UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q10-Q/A

EXPLANATORY NOTE

This amendment is being filed to correct a typographical error in stock options not included in the computation of diluted earnings (see Note 7) and to correct a typographical error in the Industrial Process Cooling Equipment section of Management's Discussion and Analysis of Financial Condition and Results of Operations.  Subsequent to the issuance of the October 31, 2008 Form 10Q, management determined that Note 7 and that the gross margin percentages for the three and nine months ending October 31, 2008 were incorrect due to a typographical error that affected one amount and two percentage figures.  These amounts were revised to reflect the correct stock options not included in the computation of diluted earnings and correct gross margin percentages.  Gross margin for the three months ended October 31, 2008 remained level compared to the prior-year period.  Gross margin for the nine months ended October 31, 2008 increased compared to the prior-year period due to significant reduction in post-sale customer support costs, which was partially offset by an unfavorable change in product mix and by lower sales volume.  These typographical errors did not affect the Condensed Consolidated Statements of Operations (Unaudited), Condensed Consolidated Balance Sheets (Unaudited),  Condensed Consolidated Statements of Cash Flows (Unaudited), and Notes to Condensed Consolidated Financial Statements (Unaudited). 

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, 2008. Reclassifications have been made in prior year financial statements to conform to the current year presentation. The results of operations for the quarter ended October 31, 2008 are not necessarily indicative of the results to be expected for the full year ending January 31, 2009. One of the reasons for this is Piping Systems’ domestic, sales and earnings are seasonal, typically higher during the second and third quarters due to favorable weather for construction over much of North America, and are correspondingly lower during the first and fourth quarters.

MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share information) 

See accompanying notes to condensed consolidated financial statements.

MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

MFRI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

MFRI, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

OCTOBER 31, 2008

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 awarded 155,600 shares stock-based compensation to employees, officers or directors during the nine-month period ended October 31, 2008. The stock-based compensation expense was as follows:

The fair values of the option awards granted prior to, but not vested as of, October 31, 2008 and 2007 respectively, were estimated on the grant dates using the Black-Scholes option pricing model and the assumptions shown in the following table:

Stock option activity for the nine months ended October 31, 2008 was as follows:

The weighted-average exercise price per nonvested stock award at grant date was $17.41 per share for the nonvested stock awards granted in 2008. Nonvested stock award activity for the nine months ended October 31, 2008 was as follows:

As of October 31, 2008, there was $2,864,000 of total unrecognized compensation cost related to nonvested stock-based compensation arrangements granted under the equity-based compensation plans. That cost is expected to be recognized over a period of 3.5 years.

Employer contributions remaining for fiscal year ending January 31, 2009 of $38,817 were paid November 2008. For the nine months ended October 31, 2008, $116,600 contributions were made.

The basic weighted average shares reconciled to diluted weighted average shares as follows:

As of December 4, 2008, a total of 11,650 stock options have been exercised since February 1, 2008.

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

On June 28, 2007, the Company loaned the joint venture $100,000. The loan and interest were paid in 2008.

Related companies balances were as follows:

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. The warranty liability was included in other accrued liabilities on the balance sheet.

Changes in the warranty liability are summarized below:

In April 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FAS 142-3”) which amends the list of factors an entity should consider in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FAS No. 142, “Goodwill and Other Intangible Assets” (“FAS No. 142”). FSP FAS 142-3 applies to intangible assets that are acquired individually or with a group of assets and intangible assets acquired in both business combinations and asset acquisitions. FAS 142-3 removes the provision under FAS No. 142 that requires an entity to consider whether the renewal or extension can be accomplished without substantial cost or material modifications of the existing terms and conditions associated with the asset. Instead, FAS 142-3 requires that an entity consider its own experience in renewing similar arrangements. An entity would consider market participant assumptions regarding renewal if no such relevant experience exists. FAS 142-3 is effective for the Company beginning February 1, 2009. The Company does not expect the provisions to have a material effect on its consolidated financial statements.

