<PAGE>
 

                      SECURITIES AND EXCHANGE COMMISSION
                             Washington, DC 20549

                                  ----------

                                   FORM 10-K


 X   ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
---  SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)
     For the fiscal year ended January 31, 1998

                                      OR

     TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
---  OF 1934 (NO FEE REQUIRED) 
     For the transition period from            to 
                                    ----------    ----------


                          Commission File No. 0-18370


                                  MFRI, INC.
            (Exact name of registrant as specified in its charter)


Delaware                                                 36-3922969
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

7720 Lehigh Avenue
Niles, Illinois 60714                                      (847) 966-1000
(Address of principal executive                      (Issuer's telephone number,
offices, including zip code)                            including area code)


          Securities registered pursuant to Section 12(b) of the Act:
                                     None


          Securities registered pursuant to Section 12(g) of the Act:
                    Common Stock, par value $.01 per share


     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 [X]  No [_]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]

     The aggregate market value of the voting securities of the registrant
beneficially owned by non-affiliates of the registrant (the exclusion of the
market value of the shares owned by any person shall not be deemed an admission
by the registrant that such person is an affiliate of the registrant), at 
March 31, 1998 was approximately $32,492,000.

     The number of shares of the registrant's common stock outstanding at 
March 31, 1998 was 4,981,004.

                      DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the following document of the registrant are incorporated
herein by reference:

           Document                                Part of Form 10-K
           --------                                -----------------
Proxy Statement for the 1998
annual meeting of stockholders                            III
<PAGE>
 
                                 PART I


Item 1.  BUSINESS

     MFRI, Inc. ("MFRI") has three business segments: Filtration Products,
Piping System Products and Industrial Process Cooling Equipment.

     The Company's Filtration Products Business is carried out by Midwesco
Filter Resources, Inc. ("Midwesco Filter"), the Piping System Products business
is carried out by Perma-Pipe, Inc. ("Perma-Pipe") and the Industrial Process
Cooling Equipment Business is carried out by the Thermal Care Division ("Thermal
Care"). Midwesco Filter and Perma-Pipe are wholly-owned subsidiaries of MFRI. As
used herein, unless the context otherwise requires, the term Company includes
MFRI, Midwesco Filter, Perma-Pipe, Thermal Care, and its subsidiaries, and their
predecessors.

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

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

     Thermal Care engineers, designs and manufactures chillers, mold temperature
controllers, cooling towers, plant circulating systems, and coolers for
industrial process applications.

     On December 3, 1997, MFRI and a wholly-owned subsidiary acquired all of the
outstanding shares of capital stock and related real estate of TDC Filter
Manufacturing, Inc., a Delaware corporation ("TDC"), pursuant to a Stock
Purchase Agreement dated December 3, 1997 ("TDC Acquisition"). TDC had sales of
approximately $11.4 million in the year ended March 30, 1997. TDC makes pleated
filter cartridges for use in air filtration and gas turbine intake systems and
supplies both original equipment manufacturers ("OEM's") and aftermarket users
of pleated filtration media.

     The information required with respect to the Company's lines of business is
included in the financial statements and related notes thereto.
<PAGE>
 
Filtration Products

     Air Filtration and Particulate Collection Systems. Air filtration and
particulate collection systems have been used for over 50 years in many
industrial applications. However, the enactment of federal and state legislation
and related regulations and enforcement have increased the demand for air
filtration and particulate collection systems by requiring industry to meet
primary and secondary ambient air quality standards for specific pollutants,
including particulate. In certain manufacturing applications, particulate
collection systems are an integral part of the production process. Examples of
such applications include the production of cement, carbon black and industrial
absorbents.

     The principal types of industrial air filtration and particulate collection
systems in use today are baghouses, cartridge collectors, electrostatic
precipitators, scrubbers and mechanical collectors. The type of technology most
suitable for a particular application is a function of such factors as the
ability of the system to meet applicable regulations, initial investment,
operating costs and the parameters of the process, including operating
temperatures, chemical constituents present, size of particulate and pressure
differential.

     Cartridge collectors and baghouses are typically box-like structures which
operate in a manner similar to a vacuum cleaner. They can contain a single
filter element or an array of several thousand cylindrical or envelope filter
elements (as short as two feet or as long as 30 feet), within a housing which is
sealed to prevent the particulate from escaping. Exhaust gases are passed
through the filtration system, and the particulate is captured on the media of
the filter element. The particulate is removed from the filter element by such
methods as mechanical shaking, reverse air flow or compressed air pulse.
Cartridge collectors and baghouses are generally used with utility and
industrial boilers, cogeneration plants and incinerators and in the chemicals,
cement, asphalt, metals, grain and foundry industries.

     In an electrostatic precipitator, the particulate in the gases is charged
as it passes electrodes and is then attracted to oppositely charged collection
plates. The collected material is periodically removed from the plates by
rapping or vibration. Electrostatic precipitators are used in such industries as
electric power generation, chemicals and pulp and paper as well as in
incinerators. Scrubbers are used for flue gas desulfurization, odor control,
acid gas neutralization and particulate collection. They operate by bringing
gases into contact with water or chemicals and are sometimes used in combination
with baghouses or electrostatic precipitators. Mechanical collectors are used to
remove relatively large particles from airstreams. They are frequently used in
association with other systems as a pre-screening device.

     Because air pollution control equipment represents a substantial capital
investment, such systems usually remain in service for the entire life of the
plant in which they are installed. A baghouse can last up to 30 years and is
typically rebagged six to eight times during its useful life. Although reliable
industry statistics do not exist, the Company believes there are more than
18,000 locations in the United States presently using baghouses and/or cartridge
collectors, many of which have multiple pieces of such equipment.

                                       2
<PAGE>
 
     Products and Services. The Company manufactures and sells a wide variety of
filter elements for cartridge collectors and baghouse air filtration and
particulate collection systems. Cartridge collectors and baghouses are used in
many industries in the United States and abroad to limit particulate emissions,
primarily to comply with environmental regulations. The Company manufactures
filter elements in standard industry sizes, shapes and fabrics and to custom
specifications, maintaining manufacturing standards for more than 10,000 styles
of filter elements to suit substantially all industrial applications. Filter
elements are manufactured from industrial yarn, fabric and papers purchased in
bulk. Most filter elements are produced from cellulose, acrylic, fiberglass,
polyester, aramid or polypropylene fibers. The Company also manufactures filter
elements from more specialized materials, sometimes using special finishes.

     The Company manufactures substantially all of the seamless tube filter bags
sold in the United States. Seamless Tube(R) filter bag fabric is knitted by the
Company on custom knitting equipment and finished using proprietary fabric
stabilization technology. The Company believes this vertically integrated
process gives it certain advantages over purchased fabric, including lower costs
and reduced inventory requirements. In addition, the Company believes its
Seamless Tube(R) product offers certain users a superior performing filtration
medium because of its fabric structure, weight and lack of a vertical seam. In
certain applications, the knitted fabric structure allows equal airflows with a
lower pressure differential than conventionally woven fabrics, thereby reducing
power costs. In other circumstances, the fabric structure and absence of a
vertical seam allows greater airflow at the same pressure differential as
conventionally woven fabrics, thereby permitting the filtration of a greater
volume of particulate laden gas at no additional cost. The Seamless Tube(R)
product often improves filter bag durability, resulting in longer life.

     The Company also markets numerous filter related products and accessories
used during the installation, operation and maintenance of cartridge collectors
and baghouses, including wire cages, which support filter bags, spring
assemblies for properly tensioning filter bags, and clamps and hanger assemblies
for attaching filter elements. Additionally, the Company markets other hardware
items used in the operation and maintenance of cartridge collectors and
baghouses, including sonic horns to supplement the removal of particulate from
the filter bag and cartridge collectors and baghouse parts such as door gaskets,
shaker bars, tube sheets, dampers, solenoid valves, timer boards, conveyors and
airlocks. The Company also manufactures wire cages. The Company currently
purchases all other filter related products and accessories for resale,
including the exclusive North American marketing rights to a Korean-manufactured
line of solenoids, valves and timers used in conjunction with pulsejet
collectors.

     The Company also provides maintenance services, consisting primarily of air
filtration system inspection and filter element replacement using a network of
independent contractors. The sale of filter related products and accessories and
collector inspection, leak detection and maintenance services accounts for
approximately 15.0 percent of the net sales of the Company's filtration products
and services.

                                       3
<PAGE>
 
     Over the past three years, the Company's filtration products business has
served more than 4,000 user locations. The Company has particular expertise in
supplying filter bags for use with electric arc furnaces in the steel industry.
The Company believes its production capacity and quality control procedures make
it a leading supplier of filter bags to large users in the electric power
industry. Orders from that industry tend to be substantial in size but are
usually at reduced margins. In the fiscal year ended January 31, 1998 ("1997"),
no customer accounted for 10.0 percent or more of net sales of the Company's
filtration products and services.

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

     The Company has an integrated sales program for its filtration products
business which consists of field-based sales personnel, manufacturers'
representatives, a telemarketing operation and computer-based customer
information systems containing data on nearly 18,000 user locations. These
systems enable the Company's sales force to access customer information
classified by industry, equipment type, operational data and the Company's
quotation and sales history. The systems remind the telemarketing personnel when
each customer is due to be called and maintain the name and position of the
customer contact. The Company believes its computer-based information systems
are instrumental in increasing its sales of filter related products and
accessories and maintenance services. The Company is adding to its database for
each of these user locations sufficient information to support such sales.

     In 1992, the Company intensified its efforts to market its filtration
products internationally by hiring employees for a new department created
specifically to target major users in foreign countries. Export sales recently
have decreased as the U.S. dollar strengthened against certain currencies and
totalled 13.0 percent of filtration products sales in the year ended January 31,
1998.

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

     Backlog. As of January 31, 1998, the dollar amount of backlog (uncompleted
firm orders) was $9,760,000. As of January 31, 1997, the amount of backlog was
$6,832,000. $200,000 of the backlog as of January 31, 1998 is not expected to be
completed in 1998.

     Raw Materials and Manufacturing. The basic raw materials used in the
manufacture of the Company's filtration products are industrial fibers and media
supplied by leading producers of such materials. The greatest volume of raw
material purchases are of woven fiberglass fabric, yarns for manufacturing
Seamless Tube(R) product and other cellulose, woven, felted and paper

                                       4
<PAGE>
 
media. For some of these materials, there are only a limited number of
suppliers. From time to time, any of these materials could be in short supply,
adversely affecting the Company's business. The Company believes supplies of all
of its materials are adequate to meet current demand. The Company's inventory
includes substantial quantities of various types of media because lead times
from suppliers are frequently longer than the delivery time required by
customers.

     The manufacturing processes for the filtration products include proprietary
computer controlled systems for measuring, cutting, tubing and marking media.
The Company also operates a number of special knitting machines and proprietary
fabric stabilization equipment to produce its Seamless Tube(R) product. The
finish assembly work on each filter bag is performed by skilled sewing machine
operators using both standard sewing equipment and specialized machines
developed by or for the Company. The manufacturing process for pleated filter
elements involves the assembly of metal and sometimes plastic end components,
filtration media and support hardware.

     The Company maintains a quality assurance program involving statistical
process control techniques for examination of raw materials, work in progress
and finished goods. Certain orders for particularly critical applications
receive 100.0 percent quality inspection.

     Competition. The filtration products business is highly competitive. In
addition, new installations of cartridge collectors and baghouses are subject to
competition from alternative technologies. The Company believes that, based on
domestic sales, BHA Group, Inc.; Donaldson Company, Inc.; the Menardi-Criswell
division of Hosokawa Micron International, Inc.; W.L. Gore & Associates, Inc.
and the Company are the leading suppliers of filter elements, parts and
accessories for cartridge collectors and baghouses. The Company believes that
Donaldson Company, Inc.; Farr Company; Clarcor, Inc. and the Company are the
leading suppliers of filtration cartridges. There are at least 50 smaller
competitors, most of which are doing business on a regional or local basis. Some
of the Company's competitors have greater financial resources than the Company.

