Perma-Pipe International Holdings, Inc. - Annual Report: 2006 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

FORM 10-K CONTENTS

JANUARY 31, 2006

PART I

Company Profile

MFRI, Inc. ("MFRI", the "Company" or the "Registrant") is engaged in the manufacture and sale of products in three distinct business segments: filtration products, piping systems and industrial process cooling equipment. As used herein, unless the context otherwise requires, the term “Company” includes MFRI and its subsidiaries, Midwesco Filter Resources, Inc., Perma-Pipe Inc., Thermal Care Inc., and their respective predecessors and subsidiaries.

The Filtration Products business segment manufactures and sells a wide variety of filter elements for air filtration and particulate collection systems. Air filtration systems are used in many industries in the United States and abroad to limit particulate emissions to comply with environmental regulations. The Filtration Products business segment markets air filtration-related products and accessories, and provides maintenance services, consisting primarily of dust collector inspection, filter cleaning and filter replacement.

The Piping System business segment engineers, designs, manufactures and sells specialty piping systems and leak detection and location systems. This segment’s specialty piping systems include (i) industrial and secondary containment piping systems for transporting chemicals, waste streams and petroleum liquids, (ii) insulated and jacketed district heating and cooling piping systems for efficient energy distribution to multiple locations from central energy plants, and (iii) oil and gas gathering flow lines and long lines for oil and mineral transportation. The Piping System business segment’s leak detection and location systems are sold as part of many of its piping systems products and on a stand-alone basis, to monitor areas where fluid intrusion may contaminate the environment, endanger personal safety, cause a fire hazard, impair essential services or damage equipment or property.

The Industrial Process Cooling Equipment business segment engineers, designs, manufactures and sells industrial process cooling equipment, including liquid chillers, mold temperature controllers, cooling towers, plant circulating systems, and related accessories for use in industrial process applications.

Additional information with respect to the Company's business segments is included in the following discussions of the separate business segments and in the financial statements and related notes thereto.

Filtration Products Business

Air Filtration and Particulate Collection Systems. Federal and state legislation and related regulations and enforcement have increased the demand for air filtration and particulate collection systems by requiring industry to meet primary and secondary ambient air quality standards for specific pollutants, including particulate. In certain manufacturing applications, particulate collection systems are an integral part of the production process. Examples of such applications include the production of cement, carbon black and industrial absorbents.

The principal types of industrial air filtration and particulate collection systems in use today are baghouses, cartridge collectors, electrostatic precipitators, scrubbers and mechanical collectors. This equipment is used to eliminate particulate from the air by passing particulate laden gases through fabric filters (filter bags) or pleated media filter elements, in the case of baghouses or cartridge collectors, and between electrically charged collector plates, in the case of electrostatic precipitators.

Products and Services. The Company manufactures and sells a wide variety of filter elements for cartridge collectors and baghouse air filtration and particulate collection systems. The Company manufactures filter elements in standard industry sizes, shapes and filtration media and to custom specifications, maintaining manufacturing standards for more than 10,000 styles of filter elements to suit substantially all industrial applications. Filter elements are manufactured from industrial yarn, fabric and papers purchased in bulk.   Most filter elements are produced from cellulose, acrylic, fiberglass, polyester, aramid or polypropylene fibers.

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 The Company also manufactures filter elements from more specialized materials, sometimes using special finishes.

The Company markets numerous filter-related products and accessories used during the installation, operation and maintenance of cartridge collectors and baghouses, including wire cages used to support filter bags, spring assemblies for proper tensioning of filter bags and clamps and hanger assemblies for attaching filter elements. In addition, the Company markets other hardware items used in the operation and maintenance of cartridge collectors and baghouses. The Company also provides maintenance services, consisting primarily of air filtration system inspection and filter element replacement, using a network of independent contractors. The sale of filter-related products and accessories, collector inspection, maintenance services and leak detection account for approximately 11% of the net sales of the Company's filtration products and services.

Over the past three years, the Company's Filtration Products Business has served more than 4,000 user locations. The Company has particular expertise in supplying filter bags for use with electric arc furnaces in the steel industry. The Company believes its production capacity and quality control procedures make it a leading supplier of filter bags to large users in the electric power industry. Orders from that industry tend to be substantial in size, but are usually at lower margins than other industries. In the fiscal year ended January 31, 2006, no customer accounted for 10% or more of net sales of the Company's filtration products and services.

Marketing. The customer base for the Company's filtration products and services is industrially and geographically diverse. These products and services are used primarily by operators of utility and industrial coal-fired boilers, incinerators and cogeneration plants and by producers of metals, cement, chemicals and other industrial products.

The Company has an integrated sales program for its Filtration Products Business, which consists of field-based sales personnel, manufacturers' representatives, a telemarketing operation and computer-based customer information systems containing data on nearly 18,000 user locations. These systems enable the Company's sales force to access customer information classified by industry, equipment type, operational data and the Company's quotation and sales history. The Company believes the computer-based information systems are instrumental in increasing sales of filter-related products and accessories and maintenance services, as well as sales of filter elements. The Company’s filtration products are marketed domestically under the names, Midwesco Filter and TDC Manufacturing.

The Company markets its U.S. manufactured filtration products internationally using domestically based sales resources to target major users in foreign countries. Export sales, which were approximately 10% of the domestic filtration company’s product sales during the year ended January 31, 2006, were slightly higher than the previous year. Nordic Air Filtration A/S (“Nordic Air”), a wholly-owned subsidiary of the Company, manufactures in Nakskov, Denmark, and markets pleated filter elements throughout Europe and Asia, primarily to original equipment manufacturers.

Trademarks. The Company owns the following trademarks covering its filtration products: Seamless Tube®, Leak Seeker®, Prekote®, We Take the Dust Out of Industry®, Pleatkeeper®, Pleat Plus® and EFC®.

Backlog. As of January 31, 2006, the dollar amount of backlog (uncompleted firm orders) for filtration products was $20,426,000. As of January 31, 2005, the amount of backlog was $17,518,000. Certain customers have placed orders that are deliverable over multiple years. Therefore, approximately $5,552,000 of the backlog as of January 31, 2006 is not expected to be completed in 2006.

Raw Materials and Manufacturing. The basic raw materials used in the manufacture of the Company's filtration products are industrial fibers and media supplied by leading producers of such materials. The majority of raw materials purchased are woven fiberglass fabric, yarns for manufacturing Seamless Tube® products and other woven, felted, spun bond and cellulose media. Only a limited number of suppliers are available for some of these materials. From time to time, any of these materials could be in short supply, adversely affecting the Company's business. The Company believes that supplies of all materials are adequate to meet current demand. The Company's inventory includes substantial quantities of various types of media because lead times from

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suppliers are frequently longer than the delivery times required by customers. Nevertheless, the Company employs an aggressive program to limit inventory to levels compatible with meeting customer needs.

Competition. The Filtration Products Business is highly competitive. In addition, new installations of cartridge collectors and baghouses are subject to competition from alternative technologies. The Company believes that, based on domestic sales, its principal competitors in this segment are: the BHA brand within GE Energy Services; the Menardi division of Beacon Industrial Group; W.L. Gore & Associates, Inc. Donaldson Company, Inc.; Farr Company; and Clarcor, Inc. There are at least 50 smaller competitors, most of which are doing business on a regional or local basis. In Europe, several companies supply filtration products, and the Company is a relatively small participant in that market. Some of the Company's competitors have greater financial resources than the Company.