The Company adopted SFAS 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements that address Fair Value Measurements for Purposes of Lease Classification or Measurement Under Statement 13” on February 1, 2008. SFAS 157-1 removes leasing transactions accounted for under FAS No. 13 “Accounting for Leases” and related guidance from the scope of FAS No. 157 “Fair Value Measurements”.  The adoption of SFAS 157-1 did not have a material effect on the Company’s consolidated financial statements.

In February 2008, the FASB issued SFAS No. 157-2, “Effective Date of FASB Statement No. 157,” which delayed the effective date of SFAS 157 “Fair Value Measurements” (SFAS 157) for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on at least an annual basis, until January 1, 2009 for calendar year-end entities. The Company does not expect the adoption of SFAS 157-2 to have a material effect on its consolidated financial statements.

In October 2008, the FASB issued SFAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” and was effective on issuance. SFAS 157-3 specifically addresses the use of judgment in determining whether a transaction in a dislocated market represents fair value, the inclusion of market participant risk adjustments when an entity significantly adjusts observable market data based on unobservable inputs, and the degree of reliance to be placed on broker quotes or pricing services. The adoption of SFAS 157-3 did not have a material effect on the Company’s consolidated financial statements.

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This standard is now the single source in GAAP for the definition of fair value, except for the fair value of leased property as defined in SFAS 13. SFAS 157 establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data oriented from independent sources (observable inputs) and (2) an entity’s own assumptions about market participants assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy under SFAS 157 are described 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 October 31, 2008, the prime rate was 4.00%, 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 0.25 and 2.25 percentage points, respectively. Monthly interest payments were made. As of October 31, 2008, the Company had borrowed $26,205,000 and had $4,271,000 available to it under the revolving line of credit. In addition, $1,226,000 of availability was used under the Loan Agreement primarily to support letters of credit to guarantee amounts committed for inventory purchases. The Loan Agreement provides that all payments by the Company's customers are deposited in a bank account from which all funds may only be used to pay the debt under the Loan Agreement. At October 31, 2008, the amount of restricted cash was $782,000. 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

Consolidated MFRI, Inc.

MFRI, Inc. ("MFRI", the "Company" or the "Registrant") is engaged in the manufacture and sale of products in three distinct reportable business segments: Piping Systems, Filtration Products, and Industrial Process Cooling Equipment. Piping Systems’ domestic sales and earnings are seasonal, typically higher during the second and third quarters due to favorable weather for construction over much of North America, and are correspondingly lower during the first and fourth quarters. The Company’s other businesses do not demonstrate seasonality. The Company website address is www.mfri.com.  All filings with the SEC are available free of charge at www.sec.gov as soon as reasonably practicable after they have been filed with, or furnished to, the SEC.

The 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 condensed 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 October 31, 2008 vs. Three months ended October 31, 2007

Net sales of $76,817,000 for the quarter increased 18.0% from $65,086,000 for the corresponding quarter in the prior year. (See discussion of each business segment below.)

Gross profit of $17,099,000 increased 52.7% from $11,200,000 in the prior-year quarter, and gross margin increased to 22.3% in the current-year quarter from 17.2% in the prior-year quarter. (See discussion of each business segment below.)

Selling expenses decreased 3.2% to $3,630,000 for the quarter from $3,749,000 in the prior-year quarter. This was primarily driven by the Industrial Process Cooling Equipment business, which had decreased commission expense from lower sales and a reduction in staffing completed in the second half of the prior year. (See discussion of each business segment below.)

General and administrative expenses increased 33.9% to $8,221,000 for the quarter from $6,141,000 in the prior-year quarter. The increase was mainly due to increased profit-based management incentive expense, increased bank fees, and additional stock compensation expense. (See discussion of each business segment below.)

Net income increased to $4,688,000 in the current quarter from $983,000 in the prior-year quarter primarily due to increased sales, the reasons summarized above and discussed in more detail below.