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

                                       5
<PAGE>
 
     Government Regulation. The Company's filtration products business to a
large extent is dependent upon government regulation of air pollution at the
federal and state levels. Federal clean air legislation requires compliance with
national primary and secondary ambient air quality standards for specific
pollutants, including particulate. The states have primary responsibility for
implementing these standards, and in some cases, have adopted more stringent
standards than those adopted by the U.S. Environmental Protection Agency ("U.S.
EPA") under the Clean Air Act Amendments of 1990 ("Clean Air Act Amendments").
Although there can be no assurances as to what the ultimate effect, if any, the
Clean Air Act Amendments will have on the Company's filtration products
business, the Company believes that the Clean Air Act Amendments are likely to
have a long term positive effect on demand for its filtration products and
services. The recent actions of the U.S. EPA to reduce the size of particulates
regulated by the National Air Quality Standard from 10 microns to 2.5 microns
could have a significant positive effect on the demand for the Company's
filtration products in future years.

Piping System Products

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

     The Company's leak detection and location systems consist of a sensor cable
attached to a microprocessor which utilizes proprietary software. The system
sends pulse signals through the sensor cable, which is positioned in the area to
be monitored (e.g., along a pipeline in the ground or in a subfloor), and
employs a patented digital mapping technique to plot pulse reflections, to
continuously monitor the sensor cable for anomalies. The system is able to
detect one to three feet of wetted cable depending upon the length of the
monitored cable and is able to determine the location of wetted cable within
five feet. Once wetted cable is detected, the microprocessor utilizes the
software to indicate the location of the leak. The Company offers a variety of
cables specific to different environments. The Company's leak detection and
location systems can sense the difference between water and petroleum products
and can detect and locate multiple leaks. With respect to these capabilities,
the Company believes that its systems are superior to systems manufactured by
other companies. Once in place, the Company's leak detection and location system
can be monitored off-site because the system can communicate with computers
through telephone lines. The Company's leak detection and location systems are
being used to monitor fueling systems at airports including those located in
Denver, Colorado; Atlanta, Georgia; Frankfurt, Germany and Hamburg, Germany and
in many clean rooms, including such facilities

                                       6
<PAGE>
 
operated by IBM, Intel and Motorola. The Company believes that, in the United
States, it is the only major supplier of the type of piping systems it sells
that manufactures its own leak detection and location systems.

     The Company's secondary containment piping systems, manufactured in a wide
variety of piping materials, are generally used for the handling of hazardous
liquids and petroleum products. Secondary containment piping systems consist of
service pipes housed within outer containment pipes, which are designed to
contain any leaks from the service pipes. Each system is designed to provide
economical and efficient secondary containment protection that will meet all
governmental environmental regulations. In 1990, the Company developed the
Double-Quik(R) thermoplastic secondary containment piping systems with leak
detection and location capabilities. This system is installed by using a
technique that allows simultaneous thermal welding of the service pipe and the
containment pipe in a single process, with a leak detection messenger cable in
place. The leak detection messenger cable is to be used subsequently to pull in
the leak detection sensor cable. In June 1993, the Company was granted a patent
on the special equipment designed to accomplish this process. In April 1998, the
Company received a patent on a method of anchoring such systems made with
different materials for the service pipe and the containment pipe.

     The Company's district heating and cooling piping systems are designed to
transport steam, hot water and chilled water to provide efficient energy
distribution to multiple locations from a central energy plant. These piping
systems consist of a carrier pipe made of steel, iron, copper or fiberglass;
insulation made of mineral wool, calcium silicate or polyurethane foam; and an
outer conduit or jacket of steel, fiberglass, polyethylene or high density
polyurethane. The Company manufactures several types of piping systems using
different materials, each designed to withstand certain levels of temperature
and pressure.

     The Company's oil and gas flowlines are designed to transport crude oil
from the well head, either on land or on the ocean floor, to the gathering
point. These piping systems consist of a carrier pipe made of steel, usually
supplied by the customer, insulation and jackets made of polyurethane and
sometimes a steel outer pipe, also usually supplied by the customer.

     The Company's piping systems are frequently custom fabricated to job site
dimensions and/or incorporate provisions for thermal expansion due to varying
temperatures. This custom fabrication helps to minimize the amount of labor
required by the installation contractor. Most of the Company's piping system
products are produced for underground installations and therefore require
trenching which is done by unaffiliated installation contractors. Generally,
sales of the Company's piping system products tend to be lower during the winter
months, due to weather constraints over much of the country. During 1997, no
single customer accounted for more than 10.0 percent of the net sales of the
Company's piping system products.

     The Company's leak detection and location systems and its secondary
containment piping systems are used primarily by operators of military and
commercial airport fueling systems, oil

                                       7
<PAGE>
 
refineries, pharmaceutical companies, chemical companies, and in museums, dry
storage areas and tunnels. The Company's district heating and cooling systems
are used primarily at prisons, housing developments, military bases,
cogeneration plants, hospitals and college campuses. The Company's oil and gas
flowlines are used primarily by major oil companies. The Company believes many
district heating and cooling systems in place are 30 to 50 years old and ready
for replacement. Replacement of district heating and cooling systems is often
motivated by the increased cost of operating older systems due to leakage and
heat loss.

     During 1997, Perma-Pipe developed a new process for the continuous
application of polyurethane insulation and protective jackets to pipe at high
speeds and within controlled dimensional tolerances. PROtherm, the new product,
was introduced to the district heating, district cooling and industrial markets
in March 1998. The Company received its first contracts to insulate and jacket
pipe assemblies for deep sea oil gathering flowlines during the first quarter of
1998. Delivery on these contracts is scheduled to begin in August 1998.

     Marketing. The Company's piping system products are used by industrially
and geographically diverse customers. The Company employs one national sales
manager and seven regional sales managers who utilize and assist a network of
approximately 85 independent manufacturer's representatives, none of whom sell
products that are competitive with the Company's piping system products. The
Company also sells its piping systems and leak detection and location systems in
Europe, through its wholly owned subsidiaries Perma-Pipe Services, Ltd. and SZE
Hagenuk GmbH ("SZE Hagenuk"). In addition, the Company has other arrangements to
market its patented leak detection and location systems in many other foreign
countries through agents. In October 1997, Perma-Pipe was awarded a $400,000
"test" order from China's Tianjin Economic Development Area Heat and Power
Corporation for specialty, high-pressure steam pipe to be used for industrial
purposes. This "test" order has been shipped to China and will be placed in
service during the second quarter of 1998. The Company believes China holds a
large market potential for the Company's products.

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

                                       8
<PAGE>
 
     Backlog. As of January 31, 1998, the dollar amount of backlog (uncompleted
firm orders) was $14,937,000, substantially all of which is expected to be
completed in 1998. As of January 31, 1997, the amount of backlog was
$14,500,000.

     Raw Materials and Manufacturing. The basic raw materials used in the
production of the Company's piping system products are pipe and tubes made of
carbon steel, alloy and plastics and various chemicals such as polyalls,
Isocyanate ("MDI"), polyester resin and fiberglass, mostly purchased in bulk
quantities. Although such materials are generally readily available, there may
be instances when any of these materials could be in short supply. The Company
believes supplies of such materials are adequate to meet current demand.

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

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

     Competition. The Company believes the competitors for its piping system
products generally include those competing in the district heating and cooling
market, specialty manufacturers of contained piping systems that offer a limited
number of pipe material choices, and leak detection and location system
manufacturers that sell in the piping market and the stand alone leak detection
system market. The piping system products business is highly competitive. The
Company believes its competition in the district heating and cooling market
consists of two other national companies, Rovanco Piping Systems, Inc. and
Thermacor Process, Inc. neither of which dominates this market, and numerous
regional competitors. The Company's secondary containment piping systems have a
wider range of competitors than those in the district heating and cooling market
and include Asahi/America, Guardian by Chemtrol and GF Plastics Systems. The
Company's oil and gas gathering flowlines face world-wide competition including
the Bredero-Shaw joint venture of Dresser Industries, Inc. and Shaw Industries,
Inc. and Logstor

                                       9
<PAGE>
 
Rohr of Denmark. Products competitive with the Company's leak detection and
location systems include: (1) cable-based systems manufactured by the TraceTek
Division of Raychem; (2) linear gaseous detector systems manufactured by Tracer
Technologies and Arizona Instrument Corp; and (3) probe systems manufactured by
Redjacket, as well as several other competitors that provide probe systems for
the service station and hydrocarbon leak detection industries.

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

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

Industrial Process Cooling Equipment

     The Company's Thermal Care division engineers, designs and manufactures
coolers for industrial purposes. The Company's cooling products include (i)
chillers (portable and central); (ii) cooling towers; (iii) plant circulating
assemblies; (iv) water, hot oil, and negative pressure temperature controllers;
(v) water treatment equipment and various other accessories; and (vi)
replacement parts and accessories relating to the foregoing products. The
Company's cooling products are used to optimize manufacturing productivity by
quickly removing heat from manufacturing processes. The principal market for the
Company's cooling products is the plastics processing industry. The Company also
sells its products to OEM's, other cooling manufacturers on a private branded
basis and to manufacturers in the laser, metallizing, and reaction injection
molding industries.

     The Company combines chillers or cooling towers with plant circulating
systems to create plant-wide systems that account for a large portion of its
business. The Company specializes in customizing cooling systems according to
customer orders.

                                       10
<PAGE>
 
     Chillers. Chillers are refrigeration units designed to provide cool water
to a process for the purpose of removing heat from the process and transferring
that heat to an area where it can be dissipated. This heat either is dissipated
using air (air cooled chillers) or water (water cooled chillers). Water cooled
chillers use a cooling tower to transfer the heat from the chiller using water
and then releasing the heat to the atmosphere with the cooling tower.

     The Company believes that it manufactures the most complete line of
chillers available in its primary market (plastics processing). The Company's
line of portable chillers are available from 1/2 horsepower to 40 horsepower and
incorporate a microprocessor that is capable of computer communications to
standard industry protocols. While portable chillers are considered to be a
commodity product by many customers, the Company believes that its units enable
it to provide the customer with quality, features, and benefits at a competitive
price.

     Central chillers are used for plant wide cooling, and while some models
incorporate their own pump and tank, most are sold with a separate pumping
system. The Company is currently the only manufacturer that offers several types
of central water cooled chillers. These chillers are distinguished by the manner
in which the compressor (refrigerant pump) and the evaporator (heat exchanger
water to refrigerant) is utilized in the chiller. The Company believes that its
ability to offer these units provides it with a unique concept sales advantage.
The Company's central chillers are available from 10 horsepower to 125
horsepower per refrigeration section.

     Cooling Towers. A cooling tower is essentially a cabinet with heat transfer
fill media that has water flow down across the fill while air is pulled up
through the fill. Cooling takes place by evaporation. Cooling towers are located
outdoors and are designed to provide approximately 85 degrees F of water to
remove heat from water cooled chillers, air compressors, hydraulic oil heat
exchangers and other processes that can effectively be cooled with such water.

     The Company markets two lines of cooling towers. The FT series towers were
introduced in 1984 and at the time were the first fiberglass cooling towers to
be sold in the U.S. The cabinets for these towers are imported from Taiwan and
are available in sizes ranging from three to 850 tons. (One tower ton equals
12,000 BTU hour of heat removal). Fiberglass cooling towers have achieved high
popularity and are available from most suppliers. The FC fiberglass tower line,
which is designed and engineered by the Company and which the Company believes
is the highest quality tower in the market today, is available from 80 to 200
tons.

     Plant Circulating Systems. The Company manufactures and markets a variety
of tanks in various sizes with pumps and piping arrangements that utilize alarms
and other electrical options. Thus, each system is unique and customized to meet
customers' individual needs. These plant circulating systems are used as an
integral part of central tower and chiller systems. This product line was
expanded in 1996 with the introduction of FRP tanks.

                                       11
<PAGE>
 
     Temperature Control Units. Most temperature control units are used by
injection molders of plastic parts to remove heat from the molds at an elevated
temperature for the purpose of improving part quality. The introduction of the
Company's totally redesigned unit, the RA series, has resulted in a doubling of
temperature control unit sales. More than 90 percent of the temperature control
units sold in the industry are water units. The remaining units use oil as the
heat transfer medium. The Company sells an oil temperature control unit
manufactured in Denmark pursuant to an exclusive marketing agreement for North
America.

     Water Treatment Equipment and Accessories. Sold as an accessory to cooling
tower systems, water treatment equipment must be used to protect the equipment
that is being cooled. The Company sells units manufactured to its specifications
by a supplier that provides all the equipment needed to properly treat the
water. While a relatively small part of Thermal Care's business, this
arrangement allows the Company to offer a complete system to its cooling
products customers. In addition, the Company provides other items to complement
a system that is purchased from a supplier and usually drop shipped directly to
a customer; principally, heat exchangers, special valves, and "radiator type"
coolers.