The Company believes quality, service, and price are the most important competitive factors in its Filtration Products Business. Often, a manufacturer has a competitive advantage when its products have performed successfully for a particular customer in the past. Additional effort is required by a competitor to market products to such a customer. In certain applications, the Company's proprietary Seamless Tube® product and customer support provide the Company with a competitive advantage. Certain competitors of the Company may have a competitive advantage with respect to their own proprietary products and processes, such as specialized fabrics and fabric finishes. In addition, some competitors may have cost advantages with respect to certain products as a result of lower wage rates and/or greater vertical integration.

Government Regulation. The Company's Filtration Products Business is substantially dependent upon governmental regulation of air pollution at the federal and state levels. Federal clean air legislation requires compliance with national primary and secondary ambient air quality standards for specific pollutants, including particulate. The states are primarily responsible for implementing these standards and, in some cases, have adopted more stringent standards than those issued by the U.S. Environmental Protection Agency (“U.S. EPA”) under the Clean Air Act Amendments of 1990 ("Clean Air Act Amendments”).

Piping Systems Business

Products and Services. The Company engineers, designs, manufactures and sells specialty piping systems and leak detection and location systems. The Company's specialty piping systems include (i)industrial and secondary containment piping systems for transporting chemicals, hazardous fluids and petroleum products, (ii) insulated and jacketed district heating and cooling piping systems for efficient energy distribution to multiple locations from central energy plants, and (iii) oil and gas gathering flow lines and long lines for oil and mineral transportation. The Company's leak detection and location systems are sold as part of many of its piping systems, and on a stand-alone basis, to monitor areas where fluid intrusion may contaminate the environment, endanger personal safety, cause a fire hazard, impair essential services or damage equipment or property.

The Company's industrial and secondary containment piping systems, manufactured in a wide variety of piping materials, are generally used for the handling of chemicals, hazardous liquids and petroleum products. Industrial piping systems often feature special materials, heat tracing, leak detection and special fabrication. Secondary containment piping systems consist of service pipes housed within outer containment pipes, which are designed to contain any leaks from the service pipes. Each system is designed to provide economical and efficient secondary containment protection that will meet all governmental environmental regulations.

With respect to the leak detection and location system capabilities, the Company believes that its systems are superior to systems manufactured by other companies. The Company's leak detection and location systems are being used to monitor fueling systems at airports, including those located in Denver, Colorado; Atlanta, Georgia; and Frankfurt and Hamburg, Germany. They are also used in facilities used for mission-critical operations such as those operated by web hosts, application service providers, internet service providers, and in many clean rooms, including such facilities operated by IBM, Intel and Motorola. The Company believes that, in the United States, it is the only major supplier of the above-referenced types of specialty piping systems that manufactures its own leak detection and location systems.

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The Company's piping systems are frequently custom-fabricated to job site dimensions and/or incorporate provisions for thermal expansion due to varying temperatures. This custom fabrication helps to minimize the amount of field labor required by the installation contractor. Most of the Company's piping systems are produced for underground installations and, therefore, require trenching, which is done by unaffiliated installation contractors. Generally, sales of the Company's piping systems tend to be lower during the winter months, due to weather constraints over much of the northern hemisphere. In the fiscal year ended January 31, 2006, no single customer accounted for more than 10% of the net sales of the Company's piping systems.

Marketing. The customer base for the Company's piping systems products is industrially and geographically diverse. The Company employs a national sales manager and regional sales managers who use and assist a network of approximately 80 independent manufacturers' representatives, none of whom sells products that are competitive with the Company's piping systems.

Recent Development. In March 2006, the Company opened a new facility (PPME), in the United Arab Emirates (“U.A.E.”). PPME will manufacture specialty pre-insulated piping systems. Initially, the plant will produce pipe that will serve the district cooling market in the U.A.E. as well as other Middle Eastern countries such as Kuwait, Qatar, and Oman. District cooling is the main air conditioning method in the Middle East. With major construction going on in Dubai and other Middle East locations, cooling needs for these buildings is expected to increase greatly. The cooling load in the Middle East is expected to grow by 4 million tons in the next 6 years, according to the International District Energy Association. PPME also intends to participate in the oil and gas markets in the region including hot oil, sulfur and liquid natural gas.

In September, 2005 the Company received initial orders for its new “Autotherm™”, automatically applied Glass Syntactic Polyurethane (GSPU) for oil and gas sub-sea flowlines. The Company’s Autotherm™ GSPU is a thermal insulation application process that continuously molds specially formulated compounds on the exterior of steel pipes for oil and gas flowlines to be installed on the sea floor connecting oil wells to their host platforms. The Autotherm™ system is designed to provide reliable insulation properties when subjected to the large hydrostatic pressures of deep water over long periods of time. These pipelines will be installed in water depths ranging from 2,000 to 4,500 feet. Insulating sub-sea oil flowlines is a common practice at these water depths in order to prevent paraffin or hydrate build-up on the internal pipe surfaces thus ensuring a steady flow of oil.

Patents, Trademarks and Approvals. The Company owns several patents covering the features of its piping and electronic leak detection systems, which expire commencing in 2006. In addition, the Company's leak detection system is listed by Underwriters Laboratories and the U.S. EPA and is approved by Factory Mutual and the Federal Communications Commission. The Company is also approved as a supplier of underground district heating systems under the federal government guide specifications for such systems. The Company owns numerous trademarks connected with its piping systems business. In addition to Perma-Pipe®, the Company owns other trademarks for its piping and leak detection systems including the following: Chil-Gard®, Double-Pipe®, Double-Quik®, Escon-A®, Ferro-Shield®, FluidWatch®, Galva-Gard®, Hi Gard®, Poly-Therm®, Pal-AT®, Ric-Wil®, Ric-Wil Dual Gard®, Stereo-Heat®, Safe-T-Gard®, Therm-O-Seal®, Uniline®, LiquidWatch®, TankWatch®, PalCom®, Xtru-therm®, Ultra-Pipe®, PEX-GARD®, and ULTRA-THERM®. The Company also owns United Kingdom trademarks for Poly-Therm®, Perma-Pipe® and Ric-Wil®, and a Canadian trademark for Ric-Wil®.

Backlog. As of January 31, 2006, the dollar amount of backlog (uncompleted firm orders) for piping and leak detection systems was $19,869,000, substantially all of which is expected to be completed in 2006. As of January 31, 2005, the amount of backlog was $18,125,000.

Raw Materials and Manufacturing. The basic raw materials used in the production of the Company's piping systems products are pipes and tubes made of carbon steel, alloy and plastics and various chemicals such as polyols, isocyanate, polyester resin, polyethylene and fiberglass, mostly purchased in bulk quantities. The Company believes that there are currently adequate supplies or sources of availability of the needed raw materials. However, there are risks and uncertainties with respect to the supply of certain of these raw materials that could impact their availability in sufficient quantities to meet the Company’s needs.

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The sensor cables used in the Company's leak detection and location systems are manufactured to the Company's specifications by companies regularly engaged in the business of manufacturing such cables. The Company owns patents for some of the features of its sensor cables. The Company assembles the monitoring component of the leak detection and location system from standard components purchased from many sources. The Company's proprietary software is installed in the system on a read-only memory chip.