Nine months ended October 31, 2008 vs. Nine months ended October 31, 2007

Net sales of $220,443,000 for the nine months increased 21.8% from $180,984,000 for the corresponding period in the prior year. (See discussion of each business segment below.)

Gross profit of $43,643,000 for the nine months increased 28.0% from $34,088,000 for the corresponding period in the prior year, while gross margin increased to 19.8% in the current year from 18.9% in the prior year. (See discussion of each business segment below.)

Selling expenses decreased 0.2% to $10,874,000 for the nine months from $11,085,000 for the corresponding period in the prior year. This was primarily driven by the Industrial Process Cooling Equipment business, which had decreased commission expense from lower sales and a reduction in staffing completed in the second half of the prior year. (See discussion of each business segment below.)

General and administrative expenses increased 28.0% to $22,188,000 for the nine months from $17,341,000 for the corresponding period in the prior year. The increase was mainly due to increased profit-based management incentive expense, increased bank fees, additional stock compensation expense and incremental expenses of $259,000 incurred to comply with Sarbanes-Oxley 404 (including consulting fees), that were not incurred in 2007 offset by a decrease in the deferred compensation expense of $410,000. (See discussion of each business segment below.)

Net income increased to $7,516,000 for the nine months from $3,464,000 for the corresponding period in the prior year primarily due to increased sales, the reasons summarized above and discussed in more detail below.

Piping Systems Business

Piping Systems’ domestic sales and earnings are seasonal, typically higher during the second and third quarters due to favorable weather for construction over much of North America, and are correspondingly lower during the first and fourth quarters.

Three months ended October 31, 2008 vs. Three months ended October 31, 2007

Net sales increased 27.4% to $37,703,000 in the current quarter from $29,584,000 in the prior-year quarter, attributed primarily to achieving market traction in the United Arab Emirates (“U.A.E.”) and the Gulf Cooperation Council (GCC) countries. The insulation of pipe for a crude oil pipeline project in India began full production in the third quarter 2008 and contributed to the increase.

Gross margin increased to 30.0% in the current quarter from 19.0% in the prior-year quarter primarily due to production efficiencies in both the domestic and international operations. Margins in the U.A.E., improved with the increased volume without corresponding increases in fixed expenses, and margins also increased due to the gross profit from the India pipeline project.

Selling expenses increased to $708,000 or 1.9% of net sales in the current quarter from $590,000 or 2.0% of net sales for the prior-year quarter. This dollar increase was mainly due to increased staffing primarily in the U.A.E., and increased commission expense related to the domestic district heating and cooling (“DHC”) sales.

General and administrative expenses increased to $3,163,000 or 8.4% of net sales in the current quarter from $1,627,000 or 5.5% of net sales for the prior-year quarter. The increase in general and administrative expenses was primarily due to the increased profit-based management incentive expense, additional administrative costs in the India pipeline project, increased bank fees and a loss in foreign currency exchange.

Nine months ended October 31, 2008 vs. Nine months ended October 31, 2007

Net sales of $107,067,000 for the nine months increased 36.3% from $78,528,000 for the corresponding period in the prior year, attributed to achieving market traction in the U.A.E., as well the GCC countries. The U.A.E. facility’s net sales were $31,279,000 in the current year compared to $16,601,000 in the corresponding period of the prior year. In addition, DHC sales increased, and the India pipeline project had sales of $4,102,000. As of October 31, 2008, the Company had completed one fourth of the contract.

Gross margin increased for the nine months to 24.3% in the current year from 21.0% in the prior year, primarily due to production efficiencies in both the domestic and international operations. Margins in the U.A.E. improved with the increased volume without corresponding increases in fixed expenses.

Selling expense increased to $1,902,000 or 1.8% of net sales in the current-year period from $1,533,000 or 2.0% of net sales in the prior-year period. The increase was mainly due to increased staffing primarily in the U.A.E. and the addition of the international sales manager in the U.S.

General and administrative expense increased to $7,611,000 or 7.1% of net sales in the current-year period, compared with $4,685,000 or 6.0% net sales in the prior-year period. The increase was primarily due to the increase in profit-based management incentive expense, additional administrative costs in the India pipeline project, increased bank fees and a loss in foreign currency exchange.

Filtration Products Business

Three months ended October 31, 2008 vs. Three months ended October 31, 2007

Net sales for the quarter remained the same at $25,400,000 from $25,421,000 in the comparable quarter in the prior year. Strong sales continued in all product lines, even though sales for this quarter were adversely impacted from production downtime associated with the relocation to the Bolingbrook facility.

Gross margin decreased to 11.3% in the current quarter from 11.9% in the prior-year quarter primarily due to the highly competitive marketplace, increasing cost of raw materials and manufacturing costs resulting from the relocation to the Bolingbrook facility.

Selling expenses increased to $1,890,000 from $1,812,000 for the comparable quarter last year. Selling expense increased as a percentage of sales to 7.4% from 7.1% for the comparable quarter last year. The increase was primarily due to additional selling personnel.

General and administrative expenses slightly decreased to $1,178,000 or 4.6% of net sales in the current quarter from $1,211,000 or 4.7% of net sales in the prior-year quarter.

Nine months ended October 31, 2008 vs. Nine months ended October 31, 2007

Net sales for the nine months increased 9.2% to $79,414,000 from $72,731,000 in the corresponding period in the prior year. This increase was due to the result of higher unit volume in all product lines, primarily to domestic power generation customers.

Gross margin decreased for the nine months to 12.7% in the current year from 14.8% in the prior year, primarily due to the highly competitive marketplace, increasing cost of raw materials and manufacturing inefficiencies resulting from the relocation to the Bolingbrook facility.

Selling expense for the nine months increased to $5,817,000 from $5,354,000 for the corresponding period in the prior year. Selling expense decreased as a percentage of net sales to 7.3% from 7.4% for the corresponding period in the prior year. The dollar increase was primarily due to additional selling personnel, travel and advertising expenses.

General and administrative expenses increased to $3,524,000 or 4.4% of net sales in the current year from $3,043,000 or 4.2% of net sales in the prior year. The increase was primarily due to the hiring of several new senior managers and increased professional service expense.

Industrial Process Cooling Equipment Business

The Company has corrected a typographical error in gross margin percentages.  The error did not affect the Registrant's sales, expenses, cash flows, or business prospects.

Three months ended October 31, 2008 vs. Three months ended October 31, 2007

Net sales of $8,692,000 for the quarter decreased 10.1% from $9,665,000 for the comparable quarter in the prior year due to lower demand for its products in the domestic plastics and printing markets.

Gross margin decreased to 22.6% in the current quarter from 26.5% in the prior-year quarter, primarily due to lower sales volume relative to fixed costs and product mix.remained level at 26.4%. 

Selling expenses decreased to $1,031,000 or 11.9% of net sales in the current quarter from $1,347,000 or 13.9% of net sales in the prior-year quarter. This was primarily driven by decreased commission expense from lower sales and a reduction in staffing completed in the second half of the prior year.

General and administrative expenses decreased in the current quarter to $906,000 or 10.4% of net sales from $1,141,000 or 11.8% of net sales in the prior-year quarter, as increased new product development expenses were offset by a gain on the sale of assets.

Nine months ended October 31, 2008 vs. Nine months ended October 31, 2007

Net sales of $25,732,000 for the nine months decreased 9.6% from $28,462,000 for the corresponding period in the prior year primarily due to lower demand for its products in the plastic and domestic printing markets.

Gross margin decreasedincreased to 24.3%25.6% in the current year from 24.9% in the prior year, primarily due to significant reduction in post-sale customer support costs, which was partially offset by an unfavorable change in product mix and by lower sales volume relative to fixed costs, partially offset by significant reduction in post sale customer support costs.volume.

Selling expense decreased to $3,155,000 or 12.3% of net sales in the current-year period from $4,197,000 or 14.7% of net sales in the prior year. This was primarily driven by decreased commission expense from lower sales and due to a reduction in staffing completed in the second half of the prior year.

General and administrative expense increased to $3,424,000 or 13.3% of net sales in the current-year period from $3,276,000 or 11.5% of net sales in the prior year, primarily due to increased new product development engineering expenses.

General Corporate and Other

Included in Corporate and Other activity is a subsidiary, which engages in the installation of heating, ventilation and air conditioning (“HVAC”) systems, but which is not sufficiently large to constitute a reportable segment. General corporate expenses included interest expense and general and administrative expenses that were not allocated to the business segments.

Three months ended October 31, 2008 vs. Three months ended October 31, 2007

Net sales of $5,022,000 for the quarter increased from $416,000 in the prior-year quarter. The sales were related to the start-up stage of the heating, ventilation and air conditioning (“HVAC”) systems business, which had a backlog (uncompleted firm orders) of $33,179,000 as of January 31, 2008.

General and administrative expenses increased to $2,974,000 in the quarter from $2,162,000 in the prior-year quarter, and increased as a percentage of total company net sales to 3.9% in the quarter from 3.3% in the prior-year quarter. The increase was due mainly to increased profit-based management incentive expense, and additional stock compensation expense of $91,000 offset by a decrease in deferred compensation expense of $60,000.

Interest expense, net of capitalized interest, increased to $745,000$744,000 for the quarter from $664,000 in the prior-year quarter due to increased borrowings.

Nine months ended October 31, 2008 vs. Nine months ended October 31, 2007

Net sales of $8,230,000 for the year increased from $1,263,000 in the prior-year. The sales were related to the start-up stage of the HVAC systems business.

General and administrative expense increased to $7,629,000 or 3.5% of consolidated net sales in the current-year nine-month period from $6,337,000 or 3.5% in the prior-year period. The increase was mainly due to the profit-based increased management incentive expense, increased incremental expenses of $259,000 incurred to comply with SOX 404 (including consulting fees) that were not incurred in the first half of 2007, stock compensation expense of $296,000, and additional staffing, offset by a decrease in deferred compensation expense of $410,000.

Interest expense, net of capitalized interest, increased to $2,022,000$2,021,000 for the current-year period from $1,751,000 for the corresponding period in the prior year primarily due to increased borrowings. Capitalized interest of $152,000 was recorded in 2008 and was attributable to the building preparations for the relocation of the Filtration Products business’ Cicero, Illinois operations to Bolingbrook, Illinois which occurred in the second and third quarters of 2008. The building was purchased in March 2008 for $6,400,000, and improvements and modifications cost an additional $1,600,000.

Income Taxes

Taxes on earnings are based on estimated annual effective rates. The 13.2% effective tax rate at October 31, 2008 is less than the statutory U.S. federal income tax rate, mainly due to the impact of tax-free foreign income and tax rate differential. The Company does not anticipate the utilization of the research and development tax credit carried over from prior years in this year but does anticipate the utilization in future years.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents as of October 31, 2008 were $2,690,000 as compared to $2,665,000 at January 31, 2008. The Company used $1,077,000 from operations during the first nine months of 2008. Operating cash flows increased by $1,979,000 from the corresponding period in the prior year. During the first nine months of 2008, net borrowings of $22,756,000 were made from mortgages and the Company’s credit facility. Exercise of stock options for the first nine months of 2008 resulted in proceeds of $37,000.

Net sales in the first nine months of 2008 increased $39,459,000, or 21.8%, compared to the prior year period net sales. The higher sales contributed to the increased balances in trade accounts receivable, inventories, trade accounts payable, and customers’ deposits. Compared to January 31, 2008, trade receivables increased by $15,010,000 mainly in the Piping Systems business, inventories increased by $15,702,000 mainly in the Piping Systems business for orders expected to ship in later months.

Net cash used for investing activities for the nine months ended October 31, 2008 was $16,925,000. Capital expenditures increased $12,695,000 from the prior year to $17,217,000. The Filtration Products business’ Cicero, Illinois operations relocated in the summer of 2008 to a building in Bolingbrook, Illinois, purchased in March 2008 for $6,400,000. Improvements and modifications cost an additional $1,600,000. The Company has financed such expenditures through real estate mortgages, equipment financing loans, internally generated funds and its revolving line of credit.

Debt totaled $55,866,000, an increase of $21,626,000 since the beginning of the current fiscal year. The Company’s borrowing under its revolving line increased $17,623,000 since the beginning of the current fiscal year, primarily to fund inventory purchases for the increased sales. Net cash provided by financing activities was $19,222,000. Stock option activity resulted in $443,000 of cash outflow, which included $480,000 tax expense of stock options exercised in addition to stock option proceeds of $37,000.

The Company’s working capital was approximately $67,565,000 at October 31, 2008 compared to approximately $39,544,000 at January 31, 2008. The change was primarily due to decreases in current maturities, increased trade accounts receivable and increased inventory offset by increases in trade accounts payable and customer deposits.

The Company’s current ratio was 2.1 to 1 for October 31, 2008 and 1.7 to 1 for January 31, 2008, respectively. Debt to total capitalization at October 31, 2008 increased to 46.2% from 36.4% at January 31, 2008.

At January 31, 2008, the Company was not in compliance with an earnings covenant (the “Covenant”) under the Loan Agreement as defined below.  A waiver was obtained for such noncompliance, and the Covenant has been amended to levels consistent with the Company’s then current business plan beginning with the period ending July 31, 2008.  At October 31, 2008, the Company was in compliance with all Loan Agreement Covenants.

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 October 31, 2008, the prime rate was 4.00%, 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 0.25 and 2.25 percentage points, respectively. Monthly interest payments were made. As of October 31, 2008, the Company had borrowed $26,205,000 and had $5,263,000 available to it under the revolving line of credit. In addition, $1,226,000 of availability was used under the Loan Agreement primarily to support letters of credit to guarantee amounts committed for inventory purchases. The Loan Agreement provides that all payments by the Company's customers are deposited in a bank account from which all funds may only be used to pay the debt under the Loan Agreement. At October 31, 2008, the amount of restricted cash was $782,000. Cash required for operations is provided by draw-downs on the line of credit.

CRITICAL ACCOUNTING ESTIMATES AND POLICIES

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) collectability is reasonably assured. All subsidiaries of the Company, except as noted below, recognize revenues upon shipment or delivery of goods or services when title and risk of loss pass to customers.

Percentage of completion revenue recognition: The Piping System business and Corporate and Other recognize revenues under the above stated revenue recognition policy except for sizable complex contracts that require periodic recognition of income based on the status of the uncompleted contracts and the current estimates of costs to complete and of progress toward completion. For these contracts, the Company uses "percentage of completion" method. The choice of accounting method is made at the time the contract is received based on the nature of the contract. 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.

Income tax provision: Deferred income taxes have been provided for temporary differences arising from differences in basis of assets and liabilities for tax and financial reporting purposes. Deferred income taxes on temporary differences have been recorded at the current tax rate. The Company assesses its deferred tax assets for realizability at each reporting period.

New accounting pronouncements: The Company adopted SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities on February 1, 2008. SFAS 159 provides the option to report certain financial assets and liabilities at fair value, with the intent to mitigate volatility in financial reporting that can occur when related assets and liabilities are recorded on different bases. The adoption of SFAS 159 did not have a material effect on the Company’s consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FAS 142-3”) which amends the list of factors an entity should consider in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FAS No. 142, “Goodwill and Other Intangible Assets” (“FAS No. 142”). FSP FAS 142-3 applies to intangible assets that are acquired individually or with a group of assets and intangible assets acquired in both business combinations and asset acquisitions. FAS 142-3 removes the provision under FAS No. 142 that requires an entity to consider whether the renewal or extension can be accomplished without substantial cost or material modifications of the existing terms and conditions associated with the asset. Instead, FAS 142-3 requires that an entity consider its own experience in renewing similar arrangements. An entity would consider market participant assumptions regarding renewal if no such relevant experience exists. FAS 142-3 is effective for the Company beginning February 1, 2009. The Company does not expect the provisions to have a material effect on its consolidated financial statements.

The Company adopted SFAS 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements that address Fair Value Measurements for Purposes of Lease Classification or Measurement Under Statement 13” on February 1, 2008. SFAS 157-1 removes leasing transactions accounted for under FAS No. 13 “Accounting for Leases” and related guidance from the scope of FAS No. 157 “Fair Value Measurements”.  The adoption of SFAS 157-1 did not have a material effect on the Company’s consolidated financial statements.

In February 2008, the FASB issued SFAS No. 157-2, “Effective Date of FASB Statement No. 157,” which delayed the effective date of SFAS 157 “Fair Value Measurements” (SFAS 157) for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on at least an annual basis, until January 1, 2009 for calendar year-end entities. The Company does not expect the adoption of SFAS 157-2 to have a material effect on its consolidated financial statements.

In October 2008, the FASB issued SFAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” and was effective on issuance. SFAS 157-3 specifically addresses the use of judgment in determining whether a transaction in a dislocated market represents fair value, the inclusion of market participant risk adjustments when an entity significantly adjusts observable market data based on unobservable inputs, and the degree of reliance to be placed on broker quotes or pricing services. The adoption of SFAS 157-3 did not have a material effect on the Company’s consolidated financial statements.

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This standard is now the single source in GAAP for the definition of fair value, except for the fair value of leased property as defined in SFAS 13. SFAS 157 establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data oriented from independent sources (observable inputs) and (2) an entity’s own assumptions about market participants assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy under SFAS 157 are described below:

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, often, though not always, invoicing customers in the same currency as the source of the products and

use of foreign currency denominated debt in Denmark, U.A.E., India and South Africa. At times the Company has attempted to mitigate interest rate risk by maintaining a balance of fixed-rate long-term debt and floating-rate debt.

A hypothetical ten percent change in market interest rates over the next year would increase or decrease interest expense on the Company's floating rate debt instruments by approximately $125,000.

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

The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of October 31, 2008. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of October 31, 2008 to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and is accumulated and communicated to the issuer’s management, including our principal executive and financial officers, to allow timely decisions regarding required disclosure.

Change in Internal Controls: There was a material weakness in internal control described in Item 9A of the Company’s January 31, 2008 10-K filed on April 30, 2008. The Company’s processes, procedures and controls related to the preparation and review of the quarterly and annual income tax provisions were not deemed effective at October 31, 2007 and January 31, 2008 to ensure that amounts related to the income tax provisions were accurate. This material weakness resulted in an accounting error, which did not affect the Company's sales, operating expenses, or cash flow. However, the error did result in the understatement of income taxes, and overstatement of current assets, total assets, and net income for the interim fiscal period reported at October 31, 2007.

Other than the material weakness noted above, there has been no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting except as discussed below.

Remediation Plan for the Material Weaknesses in Internal Control over Financial Reporting: As noted above, there was a material weakness in internal control described in Item 9A of the Company’s January 31, 2008 10-K filed on April 30, 2008. Beginning in 2005, the Company engaged a national public accounting, tax and business consulting firm with affiliates worldwide (the “Tax Advisor”) to assist the Company with calculation and review of its quarterly and annual income tax provisions and with its income tax compliance. To avoid recurrence of an error such as the one described above, the Company and Tax Advisor have changed the senior technical resources assigned to the engagement, implemented tax software, improved income tax accounting documentation, and adjusted the timing of quarterly and annual income tax accounting work.

We anticipate the actions described above and resulting improvements in controls will strengthen our internal control over financial reporting relating to accounting for income taxes and will address the related material weakness that was identified as of January 31, 2008.

PART II – OTHER INFORMATION

(Chief Executive Officer and Chief Financial Officer certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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.