The statements contained under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" and certain other information contained elsewhere in this annual report, which can be identified by the use of forward-looking terminology such as "may," "will," "expect," "continue," "remains," "intend," "aim," "should," "prospects," "could," "future," "potential," "believes," "plans," "likely" and "probable" or the negative thereof or other variations thereon or comparable terminology, constitute

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CONSOLIDATED RESULTS OF OPERATIONS

Consolidated Backlog (In thousands):                           1/31/09       1/31/08
Piping Systems                                               $  52,385     $  65,810
Filtration Products                                             35,549        38,161
Corporate and Other                                             16,051        33,179
Industrial Process Cooling Equipment                             3,835         6,315
Total                                                        $ 107,820     $ 143,465

MFRI, Inc. is engaged in the manufacture and sale of products in three distinct reportable business segments: piping systems, filtration products, and industrial process cooling equipment.

The analysis presented below and discussed in more detail throughout the MD&A was organized to provide instructive information for understanding the business going forward. However, this discussion should be read in conjunction with the consolidated financial statements in Item 8 of this report, including the notes thereto. An overview of the segment results is provided in Note 1 - Business and Segment Information to the consolidated financial statements in Item 8 of this report.

2008 Compared to 2007

Record net sales were $303,066,000 in 2008, an increase of 26.5% from $239,487,000 in 2007, with increased sales in the piping systems business and the filtration products business while the industrial process cooling business decreased.

Gross profit of $58,948,000 in 2008 increased 42.9% from $41,249,000 in 2007. Gross margin for 2008 rose to 19.5% from 17.2% in 2007.

Selling expenses increased 2.0% to $14,550,000 from $14,270,000 in 2007. This was primarily driven by increased staffing in the piping systems business and filtration products business partially offset by the industrial process cooling equipment business, which had decreased commission expense from lower sales and a reduction in staffing completed in 2007.

General and administrative expenses increased 28.0% to $30,818,000 from $24,083,000 in 2007. The increase was mainly due to increased profit-based management incentive expense, increased bank fees, additional stock compensation expense partially offset by a decrease in the deferred compensation expense of $495,000.

The Company recognized a $2,788,000 non-cash charge for goodwill impairment, which was recorded as part of continuing operations. In accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 142 ("SFAS 142"), during the first quarter each year, the Company reviews the carrying value of goodwill. The evaluation of impairment involved comparing the current fair value of the business to the carrying value. The Company used a discounted cash flow model to determine the current fair value of its reporting units. A number of significant assumptions and estimates were involved in the application of the model to forecast operating cash flows, including markets and market share, sales volumes and prices, costs to produce and working capital changes. Management considered historical experience and all available information at the time the fair values of its reporting units were estimated. However, actual fair values that could be realized in a transaction may differ from those used to evaluate the impairment of goodwill.

The recently completed goodwill impairment assessment followed the fourth quarter 2008 worsening of economic conditions. These conditions impacted both the risks considered and the calculations made. The assessment considered uncertainty about current economic market conditions in the U.S. and globally that may pose risks to the Company's customer demand. Customers may postpone spending for capital improvement and maintenance projects in response to tighter credit markets or negative financial news. The distressed financial markets caused the discount rates used in calculating the present value of estimated future cash flows to be higher than a year ago. These conditions were reflected in the Company's goodwill impairment assessment.

As a result, the estimated future cash flows of the filtration products business (whose goodwill was $1,688,000) and the industrial process cooling equipment business (whose goodwill was $1,100,000) were both lower than when goodwill impairment testing was done a year ago. All of the Company's goodwill was deemed impaired and was written off with a noncash impairment charge.

The Company's worldwide effective income tax rate for 2008 was 17.0%. The 2008 tax rate decreased as compared to 2007 mainly due to the impact of tax-free foreign income.

Net income rose to $6,689,000 in 2008 from a net loss of $298,000 in 2007 primarily due to increased sales, the reasons summarized above and discussed in more detail below.

2007 Compared to 2006

Net sales were a record at $239,487,000 in 2007, an increase of 12.2% from $213,471,000 in 2006. Sales increased in the piping systems and the filtration products businesses while the industrial process cooling business decreased.

Net income for 2007 was sharply down primarily due to the following factors:

Piping Systems:

• During the fourth quarter 2007 the U.A.E. facility received a customer contract change to a very large pipeline project which reduced the project scope as well as net sales and net income. This, along with significant unplanned cost to finish product significantly reduced net income. Also, overhead additions were made in marketing, sales and operations to bolster the skills and resources of this rapidly growing unit.

• At the New Iberia, Louisiana facility, half the third quarter 2007 was devoted to research and development of a new product for a major customer application. While progress was made, the effort was not successful and work on production of other customer orders resumed.

• Margin erosion occurred due to higher prices for raw materials, specifically steel and plastic resins, which could not be passed along to the customers under existing orders.

• The recently acquired factory in South Africa had a manufacturing error which necessitated the rework and replacement of a sizeable customer order.

• High factory labor and warranty costs along with software implementation expenses at the European pleated filter operation significantly affected results.

• Ongoing market pricing pressure in the U.S. and increasing raw materials prices worldwide also reduced margin in both pleated and bag products.

Industrial Process Cooling:

• Incurred increased expenses related to unanticipated development and field modification costs for certain refrigeration equipment previously sold to its customers. The product was temporarily removed from the market which reduced sales. Product enhancements made in Q3 and Q4, although costly to the Company, were successful and led to reintroduction of the product to the market.

• Significant expenditures were made and continue to be made in new product design and development as well as engineering staff recruitment.

• Gross profit was reduced primarily due to material cost increases which were not completely offset by selling price increases.

Other significant incremental expenses in 2007 not incurred in 2006:

• 2007 expenses to comply with SOX 404, were $938,000 compared to $9,000 in 2006.

• Start-up expenses of $664,000 for the newly created HVAC subsidiary.

• Incremental vacation expense of $422,000 to adjust the accrual for vacation pay to agree with the plan requirements.

• Additional stock compensation expense of $365,800.

• Increase of $726,000 or 32.5% from the prior year in consolidated warranty expense, mainly due to the reasons previously detailed by business segment.

Because of the above factors and other occurrences, gross profit of $41,249,000 in 2007 decreased 7.1% from $44,405,000 in 2006. Gross margin for 2007 declined to 17.2% from 20.8% in 2006.

Tax rate for 2007 was 158.3% mainly due to the valuation allowance for state and foreign net operating losses as described in Income Taxes below.

Piping Systems Business

                                                                               % Increase
(In thousands)                    2008          2007         2006           2008       2007
Net sales                    $ 151,792     $ 104,273     $ 82,166           45.6 %     26.9 %

Gross profit                 $  37,871     $  18,952     $ 16,780           99.8 %     12.9 %
As a percentage of net sales      24.9 %        18.2 %       20.4 %

Income from operations       $  24,037     $  10,623     $  9,568          126.3 %     11.0 %
As a percentage of net sales      15.8 %        10.2 %       11.6 %

2008 Compared to 2007

Net sales of $151,792,000 for 2008 increased 45.6% from $104,273,000 in 2007, attributed to achieving the Company's market share in the U.A.E., as well as other Gulf Cooperating Council countries such as Qatar, Kuwait, and Bahrain. The U.A.E. facility's net sales were $54,454,000 in the current year compared to $22,339,000 in 2007. As of January 31, 2009, the Company had completed over half of the India pipeline contract.

Gross margin as a percent of net sales increased to 24.9% in 2008 from 18.2% in 2007, primarily due to production efficiencies in both domestic and international operations. Margins in the U.A.E. improved from increased volume without corresponding increases in fixed expenses.

General and administrative expense increased to $10,994,000 or 7.2% of net sales in 2008 from $6,032,000 or 5.8% of net sales in 2007. The increase was primarily due to the increase in profit-based management incentive expense, additional administrative costs in the India pipeline project, and increased bank fees offset by a gain in foreign currency exchange.

2007 Compared to 2006

Net sales increased 26.9% to $104,273,000 in 2007 from $82,166,000 in 2006. This increase was primarily driven by $22,339,000 in 2007 sales at the U.A.E. facility compared to $2,792,000 in sales from the U.A.E. in the prior year, partially offset by decreased sales to oil and gas customers. At the New Iberia facility, half the 2007 third quarter was devoted to research and development of a new product for a major customer application. While progress was made, the effort was not successful. In the middle of October 2007, the New Iberia facility resumed work on production of customer orders.

Gross margin as a percent of net sales decreased to 18.2% in 2007 from 20.4% in 2006, primarily due to lower sales to oil and gas customers, which tend to have a higher margin over other customers and the additional product development work for oil and gas in the third quarter. Gross margin at the U.A.E. facility was lower than the piping systems business's average during its first year of rapid growth, driven in part by production of a particularly challenging order for an oil and gas customer.

Total selling expense increased to $2,297,000 or 2.2% of net sales in 2007 from $1,560,000 or 1.9% of net sales in 2006. Selling expense in the U.A.E. increased to $750,000 in 2007 from $177,000 in 2006. The increased expense was mainly due to additional staffing primarily in the U.A.E., and the addition of an international sales manager based in the U.S.

General and administrative expense increased to $6,032,000 or 5.8% of net sales in 2007 from $5,653,000 or 6.9% of net sales in 2006. The dollar increase in general and administrative expenses was primarily due to increased staffing in the U.A.E. to support the location's growth, and increased staffing in the U.S.

Filtration Products Business

The timing of large orders can have a material effect on net sales and gross profit from period to period. Pricing on large orders was generally extremely competitive and therefore resulted in relatively low gross margins.

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

                                                                                    % Increase
                                                                                  (Decrease)
(In thousands)                     2008           2007          2006            2008           2007
Net sales                     $ 105,390       $ 97,120      $ 86,362             8.5 %         12.5 %

Gross profit                  $  11,424       $ 13,776      $ 16,230           (17.1 %)       (15.1 %)
As a percentage of net sales       10.8 %         14.2 %        18.8 %

(Loss) income from operations $  (2,936 )     $  2,220      $  5,274          (232.3 %)       (57.9 %)
As a percentage of net sales       (2.8 %)         2.3 %         6.1 %

2008 Compared to 2007

Net sales increased 8.5% to $105,390,000 in 2008 from $97,120,000 in 2007. This increase was due to the result of higher unit volume in all product lines, primarily from domestic power generation customers.

Selling expense increased to $7,575,000 or 7.2% of net sales in 2008 from $6,873,000 or 7.1% of net sales in 2007. The increase in selling expense was primarily due to additional selling personnel, and increased travel and advertising expenses.

General and administrative expenses increased to $5,097,000 or 4.8% of net sales from $4,682,000 or 4.8% of net sales in 2007. The dollar increase was primarily due to the hiring of several new senior managers and increased professional service expense.

For the fourth quarter and fiscal year ended January 31, 2009, the filtration products business recorded a non-cash impairment charge of $1,688,000 in connection with the annual assessment of goodwill in accordance with SFAS 142. See Note 2 in the Notes to Consolidated Financial Statements for details with respect to impairment change incurred during 2008.

2007 Compared to 2006

Net sales increased 12.5% to $97,120,000 in 2007 from $86,362,000 in 2006. This increase was the result of increased sales in all product lines and geographic areas, primarily the result of a growing electric power generation customer base.

Gross margin as a percent of net sales decreased to 14.2% in 2007 from 18.8% in 2006, primarily due to the highly competitive marketplace, increasing cost of raw materials, customer mix and additional post-sale customer support costs, including rework and replacement of a sizeable customer order produced in the South African facility. The cost of production labor at the Denmark facility was higher than in prior years.

Selling expense increased to $6,873,000 or 7.1% of net sales in 2007 from $6,541,000 or 7.6% of net sales in 2006. The dollar increase in selling expense was primarily due to increased commission expense related to higher sales and increased advertising expense.

General and administrative expenses increased to $4,682,000 or 4.8% of net sales from $4,415,000 or 5.1% of net sales in 2006. The dollar increase was the result of additional staffing in the foreign locations and the ERP software implementation expenses incurred at the Denmark facility.

Industrial Process Cooling Equipment Business

                                                                                  % Decrease
(In thousands)                    2008          2007          2006          2008           2007
Net sales                     $ 31,738      $ 36,327      $ 41,161         (12.6 %)       (11.7 %)

Gross profit                  $  7,919      $  8,508      $ 11,274          (6.9 %)       (24.5 %)
As a percentage of net sales      25.0 %        23.4 %        27.4 %

(Loss) income from operations $ (1,765 )    $ (1,227 )    $  1,222         (43.8 %)      (200.4 %)
As a percentage of net sales      (5.6 %)       (3.4 %)        3.0 %

2008 Compared to 2007

Net sales decreased 12.6% to $31,738,000 in 2008 from $36,327,000 in 2007. The decrease was primarily due to lower demand for its products in the global plastic and domestic printing markets.

Gross margin as a percentage of net sales increased to 25.0% in 2008 from 23.4% in 2007, primarily due to significant reduction in post-sale customer support costs, partially offset by lower sales volume relative to fixed costs.

General and administrative expense decreased to $4,449,000 or 14.0% of net sales in 2008 from $4,635,000 or 12.8% of net sales in 2007. This dollar decrease was primarily due to the gain on the sale of property and staffing reductions, partially offset by increased new product development engineering expenses.

For the fourth quarter and fiscal year ended January 31, 2009, the industrial process cooling equipment business recorded a non-cash impairment charge of $1,100,000 in connection with the annual goodwill assessment in accordance with SFAS 142. See Note 2 in the Notes to Consolidated Financial Statements for details with respect to impairment change incurred during 2008.

2007 Compared to 2006

Net sales decreased 11.7% to $36,327,000 in 2007 from $41,161,000 in 2006. The decrease was primarily due to lower demand for its products in major market sectors and a temporary halt in sales of a new central chilling product line, launched in 2005, to resolve some performance issues. The product line was re-launched in the fourth quarter of 2007.

Gross margin as a percentage of net sales decreased to 23.4% in 2007 from 27.4% in 2006, primarily due to material cost increases, which were not completely offset by selling price increases, lower sales volume over which to spread fixed manufacturing overhead expenses and field modification costs for a central chilling product line. Manufacturing staff was reduced by 12% in the fourth quarter 2007 to better balance production expenses with demand.

Selling expense decreased to $5,100,000 or 14.0% of net sales in 2007 from $5,713,000 or 13.9% of net sales in 2006. The decrease was due to reduced commission expense from lower sales.

General and administrative expense increased to $4,635,000 or 12.8% of net sales in 2007 from $4,339,000 or 10.5% of net sales in 2006. This increase was primarily due to increased professional costs including employment-related hiring expenses and engineering consulting fees related to new product development.

General Corporate and Other

2008 Compared to 2007

Net sales increased to $14,146,000 in 2008 from $1,767,000 in 2007. The 2008 and 2007 net sales related to the start-up of the HVAC systems business.

General corporate expense included interest expense and general and administrative expenses that were not allocated to the business segments. General and administrative expense increased 21.8% to $10,278,000 in 2008 from $8,733,000 in 2007, and decreased as a percentage of consolidated net sales to 3.4% in 2008 from 3.6% in 2007. The dollar increase was mainly due to the increased profit-based management incentive expense, incremental expenses relating to stock compensation expense of $241,000, and additional staffing. These expenses were partially offset by decreased deferred compensation expense of $495,000. The deferred compensation plan was affected by the market value of the underlying investments. Since the underlying investment declined, the Company's liability to the employees in the plan decreased.

Interest expense, net of capitalized interest, increased 17.7% to $2,834,000 in 2008 from $2,408,000 in 2007 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 $3,159,000.

The 2007 net sales of $1,767,000 related to the start-up of the HVAC systems business. The 2006 net sales of $3,782,000 were related to other corporate business.

General and administrative expense increased 20.6% to $8,733,000 in 2007 from $7,242,000 in 2006, and increased as a percentage of consolidated net sales to 3.6% in 2007 from 3.4% in 2006. The increase was mainly due to incremental expenses of $929,000 incurred to comply with SOX 404 (including consulting fees) that were not incurred in 2006, the inclusion of $664,000 of the general and administrative expense from the newly created subsidiary that installs HVAC systems, and additional stock compensation expense of $365,800 compared to the prior year. These expenses were partially offset by decreased management incentive expense and deferred compensation expense.

Interest expense decreased 10.0% to $2,408,000 in 2007 from $2,676,000 in 2006. The decrease was primarily due to reduced borrowings.

INCOME TAXES

The Company's worldwide effective income tax rates were 17.0%, 158.3%, and 32.0% in 2008, 2007 and 2006, respectively. The 2008 tax rate decreased as compared to 2007 mainly due to the impact of tax-free foreign income.

As of January 31, 2009, the Company had undistributed earnings of certain foreign subsidiaries for which deferred taxes have not been provided. The Company intends and has the ability to reinvest these earnings for the foreseeable future outside the U.S. If these amounts were distributed to the U.S., in the form of dividends or otherwise, the Company would be subject to additional U.S. income taxes. Determination of the amount of unrecognized deferred income tax liabilities on these earnings is not practicable because such liability, if any, is dependent on circumstances existing if and when remittance occurs.

During the fourth quarter of 2007, management determined that all of its foreign net operating loss ("NOL") carryovers and most of its state NOL carryovers generated through January 31, 2008 were no longer more likely than not realizable. Additional tax expense of $583,000 or 114.2% of the 2007 rate was recorded to establish a valuation allowance against those deferred tax assets.

A reconciliation of the effective income tax rate to the U.S. Statutory tax rate is as follows:

                                                            2008         2007
Statutory tax rate                                          34.0 %       34.0 %
Differences in foreign tax rate                            (44.3 %)       6.2 %
Impairment of goodwill                                      11.8 %          0 %
Valuation Allowance for net operating losses                 3.9 %      114.2 %
State taxes, net of federal benefit                          3.8 %       24.4 %
Research tax credit                                         (1.5 %)     (43.7 %)
Return to provision adjustments                              3.5 %)      13.3 %
All other, net (benefit) expense                             5.8 %        9.9 %
Effective tax rate                                          17.0 %      158.3 %

For further information, see Note 7 - Income Taxes, in the Notes to Consolidated Financial Statements.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents as of January 31, 2009 were $2,735,000 as compared to $2,665,000 at January 31, 2008. The Company used $2,165,000 from operations in 2008. Exercise of stock options resulted in proceeds of $83,000 in 2008.

Net sales in 2008 increased $63,579,000 or 26.5% compared to 2007 net sales. The higher sales contributed to the increased balances in trade accounts receivable, inventories, and trade accounts payable. Compared to January 31, 2008, trade receivables increased by $21,131,000 primarily due to the piping systems business, of which $14,126,000 was in the U.A.E and $6,234,000 was in the HVAC business. Inventories increased by $8,297,000 in 2008 primarily due to increased raw material requirements for scheduled production. Total inventory