The Company's manufacturing processes for its piping systems include equipment and techniques to fabricate piping systems from a wide variety of materials, including carbon steel, alloy and copper piping, and engineered thermoplastics and fiberglass-reinforced polyesters and epoxies. The Company uses computer-controlled machinery for electric plasma metal cutting, filament winding, pipe coating, insulation foam and protective jacket application, pipe bending, pipe cutting and pipe welding. The Company employs skilled workers for carbon steel and alloy welding to various code requirements. The Company is authorized to apply the American Society of Mechanical Engineers code symbol stamps for unfired pressure vessels and pressure piping. The Company's inventory includes bulk resins, chemicals and various types of pipe, tube, insulation, pipe fittings and other components used in its products. The Company maintains a quality assurance program involving lead worker sign-off of each piece at each workstation, statistical process control, and nondestructive testing protocols.

Competition. The piping system products business is highly competitive. The Company believes its principal competition in this segment consists of Rovanco Piping Systems, Inc.; Thermacor Process, Inc.; Asahi/America; GF Plastics Systems; Bredero-Price, a subsidiary of Shaw Industries, Inc.; CRP of UK; Soctherm of Italy; Soccoreal of Argentina; Logstor Rohr of Denmark; TraceTek; Raychem, a Division of Tyco Thermal Controls LLC, a subsidiary of Tyco Industries; RLE Technologies; Tracer Technologies; Arizona Instrument Corp.; Veeder Root; and Pneumecator.

The Company believes that quality, service, a comprehensive product line and price are the key competitive factors in the Company's Piping Systems Business. The Company believes it has a more comprehensive line of piping systems products than any of its competitors. Certain competitors of the Company have cost advantages as a result of manufacturing a limited range of products. Some of the Company's competitors have greater financial resources than the Company.

Government Regulation. The demand for the Company's leak detection and location systems and secondary containment piping systems is driven by federal and state environmental regulation with respect to hazardous waste. The Federal Resource Conservation and Recovery Act requires, in some cases, that the storage, handling and transportation of certain fluids through underground pipelines feature secondary containment and leak detection. The National Emission Standard for Hydrocarbon Airborne Particulates requires reduction of airborne volatile organic compounds and fugitive emissions. Under this regulation, many major refineries are required to recover fugitive vapors and dispose of the recovered material in a process sewer system, which then becomes a hazardous secondary waste system that must be contained. Although there can be no assurances as to the ultimate effects of these governmental regulations, the Company believes they may increase the demand for its piping systems products.

Industrial Process Cooling Equipment Business

Products and Services. The Company engineers, designs, manufactures and sells coolers for industrial purposes. The Company's cooling products include: chillers (portable and central); cooling towers; plant circulating assemblies; hot water, hot oil, and negative pressure temperature controllers; water treatment equipment; specialty cooling devices for printing presses and ink management; and replacement parts and various accessories relating to the foregoing products. The Company's cooling products are used to optimize manufacturing productivity by quickly removing heat from manufacturing processes. The Company combines chillers and/or cooling towers with plant circulating systems to create plant-wide systems that account for a large portion of its business. The Company specializes in customizing cooling systems and their computerized controls according to customer specifications.

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The principal markets for the Company’s cooling products are thermoplastics processing and the printing industries. The Company also sells its products to original equipment manufacturers, to other cooling manufacturers on a private branded basis and to manufacturers in the laser, metallizing, and machine tool industries.

The Company believes it manufactures the most complete line of chillers available in its primary markets. It incorporates a microprocessor capable of computer communications to standard industry protocols. While portable chillers are considered to be a commodity product by many customers, the Company believes that its units enable it to provide the customer with quality, features, customization and other benefits at a competitive price. The Company believes that the ability to offer central chillers that are used for plant-wide cooling provides it with a unique, total cooling approach concept sales advantage.

Marketing. In general, the Company sells its cooling products in the domestic and international thermoplastics and printing markets as well as to manufacturers of digital video discs (“DVDs”) and other non-plastics industries that require specialized heat transfer equipment. Domestic thermoplastics processors are the largest market served by the Company, representing the core of its business.

There are approximately 8,000 companies processing plastic products in the United States, primarily using injection molding, extrusion, and blow molding machinery. The Company believes the total U.S. market for water cooling equipment in the plastics industry is $100 million annually, and that the Company is one of the three largest suppliers of such equipment to the plastics industry. The Company believes that the plastics industry is a mature industry with growth generally consistent with that of the national economy. Due to the high plastics content in many major consumer items, such as cars and appliances, this industry experiences cyclical economic activity. The Company believes that it is recognized in the domestic plastics market as a quality equipment manufacturer and that it will be able to maintain current market share, with potential to increase its market share through product development. The Company's cooling products are sold through independent manufacturers' representatives on an exclusive-territory basis. Twenty representatives are responsible for covering the United States and are supported by four regional managers employed by the Company.

Sales of the Company's cooling products outside the United States have mainly been in Latin America. Some international sales have been obtained elsewhere as a result of the assembly of complete worldwide PET (plastic bottle) plants by multinational companies. The Company believes that it has a significant opportunity for growth due to the high quality of its equipment and the fact that it offers complete system design. Many United States competitors do not provide equipment outside the U.S. and, while European competitors sell equipment in Latin America, the Company believes that they lack system design capabilities and have a significant freight disadvantage. The Company markets its cooling products through a combination of manufacturers' representatives, distributors and consultants managed by regional managers, reporting to a National Sales and Marketing Manager.

The Company has increased sales to non-plastics industries that require specialized heat transfer equipment, usually sold to end users as a package by the supplier of the primary equipment, particularly in the laser industry, metallizing industry, and machine tool industry. The Company believes that the size of this market is more than $200 million annually. The original equipment manufacturer generally distributes products to the end user in these markets.

Trademarks. The Company has registered the trademarks Thermal Care®, AWS® and Applied Web Systems®.

Backlog. As of January 31, 2006, the dollar amount of backlog (uncompleted firm orders) for industrial process cooling equipment was $9,306,000, substantially all of which is expected to be completed in 2006. As of January 31, 2005, the amount of backlog was $5,321,000.

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Raw Materials and Manufacturing. The Company uses prefabricated sheet metal and subassemblies manufactured by both Thermal Care and outside vendors for temperature controller fabrication. The production line is self-contained to reduce handling required to assemble, wire, test, and crate the units for shipment.

Cooling towers up to 120 tons in capacity are assembled to finished goods inventory, which allows the Company to meet quick delivery requirements. The cooling towers are manufactured using fiberglass and hardware components purchased from several sources. The wet deck is cut from bulk fill material and installed inside the tower. Customer-specified options can be added at any time. The Company believes that its access to sheet metal, subassemblies, fiberglass and hardware components is adequate.

The Company assembles all plant circulating systems by fabricating the steel to meet the size requirements and adding purchased components to meet customers’ specifications. Portable chillers are assembled utilizing components both manufactured by the Company and supplied by outside vendors. Central chillers are manufactured to customer specifications.

Competition. The Company believes that there are about 15 competitors selling cooling equipment in the domestic plastics market. The Company further believes that three manufacturers, including the Company, account for approximately 50% of the domestic plastics cooling equipment market. Many international customers, with relatively small cooling needs, are able to purchase small refrigeration units (portable chillers) that are manufactured in their respective local markets at prices below that which the Company can offer due to issues such as freight cost and customs duties. However, such local manufacturers often lack the technology and products needed for plant-wide cooling systems. The Company believes that its reputation for producing quality plant-wide cooling products results in a significant portion of the Company’s business in this area.

The Company believes that quality, service, a comprehensive product line and price are the key competitive factors in its Industrial Process Cooling Equipment Business. The Company believes that it has a more comprehensive line of cooling products than any of its competitors. Certain competitors of the Company have cost advantages as a result of manufacturing in non-union shops and offering a limited range of products. Some of the Company's competitors may have greater financial resources than the Company.

Government Regulation. The Company does not expect compliance with federal, state and local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment to have a material effect on capital expenditures, earnings or the Company’s competitive position. Management is not aware of the need for any material capital expenditures for environmental control facilities for the foreseeable future. Regulations, promulgated under the Federal Clean Air Act, prohibit the manufacture and sale of certain refrigerants. The Company does not use these refrigerants in its products. The Company expects that suitable refrigerants conforming to federal, state and local laws and regulations will continue to be available to the Company, although no assurances can be given as to the ultimate effect of the Federal Clean Air Act and related laws on the Company.

Employees

As of March 31, 2006, the Company had 760 full-time employees, 83 of whom were engaged in sales and marketing, 215 of whom were engaged in management, engineering and administration, and 462 were engaged in production. Hourly production employees of the Company's Filtration Products Business in Winchester, Virginia are covered by a collective bargaining agreement with the International United Automobile, Aerospace & Agricultural Implement Workers of America, which expires in October 2006. Most of the production employees of the Company's Industrial Process Cooling Equipment Business are represented by two unions, the United Association of Journeymen and Apprentices of the Plumbing and Pipefitting Industry of the United States (UAJAPPI) and the International Brotherhood of Electrical Workers Union (IBEW). The collective bargaining agreement for UAJAPPI is scheduled to expire on June 1, 2006, and the IBEW agreement expires on May 31, 2006, with both agreements thereafter continuing to be in effect for yearly periods unless amended or terminated in writing. The collective bargaining agreement of the Piping Systems Business in Lebanon, Tennessee, with the Metal Trades Division of UAJAPPI expires in March 2007.

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Executive Officers of the Registrant

The following table set forth information regarding the officers of the Company as of March 31, 2006:

All of the officers serve at the discretion of the Board of Directors.

David Unger has been employed by the Company and its predecessors in various executive and administrative capacities since 1958, served as President of Midwesco, Inc. (“Midwesco”) from 1972 through January 1994, and was Vice President from February 1994 through December 1996. He was also a director of Midwesco from 1972 through December 1996 and served that company in various executive and administrative capacities from 1958 until the consummation of the merger of Midwesco into the Company in December 1996 (the “Merger”). He became a director and Vice President of the company formed to succeed to the non-Thermal Care business of Midwesco (“New Midwesco”). He is the Company’s Chairman of the Board of Directors and Chief Executive Officer.

Henry M. Mautner has been employed by the Company and its predecessors in various executive capacities since 1972, served as Chairman of Midwesco from 1972 through December 1996, and served that company in various executive and administrative capacities from 1949 until the consummation of the Merger. Since the consummation of the Merger, he has served as the Chairman of New Midwesco. Mr. Mautner is the father of Bradley E. Mautner.

Bradley E. Mautner has been employed by the Company and its predecessors in various executive and administrative capacities since 1978, has served as President and Chief Operating Officer since December 2004, was Executive Vice President from December 2002 to December 2004, was Vice President of the Company from December 1996 through December 2002 and has been a director of the Company since 1995. From 1994 to the consummation of the Merger, he served as President of Midwesco and since December 30, 1996 he has

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served as President of New Midwesco. In addition, since February 1996, he has served as the Chief Executive Officer of Midwesco Services, Inc. (“Midwesco Services”) which was 50% owned by New Midwesco until May 19, 2000, at which time it became a wholly-owned subsidiary of New Midwesco. On November 17, 2000, Midwesco Services was merged into New Midwesco (“Midwesco Services Merger”). From February 1988 to January 1996, he served as the President of Mid Res Inc. (predecessor to Midwesco Services). Bradley E. Mautner is the son of Henry M. Mautner.

Gene K. Ogilvie has been employed by the Company and its predecessors in various executive capacities since 1969. He has been general manager of Midwesco Filter or its predecessor since 1980 and President and Chief Operating Officer of Midwesco Filter since 1989. From 1982 until the consummation of the Midwesco Merger, he served as Vice President of Midwesco, Inc.

Fati A. Elgendy, who has been associated with the Company and its predecessors since 1978, was Vice President, Director of Sales of the Perma-Pipe Division of Midwesco, Inc. from 1990 to 1991. In 1991, he became Executive Vice President of the Perma-Pipe Division, a position he continued to hold after the acquisition by the Company to form Perma-Pipe. In March 1995, Mr. Elgendy became President and Chief Operating Officer of Perma-Pipe.

Don Gruenberg has been employed by the Company and its predecessors in various executive capacities since 1974, with the exception of a period in 1979-1980. He has been general manager of Thermal Care or its predecessor since 1980, and was named President and Chief Operating Officer of Thermal Care in 1988. He has been a Vice President and director of the Company since December 1996.

Michael D. Bennett has served as the Chief Financial Officer and Vice President of the Company and its predecessors since August 1989.

Thomas A. Benson has served as Vice President Sales and Marketing of Thermal Care since May 1988.

Billy E. Ervin has been Vice President, Director of Production of Perma-Pipe since 1986.

Robert A. Maffei has been Vice President, Director of Sales and Marketing of Perma-Pipe since August 1996. He had served as Vice President, Director of Engineering of Perma-Pipe since 1987 and was an employee of Midwesco, Inc. from 1986 until the acquisition of Perma-Pipe by the Company in 1994.

Herbert J. Sturm has served the Company since 1975 in various executive capacities including Vice President, Materials and Marketing Services of Midwesco Filter.

Competition Business. The businesses in which the Company is engaged are highly competitive. Many of the competitors are larger than the Company and have more resources. Many of the Company’s products are also subject to competition from alternative technologies and alternative products. To the extent the Company relies upon a single source for key components of several of its products, the Company believes that there are alternate sources available for such components; however, there can be no assurance that the interruption of supplies of such components would not have an adverse effect on the financial condition of the Company, and that the Company, if required to do so, would be able to negotiate agreements with alternative sources on acceptable terms.

Government Regulation. The demand for the Company’s leak detection and location systems and secondary containment piping systems is driven primarily by government regulation with respect to hazardous waste. Laws such as the Federal Resource Conservation and Recovery Act (“RCRA”), and standards such as the National Emission Standard for Hydrocarbon Airborne Particulates (“NESHAP”), have increased the demand for the Company’s leak detection and location and secondary containment piping systems. The Company’s filtration products business to a large extent is dependent on governmental regulation of air pollution at the federal and state levels. The Company believes that continuing growth in the sale of filtration products and

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services will be materially dependent on continuing enforcement of environmental laws such as the Federal Clean Air Act Amendments of 1990 (“Clean Air Act Amendments”). Although changes in such environmental regulations could significantly alter the demand for the Company’s products and services, the Company does not believe that such a change is likely to decrease demand in the foreseeable future. In addition, the Company has experienced, and may experience additional, increased costs of compliance with other government regulation, such as the Sarbanes-Oxley Act.

Dividends. The Company has not paid dividends in the past and does not anticipate paying cash dividends on its common stock in the foreseeable future. The Company’s line of credit agreement contains certain restrictions on payment of dividends.

Changes in Government Policies and Laws, Worldwide Economic Conditions. The Company anticipates that international sales will represent an increasing portion of its total sales and that continued growth and profitability may require further international expansion. The Company’s financial results could be affected by changes in trade, monetary and fiscal policies, laws and regulations, or other activities of U.S. and non-U.S. governments, agencies and similar organizations. These conditions include but are not limited to changes in a country’s or region’s economic or political conditions, trade regulations affecting production, pricing and marketing of products, local labor conditions and regulations, reduced protection of intellectual property rights in some countries, changes in the regulatory or legal environment, restrictions on currency exchange activities, burdensome taxes and tariffs and other trade barriers. International risks and uncertainties, including changing social and economic conditions as well as terrorism, political hostilities and war, could lead to reduced international sales and reduced profitability associated with such sales.

Economic Factors. The Company is exposed to fluctuations in currency exchange rates and commodity prices. The Company monitors and manages currency exposures that are associated with monetary asset positions, committed currency purchases and sales, and other assets and liabilities created in the normal course of business. Failure to successfully manage these risks could have an adverse impact on the Company’s financial position, results of operations and cash flows.

Seasonality. Sales in the Piping Systems business segment have a tendency to be lower during the winter months due to weather constraints in the northern hemisphere. Severity and duration of winter weather could have an adverse effect on the results of this segment.

None

Filtration Products Business

Piping Systems Business

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Industrial Process Cooling Equipment Business

The Company's principal executive offices which occupied approximately 43,000 square feet of space in Niles, Illinois is owned by the Company. The Company believes its properties and equipment are well maintained and in good operating condition and that productive capacities will generally be adequate for present and currently anticipated needs.

For further information regarding lease commitments, see note 7 of the notes to consolidated financial statements.

None

None.

PART II

The Company’s fiscal year ends on January 31. Years described as 2005, 2004 and 2003 are the fiscal years ended January 31, 2006, 2005 and 2004, respectively. Balances described as balances as of 2005 and 2004 are balances as of January 31, 2006 and 2005, respectively.

The Company's Common Stock is traded on the Nasdaq National Stock Market under the symbol "MFRI." The following table sets forth, for the periods indicated, the high and low Common Stock sale prices as reported by the Nasdaq National Market for 2004 and for 2005.

As of May 10, 2006, there were approximately 100 stockholders of record.

The Company has never declared or paid a cash dividend and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. Management presently intends to retain all available funds for the development of the business and for use as working capital. Future dividend policy will depend upon the

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Company's earnings, capital requirements, financial condition and other relevant factors. The Company's line of credit agreement contains certain restrictions on the payment of dividends.

Neither the Company nor any “affiliated purchaser” as defined in Rule 10b-18 purchased any shares of the Company’s Common Stock during the period covered by this report. The Company has not made any sale of unregistered securities during the preceding three years.

The following selected financial data for the Company for the years 2005, 2004, 2003, 2002, and 2001 are derived from the financial statements of the Company. The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included herein in response to Item 7 and the consolidated financial statements and related notes included herein in response to Item 8.

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 annual 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.

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RESULTS OF OPERATIONS

MFRI, Inc.

MFRI, Inc. ("MFRI", the "Company" or the "Registrant") is engaged in the manufacture and sale of products in three distinct business segments: filtration products, piping systems and industrial process cooling equipment. 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. The Company’s other businesses do not demonstrate seasonality.

Our analysis presented below is organized to provide instructive information for understanding the business going forward. However, this discussion should be read in conjunction with the consolidated financial statements in Item 8 of this report, including the notes thereto. An overview of the segment results is provided in Note 10 - Business Segment and Geographic Information to the consolidated financial statements in Item 8 of this report.

2005 Compared to 2004

Net sales of $154,587,000 in 2005 increased 6.5% from $145,096,000 in 2004. Sales increased in all business segments. Gross profit of $32,686,000 in 2005 increased 5.0% from $31,128,000 in 2004. Gross margin decreased to 21.1% of net sales in 2005 from 21.5% in 2004. (See discussion of each business segment below.)

Selling expense increased 18.2% to $12,383,000 in 2005 from $10,477,000 in 2004 due primarily to increased number of selling personnel and related commissions. (See discussion of each business segment below.)

General and administrative expenses increased 13.9% to $17,624,000 in 2005 from $15,474,000 in 2004. General administrative expense increases included $656,000 related to professional services expenses and use of consultants for Sarbanes-Oxley Section 404 (“SOX404”) compliance related spending. Other general administrative expense increases included $585,000 in start up costs described in the Piping Systems Business section of this report, and costs from operations interruption related to Hurricane Rita. The plant located in New Iberia, LA suffered damage of $172,000 and was not operational for most of October 2005. (See discussion of each business segment below.)

Net income declined to $531,000 or $0.10 per common share (basic), compared to net income of $2,813,000 or $0.56 per common share in 2004. The decrease in net income was primarily for reasons summarized above and discussed in more detail below.

2004 Compared to 2003

Net sales of $145,096,000 in 2004 increased 20.0% from $120,889,000 in 2003. Sales increased in all business segments. Gross profit of $31,128,000 in 2004 increased 26.5% from $24,598,000 in 2003. Gross margin increased to 21.5% of net sales in 2004 from 20.3% in 2003. (See discussion of each business segment below.)

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Selling, general and administrative expenses increased 2.5% to $25,951,000 in 2004 from $25,319,000 in 2003. (See discussion of each business segment below.)

Net income rose to $2,813,000 or $0.56 per common share (basic), compared with a loss of $1,097,000 or $0.22 per common share in 2003. The increase in net income was due to increased revenue and increased gross profit.

Filtration Products Business

The Filtration Products Business sales consist primarily of a large number of small orders and a limited number of large orders. The large orders are primarily from electric utilities and original equipment manufacturers. In 2005, the average order amount was approximately $3,900. The timing of large orders can have a material effect on net sales and gross profit from period to period. Pricing on large orders was generally extremely competitive and therefore resulted in lower gross margins. In 2005, 2004 and 2003, no customer accounted for 10% or more of the net sales of the Company’s filtration products and services.

The Company’s Filtration Products Business is dependent on government regulation of air quality at the federal and state levels. The Company believes that growth in the sale of its filtration products and services will be materially dependent on continued enforcement of environmental laws such as the Clean Air Act Amendments. Although there can be no assurance what the ultimate effect of the Clean Air Act Amendments will be on the Company’s Filtration Products Business, the Company believes that the Clean Air Act Amendments are likely to have a positive long-term effect on demand for the Company’s filtration products and services.

2005 Compared to 2004

Net sales increased 4.3% to $64,413,000 in 2005 from $61,740,000 in 2004. This increase was primarily the result of increased sales of filter elements. This increase was offset to some extent by a decline in sales of related products. The increase in sales also resulted from better economic conditions in general and improved conditions in the domestic steel industry in particular.

Gross profit as a percent of net sales decreased to 18.3% in 2005 from 20.0% in 2004, primarily as a result of a decline in gross margin on filter bag sales as a result of competitive marketplace pricing and product mix.

Selling expense increased to $6,388,000 or 9.9% of net sales in 2005 from $5,644,000 or 9.1% of net sales in 2004. The increase was primarily due to additional selling resources and increased travel expenses.

General and administrative expenses decreased by 0.2% of net sales to $3,150,000 or 4.9% of net sales from $3,137,000 or 5.1% of net sales in 2004. This dollar increase was primarily the result of increased legal expense and depreciation expense. The increase in depreciation expense was related to installed computer hardware and software.

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2004 Compared to 2003

Net sales increased 12.5% to $61,740,000 in 2004 from $54,872,000 in 2003. This increase was the result of increased sales of all product lines. This increase was primarily due to a better economic environment including improved conditions in the domestic steel industry.

Gross profit as a percent of net sales increased to 20.0% in 2004 from 17.8% in 2003, primarily as a result of improved manufacturing efficiency on higher unit volume and a favorable product mix.

Selling expense increased to $5,644,000 or 9.1% of net sales in 2004 from $5,531,000 or 10.1% of net sales in 2003. The increase primarily resulted from increased selling expense in pleated element product line.

General and administrative expenses decreased by 0.6% of sales to $3,137,000 or 5.1% of net sales in 2004 from $3,106,000 or 5.7% of net sales in 2003. This dollar increase was 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.

The Company’s leak detection and location systems generally have higher profit margins than its District Heating and Cooling (“DHC”) piping systems and secondary containment piping systems. The Company has benefited from continuing efforts to have its leak detection and location systems included as part of the customers’ original specifications for construction projects.

The Company’s Piping Systems Business is characterized by a large number of small and medium orders and a small number of large orders. The average order amount for 2005 was approximately $58,000. In 2005, 2004 and 2003, no customer accounted for 10% or more of net sales of the Company’s Piping Systems Business. The timing of such orders can have a material effect on the comparison of net sales and gross profit from period to period. Most of the Company’s piping systems are produced for underground installations and, therefore, require trenching, which is performed directly for the customer by installation contractors unaffiliated with the Company.

2005 Compared to 2004

Net sales increased 1.1% to $54,657,000 in 2005 from $54,053,000 in 2004, primarily due to a slight increase in the oil and gas piping products.

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Gross profit as a percent of net sales increased to 19.9% in 2005 from 19.0% in 2004, mainly due to product mix and an increase in the oil and gas piping products.

Selling expense increased to $1,442,000 or 2.6% of net sales in 2005 from $1,209,000 or 2.2% of net sales in 2004. The increase was primarily due to additional personnel early in the year.

General and administrative expense increased to $4,360,000 or 8.0% of net sales in 2005 from $3,670,000 or 6.8% of net sales in 2004. In March, 2006 the Company opened a new facility (PPME), in the U.A.E. The company will manufacture specialty pre-insulated piping systems for Dubai, other parts of the U.A.E., and other markets in the region. The increase in general and administrative expense was primarily due to $585,000 in start up costs related to PPME. In addition, the plant located in New Iberia, LA suffered hurricane damage of $172,000 and was not operational for most of October 2005.

2004 Compared to 2003

Net sales increased 33.4% to $54,053,000 in 2004 from $40,523,000 in 2003. This increase was primarily due to some recovery from the weak economy in both the private and public sectors and to a single large international sale.

Gross profit as a percent of net sales increased to 19.0% in 2004 from 18.5% in 2003, mainly due to product mix and increased volume.

Selling expense decreased to $1,209,000 or 2.2% of net sales in 2004 from $1,250,000 or 3.1% of net sales in 2003. The decrease was primarily due to one less sales employee.

General and administrative expense decreased to $3,670,000 or 6.8% of net sales in 2004 from $3,985,000 or 9.8% of net sales in 2003. The decrease was primarily due to a 2003 legal settlement of $510,000 and legal fees associated with that settlement.

Industrial Process Cooling Equipment Business

The Company’s Industrial Process Cooling Equipment Business is characterized by a large number of relatively small orders and a limited number of large orders. In 2005, the average order amount was approximately $4,900. In 2005, 2004 and in 2003, no customer accounted for 10% or more of net sales of the Cooling Equipment Business.

2005 Compared to 2004

Net sales increased 21.2% to $35,517,000 in 2005 from $29,303,000 in 2004 mainly due to improved conditions in domestic plastic molding and printing markets and continued economic recovery.

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Gross profit as a percentage of net sales decreased to 28.3% in 2005 from 29.1% in 2004, primarily due to pricing pressure in international markets and material cost increases.

Selling expense increased to $4,553,000 or 12.8% of net sales in 2005 from $3,624,000 or 12.4% of net sales in 2004. The increase was primarily due to additional personnel and higher commissions associated with increased sales.

General and administrative expense increased to $3,969,000 or 11.2% of net sales in 2005 from $3,330,000 or 11.4% of net sales in 2004. The dollar increase was primarily due to increased professional services expenses and costs of $290,000 for the use of consultants to implement production planning systems.

2004 Compared to 2003

Net sales increased 14.9% to $29,303,000 in 2004 from $25,494,000 in 2003 mainly due to some recovery from the weak economy. Sales increased in both the domestic and international markets.

Gross profit as a percentage of net sales increased to 29.1% in 2004 from 28.6% in 2003, primarily due improved pricing and production efficiencies

As a percentage of sales, selling expense decreased 0.8% to $3,624,000 or 12.4% of net sales in 2004 from $3,361,000 or 13.2% of net sales in 2003. The dollar increase was primarily due to the higher commissions associated with increased sales.

General and administrative expense decreased 1.2% of sales to $3,330,000 or 11.4% of net sales in 2004 from $3,201,000 or 12.6% of net sales in 2003. The dollar increase was primarily due to higher costs for the international operation resulting from additional personnel and increased product development costs.

General Corporate Expense

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

2005 Compared to 2004

General and administrative expense increased 15.1% to $6,146,000 in 2005 from $5,337,000 in 2004, and increased as a percentage of consolidated net sales to 4.0% in 2005 from 3.7% in 2004. The increase was mainly due to expenses incurred to comply with Sarbanes-Oxley including consulting fees of $656,000, additional personnel of $130,000 primarily in the accounting and control area, and increased group insurance expense of $110,000.

Interest expense increased 10.9% to $1,839,000 in 2005 from $1,658,000 in 2004. The increase was primarily due to the increase in interest rates and an increase of net borrowings.

2004 Compared to 2003

General and administrative expense increased 9.2% from $4,885,000 in 2003 to $5,337,000 in 2004, and decreased as a percentage of consolidated net sales from 4.0% in 2003 to 3.7% in 2004. The dollar increase was mainly due to management incentive compensation earned and building repairs and maintenance costs.

Interest expense decreased 17.2% to $1,658,000 in 2004 from $2,003,000 in 2003. The decrease was primarily due to lower interest expense due to the sale of a building in Winchester, Virginia in June 2004, and to lower floating interest rates in 2004. Interest income on federal tax refunds was received in 2004.

