Perma-Pipe International Holdings, Inc. - Quarter Report: 2007 April (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, 2007. Reclassifications have been made in prior year financial statements to conform to the current year presentation. The results of operations for the quarter ended April 30, 2007 are not necessarily indicative of the results to be expected for the full year ending January 31, 2008. One of the reasons for this is that, generally, sales of the Company’s piping systems have had a tendency to be lower during the winter months, due to weather constraints over much of the northern hemisphere.

MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share information)

See notes to condensed consolidated financial statements.

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MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

See notes to condensed consolidated financial statements.

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MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See notes to condensed consolidated financial statements.

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MFRI, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

APRIL 30, 2007

Effective February 1, 2006, the Company adopted the fair value recognition provision of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) using the modified-prospective-transition method. Under this transition method, compensation cost recognized includes compensation costs for all share-based payments granted prior to, but not vested as of February 1, 2006 based on the fair value at grant date estimated in accordance with SFAS 123. The Company has not awarded stock-based compensation to employees, officers or directors during the three-month period ended April 30, 2007. The stock-based compensation expense for the three months ended April 30, 2007 and 2006 was $47,300 and $15,000, respectively.

The fair values of the option awards granted prior to but not vested as of April 2007 and 2006 respectively, were estimated on the grant date using the Black-Scholes option pricing model and the assumptions shown in the following table:

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respectively. Future amortization over the next five years ending January 31, will be 2008 - $30,000, 2009 - $27,000, 2010 - $23,000, 2011 - $21,000, 2012 - $18,000.

Employer contributions remaining for fiscal year ending January 31, 2008 are expected to be $97,044.

As of June 5, 2007 a total of 17,352 stock options were exercised since February 1, 2007.

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

The OCI unrealized gain on marketable securities of $66,000 at April 30, 2007 is gross of an $18,000 tax benefit.

Related company accounts receivable of $356,000 and $583,000 were included in the receivable balances at April 30, 2007 and January 31, 2007, respectively. Related company accounts payable of $400,000 and $599,000 were included in the payable balance at April 30, 2007 and January 31, 2007.

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The Company recorded revenue of $229,000 during the first quarter of 2007 and $2,485,000 during the first quarter of 2006 pursuant to a contract wholly-subcontracted to such company.

The Company issues a standard warranty with the sale of its products and sells extended warranty contracts to customers. The Company’s recognition of warranty liability is based, generally, on analyses of warranty claims experiences in the operating units in the preceding years. Changes in the warranty liability in 2007 are summarized below:

In the first quarter of 2007, the Company adopted FIN 48. The total amount of unrecognized tax liability as of February 1, 2007 was approximately $504,300, all of which would impact the effective tax rate if recognized. This was recorded as a decrease to retained earnings as of February 1, 2007. Included in the total unrecognized tax liability were estimated accrued interest of $38,300 and penalties of $31,300. The Company’s policy is to exclude interest and penalties from income tax expense.

In February 2007, the Company sold 1,003,000 shares of common stock at a price of $18.50 per share pursuant to the Company’s existing shelf registration statement previously filed and declared effective by the U.S. Securities and Exchange Commission. The net proceeds of $18,322,000 from such sale were utilized to pay down the revolving line of credit. As a result, increased revolving line of credit borrowing capacity is available to finance future general business needs.

On July 11, 2002, the Company entered into a secured loan and security agreement with a financial institution ("Loan Agreement"). The Loan Agreement was amended and restated on December 15, 2006. Under the terms of the Loan Agreement, which matures on November 13, 2010, the Company can borrow up to $38,000,000, 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 April 30, 2007, the prime rate was 8.25%, 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 1.75 percentage points, respectively. Monthly interest payments were made. As of April 30, 2007, the Company had borrowed $9,341,000 and had $12,434,000 available to it under the revolving line of credit. In addition, $6,684,000 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

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funds may only be used to pay the debt under the Loan Agreement. At April 30, 2007, the amount of restricted cash was $993,000. 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.

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, including the notes thereto. An overview of the segment results is provided in Note 9 of the Notes to Condensed Consolidated Financial Statements (Unaudited) contained in Item 1 of this report.

Three months ended April 30, 2007 vs. Three months ended April 30, 2006

Net sales of $56,954,000 for the quarter increased 21.4% from $46,932,000 in the prior-year quarter. (See discussion of each business segment below.)

Gross profit of $10,792,000 increased 10.1% from $9,805,000 in the prior-year quarter, and gross margin decreased to 18.9% of net sales in the current year from 20.9 % of net sales in the prior-year. (See discussion of each business segment below.)