     Parts. The Company strives to fill cooling parts orders within 24 hours and
sells parts at competitive margins in order to enhance new equipment sales.

     Marketing. In general, the Company sells its cooling products to three
different markets.

     1.   The domestic plastics market is the largest market served by Thermal
Care, representing the core of its business. There are approximately 8,000
companies processing plastic products in the United States, primarily using
injection molding, extrusion, and blow molding machinery. The Company believes
that the total U.S. market for water cooling equipment in the plastics industry
is $101 million annually, and that the Company is the third largest supplier of
heat transfer equipment to the plastics industry with a market share of 14.0
percent to 16.0 percent. The Company believes that the plastics industry is a
mature industry with growth generally consistent with that of the national
economy. Due to the high plastics content in many major consumer items, such as
cars and appliances, this industry experiences economic cyclical activity. The
Company believes that it is recognized in the domestic plastics market as a
quality equipment manufacturer and that the Company will be able to maintain its
market share with opportunities for increased share through product development.
The Company's cooling products are sold through independent manufacturers'
representatives on an exclusive territory basis. Seventeen agencies are
responsible for covering the United States and are supported by four Thermal
Care regional managers.

                                       12
<PAGE>
 
     2.   The primary emphasis for the sale of the Company's cooling products
outside the United States has been in Latin America and through system design
consultants' assembly of complete world wide PET (plastic bottle) plants,
significant numbers of which are being built by large companies. This activity
is currently recovering from a decline in recent years due to the devaluation of
the Mexican peso. The Company believes that Thermal Care has a significant
opportunity for growth due to the high quality of its equipment and the fact
that it offers complete system design. Many United States competitors do not
provide equipment outside of the U.S., and while there are European competitors
selling equipment in Latin America, the Company believes that they lack system
design capabilities and have a significant freight disadvantage. The Company
markets its cooling products through a combination of manufacturers'
representatives, distributors, and consultants, some of which are recognized as
the leaders in the distribution of plastics machinery throughout Latin America.

     3.   An increasing share of the Company's sales is to non-plastics
industries that require specialized heat transfer equipment, usually sold to 
end-users as a package by the supplier of the primary equipment. The Company's
sales in the laser industry, metallizing industry, and reaction injection
molding industry have been particularly strong. The Company believes that the
size of this market is more than $200 million annually. The Company expects
growth in this market due to its ability to work with OEM's that perceive the
Company to be a quality supplier. Distribution of products to the end user in
this market is generally handled by the OEM. The Company is establishing a
manufacturers' network to cover approximately one half the U.S.

     Trademarks. The Company registered the trademark "Thermal Care" with the
U.S. Patent and Trademark Office in August 1986.

     Backlog. As of January 31, 1998, the dollar amount of Thermal Care's
backlog (uncompleted firm orders) was $4,692,000. As of January 31, 1997, the
amount of backlog was $4,513,000.

     Raw Materials and Manufacturing. Thermal Care's production facility
utilizes approximately 63,000 square feet with an additional 13,000 square feet
of inventory storage space. The plant layout is designed to facilitate movement
through multiple work centers. Thermal Care's Manufacturing Accounting
Production Inventory Control System ("MAPICS") supports its manufacturing
operations. The status of the customer order at any given moment can be
determined through the MAPICS system.

     The Company utilizes prefabricated sheet metal and sub-assemblies
manufactured by both Thermal Care and outside vendors for temperature controller
fabrication. This reduces the labor to complete finished goods. The production
line is self-contained, allowing the Company to assemble, wire, test, and crate
the units for shipment with minimal handling.

                                       13
<PAGE>
 
     FT towers up to 100 tons in capacity are assembled to finished goods
inventory, which allows the Company to meet quick delivery requirements.  Towers
in excess of 100 tons in capacity are shipped for field assembly.  The Company
employs field technicians that can assist the customer with assembly.  FT
cooling towers are manufactured using fiberglass and hardware components
purchased from a Taiwanese manufacturer, which is the Company's sole source for
such products.  The wet deck is cut from bulk fill material and installed inside
the tower.  Customer-specified options can be added at any time.

     The FC towers are rectangular in design and are engineered by the Company.
Two different cabinet sizes of the FC tower account for 16 different model
variations.  Some of these models are certified by the Cooling Tower Institute
with stringent capacity guarantees.  All FC cooling towers are assembled at the
Company's Niles facility.  FC towers can be shop assembled before shipment.

     The Company assembles all plant circulating systems by fabricating the
steel to meet the size requirements and adding purchased components to meet the
customer specifications.  Electrical control boxes assembled in the electrical
panel shop are then added to the tank and hardwired to all electrical
components.  The interior of the tank is coated with an immersion service epoxy
and the exterior is painted in a spray booth.  In 1995, the Company developed a
fiberglass tank for nonferrous applications.

     Portable chillers are assembled utilizing components manufactured by the
Company and supplied by outside vendors.  Portable chillers are assembled using
a condensing unit, a non-corrosive tank, hose, and prepainted sheet metal.  Many
of the components utilized in these chillers are fabricated as sub-assemblies
and held in inventory.  Once the water and refrigeration components have been
assembled, the unit is moved to the electrical department for the addition of
control sub-assemblies and hardwiring.  The chillers are then evacuated, charged
with refrigerant and tested under fully loaded conditions.  The final production
step is to clean, insulate, label, and crate the chiller for shipment.

     Central chillers are manufactured to customer specifications.  Many of the
components are purchased to the job requirements and production is planned so
that sub-assemblies are completed to coincide with the work center movements.
After mechanical and electrical assembly, the chiller is evacuated, charged with
refrigerant and tested at full and partial load conditions.  The equipment is
then insulated and prepared for painting.  The final production step completes
the quality control inspection and prepares the unit for shipment.


     Competition. The Company believes that there are approximately 13
competitors selling cooling equipment in the domestic plastics market. Three
manufacturers, including the Company, collectively share approximately 75.0
percent of the plastics market. Many potential foreign customers with relatively
small cooling needs are able to purchase small refrigeration units (portable
chillers) that suit their needs and are manufactured in their respective local
markets at prices below that which the Company can offer competing products.
However, such local manufacturers often lack the technology and products needed
for plant-wide cooling. The 

                                       14
<PAGE>
 
Company believes that its positive reputation for producing quality plant-wide
cooling product results in a significant portion of the business in this area.

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

     Government Regulation. The Company does not expect its compliance with
Federal, State and local provisions regulating the discharge of materials into
the environment or otherwise relating to the protection of the environment to
have a material effect upon the capital expenditures, earning or competitive
position of Thermal Care, nor is management aware of the need for any material
capital expenditures for environmental control facilities for the remainder of
the current fiscal year or for the foreseeable future. Although regulations
recently promulgated under the Federal Clean Air Act prohibit the manufacture
and sale of certain refrigerants, none of these refrigerants are used by the
Company in its products. Although there can be no assurance as to the ultimate
effect on the Company of the Clean Air Act and related laws, the Company expects
that suitable refrigerants conforming to federal, state and local laws and
regulations will continue to be available to the Company.

Employees

     As of March 31, 1998, the Company had 754 full-time employees, 99 of whom
were engaged in sales and marketing, 97 of whom were engaged in management and
administration, and the remainder were engaged in production. Hourly production
employees of the Company's filtration products business in Winchester, Virginia
are covered by a collective bargaining agreement with the International United
Automobile, Aerospace & Agricultural Implement Workers of America, which expires
in October 2000. Most of production employees of the Company's cooling products
business are represented by two unions, the Pipefitters and the International
Brotherhood of Electrical Workers unions pursuant to collective bargaining
agreements, both of which expire on June 1, 1998. The Company anticipates that
this contract will be renegotiated without significant difficulty and that the
resulting wage and benefit increases will be consistent with competitive
industry and community standards. The piping system products' collective
bargaining agreement with the Pipefitters Union-metal trade division, expires in
March 2001.

                                       15
<PAGE>
 
Year 2000 Issues

     The Company has organized a program to evaluate and identify any material
Year 2000 issues. Please see Item 7, Management's Discussion and Analysis of
Financial Condition and Results of Operations for additional information.

Executive Officers of the Registrant

     The following table sets forth information regarding the executive officers
of the Company as of March 31, 1998:


<TABLE>
<CAPTION>
                                                                    Executive Officer of
                                                                     the Company or its
                      Age                  Position                  Predecessors Since
                      ---                  --------                  ------------------
<S>                   <C>   <C>                                      <C>
David Unger           63    Chairman of the Board of Directors,             1972
                            President and Chief Executive Officer
Henry M. Mautner      71    Vice Chairman of the Board of                   1972
                            Directors
Bradley E. Mautner    42    Vice President and Director                     1994
Gene K. Ogilvie       58    Vice President and Director                     1969
Fati A. Elgendy       49    Vice President and Director                     1990
Don Gruenberg         55    Vice President and Director                     1980
Michael D. Bennett    53    Vice President, Secretary and                   1989
                            Treasurer
Billy E. Ervin        52    Vice President                                  1986
Joseph P. Findley     58    Vice President                                  1991
J. Tyler Headley      47    Vice President                                  1973
Robert A. Maffei      49    Vice President                                  1987
Herbert J. Sturm      47    Vice President                                  1977
Stephen P. Russell    44    Vice President                                  1988
Thomas A. Benson      45    Vice President                                  1985
</TABLE>

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

                                      16
<PAGE>
 
     David Unger has been employed by the Company and its predecessors in
various executive and administrative capacities since 1958, has served as
President of Midwesco, Inc. from 1972 through January 1994 and was Vice
President from February 1994 through December 1996. He was a director of
Midwesco, Inc. from 1972 through December 1996, and served that company in
various executive and administrative capacities from 1958 until the consummation
of the merger of Midwesco, Inc. into MFRI, Inc. (the "Midwesco Merger"). He is a
director of the company formed to succeed to the non-Thermal Care business of
Midwesco, Inc.

     Henry M. Mautner has been employed by the Company and its predecessors in
various executive capacities since 1972, has served as chairman of Midwesco,
Inc., from 1972 through December 1996, and served that company in various
executive and administrative capacities from 1949 until the consummation of the
Midwesco Merger. Since the consummation of the Midwesco Merger, he has served as
the chairman of the Company formed to succeed to the non-Thermal Care businesses
of Midwesco, Inc. Mr. Mautner is the father of Bradley E. Mautner.

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

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

     Bradley E. Mautner has served as Vice President of the Company since
December 1996 and has been a director of the Company since 1995. From 1994 to
the consummation of the Midwesco Merger, he served as President of Midwesco,
Inc. and since December 30, 1996 he has served as President of the company
formed to succeed to the non-Thermal Care business of Midwesco, Inc. In
addition, since February 1996, he has served as the Chief Executive Officer of
Midwesco Services, Inc. (formerly known as Mid Res, Inc.). From February 1988 to
January 1996, he served as the President of Mid Res, Inc. Bradley E. Mautner is
the son of Henry M. Mautner.

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

                                       17
<PAGE>
 
     Michael D. Bennett has served as the Chief Financial Officer and Vice
President of MFRI and its predecessors since August 1989.

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

     Joseph P. Findley has been Vice President, Manufacturing, of Midwesco
Filter since October 1991, having served as Manager, Quality Control and
Assurance since January 1989.  From 1971 to 1988, he served in various executive
capacities for the Menardi-Criswell division of Hosokawa Micron International,
Inc. and a predecessor of that division.

     J. Tyler Headley has been employed by the Company in various executive
capacities since 1973 and has served as Vice President, Marketing and Sales of
Midwesco Filter since May 1986.

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

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

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

     Stephen P. Russell has been employed by Thermal Care since March 1984, has
served in executive capacities since December 1985, and has been Vice President
Operations of Thermal Care since February 1994.

Item 2.  PROPERTIES

     The Company's principal executive offices, and the production facilities
for the Company's cooling products business, are located in a 126,000 square
foot facility leased by the Company at 7720 Lehigh Avenue, Niles, Illinois
60714.  The production facilities for the Company's filtration products are
located in buildings totalling 164,500 square feet situated on approximately 15
acres owned by the Company in a modern industrial park in Winchester, Virginia
and a 130,700 square foot building in an industrial neighborhood in Cicero,
Illinois.  The Cicero, Illinois facility was purchased by the Company as a part
of the TDC Acquisition in December 1997.  The primary production facilities for
the Company's piping system products are located on approximately 24 acres of
land in a modern industrial park in Lebanon, Tennessee, and are housed in four
buildings, which total 120,000 square feet and contain manufacturing, warehouse
and office facilities.   The Company owns the buildings and the land for the
Tennessee facility.  The Company leases a 55,000 square foot warehouse facility
in Niles, Illinois and a 2,600 square foot office and warehouse facility located
in Riverside, California.

                                       18
<PAGE>
 
     The Company believes its properties and equipment are well maintained, in
good operating condition and that their productive capacities will be generally
adequate for its present and currently anticipated needs.

     Compliance with environmental regulations by the Company in its
manufacturing operations has not had, and is not anticipated to have, a material
effect on the capital expenditures, earnings or competitive position of the
Company.

Item 3.  LEGAL PROCEEDINGS

     Midwesco, Inc., or one of its affiliates, PermAlert ESP, Inc. ("PermAlert")
or Perma-Pipe, Inc. ("PPI"), was a party to three lawsuits (the "Pending
Suits"), each of which, upon consummation of the Midwesco Merger, became the
obligations of MFRI.

     Pursuant to the merger agreement entered into in connection with the
Midwesco Merger, from and after the effective time of the Midwesco Merger (the
"Effective Time"), MFRI has or will bear all costs and expenses of the Pending
Suits, including, but not limited to, any judgments or settlement costs (the
"Expenses"); provided, however, after MFRI has spent an aggregate of $400,000 in
Expenses, all such Expenses of the Pending Suits will be paid from a special
escrow holding 66,890 shares of MFRI common stock (the "Special Escrow").

     IHP Industrial v. Perm Alert ESP was filed in May 1996, in the Circuit
Court of Lauderdale County, Mississippi. It involves a contract which PermAlert
entered into with IHP Industrial, Inc. to supply a contained piping system for
underground transport of jet fuel at the Air National Guard field in Meridian,
Mississippi. The original purchase order for the project was $724,000 and
subsequent change orders increased the contract price to $749,000. The plaintiff
is seeking damages in excess of $833,000, based on claims for breach of
warranty, misrepresentation and negligence. PermAlert has filed a counter-claim
for $194,000, for amounts due under the original contract, including change
orders, and for extras involved in the repair of the contained piping system.

     State Farm Mutual Automobile Ins. Co. v. George Hyman Constr. Co, et al. In
July 1996, defendant J.A. House, Inc. ("J.A. House") sued Perma-Pipe in a Third
Party Complaint in that litigation. The claim against Perma-Pipe related to a
sub-contract which Perma-Pipe entered with J.A. House, pursuant to which Perma-
Pipe agreed to supply a hot water supply and return piping system with leak
detection capabilities, for the construction of the State Farm Mutual Automobile
Insurance Company complex in Bloomington, Illinois. Perma-Pipes' involvement in
this matter was settled during 1997 by Perma-Pipe's payment of $120,000.

     In May 1993, Midwesco, Inc. and PermAlert filed a complaint against PPG
Industries, Inc. ("PPG") and Crain Brothers, Inc. ("Crain"). This case involved
an agreement between PermAlert and PPG for the manufacture and delivery, by
PermAlert, of a chlorine pipeline and related services. Perma-Alert paid
$230,000 as part of an overall settlement with PPG and the court dismissed the
matter in consideration of the settlement.

                                       19
<PAGE>
 
     In the event there are no shares of MFRI common stock in the Special
Escrow, the responsibility for the Pending Suits will be solely that of MFRI.
Upon the disposition or termination of all of the Pending Suits, any shares in
the Special Escrow will be distributed to the shareholders of Midwesco, Inc. as
of the Effective Time prorata to their interests in Midwesco, Inc. at the
Effective Time. During 1997, costs of these lawsuits, including the settlements
of two of the lawsuits, exceeded the reserve by approximately $177,000, which
will be reimbursed from the Special Escrow. Management believes that the
settlement costs of the pending lawsuit will not exceed the remaining balance in
the Special Escrow.

Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

                                       20
<PAGE>
 
                                    PART II



Item 5.   MARKET FOR REGISTRANT'S COMMON
          EQUITY AND RELATED STOCKHOLDER MATTERS


     The Company's Common Stock is traded on The Nasdaq National Stock Market
under the symbol "MFRI." The following table sets forth, for the periods
indicated, the high and low sales prices as reported by the Nasdaq National
Market for 1996 and for 1997.


<TABLE>
<CAPTION>
                       1996                              High          Low
                       ----                             ------        -----
<S>                                                    <C>            <C>
First Quarter...................................        $ 7.25        $5.75
Second Quarter..................................          8.00         6.50
Third Quarter...................................          8.13         6.63
Fourth Quarter..................................          8.13         6.88
                                                              
                       1997                              High          Low
                       ----                             ------        -----
First Quarter...................................        $ 8.63        $6.75
Second Quarter..................................         10.50         6.63
Third Quarter...................................         10.50         8.94
Fourth Quarter..................................         10.50         7.75
                                                         
</TABLE>



     As of January 31, 1998, there were approximately 150 stockholders of
record, and approximately 1,350 beneficial stockholders of the Company's Common
Stock.

     The Company has never declared or paid a cash dividend and does not
anticipate paying cash dividends on its common stock in the foreseeable future.
Management presently intends to retain all available funds for the development
of the business and for use as working capital. Future dividend policy will
depend upon the Company's earnings, capital requirements, financial condition
and other relevant factors. The Company's line of credit agreement contains
certain restrictions on the payment of dividends. The primary restriction limits
dividends to a cumulative amount of up to 50% of net income.


                                      21
<PAGE>
 
Item 6.  SELECTED FINANCIAL DATA


     The following selected financial data for the Company for the years 1997,
1996, 1995, 1994 and 1993 are derived from the financial statements of the
Company. The information set forth below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included herein in response to Item 7 and the consolidated financial
statements and related notes included herein in response to Item 8.


<TABLE>
<CAPTION>
                                                            Fiscal Year ended January 31,
                                             ---------------------------------------------------------
<S>                                     <C>            <C>          <C>           <C>         <C> 
(In thousands, except per share data)        1998          1997         1996          1995        1994 
                                             ----          ----         ----          ----        ---- 
Statements of operations data:
Net sales                                $111,240       $93,573      $85,838       $75,495     $29,866
Income from operations                      6,224         6,396        4,738         2,384       2,459
Net income                                  2,758         3,230        2,373         1,203       1,534
Net income per share - basic                 0.55          0.71         0.52          0.27        0.54
Net income per share - diluted               0.54          0.70         0.52          0.27        0.54

                                                                 As of January 31,
                                             ---------------------------------------------------------
(In thousands)                               1998          1997         1996          1995        1994                              
                                             ----          ----         ----          ----        ---- 
Balance Sheet data:
Total assets                              $92,941       $75,328      $58,985       $47,917     $36,898
Long-term debt, less current
   portion                                 33,073        22,627       14,050         6,650       3,100
Capitalized leases,
   less current portion                     2,202         1,294          217           252         147
                                               
</TABLE>

     The following table sets forth statements of operations data for the
Company's industrial process cooling equipment business. See Notes 4 and 11 to
Notes to Financial Statements. This information is not included in the accounts
of the Company prior to December 30, 1996 because the Midwesco Merger was not
effected until December 30, 1996. Since Thermal Care was a division of Midwesco,
Inc. prior to the Midwesco Merger, per share data is not available.

<TABLE>
<CAPTION>
                                               Fiscal Year Ended January 31,
                                             ----------------------------------
(In thousands)                               1997      1996      1995      1994
                                             ----      ----      ----      ----
<S>                                       <C>       <C>       <C>       <C> 
Thermal Care statements of operations
   data: (1)
Net Sales                                 $20,036   $19,775   $18,528   $13,127
Income (loss) from continuing operations      661     1,318     1,623       (89)
Net Income (loss)                           1,161       894       936       128
Net Income (loss) per share                  NA         NA        NA        NA

-----------------
</TABLE> 

(1)  The 1994 Thermal Care statement of operations data reflects the operations
     of Perma-Pipe as discontinued operations.



                                      22
<PAGE>
 
Item 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS
          OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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" and "likely" 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.

The Company's fiscal year ends on January 31. Fiscal years 1997, 1996 and 1995
ended on January 31, 1998, 1997 and 1996, respectively. Balances described as
balances as of 1997, 1996 and 1995 are balances as of January 31, 1998, 1997 and
1996, respectively.

<TABLE> 
<CAPTION> 

RESULTS OF OPERATIONS
Overview
--------
                             [GRAPH APPEARS HERE]
<S>                        <C>                         <C> 
Net Sales                  Gross Profit                Net Income
---------                  ------------                ----------
(in millions)              (in millions)               (in millions)

1997  111.240              1997  27.935                  1997  2.758

1996   93.573              1996  21.805                  1996  3.230

1995   85.838              1995  16.880                  1995  2.373
</TABLE> 



1997 Compared to 1996

Net sales increased 18.9 percent in 1997 to $111,240,000 from $93,573,000 in
1996. Gross profit for 1997 was $27,935,000 or 25.1 percent of net sales, an
increase of 28.1 percent from the $21,805,000 or 23.3 percent of net sales
reported in 1996. Net sales and gross profit increased in 1997 primarily due to
the inclusion of a full year of operations of the Company's industrial process
cooling equipment business which was acquired in December 1996 through the
merger of Midwesco, Inc. into MFRI, Inc. (the "Midwesco Merger"). The accounts
of this business were not included in the accounts of the Company prior to the
acquisition date. This increase was partially offset by a decline in


                                      23
<PAGE>
 
sales of the piping system products business, as a major secondary containment
sale essentially completed in 1996 was not replaced in 1997.

Net income decreased 14.6 percent from $3,230,000 or $0.71 per common share
(basic) in 1996 to $2,758,000 or $0.55 per common share (basic) in 1997. The
increase in 1997 net income attributable to the acquisition of the industrial
process cooling equipment business in the Midwesco Merger was more than offset
by warranty costs related to the piping system products business and costs
incurred to defend two patent infringement lawsuits.

1996 Compared to 1995

Net sales of $93,573,000 in 1996 increased 9.0 percent from the $85,838,000
reported in 1995. Gross margins increased 29.2 percent from $16,880,000 or 19.7
percent of net sales in 1995 to $21,805,000 or 23.3 percent of net sales in
1996.

Net income of $3,230,000 or $0.71 per common share (basic) in 1996 increased
36.1 percent from $2,373,000 or $0.52 per common share (basic) in 1995.

Net sales increased in 1996 mainly due to the inclusion of a full year of
operations of SZE Hagenuk GmbH, acquired in December 1995, and approximately one
month of the operations of the industrial process cooling equipment business,
acquired in December 1996 in the Midwesco Merger, coupled with a major domestic
secondary containment sale booked by the piping system products business in 1995
and essentially completed in 1996. The increase in margins and net income were
primarily the result of product mix of sales in the piping system products
business, as the domestic secondary containment sales and the sales of SZE
Hagenuk GmbH yield a higher than average gross profit as a percent of net sales.

Filtration Products Business

The Company's filtration products business is characterized by a large number of
relatively small orders and a limited number of large orders, typically from
electric utilities. In 1997, the average order amount was approximately $5,726.
The timing of large orders can have a material effect on the comparison of net
sales and gross profit from period to period. Large orders generally are highly
competitive and result in a lower gross margin. In 1997, 1996 and 1995, no
customer accounted for 10 percent or more of the net sales of the Company's
filtration products and services.

The Company's filtration products business, to a large extent, is dependent on
government regulation of air pollution at the federal and state levels. The
Company believes that continuing growth in the sale of its filtration products
and services will be materially dependent on continuing enforcement of
environmental laws such as the Clean Air Act Amendments. Although there can be
no assurances as to what ultimate effect, if any, the Clean Air Act Amendments
will have on the Company's filtration products


                                      24

<PAGE>
 
business, the Company believes that the Clean Air Act Amendments are likely to
have a long-term positive effect on demand for the Company's filtration products
and services.

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------
Filtration Products Business
(In thousands)                                                                    % Increase
                                                                                  (Decrease)
                                                                              -----------------
                                        1997         1996         1995          1997         1996
                                    -----------  -----------  -----------  ------------  ----------
<S>                                 <C>          <C>          <C>          <C>           <C>
Net sales                              $40,145      $37,563      $36,590          6.9%         2.7%
 
Gross margins                           10,243        9,862        8,727          3.9%        13.0%
    As a percentage of net sales          25.5%        26.3%        23.9%
 
Income from operations                   4,140        4,615        4,086        (10.3%)       12.9%
    As a percentage of net sales          10.3%        12.3%        11.2%
---------------------------------------------------------------------------------------------------
</TABLE>
                                                                                
1997 Compared to 1996

Net sales increased 6.9 percent to $40,145,000 in 1997 from $37,563,000 in 1996
primarily due to higher sales of filter elements for cartridge collectors.

Gross profit as a percent of net sales was 25.5 percent in 1997 compared to 26.3
percent in 1996. Unfavorable product mix and the attendant manufacturing
inefficiencies were the major causes of the decline in the gross profit margin.

Selling expense increased 14.1 percent from $3,265,000 or 8.7 percent of net
sales in 1996 to $3,726,000 or 9.3 percent of net sales in 1997, largely due to
additional sales resources.

General and administrative expenses increased from $1,982,000 in 1996 to
$2,377,000 in 1997 and from 5.3 percent to 5.9 percent of net sales. The cost of
additional administrative resources and expenses, primarily legal expenses
related to a patent infringement dispute in 1997, were partially offset by
reduced research and development expenses.

1996 Compared to 1995

Net sales increased 2.7 percent from $36,590,000 to $37,563,000 due to higher
unit sales across most product lines.

Gross profit as a percentage of net sales increased from 23.9 percent to 26.3
percent, primarily due to higher intake margins and a favorable product mix.


                                      25
<PAGE>
 
Selling expense increased from $2,783,000 to $3,265,000 and from 7.6 percent to
8.7 percent of net sales. The increase is primarily the result of increased
international selling expenses, additional domestic sales and marketing staffing
and higher gross profit-related incentive compensation.

General and administrative expenses increased from $1,858,000 to $1,982,000 and
from 5.1 percent to 5.3 percent of net sales, primarily the result of profit-
related incentive compensation.

Piping System Products Business

Generally, the Company's leak detection and location systems and secondary
containment piping systems have higher profit margins than its district heating
and cooling piping systems. However, the Company has been able to improve the
margins for its district heating and cooling piping systems by booking orders
more selectively. The Company has benefitted from continuing efforts to have its
leak detection and location systems and secondary containment piping systems
included as part of the customers' original specifications for an increasing
number of construction projects.

Although demand for the Company's secondary containment piping system products
is generally affected by its customers' need to comply with governmental
regulations, purchases of such products at times may be delayed by customers due
to adverse economic factors. In 1997, 1996 and 1995, no customer accounted for
10 percent or more of net sales of the Company's piping system products.

The Company's piping system products business is characterized by a large number
of small and medium orders and a small number of large orders. The average order
amount for 1997 was approximately $29,512. The timing of such orders can have a
material effect on the comparison of net sales and gross profit from period to
period. Most of the Company's piping system products are produced for
underground installations and, therefore, require trenching, which is performed
directly for the customer by installation contractors unaffiliated with the
Company. Generally, sales of the Company's piping system products tend to be
lower during the winter months, due to weather constraints over much of the
country.


                                      26
<PAGE>
 

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------
Piping System Product Business
------------------------------
(In thousands)                                                                    % Increase
                                                                                  (Decrease)
                                                                           ------------------------
                                       1997         1996         1995          1997         1996
                                    -----------  -----------  -----------  ------------  ----------
<S>                                 <C>          <C>          <C>          <C>           <C>
Net sales                              $46,232      $54,194      $49,248        (14.7%)       10.0%
 
Gross margins                            9,723       11,373        8,153        (14.5%)       39.5%
    As a percentage of net sales          21.0%        21.0%        16.6%
 
Income from operations                   2,347        4,033        2,585        (41.8%)       56.0%
    As a percentage of net sales           5.1%         7.4%         5.2%
----------------------------------------------------------------------------------------------------
</TABLE>


1997 Compared to 1996

Net sales decreased 14.7 percent from $54,194,000 in 1996 to $46,232,000 in
1997, primarily due to a major secondary containment sale essentially completed
in 1996 which was not replaced in 1997.

Gross profit as a percent of sales remained unchanged at 21.0 percent in spite
of costs incurred to rectify a substantial warranty claim relating to a piping
system of a design which has been discontinued.

Selling expense decreased from $2,583,000 in 1996 to $2,498,000 in 1997 due to a
reduction in sales literature requirements.  Product catalogs and brochures were
ordered in bulk in 1996.  Selling expense as a percent of net sales increased
from 4.8 percent to 5.4 percent due to the sales expense being spread over a
smaller sales base.

General and administrative expense increased from $4,757,000 in 1996 to
$4,878,000 in 1997 and from 8.8 percent to 10.6 percent of net sales mainly due
to legal expenses related to a patent infringement lawsuit.

Foreign net sales decreased from $6,207,000 in 1996 to $5,741,000 in 1997 and
foreign operating income decreased from $589,000 to $341,000, due primarily to a
decline in SZE Hagenuk sales.


1996 Compared to 1995

Net sales increased 10.0 percent from $49,248,000 to $54,194,000, due primarily
to a major domestic secondary containment sale booked in 1995 and essentially
completed in 1996, and to a full year's sales from SZE Hagenuk, which was
acquired late in 1995.


                                      27
<PAGE>
 
Gross profit as a percent of net sales increased from 16.6 percent to 21.0
percent, due primarily to favorable product mix, as the increased domestic
secondary containment sales and SZE Hagenuk sales yield higher than average
gross profits as a percent of net sales.

Selling expense increased from $1,802,000 to $2,583,000 and from 3.7 percent to
4.8 percent of net sales, due primarily to increased profit-related incentive
compensation and the full year's expenses of SZE Hagenuk acquired in late 1995.

General and administrative expense increased from $3,766,000 to $4,757,000 and
from 7.6 percent to 8.8 percent of net sales. The increase resulted primarily
from increased staffing in customer service and the inclusion of SZE Hagenuk for
a complete year.

Foreign net sales increased from $3,659,000 to $6,207,000 and foreign operating
income increased from $206,000 to $589,000, due primarily to the inclusion of a
full year's operations of SZE Hagenuk.


Industrial Process Cooling Equipment Business

The Company's cooling products business is characterized by a large number of
relatively small orders and a limited number of large orders. In 1997, the
average order amount was approximately $4,033. Generally, sales to original
equipment manufacturers ("OEM's") have lower profit margins than sales to the
domestic and international plastics industries and other markets. Large orders
are generally highly competitive and result in lower profit margins. In 1997,
1996 and 1995, no customer accounted for 10 percent or more of the Company's
cooling products net sales. Although the accounts of the industrial process
cooling equipment business were not included in the accounts of the Company
prior to December 30, 1996, the following pro forma information is presented to
help the reader understand this business.

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------
Industrial Process Cooling Equipment Business
-----------------------------------------------
(In thousands)                                                                  % Increase
                                                        Pro Forma               (Decrease)
                                                ------------------------  -----------------------
                                      1997         1996         1995         1997        1996
                                   -----------  -----------  -----------  ----------  -----------
<S>                                <C>          <C>          <C>          <C>         <C>
Net sales                             $24,863      $20,036      $19,776        24.1%         1.3%
 
Gross margins                           7,969        5,875        4,529        35.6%        29.7%
    As a percentage of net sales         32.1%        29.3%        22.9%

Income from operations                  2,836          661        1,319       329.0%       (49.9%)
    As a percentage of net sales         11.4%         3.3%         6.7%
----------------------------------------------------------------------------------------------------
</TABLE>
                                                                                

                                      28
<PAGE>
 
1997 Compared to 1996

Net sales increased 24.1 percent to $24,863,000 in 1997 from $20,036,000 in
1996, resulting from higher sales across all product lines, especially tanks and
central chiller systems.

Gross profit as a percentage of net sales increased from 29.3 percent in 1996 to
32.1 percent in 1997 primarily due to plant efficiencies from larger production
volumes.

Selling expenses increased from $2,700,000 in 1996 to $3,055,000 in 1997,
primarily due to higher commission expense related to the increased sales
volume. Selling expense as a percentage of net sales declined from 13.5 percent
to 12.3 percent due to selling expenses being spread over a larger sales base in
1997.

General and administrative expenses decreased from $2,514,000 to $2,078,000 and
from 12.5 percent of net sales to 8.4 percent of net sales. Pro forma general
and administrative expenses for 1996 included a provision for lawsuits described
as follows: Pro forma general and administrative expenses for 1996 include a
provision of $400,000 for the estimated ultimate cost of three lawsuits which
had been considered in negotiating the acquisition price of the Midwesco Merger
and which, upon consummation of the Midwesco Merger, became the obligations of
MFRI. Pursuant to the merger agreement relating to the Midwesco Merger, should
MFRI spend more than an aggregate of $400,000 in costs, expenses, judgments or
settlements of such lawsuits, additional amounts will be paid from a special
escrow holding 66,890 shares of MFRI common stock, such escrow having been
established as a part of the Midwesco Merger. During 1997, costs of these
lawsuits, including the settlements of two of the lawsuits, exceeded the
$400,000 reserve by approximately $177,000, which will be reimbursed from the
special escrow. Management believes that the settlement costs of the pending
lawsuit will not exceed the remaining balance in the special escrow. Also
included in the pro forma general and administrative expenses for 1996 was
$634,000 of corporate administrative expenses attributed to support of this
business. Without such pro forma adjustments of $1,034,000, 1996 general and
administrative expenses totalled $1,480,000. The increase from $1,480,000 to
$2,078,000 consisted primarily of other corporate expenses which were not
directly charged to this business prior to 1997.


1996 Compared to 1995

Net sales increased 1.3 percent from $19,776,000 to $20,036,000. The increase
was due primarily to additional OEM portable chiller sales partially offset by
lower export sales, mainly resulting from a large sale in 1995 for a plastic
bottle manufacturing plant in China which was not replaced in 1996.

Gross profit as a percent of net sales increased from 22.9 percent to 29.3
percent primarily due to a more favorable sales product mix coupled with
commission expenses


                                      29
<PAGE>
 
of $1,506,000 in 1996 which were classified as selling expenses. Commission
expenses were included in cost of sales in 1995.

Selling expenses increased from $1,206,000 to $2,700,000 and from 6.1 percent to
13.5 percent of net sales. The increase was due primarily to classifying the
commission expenses of $1,506,000 described above as selling expenses in 1996
rather than cost of sales as in 1995.

General and administrative expenses increased from $2,004,000 to $2,514,000 and
from 10.1 percent to 12.5 percent of net sales, due primarily to increased
engineering sales support expenses and to the $400,000 provision for lawsuits
described above.


General Corporate Expenses
--------------------------

General corporate expenses include general and administrative expense not
allocated to business segments and interest expense.


1997 Compared to 1996

General and administrative expenses not allocated to business segments increased
from $2,389,000 in 1996 to $3,099,000 in 1997, primarily due to the expense of
supporting the industrial process cooling equipment business acquired in the
Midwesco Merger for the entire year of 1997. Such expenses were included in the
1996 pro forma results of operations of the industrial process cooling equipment
business.

Interest expense was $1,640,000 in 1997, compared to $992,000 in 1996, mainly
because of higher borrowings to finance working capital, fixed asset additions,
and the acquisition of TDC and the inclusion of the debt acquired in the
Midwesco merger for the full year in 1997. (See also Liquidity and Capital
Resources.)


1996 Compared to 1995

General and administrative expenses not allocated to business segments increased
from $1,933,000 to $2,389,000, due primarily to increased profit-based incentive
compensation, expenses of upgrading the Company's computer hardware and
software, and higher administrative, financial management and accounting
salaries expense. The increased administrative, financial management and
accounting salaries expenses reflect shifts in time devoted to corporate
administrative matters from other areas, with some offsetting decrease in Perma-
Pipe administrative expense. The December 30, 1996, acquisition of Midwesco had
a minimal effect on general corporate expenses.

Interest expense increased from $925,000 to $992,000 due primarily to higher
borrowings to finance working capital, fixed asset acquisitions, the acquisition
of SZE Hagenuk, and the purchase of real estate to provide for the expansion of
Midwesco Filter in Winchester, Virginia.


