

Gross profit as a percent of net sales decreased to 21.3% from 22.9% due to slightly lower margins on jobs.

Selling expense increased to $337,000 or 1.9% of net sales in the current year quarter from $276,000 or 1.8% of net sales for the prior-year quarter. The increase was primarily due to higher commissions related to higher sales and a headcount addition.

General and administrative expense increased to $1,229,000 or 6.9% of net sales in the current year quarter from $1,038,000 or 6.9% of net sales for the prior-year quarter. The increase was primarily due to additional headcount, professional services and development expenses.

Six months ended July 31

Net sales of $29,033,000 for the six months increased 18.2% from $23,987,000 for the comparable period in the prior year. This increase is primarily due to some recovery from the weak economy.

Gross profit as a percent of net sales increased to 21.3% from 19.3%, mainly due to an increase in the price of steel.

Selling expense increased to $729,000 or 2.5% of net sales in the current year period from $599,000 or 2.5% of net sales in the prior year period. The dollar increase is primarily due to higher commissions related to higher sales and a headcount addition.

General and administrative expense increased to $2,223,000 or 7.7% net sales in the current year period, compared with $1,805,000 or 7.5% net sales in the prior year period. The increase is primarily due to higher incentive expenses, additional headcount and development expenses.

Industrial Process Cooling Equipment Business

Three months ended July 31

Net sales of $8,043,000 for the quarter increased 4.4% from $7,701,000 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 27.0% of net sales from 29.5% of net sales in the prior-year quarter, primarily due to pricing pressure in international markets and material cost increases.

Selling expense increased to $973,000 or 12.1% of net sales in the current-year quarter from $855,000 or 11.1% of net sales in the prior-year quarter. The increase was due to additional headcount and higher commissions due to increased sales.

General and administrative expense increased to $1,000,000 or 12.4% of net sales from $769,000 or 10.0% of net sales in the prior-year quarter. This dollar increase was primarily due to increased professional services expenses and use of consultants.

Six months ended July 31

Net sales of $15,902,000 for the six months increased 9.3% from $14,543,000 for the comparable period in the prior year, mainly due to improved conditions in all domestic markets.

Gross margin remained level at 28.2% of net sales.

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Selling expense increased to $1,973,000 or 12.4% of net sales in the current year period from $1,712,000 or 11.8% 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 $1,947,000 or 12.2% of net sales in the current year period from $1,603,000 or 11.0% 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 July 31

General and administrative expense increased to $1,840,000 or 4.5% of net sales in the current year quarter from $1,245,000 or 3.3% of net sales in the prior-year quarter. The increase was mainly due to expenses incurred to comply with Sarbanes-Oxley including consulting fees and additional headcount.

Interest expense increased to $478,000 for the current year quarter from $455,000 in the prior-year quarter. The increase was primarily due to the increase in the prime interest rate.

Six months ended July 31

General and administrative expense increased from $2,434,000 in the prior year period to $3,476,000 in the current-year six-month period, and increased as a percentage of net sales from 3.5% in the prior year period to 4.5% in the current year period. The increase is mainly due to expenses incurred to comply with Sarbanes-Oxley including consulting fees and additional headcount.

Interest expense decreased to $864,000 for the current year period from $875,000 for the comparable period in the prior year. The decrease is primarily due to a repayments of debt at 10% per annum and the sale of a building in Winchester, Virginia in June 2004.

Taxes on earnings reflect the estimated annual effective rates for the period ended July 31, 2005. The 29% effective tax rate for the six months ended July 31 is less than the statutory U.S. federal income tax rate and less than the prior-year quarter’s of 41% principally due to the benefit of lower statutory tax rates in the foreign jurisdictions.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents as of July 31, 2005 were $476,000 as compared to $723,000 at January 31, 2005. The Company used $2,533,000 from operations during the first six months. Operating cash flows decreased by $284,000 from the same period in the prior-year. A cash distribution of $195,000 was received from the Company’s investment in a joint venture. Net borrowings of $4,444,000 from the Company’s credit facility, were used to support $2,101,000 in capital spending. Exercise of stock options resulted in $91,000 of cash inflow.

Trade receivables increased $1,775,000 and inventories increased $1,201,000 from January 31, 2005 due to increased production and sales. Prepaid expenses and other current assets increased $546,000 due to a premium on property insurance paid and increase relating to income taxes payable. Other operating assets and liabilities decreased $1,473,000 from January 31, 2005.

Net cash used for investing activities for the six months ended July 31, 2005 was $1,896,000. Current year capital expenditures included construction of a warehouse and equipment purchases. Capital expenditures increased $1,466,000 from the prior-year period. Proceeds from sale of property and equipment decreased

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$1,777,000 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 $31,707,000, an increase of $4,169,000 since the beginning of the year. Net cash inflows from financing activities were $4,535,000, primarily as a result of borrowings of $17,113,000 and payments of $12,669,000. Exercise of stock options resulted in $91,000 of cash inflow.

The following table summarizes the Company’s estimated contractual obligations, excluding the revolving lines of credit of 15,171,000 at July 31, 2005: