Mfri Inc (MFRI) SEC Quarterly Report (10-Q) for Q2 2016

For the quarterly period ended April 30, 2016

(Exact name of registrant as specified in its charter)

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes o No x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

On June 3, 2016 , there were 7,384,769 shares of the registrant's common stock outstanding.

(In thousands, except per share data)

See accompanying notes to consolidated financial statements.

Note: Earnings per share calculations could be impacted by rounding.

(In thousands)

See accompanying notes to consolidated financial statements.

MFRI, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

MFRI, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See accompanying notes to consolidated financial statements.

(Tabular amounts presented in thousands, except per share amounts)

Prior to January 29, 2016, the Company had a Filtration Products segment. This business is reported as discontinued operations in the consolidated financial statements and the notes to consolidated financial statements have been restated to conform to the current year reporting of this business. For further information, see "Notes to Consolidated Financial Statements Note 4 Discontinued operations".

For the three months ended April 30, 2016 , one customer accounted for 15% of the Company's consolidated net sales, and for the three months ended April 30, 2015 , one customer accounted for 11% of the Company's consolidated net sales.

At April 30, 2016 , two customers accounted for 28% of accounts receivable. Two customers accounted for 46% of accounts receivable at January 31, 2016 .

The purchase price was $13.1 million CAD ( $9.6 million USD) in cash and debt at closing and is subject to certain post-closing adjustments. The initial accounting for this acquisition is not complete pending detailed analyses of the facts and circumstances that existed as of the acquisition date. The following table represents the preliminary allocation of the total consideration in the acquisition of BPPC:

The acquisition has preliminarily resulted in approximately $2.7 million of goodwill. The Company incurred legal, professional and other costs related to this acquisition. These costs were recognized as general and administrative expenses.

In the quarter, the Company recognized a non-cash loss of $1.6 million which represents the difference between the pre-existing book value interest in BPPC immediately prior to the acquisition remeasured to its fair value upon the acquisition date.

Pro Forma results - The following table summarizes, on a pro forma basis, the combined results of operations of the Company and the acquired business as though the acquisition had occurred as of February 1, 2015. The pro forma amounts presented are not necessarily indicative of either the actual consolidated results had the acquisition occurred as of February 1, 2015, or of future consolidated operating results.

Pro forma results presented above primarily reflect revenues that were down due to the effect of oil prices on customer demand in the U.S. and Canada and on certain market conditions in the Middle East. Pro forma

adjustments described above have been tax effected using the Company's effective rate during the respective periods.

Components of assets, and liabilities from discontinued operations consist of the following:

Cashflows from discontinued operations:

The Company's consolidated effective tax rate ("ETR") from continuing operations was 4.1% and (0.8)% for the three months ended April 30, 2016 and 2015 , respectively. The change in the ETR from the prior year to the current year is mainly due to the addition of the Canadian activity.

The amount of unrecognized tax benefits, including interest and penalties, at April 30, 2016 , recorded in other long-term liabilities was $0.1 million , all of which would impact the Company's effective tax rate if recognized.  The Company includes accrued interest and penalties related to uncertain tax positions in income tax expense, with $1 thousand included in expense for the current quarter.  The amount of accrued interest and penalties at April 30, 2016 , associated with unrecognized tax benefits was $46 thousand .

The Company's former headquarters in Niles, Illinois is presented as held for sale at fair market value as of April 30, 2016 . There are no indications of impairment related to these assets.

Goodwill. Goodwill represents the excess of purchase price over the fair value of the net assets acquired in conjunction with the Company's acquisition of BPPC.

Stock-based compensation for 2016 was a benefit year-to-date due to cancellations. Most of these cancellations related to former employees from the Company's discontinued operations. The increase in the restricted stock based compensation expense relates to a grant in March 2016 and the conversion of performance restricted stock units to time-based restricted shares. This increase is partially offset by a decrease in management incentive compensation expense.

The fair value of the outstanding option awards was estimated on the grant dates using the Black-Scholes option pricing model.

As of April 30, 2016 , there was $0.4 million of total unrecognized compensation expense related to unvested stock options. The expense is expected to be recognized over a period of 1.8 years.

The following table summarizes restricted stock activity for the year:

As of April 30, 2016 , there was $0.8 million of unrecognized compensation expense related to unvested restricted stock granted under the plans. The cost is expected to be recognized over the weighted-average period of 2.4 years .

Interest rates vary based on the average availability in the preceding fiscal quarter and are: (a) a margin in effect plus a base rate, if below certain availability limits; or (b) a margin in effect plus the Eurodollar rate for the corresponding interest period. As of April 30, 2016 , the Company had borrowed $7.2 million at 3.5% and 2.19% and had $5.6 million available to it under the revolving line of credit. In addition, $0.3 million of availability was used under the Credit Agreement primarily to support letters of credit to guarantee amounts committed for inventory purchases. Cash required for operations, as needed, is provided by draw downs on the line of credit.

On February 1, 2016, the Company entered into a promissory note with United Pipeline Systems Limited, an affiliate of Aegion, Inc. for $2.0 million . The promissory note b ears interest at prime, which was 3.25% at April 30, 2016, plus 5% and matures on August 1, 2016 .

The Company held a marketable equity security of approximately $0.1 million at April 30, 2016 , which it classified as available-for-sale and recorded in other non-current assets on the Consolidated Balance Sheet. This security is carried at estimated fair value with unrealized gains and losses reflected in Accumulated Other Comprehensive Income and classified as Level 1 in the fair value hierarchy. The assessment for impairment of marketable equity securities as available-for sale is based on established financial methodologies, including quoted market prices for publicly traded securities. If the Company determines that a loss in the value of the investment is other than temporary, any such losses are recorded in other expense (income), net.

In April 2015, the FASB issued authoritative guidance to simplify the balance sheet presentation of debt issuance costs. Under the new guidance, debt issuance costs is presented as a reduction of the carrying amount

of the debt liability. The guidance was effective for the Company beginning February 1, 2016 and was applied retrospectively for all periods presented. The Company adopted this guidance and it did not have a material impact on the Company's financial statements.

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40) - Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern ("ASU 2014-15"). ASU 2014-15 provides guidance about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. ASU 2014-15 is effective for annual periods ending after December 15, 2016, and for annual periods and interim periods thereafter. Early adoption is permitted. The adoption of ASU 2014-15 is not expected to have an impact on the Company's consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. This new standard provides for a single comprehensive model and supersedes most current revenue recognition guidance, including industry specific guidance, and provides for enhanced disclosure requirements. The objective of the new guidance is to improve the consistency, comparability and usefulness to users of financial statements. On April 1, 2015, FASB decided to defer the effective date of the new revenue standard by one year. As a result, public entities would apply the new revenue standard for fiscal years, and interim periods within those years, beginning after December 15, 2017. ASU 2014-09 provides for two implementation methods (1) full retrospective application to each prior period or (2) modified retrospective application with the cumulative effect as of the date of adoption. The Company is evaluating the financial statement impacts of the guidance in this ASU and determining which transition method will be utilized.

In May, 2016, the Company also completed the sale of its Bolingbrook Filtration facility to a third party at a purchase price of $7.1 million . The sale generated approximately $1.9 million in net cash after expenses and mortgage payoffs.

The statements contained under the caption MD&A and other information contained elsewhere in this quarterly 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 as a result of many factors, including but not limited to those under the heading Item 1A. Risk Factors included in the Company's latest Annual Report on Form 10-K.

MFRI, Inc. is engaged in the manufacture and sale of products in one reportable segments: Piping Systems. The Company website is www.mfri.com . Since the Piping Systems segment is based on large discrete projects,

operating results could be negatively impacted in the future as a result of large variations in the level of market demand in both geographies and reporting periods.

This discussion should be read in conjunction with the consolidated financial statements, including the notes thereto, contained elsewhere in this report. An overview of the segment results is provided in "Notes to Consolidated Financial Statements, Note 2 Business segment reporting" contained in Item 1 of this report.

For the three months ended April 30, 2016 , one customer accounted for 15% of the Company's consolidated net sales, and for the three months ended April 30, 2015 , one customer accounted for 11% of the Company's consolidated net sales.

At April 30, 2016 , two customers accounted for 28% of accounts receivable. Two customers accounted for 46% of accounts receivable at January 31, 2016 .

Prior to January 29, 2016, the Company was also engaged in the manufacture and sale of products in the Filtration Products segment.  On January 29, 2016, the Company sold certain assets and liabilities of its TDC Filter business based in Bolingbrook, Illinois and its Nordic Air Filtration, Denmark and Nordic Air Filtration, Middle East businesses. The remaining domestic fabric filter business, which is included in discontinued operations, is operational and selling product as of April 30, 2016. The Company is currently engaged in liquidating the assets of this business. This business is reported as discontinued operations in the consolidated financial statements and the notes to consolidated financial statements have been revised to conform to the current year reporting. There was $16.0 thousand of tax benefit for the three months ended April 30, 2016 . For further information, see "Notes to Consolidated Financial Statements, Note 4 Discontinued operations".

Three months ended April 30, 2016 ( " current quarter " ) vs. Three months ended April 30, 2015 ( " prior-year quarter " )

On December 31, 2015, MFRI entered into a purchase agreement with its joint venture partner Aegion Corporation to acquire the remaining 51% ownership of BPPC, a coating and insulation company in Camrose, Alberta, which acquisition closed on February 4, 2016.

The purchase price was $13.1 million CAD ($9.6 million) in cash and debt at closing and is subject to certain post-closing adjustments. The initial accounting for this acquisition is not complete pending detailed analyses of the facts and circumstances that existed as of the acquisition date.

The acquisition has preliminarily resulted in approximately $2.7 million of goodwill, which is expected to be deductible for tax purposes. The Company incurred legal, professional and other costs related to this acquisition. These costs were recognized as general and administrative expenses.

Current quarter vs. prior-year quarter

Net sales increased 14% to $23.1 million in the current quarter from $20.3 million in the prior-year quarter. $2.1 million of the increase occurred in the Canadian facility. The remaining increase was driven by large projects in the U.S. and India offsetting decreases in the Middle East.

Gross margin decreased to 9% of net sales in the current quarter from 12% of net sales in the prior-year quarter. Gross margin and gross profit decreased due to pricing pressure in the Middle East, an excess inventory reserve adjustment of $0.2 million recorded in the current quarter, and operations of the newly acquired Canadian facility which had relatively low utilization.

General and administrative expenses decreased to $2.3 million from $2.6 million . The Canadian facility had $0.4 million in general and administrative expenses in the current quarter, of which $0.2 million was foreign exchange loss. There was a decrease of $0.9 million in comparable general and administrative expenses year over year.

Selling expenses increase to $1.4 million from $1.2 million mainly due to the addition of the Canadian activity.

Current quarter vs. prior-year quarter

Corporate operating expenses include general and administrative expenses that are not allocated to the segment. General and administrative expenses increased to $2.8 million in the current quarter from $2.1 million in the prior-year quarter. This increase was due to higher stock compensation expense and increased professional service expenses. In the current quarter, the Company had a reduction of its workforce and incurred severance expense of $0.3 million .

Net interest expense increased to $226 thousand in the current quarter from income of $79 thousand in the prior-year quarter. Interest income decreased in India because of a dividend made to support the acquisition of BPPC.

Pretax loss from continuing operations was $6.4 million in the current quarter versus $3.3 million in the prior-year quarter. The factors contributing to the 2016 results were:

The Company's consolidated effective tax rate ("ETR") from continuing operations was 4.1% and (0.8)% for the three months ended April 30, 2016 and 2015 , respectively. The change in the ETR from the prior year to the current year is due to the addition of the Canadian activity. The Company remains in a domestic NOL carryforward position. For additional information, see "Notes to Consolidated Financial Statements, Note 5 Income taxes".

Cash and cash equivalents as of April 30, 2016 were $12.9 million compared to $16.6 million at January 31, 2016 . At April 30, 2016 , $0.2 million was held in the U.S., and $12.7 million was held at the foreign subsidiaries. The Company's working capital was $22.6 million on April 30, 2016 compared to $30.3 million on January 31, 2016 .

Of the working capital components, accounts receivable decreased $12.2 million, inventory decreased $3.3 million and accounts payable decreased $4.2 million. Net cash provided by operating activities during the first three months of 2016 was $7.1 million compared to $0.8 million of net cash used during the first three months of 2015 .

During the quarter, the Company paid $2.2 million under its terminated deferred compensation plans. $1.9 million of these payments were funded by the sale of life insurance contracts previously purchased by the Company.

The Company has not provided Federal tax on unremitted earnings of its Middle East subsidiaries. The Company does not believe that it will be necessary to repatriate investments from these subsidiaries.

Net cash used in investing activities for the three months ended April 30, 2016 was $5.5 million of which $7.8 million is related to the acquisition of BPPC.

Debt totaled $15.3 million at April 30, 2016 , a net decrease of $0.2 million compared to the beginning of the current fiscal year. For additional information, see "Notes to Consolidated Financial Statements, Note 11 Debt". Net cash used in financing activities was $5.8 million for the three months ended April 30, 2016 .

On September 24, 2014, the Company entered into a Credit and Security Agreement with a financial institution as amended ("Credit Agreement"). Under the terms of the Credit Agreement, which matures on September 24, 2019 , the Company can borrow up to $15.0 million , subject to borrowing base availability from secured domestic assets and other requirements, under a revolving line of credit. The Loan Agreement covenants restrict debt, liens, and investments, and require attainment of specific levels of profitability and cash flows . At April 30, 2016 , the Company was in compliance with loan covenants. The domestic revolving line balance as of January 31, 2016 and April 30, 2016 was included as a current liability on the consolidated balance sheets.

Interest rates vary based on the average availability in the preceding fiscal quarter and are: (a) a margin in effect plus a base rate, if below certain availability limits; or (b) a margin in effect plus the Eurodollar rate for the corresponding interest period. As of April 30, 2016 , the Company had borrowed $7.2 million at 3.5% and 2.19% and had $5.6 million available to it under the revolving line of credit. In addition, $0.3 million of availability was used under the Credit Agreement primarily to support letters of credit to guarantee amounts committed for inventory purchases. Cash required for operations, as needed, is provided by draw downs on the line of credit.

The Company believes its current cash and cash flow from operations, together with borrowing capacity under the revolving credit facilities, will be sufficient to fund anticipated operations, working capital and capital spending needs for at least the next 12 months.

On February 1, 2016, the Company entered into a promissory note with United Pipeline Systems Limited, an affiliate of Aegion, Inc. for $2.0 million . The promissory note bears interest at prime, which was 3.25% at April 30, 2016 , plus 5% and matures on August 1, 2016.

Critical accounting policies are described in Item 7. MD&A and in the Notes to the Consolidated Financial Statements for the year ended January 31, 2016 contained in the Company's most recent annual report on Form 10-K. Any new accounting policies or updates to existing accounting policies as a result of new accounting pronouncements have been discussed in Notes to Consolidated Financial Statements in this Quarterly Report on Form 10-Q. The application of critical accounting policies may require management to make assumptions, judgments and estimates about the amounts reflected in the Consolidated Financial Statements. Management uses historical experience and all available information to make these estimates and judgments and different amounts could be reported using different assumptions and estimates.

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 April 30, 2016 . This evaluation included consideration of the controls, processes, and procedures that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on management's identification of previously reported material weaknesses in our internal control over financial reporting related to period end review over certain calculations and estimates did not operate effectively, which resulted in a failure to timely file a current report on Form 8-K and management also found an error in estimating excess and obsolete inventory reserves, management has concluded that our disclosure controls and procedures were not effective. Steps to remediate the weaknesses are discussed below, and we currently expect the material weaknesses to be fully remediated by July 31,2016.

Notwithstanding the material weaknesses described above, our management, including our Chief Executive Officer and Chief Financial Officer, has concluded that the financial statements included in this Quarterly Report on Form 10-Q present fairly, in all material respects, our financial position, results of operations, and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States.

Change in Internal Controls: A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.

As reported in our assessment of the effectiveness of our internal control over financial reporting as of January 31, 2016 described in Item 9A of the Company's January 31, 2016 10-K filed on April 28, 2016. The Company's processes, procedures and controls related to the preparation, review and filing related to management's period end review over certain calculations and estimates did not operate effectively, which resulted in a failure to timely file a current report on Form 8-K and Management also found an error in estimating excess and obsolete inventory reserves.

Remediation Plan for the Material Weakness in Internal Control over Financial Reporting: To address the material weakness regarding timely filing of the current report on Form 8-K, the Company has adopted revised policies to ensure that management's review process over complex estimates and calculations properly factors in all relevant assumptions and required inputs and include inputs from outside advisors as appropriate. To address the material weakness regarding excess and obsolete inventory reserves, we have also implemented certain remedial measures. The Company now calculates excess and obsolete inventory reserve centrally and qualitative assessments are reviewed by appropriate operations management as well as the Corporate Controller on a quarterly basis. The excess and obsolete inventory reserve methodology is now calculated using the demand, the age of the inventory and

specific identification determined based on extended value of excess inventory. The new controls have not been operating long enough to evaluate their operating effectiveness.

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.