                                      30
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

On September 14, 1995, and October 18, 1995, respectively, Midwesco Filter and
Perma-Pipe received the proceeds of Industrial Revenue Bonds. Such proceeds are
available for capital expenditures related to manufacturing capacity expansions
and efficiency improvements during a three-year period commencing in the fourth
quarter of 1995 in the filtration products business in Winchester, Virginia
($3,150,000) and the piping systems products business in Lebanon, Tennessee
($3,150,000). The bonds bear interest at a variable rate, which initially
approximated five percent per annum, including letters of credit and remarketing
fees. Each bond indenture establishes a trusteed project fund for deposit of the
bond proceeds. The trustee is authorized to make disbursements from the project
fund upon requisition from the Company to pay costs of capital expenditures
which comply with the requirements of the loan agreement for each bond. Pending
such disbursements, the trustee invests the balance of the project fund in
investments defined by the indenture and limited by applicable law. Such
invested funds totaled $2,929,000 at January 31, 1998. The bonds are fully
secured by bank letters of credit which expire approximately two years from the
date of issuance; the Company expects to arrange for renewal, reissuance or
extension of the letters of credit prior to expiration.

On May 8, 1996, the Company purchased for approximately $1.1 million a 10.3-acre
parcel of land with a 67,000 square foot building adjacent to its Midwesco
Filter property in Winchester, Virginia. The purchase was financed 80% by a
seven-year mortgage bearing interest at 8.38% and 20% by the industrial revenue
bonds described above.

At January 31, 1998, a capacity expansion project at the Lebanon, Tennessee
piping systems manufacturing facility was essentially complete. This project was
primarily financed from the proceeds of the Tennessee Industrial Revenue Bonds.

The Company has a positive working capital of $31.3 million and a current ratio
of 2.6 to 1 at January 31, 1998.

Working capital and investment needs of the Company have historically been
funded through the Company's operations and a revolving line of credit. To
finance the September 1994 acquisition of Ricwil Piping Systems Company, the
Company borrowed $4,000,000 from a bank under a term loan. The Company assumed
approximately $6,611,000 of Midwesco, Inc. long-term debt in the Midwesco
Merger, $5,000,000 of which represented assumed bank and other debt, with the
remainder representing assumed capitalized lease obligations. Effective December
15, 1996, the Company replaced its revolving line of credit and the unpaid
portion of the $4,000,000 September 1994 term loan with $15 million of fixed
rate senior unsecured notes due 2007 (the "Notes") and a new $5 million floating
rate unsecured revolving line of credit. Proceeds of the Notes were also used to
repay the Midwesco, Inc. debt assumed by the Company. The Notes bear interest at
an annual rate of 7.21% and require principal payment

                                       31
<PAGE>
 
beginning in the year ended January 31, 2001, and continuing annually
thereafter, resulting in a seven-year average life.

During 1997, the terms of the unsecured credit agreement were amended. Under the
terms of the agreement as amended, the Company may borrow up to $12,000,000
under a revolving line of credit which matures on March 31, 2000. Interest rates
are based on one of two options selected by the Company at the time of each
borrowing - the prime rate or the LIBOR rate plus a margin for the term of the
loan. At January 31, 1998, the prime rate was 8.50 percent and the margin added
to the LIBOR rate, which is redetermined each quarter based on the Company's
interest coverage ratio, was 1.75 percent. The Company had borrowed $10,950,000
under the revolving line of credit at January 31, 1998. Additionally, $449,000
was drawn under the agreement as letters of credit principally to guarantee
performance to third parties resulting from various trade activities. The loan
agreement contains certain financial covenants. As of January 31, 1998, the
Company was not in compliance with one such financial covenant. The Company has
obtained a waiver for such non-compliance.

YEAR 2000

Certain computer systems with date-sensitive programs may not properly recognize
the year 2000 and may, as a result, create unreliable data or fail to operate at
all in the year 2000 and thereafter. Such occurrences could have a material
adverse effect on the Company's results of operations and financial condition.
Accordingly, the Company is assessing its financial and operating systems for
the presence of such deficiencies and is developing and executing detailed
corrective plans. The Company is also communicating with significant suppliers
of goods and services and with customers to assess its exposure to their
potential year 2000 issues. Finally, the Company is assessing its products for
the presence of technology which might adversely affect those products and the
customers to whom they have been delivered. Although there can be no assurances,
based on current assessments, Management expects the Company's year 2000 issues
to be identified and corrected before the year 2000, and does not expect the
costs of correction to have a material adverse effect on the Company's results
of operations or financial condition.

                                       32
<PAGE>
 
Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The consolidated financial statements of the Company as of January 31, 1998
and January 31, 1997 and for each of the three years in the period ended January
31, 1998 and the notes thereto are set forth elsewhere herein.

Item 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE

         Not applicable.

                                   PART III

Item 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Information with respect to directors of the Company is incorporated herein
by reference to the table under the caption "Nominees For Election as Directors"
and the textual paragraphs following the aforesaid table in the Company's proxy
statement for the 1998 annual meeting of stockholders.

     Information with respect to executive officers of the Company is included
in Item 1, Part I hereof under the caption "Executive Officers of the
Registrant."

Item 11.  EXECUTIVE COMPENSATION

     Information with respect to executive compensation is incorporated herein
by reference to the information under the caption "Executive Compensation" in
the Company's proxy statement for the 1998 annual meeting of stockholders.

Item 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     Information with respect to security ownership of certain beneficial owners
and management of the Company is incorporated herein by reference to the
information under the caption "Beneficial Ownership of Common Stock" in the
Company's proxy statement for the 1998 annual meeting of stockholders.

Item 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Information with respect to certain relationships and transactions is
incorporated herein by reference to the information under the caption "Certain
Transactions" in the Company's proxy statement for the 1998 annual meeting of
stockholders.

                                       33
<PAGE>
 
                                    PART IV

Item 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K

     a.   (1)  Consolidated Financial Statements
               Refer to Part II, Item 8 of this report.

          (2)  Financial Statement Schedule
               a.  Schedule II - Valuation and Qualifying Accounts

          (3)  The exhibits, as listed in the Exhibit Index set forth on pages
               59 and 60, are submitted as a separate section of this report.

     b.   During the last quarter of the fiscal year ended January 31, 1998, the
          Company filed a Current Report on Form 8-K dated December 12, 1997.

     c.   See Item 14(a)(3) above.

     d.   The response to this portion of Item 14 is submitted as a separate
          section of this report.

                                      34
<PAGE>
 
INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of MFRI, Inc. and subsidiaries:

We have audited the accompanying consolidated balance sheets of MFRI, Inc. and
subsidiaries as of January 31, 1998 and 1997, and the related consolidated
statements of income, stockholders' equity, and cash flows for each of the three
years in the period ended January 31, 1998. Our audits also included the
financial statement schedule listed in the Index at Item 14(a)(2). These
financial statements and financial statement schedule are the responsibility of
the Corporation's management. Our responsibility is to express an opinion on the
financial statements and financial statement schedule based on our audits.

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

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of MFRI, Inc. and subsidiaries as of
January 31, 1998 and 1997, and the results of their operations and their cash
flows for each of the three years in the period ended January 31, 1998 in
conformity with generally accepted accounting principles. Also, in our opinion,
such financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.

DELOITTE & TOUCHE LLP


April 30, 1998

                                      35
<PAGE>
 
MFRI, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(In thousands except per share information)

<TABLE>
<CAPTION>
                                                1997       1996       1995
 
                                              Fiscal Year Ended January 31,
----------------------------------------------------------------------------
                                                1998       1997       1996
<S>                                           <C>         <C>        <C>
Net sales                                     $111,240    $93,573    $85,838
 
Cost of sales                                   83,305     71,768     68,958
                                              --------    -------    -------
 
Gross profit                                    27,935     21,805     16,880
 
Operating expenses:
 Selling expense                                 9,279      6,104      4,585
 General and administrative expense             11,735      8,740      6,993
 Management services agreement - net               697        565        564
                                              --------    -------    -------
  Total operating expenses                      21,711     15,409     12,142
                                              --------    -------    -------
 
Income from operations                           6,224      6,396      4,738
 
Interest expense - net                           1,640        992        925
                                              --------    -------    -------
 
Income before income taxes                       4,584      5,404      3,813
 
Income taxes                                     1,826      2,174      1,440
                                              --------    -------    -------
 
Net income                                    $  2,758    $ 3,230    $ 2,373
                                              ========    =======    =======
 
Net income per common share - basic              $0.55      $0.71      $0.52

Net income per common share - diluted            $0.54      $0.70      $0.52
 
Weighted average common shares outstanding       4,971      4,575      4,529
 
Weighted average common shares outstanding
 assuming full dilution                          5,115      4,628      4,546
</TABLE>

See notes to consolidated financial statements.

                                       36
<PAGE>
 
MFRI, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(In thousands except per share information)

<TABLE>
<CAPTION>
 
                                                              As of January 31,
ASSETS                                                          1998      1997
-------------------------------------------------------------------------------
<S>                                                           <C>       <C>
Current Assets:
    Cash and cash equivalents                                 $   976   $ 3,416
    Trade accounts receivable, less allowance for doubtful
        accounts of $209 in 1997 and $270 in 1996              21,641    18,759
    Accounts receivable - related companies                       342       157
    Costs and estimated earnings in excess of billings
        on uncompleted contracts                                3,489     2,807
    Income taxes receivable                                     1,096       186
    Inventories                                                19,595    17,244
    Deferred income taxes                                       2,308     2,193
    Prepaid expenses and other current assets                   1,320       487
                                                              -------   -------
            Total current assets                               50,767    45,249
                                                              -------   -------
 
Restricted Cash from Bond Proceeds                              2,929     3,880
 
Property, Plant and Equipment, Net                             23,030    15,054
 
Other Assets:
    Patents, net of accumulated amortization                    1,033     1,128
    Goodwill, net of accumulated amortization                  12,399     8,120
    Other assets                                                2,783     1,897
                                                              -------   -------
            Total other assets                                 16,215    11,145
                                                              -------   -------
 
Total Assets                                                  $92,941   $75,328
                                                              =======   =======
 
LIABILITIES AND STOCKHOLDERS' EQUITY
-------------------------------------------------------------------------------
Current Liabilities:
    Drafts payable                                            $ 1,882   $ 1,598
    Trade accounts payable                                      7,180     6,261
    Accounts payable - related companies                           30        16
    Accrued compensation and payroll taxes                      1,731     1,579
    Other accrued liabilities                                   1,783     1,128
    Commissions payable                                         5,821     6,049
    Current maturities of long-term debt                          573       564
    Billings in excess of costs and estimated earnings
        on uncompleted contracts                                  461       210
                                                              -------   -------
            Total current liabilities                          19,461    17,405
                                                              -------   -------
 
Long-term debt, less current maturities                        35,275    23,921
Deferred income taxes                                           1,453     1,059
Other                                                             711        89
                                                              -------   -------
            Total long-term liabilities                        37,439    25,069
                                                              -------   -------
 
Stockholders' Equity:
    Common stock, $0.01 par value, authorized 15,000
        shares; 4,981 and 4,962 issued and
        outstanding in 1997 and 1996, respectively                 50        50
    Additional paid-in capital                                 21,864    21,384
    Retained earnings                                          14,236    11,478
    Accumulated translation adjustment                           (109)      (58)
                                                              -------   -------
            Total stockholders' equity                         36,041    32,854
                                                              -------   -------
 
Total Liabilities and Stockholders' Equity                    $92,941   $75,328
                                                              =======   =======
</TABLE>

See notes to consolidated financial statements.

                                       37
<PAGE>

MFRI INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands)
<TABLE>
<CAPTION>

                                          Common Stock          Additional     Returnable                Accumulated
                                       -------------------       Paid-in      Shares Held     Retained   Translation
                                       Shares       Amount       Capital       in Escrow      Earnings    Adjustment       Total
----------------------------------------------------------------------------------------------------------------------------------
<S>                                    <C>           <C>         <C>             <C>          <C>            <C>          <C>
Balance, January 31, 1995               4,529        $ 47        $ 18,876        $(877)       $ 5,875        $  19        $ 23,940
                                         
Net income                                                                                      2,373                        2,373
Shares returned from escrow due to       
 Ricwil settlement                         (5)         (2)           (909)         877                                         (34)
Unrealized translation adjustment                                                                              (56)            (56)
----------------------------------------------------------------------------------------------------------------------------------
Balance, January 31, 1996               4,524          45          17,967            -          8,248          (37)         26,223
                                         
Net income                                                                                      3,230                        3,230
Shares issued in connection with the     
 acquisition of Eurotech                   31                         214                                                      214
Shares issued in connection with the     
 acquisition of Midwesco                2,124          22          16,718                                                   16,740
Shares held by Midwesco retired at       
 time of Midwesco acquisition          (1,718)        (17)        (13,518)                                                 (13,535)
Stock options exercised                     1                           3                                                        3
Unrealized translation adjustment                                                                              (21)            (21)
----------------------------------------------------------------------------------------------------------------------------------
Balance, January 31, 1997               4,962          50          21,384            -         11,478          (58)         32,854
                                         
Net income                                                                                      2,758                        2,758
Stock options issued in connection       
 with the acquisition of                 
 TDC Filter Manufacturing, Inc.                                       369                                                      369
Stock options exercised                    19                         115                                                      115
Unrealized translation adjustment                                                                              (51)            (51)
Other                                                                  (4)                                                      (4)
----------------------------------------------------------------------------------------------------------------------------------
Balance January 31, 1998                4,981        $ 50        $ 21,864        $   -        $14,236        $(109)       $ 36,041
==================================================================================================================================
</TABLE>

See notes to consolidated financial statements.

                                      38
<PAGE>
 
MFRI, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

<TABLE>
<CAPTION>
                                                          1997       1996       1995
 
                                                        Fiscal Year Ended January 31,
                                                          1998       1997       1996
--------------------------------------------------------------------------------------
<S>                                                     <C>        <C>        <C>
Cash Flows from Operating Activities:
  Net income                                            $  2,758   $  3,230   $  2,373
  Adjustments to reconcile net income to
   net cash flows from operating activities:
     Provision for depreciation and amortization           2,715      1,810      1,335
     Deferred income taxes                                   276       (189)        52
     Foreign currency translation adjustment                 (51)       (21)       (56)
     Change in operating assets and liabilities,
      net of effects of purchased businesses:
       Accounts receivable                                (1,815)      (463)    (1,010)
       Income taxes receivable                              (868)       177       (265)
       Inventories                                        (1,356)        64     (1,774)
       Prepaid expenses and other assets                  (2,395)       512     (1,151)
       Accounts payable                                     (778)    (1,417)      (766)
       Compensation and payroll taxes                         56        461        127
       Other accrued liabilities                           1,132        537         (4)
                                                        --------   --------   --------
Net Cash Flows from Operating Activities                $   (326)  $  4,701   $ (1,139)
                                                        --------   --------   --------
 
Cash Flows from Investing Activities:
  Change in restricted cash from Industrial
   Revenue Bonds                                             951      1,166     (5,046)
  Acquisitions of businesses, net of cash acquired        (7,293)      (211)      (690)
  Purchases of property and equipment                     (4,385)    (2,726)    (2,259)
                                                        --------   --------   --------
Net Cash Flows from Investing Activities                 (10,727)    (1,771)    (7,995)
                                                        --------   --------   --------
 
Cash Flows from Financing Activities:
  Net payments on capitalized lease obligations             (509)      (295)      (151)
  Proceeds from issuance of Industrial Revenue
   Bonds                                                                         6,300
 Borrowings under revolving, term and
   mortgage loans                                         25,427     38,242     18,500
  Repayment of bank debt                                 (16,420)   (37,913)   (15,550)
 Stock options exercised                                     115          3          -
                                                        --------   --------   --------
Net Cash Flows from Financing Activities                   8,613         37      9,099
                                                        --------   --------   --------
 
Net Increase (Decrease) in Cash and Cash Equivalents      (2,440)     2,967        (35)
Cash and Cash Equivalents - Beginning of Year              3,416        449        484
                                                        --------   --------   --------
Cash and Cash Equivalents - End of Year                 $    976   $  3,416   $    449
                                                        ========   ========   ========
</TABLE>


See notes to consolidated financial statements.

                                      39
<PAGE>
 
MFRI, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED JANUARY 31, 1998, 1997 AND 1996


NOTE 1 -- BASIS OF PRESENTATION


MFRI, Inc. ("MFRI") was incorporated on October 12, 1993, and on January 28,
1994 became successor by merger to Midwesco Filter Resources, Inc. ("Midwesco
Filter"), when all the assets of the Perma-Pipe division of Midwesco, Inc.
("Perma-Pipe"), were acquired, subject to specified liabilities, in exchange for
cash and common stock of MFRI.

Through the merger of Midwesco, Inc. ("Midwesco") into MFRI on December 30, 1996
(the "Midwesco Merger"), MFRI acquired all the assets of Midwesco's Thermal Care
business ("Thermal Care"), subject to specified liabilities which included the
following: all liabilities associated with three lawsuits arising from warranty
obligations of Perma-Pipe; Midwesco's rights under leases, primarily its lease
of the building in Niles, Illinois that serves as the principal offices of both
MFRI and Midwesco and as the manufacturing facility of Thermal Care; the
deferred tax assets of Midwesco and 1,718,000 shares of the common stock of MFRI
owned by Midwesco. Prior to the Midwesco Merger, Midwesco was primarily owned by
certain management stockholders of MFRI and their families.

Fiscal Year:  The Company's fiscal year ends on January 31. Fiscal years 1997,
1996 and 1995 ended on January 31, 1998, 1997 and 1996, respectively. Balances
described as balances as of 1997, 1996 and 1995 are balances as of January 31,
1998, 1997 and 1996, respectively.

Principles of Consolidation:  The consolidated financial statements of MFRI
include the accounts of MFRI and its wholly-owned subsidiaries, Midwesco Filter
and Perma-Pipe; Perma-Pipe's subsidiaries, Perma-Pipe Services, Ltd. ("PPSL"),
Ricwil Piping Systems Company ("Ricwil") subsequent to September 30, 1994 and
until its dissolution on November 21, 1997 (see Note 4), and SZE Hagenuk GmbH of
Hamburg, Germany ("SZE Hagenuk") subsequent to December 6, 1995 and Midwesco
Filter's subsidiary, TDC Filter Manufacturing, Inc. ("TDC") subsequent to
December 3, 1997 (collectively, the "Company"). All significant intercompany
balances and transactions have been eliminated.

Nature of Business:  Midwesco Filter is engaged principally in the manufacture
and sale of filter elements for use in industrial air filtration systems. Air
filtration systems are used in a wide variety of industries in the United States
and abroad to limit particulate emissions, primarily to comply with
environmental regulations. Perma-Pipe is engaged in engineering, designing and
manufacturing specialty piping systems and leak detection and location systems.
Thermal Care is engaged in engineering, designing and manufacturing industrial
process cooling equipment, including chillers, cooling towers, pump and tank
assemblies, temperature controllers, and water treatment equipment.

                                       40
<PAGE>
 
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition: Midwesco Filter, TDC, SZE Hagenuk and Thermal Care
recognize revenues at the date of shipment. Perma-Pipe and PPSL recognize
revenues on contracts under the "percentage of completion" method. The
percentage of completion is determined by the relationship of costs incurred to
the total estimated costs of the contract.

Provisions are made for estimated losses on uncompleted contracts in the period
in which such losses are determined. Changes in job performance, job conditions,
and estimated profitability, including those arising from contract penalty
provisions and final contract settlements may result in revisions to costs and
income; such revisions are recognized in the period in which they are
determined. Claims for additional compensation due the Company are recognized in
contract revenues when realization is probable and the amount can be reliably
estimated.

Use of Estimates:  The presentation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amount of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

Operating Cycle:  The length of Perma-Pipe and PPSL contracts vary, but are
typically less than one year. The Company includes in current assets and
liabilities amounts realizable and payable in the normal course of contract
completion unless completion of such contracts extends significantly beyond one
year.

Cash Equivalents:  All highly liquid investments with a maturity of three months
or less when purchased are considered to be cash equivalents.

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. Inventories consist of the following:
<TABLE>
<CAPTION>

(In thousands)
                     1997        1996
                    -------     -------
<S>                 <C>         <C>

Raw materials       $14,296     $12,443
Work in process       1,557       2,011
Finished goods        3,742       2,790
                    -------     -------
Total               $19,595     $17,244
                    =======     =======
</TABLE> 

Long-Lived Assets:  Property, plant and equipment are stated at cost. Interest
is capitalized in connection with the construction of major facilities and
amortized over the asset's estimated useful life. In 1997, $54,000 of interest
cost was capitalized. No interest was capitalized in 1996 and 1995.

                                       41
<PAGE>
 
Depreciation is computed using the straight-line method over the estimated
useful lives of the assets, which range from three to 30 years. Amortization of
assets under capital leases is included in depreciation and amortization.

The Company's investment in property, plant and equipment as of January 31 is
summarized below:
<TABLE>
<CAPTION>
(In thousands)
<S>                                                <C>         <C>

                                                    1997        1996
                                                   -------     -------

Land, buildings and improvements                   $11,575     $ 6,846
Machinery and equipment                             13,276       9,237
Furniture and office equipment                       3,873       2,919
Transportation equipment                             1,304       1,147
                                                   -------     -------
                                                   $30,028     $20,149
Less accumulated depreciation and amortization       6,998       5,095
                                                   -------     -------
Property, plant and equipment, net                 $23,030     $15,054
                                                   =======     =======
</TABLE>

Goodwill reflected in the consolidated financial statements relates to the
Company's 1993 acquisition of Perma-Pipe, the 1994 acquisition of Ricwil, the
1996 acquisition of Midwesco and the 1997 acquisition of TDC. The Company
amortizes goodwill on the straight-line basis over 40 years for the Perma-Pipe,
Ricwil and TDC acquisitions and 25 years for the Midwesco acquisition.
Accumulated amortization was $606,000 and $354,000 at January 31, 1998 and 1997,
respectively.

Patents are capitalized and amortized on the straight-line basis over a period
not to exceed the legal lives of the patents. Accumulated amortization was
$484,000 and $359,000 at January 31, 1998 and 1997, respectively.

In 1996, the company adopted Statement of Financial Accounting Standards
("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of." The statement requires the recognition of
an impairment loss for an asset held for use when the estimate of undiscounted
future cash flows expected to be generated by the asset is less than its
carrying amount. Measurement of the impairment loss is based on fair value of
the asset. Generally, fair value will be determined using valuation techniques
such as the present value of expected future cash flows. The Company's past
policy was to measure an impairment loss for assets held for use based on
expected undiscounted future cash flows. Adoption of this statement will result
in recognition of a larger loss, based on discounted future cash flows, in the
year of impairment and lower depreciation charges over the remaining life of the
asset. Since adoption, no impairment losses have been recognized. The
recognition and measurement of impairment losses for long-lived assets to be
disposed of under SFAS No. 121 is consistent with the Company's past practice.

Foreign Currency:  The balance sheet accounts of PPSL and SZE Hagenuk are
translated into United States dollars at the balance sheet date exchange rate
and statement of operation items are translated at the average exchange rate for
the year; resulting balance sheet translation adjustments are reflected as a
separate component of stockholders' equity. PPSL generates and expends cash in
the functional currency of the United Kingdom. SZE Hagenuk's functional currency
is that of the Federal Republic of Germany.

                                       42
<PAGE>
 
Financial Instruments:  The Company utilizes foreign currency forward contracts
to reduce exposure to exchange rate risks primarily associated with transactions
in the regular course of the Company's export and international operations. The
Company utilizes forward contracts which are short-term in duration, generally
one year or less. The major currency exposure hedged by the Company is the
Canadian dollar. The contract amount, carrying amount and fair value of these
contracts were not significant at January 31, 1998, 1997 and 1996.

Net Income Per Common Share:  The Company adopted SFAS No. 128, "Earnings per
Share," in 1997, which requires the disclosure of two earnings per common share
("EPS") amounts: basic and diluted. EPS are computed by dividing net income by
the weighted average number of common shares outstanding (basic) plus all
potentially dilutive common shares outstanding during the year (diluted). EPS
computations for all prior years have been restated to reflect the provisions of
SFAS No. 128.

The basic weighted average shares reconciles to fully diluted weighted average
shares as follows:

<TABLE>
<CAPTION>
(In thousands)
                                                      1997       1996       1995
                                                      -----      -----      -----
<S>                                                  <C>        <C>        <C> 
Net Income                                           $2,758     $3,230     $2,373
                                                     ======     ======     ======
Basic weighted average common shares outstanding      4,971      4,575      4,529

Dilutive effect of stock options                        144         53         17
                                                     ------     ------     ------

Weighted average common shares
    outstanding assuming full dilution                5,115      4,628      4,546
                                                     ======     ======     ======
Net income per common share -- basic                 $ 0.55     $ 0.71     $ 0.52

Net income per common share -- diluted               $ 0.54     $ 0.70     $ 0.52
</TABLE> 

In 1997, 1996 and 1995, the weighted average number of stock options not
included in the computation of diluted earnings per share of common stock
because the options exercise price exceeded the average market price of the
common shares were 45,300, 172,075 and 291,700, respectively. These options were
outstanding at the end of each of the respective years.