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Income Taxes

The effective income tax expense (benefit) rates were 48.7%, 24.9%, and (50.8%) in 2005, 2004 and 2003, respectively. The differences between the effective income tax rate and the U.S. Statutory tax rate for 2005 and 2004 were:

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents as of January 31, 2006 were $1,114,000 as compared to $723,000 at January 31, 2005. The Company generated $2,134,000 from operations in 2005. Operating cash flows increased by $1,885,000 from 2004. There were $46,000 in proceeds from the sale of property, plant and equipment. Cash distributions of $270,000 in 2005 were received from the Company’s investment in a joint venture. These cash flows were used to support $6,315,000 in capital spending.

Trade receivables decreased $2,129,000 due to collection of Piping Systems Business aged receivables. Inventories increased $2,662,000 in 2005 due to increased make and hold orders that will ship in 2006. Prepaid expenses and other current assets increased $639,000 in 2005 partially due to an increase in deferred tax assets and prepaid insurance due to a change in funding method for workers compensation insurance. Other operating assets and liabilities decreased $1,618,000 in 2005.

Net cash used in 2005 investing activities was $5,999,000. Capital expenditures in 2005 increased to $6,315,000 from $1,755,000 in 2004. In March 2006, the Company opened a new facility (PPME), in the U.A.E. The company will manufacture specialty pre-insulated piping systems for Dubai, other parts of the U.A.E., and other markets in the region. Capital expenditures of $3,445,000 in equipment and other costs relate to PPME. Capital expenditures of $1,258,000 relate to the Company’s construction of a new 20,900 square foot addition to production facilities which was completed in 2005 for filtration products in Denmark. Other capital expenditures included those related to new Enterprise Resources Planning system software and to equipment purchases.

The Company estimates that capital expenditures for 2006 will be approximately $7,300,000. Other capital expenditures primarily will relate to machinery and equipment, building and leasehold improvements, and computer hardware and software purchases. The Company may finance capital expenditures through equipment financing loans, internally generated funds and its revolving line of credit.

Debt totaled $31,286,000, an increase of $3,748,000 since the beginning of 2005. Net cash inflows from financing activity were $4,203,000, primarily consisting of $4,004,000 in net borrowings on debt obligations.

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The following table summarizes the Company’s estimated contractual obligations excluding the revolving lines of credit of $14,567,000 at January 31, 2006.

Other long term liabilities of $2,866,000 were composed primarily of accrued pension cost and deferred compensation.

The Company’s working capital was approximately $28,543,000 at January 31, 2006 compared to approximately $26,332,000 at January 31, 2005. This increase was partially due to the decrease in accounts payable offset by the increase in inventories.

The Company’s current ratio was 2.2 to 1 and 2.0 to 1 at January 31, 2006 and January 31, 2005, respectively. Debt to total capitalization at January 31, 2006 increased to 49.6% from 46.8% at January 31, 2005.

Financing

At January 31, 2006 and October 31, 2005, the Company was not in compliance with two financial performance covenants under the Loan Agreement (see the paragraphs below that describe the Loan Agreement). The Company has received a waiver and amendment dated May 10, 2006 from the lender. The Company has made all required payments of principal and interest under the Loan Agreement to date.

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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, which matures on November 30, 2007, the Company can borrow up to $27,000,000, subject to borrowing base and other requirements, under a revolving line of credit. The Loan Agreement covenants restrict debt, liens, and investments, do not permit payment of dividends, and require attainment of certain levels of profitability and cash flows. 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 January 31, 2006, the prime rate was 7.5%, and the margins added to the prime rate and the LIBOR rate, which are determined each quarter based on the applicable financial statement ratio, were 0.25 and 2.25 percentage points, respectively. Monthly interest payments were made. The average interest rate for the year ending January 31, 2006 was 6.02%. As of January 31, 2006, the Company had borrowed $13,612,000 and had $1,423,000 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 Industrial Revenue Bond borrowings. 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 January 31, 2006, the amount of restricted cash was $369,000. 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 interest rate swap was effective as a cash flow hedge and no charge to earnings was required during the year ended January 31, 2006. The fair value of the derivative financial instrument was $20,500, and $13,500, net of deferred tax benefits of $7,000, was recorded in other assets and accumulated other comprehensive income associated with the cash flow hedge at January 31, 2006.

On March 28, 2005, the Company's Loan Agreement was amended to (1) add a term loan of $4,300,000 ("Term Loan") and (2) amend certain covenants. The total that can be borrowed under the Loan Agreement was unchanged at $27,000,000, subject to borrowing base and other requirements. Interest rates under the Term Loan 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 March 28, 2005 the prime rate was 5.75% and the margins added to the prime rate and the LIBOR rate, which are determined each quarter based on the applicable financial statement ratio, were 1.25 and 3.5 percentage points, respectively. The Company is scheduled to pay $215,000 of principal on the first days of March, June, September, and December in each year, commencing on June 1, 2005 and ending on September 30, 2007, with the remaining unpaid principal payable on November 30, 2007.

On May 10, 2006, the Company’s Loan Agreement was amended to (1) increase the revolving credit line to $30,000,000 subject to borrowing base and other requirements, (2) add an equipment loan facility (“Equipment Loan Facility”) of $1,000,000 subject to certain restrictions, and (3) amend certain financial performance covenants. Interest rates under the Equipment Loan Facility 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 May 10, 2006 the prime rate was 8.00% and the margins added to the prime rate and the LIBOR rate, which are determined each quarter based on the applicable financial statement ratio, were .50 and 2.50 percentage points, respectively.

The proceeds of the Term Loan were used to repay the outstanding balance due under the Company's Note Purchase Agreements ($3,125,000), which have now been cancelled and to reduce the Company's revolving debt under the Loan Agreement ($1,175,000). Interest rates under the Note Purchase Agreements had been 10% per annum.

The Company also has short-term credit arrangements used by its European subsidiaries. These credit arrangements are generally in the form of overdraft facilities at rates competitive in the countries in which the Company operates. At January 31, 2006, borrowings under these credit arrangements totaled $955,000; an additional $691,000 remained unused.

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CRITICAL ACCOUNTING POLICIES

Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company has accounting policies which it believes are important to the Company's financial condition and results of operations, and which require the Company to make estimates about matters that are inherently uncertain. These critical accounting policies include revenue recognition, realizability of inventories, collectibility of accounts receivable, depreciation of plant and equipment, and income taxes. The Company believes that the above critical policies have resulted in past actual results approximating the estimated amounts in those areas.

Percentage of Completion Method Revenue Recognition: Perma-Pipe recognizes revenues on contracts under the "percentage of completion" method. The percentage of completion is determined by the relationship of costs incurred to the total estimated costs of the contract. Provisions are made for estimated losses on uncompleted contracts in the period in which such losses are determined. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions and final contract settlements may result in revisions to costs and income. Such revisions are recognized in the period in which they are determined. Claims for additional compensation due the Company are recognized in contract revenues when realization is probable and the amount can be reliably estimated.

Revenue Recognition: The Company recognizes revenues when all the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the seller’s price to the buyer is fixed or determinable, and (iii) collectibility is reasonably assured. All subsidiaries of the Company except Perma-Pipe recognize revenues when product has been shipped (for FOB shipping point orders) or delivered (for FOB destination sales) or when services have been rendered.