Selling expenses increased 2.6% to $3,801,000 for the quarter from $3,706,000 in the prior-year quarter due primarily to additional selling personnel. (See discussion of each business segment below.)

General and administrative expenses increased 2.9% to $5,111,000 for the quarter from $4,967,000 in the prior-year quarter. (See discussion of each business segment below.)

Net income rose to $1,038,000 in the current quarter from $151,000 in the prior-year quarter primarily for reasons summarized above and discussed in more detail below, including the favorable income tax effect of $663,000 of United Arab Emirates (“U.A.E.”) facility net income which was not taxable. Because the U.A.E. facility is located in an area with no income taxes, future earnings generated there will also be free of income taxes.

Filtration Products Business

Three months ended April 30, 2007 vs. Three months ended April 30, 2006

Net sales for the quarter increased 42.4% to $26,437,000 from $18,565,000 in the prior-year quarter. This increase was primarily the result of increased sales of filter bags, pleated products and related services.

Gross profit as a percent of net sales declined to 15.7% in the current year from 17.8% in the prior-year primarily as a result of product mix and a highly competitive market place.

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Selling expenses increased to $1,872,000 from $1,726,000 in the prior-year quarter and decreased as a percentage of sales to 7.1% from 9.3% of net sales in the prior-year quarter. The dollar increase was primarily due to additional selling personnel and inclusion of the selling expenses of the South African facility acquired in April 2006.

General and administrative expenses increased to $964,000 in the current-year quarter from $897,000 in the prior-year quarter and decreased as a percentage of sales to 3.7% from 4.8% of net sales in the prior-year quarter. The dollar increase was primarily the result of the inclusion of the general and administrative expenses of the South African facility acquired in April 2006.

Piping Systems Business

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

Three months ended April 30, 2007 vs. Three months ended April 30, 2006

Net sales increased 45.6% to $20,740,000 in the current quarter from $14,246,000 in the prior-year quarter. This increase was primarily due to an increase in the domestic heating and cooling business and $3,253,000 in sales from the U.A.E. facility.

Gross profit as a percent of net sales increased to 21.5% in the current quarter from 20.4% in the prior-year quarter primarily due to higher sales margins at the U.A.E. facility.

Selling expenses increased to $471,000 or 2.3% of net sales in the current year quarter from $425,000 or 3.0% of net sales for the prior-year quarter. The dollar increase was primarily due to additional selling personnel at the new facility in the U.A.E.

General and administrative expenses increased to $1,464,000 or 7.1% of net sales in the current year quarter from $1,390,000 or 9.8% of net sales for the prior-year quarter. General administrative expenses increased primarily due to management incentive compensation earned as a result of improved profitability.

Industrial Process Cooling Equipment Business

Three months ended April 30, 2007 vs. Three months ended April 30, 2006

Net sales of $9,442,000 for the quarter decreased 18.9% from $11,636,000 in the prior-year quarter. The decrease was due primarily to conditions in printing and industrial markets.

Gross profit decreased to 23.4% of net sales in the current quarter from 30.2% of net sales in the prior-year quarter, primarily due to additional post sale customer support costs and an increasing original equipment manufacturer customer sales mix.

Selling expenses decreased to $1,459,000 or 15.5% of net sales in the current-year quarter from $1,556,000 or 13.4% of net sales in the prior-year quarter. The dollar decrease was due to lower commissions due to decreased sales.

General and administrative expenses increased to $1,154,000 or 12.2% of net sales from $1,057,000 or 9.1% of net sales in the prior-year quarter. This increase was primarily due to additional recruiting expenses.

General Corporate and Other

Three months ended April 30, 2007 vs. Three months ended April 30, 2006

During the first quarter 2006, the Company recognized $2,485,000 in revenue pursuant to a contract wholly subcontracted to a related company, Midwesco, Inc., for installation of a heating, ventilation and air conditioning (HVAC) system for a high rise building in Chicago. During the fourth quarter 2006, the Company created a new subsidiary, Midwesco Mechanical and Energy, Inc., that was not material to the financial statements, in which the Company intends to engage in similar activities.

The first quarter 2007, included sales of $335,000 not related to the Company’s three reportable business segments.

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

General and administrative expenses decreased to $1,530,000 in the current year quarter from $1,626,000 in the prior-year quarter, and decreased as a percentage of total company net sales to 2.7% in the current year quarter from 3.5% in the prior-year quarter. The decrease was mainly due to a group insurance refund related to the prior year offset by inclusion of the new subsidiary.

Interest expense decreased to $476,000 for the current year quarter from $556,000 in the prior-year quarter. The decrease was due to reduced borrowings.