Inventories: Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method for substantially all inventories.

Goodwill and other intangible assets with indefinite lives: The Company reviews the carrying value of goodwill in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, which requires that goodwill and other intangible assets with indefinite lives be analyzed for impairment on an annual basis or when there is reason to suspect that their values have been impaired. For the 2005 and 2004, evaluations the fair value was determined using discounted cash flows and other market-related valuation models. Certain estimates and judgments are required in the application of the fair value models. Based upon the Company’s evaluations for 2005 and 2004, no impairment of goodwill was required. Goodwill was $2,509,000 and $2,616,000 at January 31, 2006 and 2005, respectively. As of January 31, 2006 and 2005, $1,100,000 of goodwill was allocated to the Industrial Process Cooling Equipment segment. As of January 31, 2006 and 2005 $1,409,000 and $1,516,000, respectively, was allocated to the Filtration Products segment. The change in goodwill of the Filtration Products segment was due to foreign currency translation.

ACCOUNTING PRONOUNCEMENTS

In April 2005, the SEC announced the adoption of a new rule that amends the compliance dates for SFAS No. 123 (revised 2004), Share-Based Payment (Statement No. 123R). SFAS No. 123R, as amended, is applicable for all fiscal years beginning after June 15, 2005. As a result the Company is required to implement SFAS 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 Company does not expect the adoption of SFAS 123R to have a material effect on its financial statements.

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On December 5, 2005, the Board of Directors of 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.

FAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” with an effective date of December 15, 2005 provides an elective alternative transition method. The Company has one year from December 15, 2005, the initial adoption of SFAS No. 123R to evaluate the available transition alternatives and make its one-time election. The transition method prescribed by SFAS 123R will be followed until the alternative method is elected.

In December 2003, the FASB issued Interpretation No. 46R, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” which requires that the assets, liabilities, and the results of activities of a variable interest entity in which a business enterprise has controlling financial interest be included in consolidation with those of the business enterprise. Adoption of FIN No. 46R did not apply to the Company.

The Company is subject to market risk associated with changes in foreign currency exchange rates, interest rates and commodity prices. Foreign currency exchange rate risk is 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 has used foreign currency forward contracts to reduce exposure to exchange rate risks. The forward contracts are short-term in duration, generally one year or less. The major currency exposure hedged by the Company has been the Canadian dollar. The contract amounts, carrying amounts and fair values of these contracts were not significant at January 31, 2006, 2005 and 2004.

The Company has attempted to mitigate its interest rate risk by maintaining a balance of fixed-rate long-term debt and floating-rate debt.

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.

At January 31, 2006 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 year ended January 31, 2006. The fair value of the derivative financial instrument was $20,500, and $13,500, net of deferred tax benefits of $7,000, was recorded in other assets and accumulated other comprehensive income associated with the cash flow hedge at January 31, 2006.

A hypothetical ten percent change in market interest rates over the next year would increase interest on the Company's floating rate debt instruments by approximately $66,000.

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 the Company uses in the production of piping systems. The Company attempts to mitigate such risks 

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 by obtaining price commitments from its commodity suppliers and, when it appears appropriate, purchasing quantities in advance of likely price increases.

The consolidated financial statements of the Company for each of the three years in the period ended as of January 31, 2006, 2005 and 2004 and the notes thereto are set forth elsewhere herein.

None.

As of January 31, 2006, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, as amended. Based solely on the material weakness described below, the Company's Chief Executive Officer and Chief Financial Officer concluded that, as of January 31, 2006, the Company's disclosure controls and procedures were not effective as of the end of the fiscal period covered by this Report on Form 10-K. The Company has restated previously reported 2005 quarterly financial results. Due to this material weakness, the Company, in preparing its consolidated financial statements as of and for the period ended January 31, 2006, performed additional procedures relating to inventory to enable it to conclude that the consolidated financial statements were prepared in accordance with U.S. generally accepted accounting principles.

When processing inventory transactions using an Enterprise Resources Planning system installed in December 2004 at the Company's production facility for filtration products in Winchester, VA ("Winchester Facility"), errors were made subsequent to Winchester Facility's January 31, 2005 physical inventory, and during each of the interim fiscal quarters of 2005, which were discovered by Registrant's accounting personnel only when analyzing the Winchester Facility physical inventory as of January 31, 2006. The errors did not affect the quantity of physical inventory, and no restatement for any such period affects the Registrant's sales, cash flows, or business prospects. However, the errors did result in the overstatement of inventories, current assets, total assets, income before income taxes, and net income for each of the interim fiscal quarters of 2005.

Changes in Internal Controls.

Since January 31, 2006, the Company has taken steps to correct transaction processing procedures, accounting controls and reporting controls at the Winchester Facility to prevent recurrence of such errors. The Company has also examined controls and procedures at the Registrant's other locations to detect the presence of possible weaknesses similar to those that caused the above errors, and has analyzed the inventory accounts at Registrant's other locations to detect the possible presence of errors similar to those described above. No such weaknesses or errors were detected.

Other than the change discussed above, there have been no significant changes in the Company's internal controls, or in other factors that could significantly affect these controls, subsequent to the date of that evaluation.

None.

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PART III

Information with respect to directors of the Company is incorporated herein by reference to the table under the caption "Nominees for Election as Directors" and the textual paragraphs following the aforesaid table and the information contained under the captions “Board of Director Meetings and Committees” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company's proxy statement for the 2006 annual meeting of stockholders.

Information with respect to executive officers of the Company is included in Item1, Part I hereof under the caption "Executive Officers of the Registrant."

Information with respect to executive compensation is incorporated herein by reference to the information under the caption "Executive Compensation" in the Company's proxy statement for the 2006 annual meeting of stockholders.

Information with respect to security ownership of certain beneficial owners and management of the Company and related stockholder matters is incorporated herein by reference to the information under the captions "Beneficial Ownership of Common Stock" and “Equity Compensation Plan Information” in the Company's proxy statement for the 2006 annual meeting of stockholders.

Information with respect to certain relationships and transactions is incorporated herein by reference to the information under the caption "Certain Transactions" in the Company's proxy statement for the 2006 annual meeting of stockholders.

Information with respect to the independence of the Company’s public accountants and the fees paid to such accountants is incorporated herein by reference to the information under the caption “Independent Registered Public Accounting Firm” in the Company’s proxy statement for the 2006 annual meeting of stockholders.

PART IV

24

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Chicago, Illinois
May 10, 2006

25

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

MFRI, Inc. and subsidiaries

Chicago, Illinois

We have audited the accompanying consolidated statements of operations, stockholders’ equity, and cash flows for the year ended January 31, 2004 of MFRI, Inc. and subsidiaries. Our audit also included the financial statement schedule listed in the Index at Item 15a(2) for the year ended January 31, 2004. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.

We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the results of MFRI, Inc. and subsidiaries’ operations and their cash flows for the year ended January 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule for the year ended January 31, 2004, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

DELOITTE & TOUCHE LLP

Chicago, Illinois

May 14, 2004

26

MFRI, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands except per share information)

See accompanying notes to consolidated financial statements.

27

MFRI, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands except per share information)