Taxes

Taxes on earnings reflect the estimated annual effective rates. Due to the seasonality of the Piping Systems business, the annual estimated U.S. income versus foreign income that is earned in a tax free zone differs as compared to the first quarter’s actual U.S. income versus foreign income. The 27.1% effective tax rate for the first quarter 2007 is less than the statutory U.S. federal income tax rate due mainly to the favorable income tax effect of the tax free income from the U.A.E.

LIQUIDITY AND CAPITAL RESOURCES

In February 2007, the Company sold 1,003,000 shares of common stock at a price of $18.50 per share pursuant to the Company’s existing shelf registration statement previously filed and declared effective by the U.S. Securities and Exchange Commission. The net proceeds of $18,322,000 from this sale were utilized to pay down the revolving line of credit. As a result, increased revolving line of credit borrowing capacity is available to finance future general business needs.

Cash and cash equivalents as of April 30, 2007 were $1,125,000 as compared to $565,000 at January 31, 2007. The Company used $5,380,000 from operations during the first three months. Operating cash flows increased by $265,000 from the corresponding period in the prior year. Net payments of $8,400,000 from the Company’s credit facility were made. Exercise of stock options resulted in proceeds of $18,000.

Compared to January 31, 2007, trade receivables increased by $949,000, inventories increased by $1,065,000, and other operating assets and liabilities decreased by $2,630,000.

Net cash used for investing activities for the three months ended April 30, 2007 was $869,000. Capital expenditures decreased $879,000 from the prior year to $1,156,000.

Debt totaled $30,858,000, a decrease of $8,177,000 since the beginning of the year. Net cash inflows from financing activities were $6,631,000. Stock option activity resulted in $18,000 of cash inflow.

The Company’s working capital was approximately $43,509,000 at April 30, 2007 compared to approximately $30,734,000 at January 31, 2007. The change was primarily due to the decreases in accounts payable and payment of management incentive compensation and commissions payable.

The Company’s current ratio was 2.1 to 1 for April 30, 2007 and 1.6 to 1 for January 31, 2007, respectively. Debt to total capitalization at April 30, 2007 decreased to 34.7% from 50.1% in January 31, 2007.

At April 30, 2007, the Company was in compliance with covenants under the Loan Agreement as defined below.

On July 11, 2002, the Company entered into a secured loan and security agreement with a financial institution ("Loan Agreement"). The Loan Agreement was amended and restated on December 15, 2006. Under the terms of the Loan Agreement, which matures on November 13, 2010, the Company can borrow up to $38,000,000, 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 April 30, 2007, the prime rate was 8.25%, 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 1.75 percentage points, respectively. Monthly interest payments were made. As of April 30, 2007, the Company had borrowed $9,341,000 and had $12,434,000 available to it under the revolving line of credit. In addition, $6,684,000 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

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the debt under the Loan Agreement. At April 30, 2007, the amount of restricted cash was $993,000. Cash required for operations is provided by draw-downs on the line of credit.

CRITICAL ACCOUNTING POLICIES

Reclassifications: Reclassifications were made to prior-year financial statements to conform to the current-year presentations.

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 the above critical policies have resulted in past actual results approximating the estimated amounts in those areas.

Revenue Recognition: The Company recognizes revenues including shipping and handling charges billed to customers, 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 the Piping Systems business, recognize revenues upon shipment or delivery of goods or services when title and risk of loss pass to customers.

Percentage of Completion Method Revenue Recognition: Piping Systems business 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.

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 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 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. Refer to Note 4 Goodwill in Notes to Condensed Consolidated Financial Statements.

Stock Options: Effective February 1, 2006, the Company adopted the fair value recognition provision of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) using the modified-prospective-transition method. Under this transition method, compensation cost recognized includes compensation costs for all share-based payments granted prior to, but not vested as of February 1, 2006 based on the fair value at grant date estimated in accordance with SFAS 123. In accordance with SFAS 123R, results for prior periods have not been restated.

The Company was subject to market risk associated with changes in foreign currency exchange rates and interest rates. Foreign currency exchange rate risk was mitigated through maintenance of local production facilities in the markets served, invoicing of customers in the same currency as the source of the products and use of foreign currency denominated debt in Denmark.

At January 31, 2007 one interest rate swap agreement was in effect with a notional value of $15,000,000 maturing in 2011. The swap agreement exchanges the variable rate to fixed interest rate payments of 5.13% plus LIBOR margin. On February 5, 2007 the Company terminated such interest rate swap and recognized a loss of $72,500.

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 $96,000.

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

As of April 30, 2007, the Company carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.

PART II – OTHER INFORMATION

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SIGNATURES

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

MFRI, INC.

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