Fair Value of Financial Instruments:  The carrying value of cash and cash
equivalents, accounts receivable, restricted cash and accounts payable are
reasonable estimates of their fair value due to their short-term nature. The
carrying values of long-term obligations are a reasonable estimate of their fair
values as the interest rates approximate rates currently available to the
Company for debt with similar terms and remaining maturities.

                                       43
<PAGE>
 
Stock Options:  The Company follows Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"), and related
interpretations, in accounting for its employee stock options. Under APB 25,
because the exercise price of the stock option equals the market price of the
underlying stock on the issuance date, no compensation expense is recognized.
Pro forma net income and net income per share is presented in Note 13 as if the
alternative fair value method of accounting provided for under SFAS No. 123,
"Accounting for Stock-Based Compensation," had been applied to employee stock
options granted after January 31, 1995. The fair value method of accounting is
used for all stock options other than employee stock options in accordance with
SFAS No. 123.

New Accounting Pronouncements:  In June 1997, the Financial Accounting Standards
Board issued SFAS No. 130, "Reporting Comprehensive Income" and SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." In
February 1998, SFAS No. 132, "Employers' Disclosures about Pensions and Other
Postretirement Benefits" was issued. SFAS No. 130 establishes standards for
reporting and display of comprehensive income and its components. SFAS No. 131
establishes standards for reporting information about operating segments and
related disclosures about products and services, geographic areas and major
customers. SFAS No. 132 revises current disclosure requirements for employers'
pensions and other retiree benefits. These standards are effective for years
beginning after December 15, 1997. These standards expand or modify current
disclosures and, accordingly, will have no impact on the Company's reported
financial position, results of operations and cash flows. The Company is
assessing the impact of SFAS No. 131 on its reported segments.

Reclassifications:  Certain previously reported amounts have been reclassified
to conform with the current period presentation.

NOTE 3 -- RELATED PARTY TRANSACTIONS

The Company leases its primary building from two significant management
stockholders under a lease agreement. During 1997, the Company paid $567,000
under this agreement. The Company also provides certain services and facilities
to companies primarily owned by those management shareholders and purchases
certain services from those companies under management services agreements.
During 1997, the Company received $587,000 and paid $100,000 under such
agreements.

Prior to the Company's acquisition of Midwesco, Midwesco provided certain
services and facilities to the Company and the Company provided certain services
to Midwesco under management services agreements. Pursuant to such agreements,
the Company reimbursed Midwesco $600,000 and $564,000 during the years 1996 and
1995, respectively and Midwesco reimbursed the Company $35,000 during 1996. No
amounts were reimbursed by Midwesco to the Company in 1995.

The lease agreement and the management services agreements have been approved by
the Company's Independent Directors (Note 13). Management of the Company
believes the amounts paid and received under these agreements were comparable to
those which would have been paid and received under arms-length transactions.

                                       44
<PAGE>
 
NOTE 4 -- ACQUISITIONS

TDC

On December 3, 1997, MFRI and a subsidiary acquired all the outstanding shares
of capital stock of TDC, together with its offices and manufacturing facility,
for an aggregate purchase price of $9,732,000. This amount includes $2,003,000
to repay the debt of TDC and options to purchase 75,000 shares of MFRI, the fair
value of which was estimated to be $369,000 on the date issued using the Black-
Scholes option pricing model. (See Note 13.)

The acquisition was accounted for as a purchase and the accounts of TDC have
been included in the consolidated financial statements since the date of
acquisition. The purchase price was allocated to the assets and liabilities
acquired, based on their estimated fair values. The excess ($4,822,000) of the
purchase price over the fair value of net assets acquired has been recorded as
goodwill and is being amortized over a 40 year period on the straight-line
basis.

Thermal Care

On December 30, 1996, through the Midwesco Merger, MFRI acquired the Thermal
Care business of Midwesco, for 406,000 shares of the Company's stock (net of
1,718,000 shares previously owned by Midwesco and canceled in the merger),
valued at $7.88 per share or $3,204,000.

The acquisition has been accounted for as a purchase and the accounts of Thermal
Care have been included in the consolidated financial statements since the date
of acquisition, including income from operations ($137,000 - see Note 11), net
income ($84,000) and net income per common share ($0.02). The purchase price was
allocated to the assets and liabilities acquired, based on their estimated fair
values. The excess ($3,094,000) of the purchase price over the fair value of net
assets acquired has been recorded as goodwill and is being amortized over a 25
year period on the straight line basis.

The pro forma results of operations as if the acquisition of Thermal Care had
occurred on February 1, 1995 are presented below. Included in the pro forma
results for the year 1996, is a pro forma pretax provision of $400,000 (after
tax $244,000 or $0.05 per share) for the estimated ultimate cost of three
lawsuits which had been considered in negotiating the acquisition price of the
Midwesco Merger and which, upon the consummation of the Midwesco Merger, became
the obligations of MFRI. Pursuant to the agreement relating to the Midwesco
Merger, should MFRI spend more than an aggregate of $400,000 in costs, expenses,
judgments or settlements of such lawsuits, additional amounts will be paid from
a special escrow holding 66,890 shares of MFRI common stock, such escrow having
been established as part of the Midwesco Merger. During 1997, costs of these
lawsuits, including the settlements of two of the lawsuits, exceeded the reserve
by approximately $177,000, which will be reimbursed from the special escrow.
Management believes that the settlement costs of the pending lawsuit will not
exceed the remaining balance in the special escrow.

                                       45
<PAGE>

The following represents the unaudited pro forma results of operations as if the
acquisition of Thermal Care had occurred on February 1, 1995.

(In thousands)
<TABLE>
<CAPTION>

                                                  1996                1995
                                                --------            --------
<S>                                             <C>                 <C>
Net sales                                       $111,793            $105,613

Income after taxes before pro forma
 lawsuit provision                                 3,604               2,676
Income after taxes per common share
 before pro forma lawsuit provision             $   0.73            $   0.54

Net Income                                         3,362               2,676
Net income per common share-basic               $   0.68            $   0.54

Weighted average common shares outstanding         4,945               4,935
</TABLE>


SZE Hagenuk

On December 6, 1995, Perma-Pipe acquired for $690,000 cash the net assets of the
leak detection operations of Hagenuk GmbH. The acquisition has been accounted
for as a purchase and the accounts of the new subsidiary, SZE Hagenuk,
established to carry on these activities, have been included in the consolidated
financial statements since the date of acquisition.

Ricwil

On September 30, 1994, MFRI and a subsidiary acquired substantially all of the
assets of Ricwil, net of specified assumed liabilities, for an aggregate
purchase price of $4,822,000. This amount includes $2,662,000 to repay the debt
of Ricwil and up to 185,000 shares of MFRI common stock valued at $1,300,000.
The shares of common stock were issued at closing and held in escrow subject to
final determination of the purchase price. In the years ended January 31, 1995
and 1996, final settlements regarding the purchase price were reached, resulting
in the return of 130,000 shares of common stock to the Company.

The acquisition was accounted for as a purchase and the accounts of Ricwil have
been included in the consolidated financial statements since the date of
acquisition. The purchase price was allocated to the assets and liabilities
acquired, based on their estimated fair values. The excess ($2,835,000) of the
purchase price over the fair value of net assets acquired has been recorded as
goodwill and is being amortized over a 40 year period on the straight-line
basis.

Following the acquisition, the business of Ricwil was absorbed into Perma-Pipe
and, on November 21, 1997, Ricwil Piping Systems Company was dissolved.

NOTE 5 -- RETENTION RECEIVABLE

Retention of $1,170,000 and $1,068,000 at the year end 1997 and 1996,
respectively, is included in the balance of trade accounts receivable.

                                       46
<PAGE>

 
NOTE 6 -- COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS

Costs and estimated earnings on uncompleted contracts are as follows:

<TABLE>
<CAPTION>
 
(In thousands)
                                                              1997      1996
                                                             -------   -------
<S>                                                          <C>       <C>
Costs incurred on uncompleted contracts                      $13,470   $16,902
Estimated earnings                                             3,714     4,201
                                                             -------   -------
Earned revenue                                                17,184    21,103
Less billings to date                                         14,156    18,506
                                                             -------   -------
Total                                                        $ 3,028   $ 2,597
                                                             =======   =======
                                                                      
Classified as follows:                                                
                                                                  
Costs and estimated earnings in excess of billings on
  uncompleted contracts                                      $ 3,489   $ 2,807
Billings in excess of costs and estimated earnings on
  uncompleted contracts                                         (461)     (210)
                                                             -------   -------
Total                                                        $ 3,028   $ 2,597
                                                             =======   =======
</TABLE>                                                 
                                                         

NOTE 7 -- DEBT

Long-term debt consists of the following:

<TABLE>
<CAPTION>
(In thousands)

                                                              1997      1996
                                                             -------   -------
<S>                                                          <C>       <C>
Unsecured 7.21% senior notes due 2007                        $15,000   $15,000
Revolving bank loan                                           10,950      --
Industrial Revenue Bonds                                       6,300     6,300
Capitalized lease obligations (Note 8)                         2,611     2,256
Mortgage note                                                    843       862
Other                                                            144        67
                                                             -------   -------
                                                             $35,848   $24,485
Less current maturities                                          573       564
                                                             -------   -------
Total                                                        $35,275   $23,921
                                                             =======   =======
</TABLE>

The Company issued $15,000,000 of unsecured 7.21 percent senior notes due
January 31, 2007 to institutional investors. $10,000,000 was received on
December 20, 1996 and $5,000,000 on January 22, 1997. Level principal repayments
are scheduled to be made beginning January 31, 2001. Earlier principal payments
can be made at the Company's option. Certain financial covenants are required to
be met as long as the notes are outstanding. At January 31, 1998, the Company
was in compliance with these covenants.


                                       47

<PAGE>
 
On December 19, 1996, the Company entered into an unsecured credit agreement
with a bank. Under the terms of the agreement as amended, the Company may borrow
up to $12,000,000 under a revolving line of credit which matures on March 31,
2000. Interest rates are based on one of two options selected by the Company at
the time of each borrowing - the prime rate or the LIBOR rate plus a margin for
the term of the loan. At January 31, 1998, the prime rate was 8.50 percent and
the margin added to the LIBOR rate, which is redetermined each quarter based on
the Company's interest coverage ratio, was 1.75 percent. The Company had
borrowed $10,950,000 under the revolving line of credit at January 31, 1998.
Additionally, $449,000 was drawn under the agreement as letters of credit
principally to guarantee performance to third parties resulting from various
trade activities. The loan agreement contains certain financial covenants. As of
January 31, 1998, the Company was not in compliance with one such financial
covenant. The Company has obtained a waiver for such non-compliance.

On September 14, 1995, and October 18, 1995, respectively, Midwesco Filter and
Perma-Pipe issued Industrial Revenue Bonds, the proceeds of which are available
for capital expenditures related to manufacturing capacity expansions and
efficiency improvements during a three-year period commencing in the fourth
quarter of 1995 for Midwesco Filter in Winchester, Virginia ($3,150,000) and
Perma-Pipe in Lebanon, Tennessee ($3,150,000). The bonds bear interest at a
variable rate, which approximated 5% at January 31, 1998, including letters of
credit and remarketing fees. Each bond indenture established a trusteed project
fund for deposit of the bond proceeds. The trustee is authorized to make
disbursements from the project fund upon requisition from the Company to pay
costs of capital expenditures which comply with the requirements of the loan
agreements. Pending such disbursements, the trustee invests the balance of the
project fund in investments defined by the indenture and limited by applicable
law. Such invested funds totaled $2,929,000 at January 31, 1998 and $3,880,000
at January 31, 1997. The bonds are fully secured by bank letters of credit which
expire approximately two years from issuance; the Company expects to arrange for
renewal, reissuance or extension of the letters of credit prior to expiration.

On May 8, 1996, the Company purchased for approximately $1.1 million a 10.3-acre
parcel of land with a 67,000-square foot building adjacent to its Midwesco
Filter property in Winchester, Virginia. The purchase was financed 80% by a
seven-year mortgage bearing interest at 8.38% and 20% by the industrial revenue
bonds described above.

Scheduled maturities, excluding the revolving line of credit, for each of the
next five years are as follows: 1999 - $573,000; 2000 - $202,000; 2001 -
$2,253,000; 2002 - $2,201,000; 2003 - $2,204,000; thereafter $17,465,000.


                                       48

<PAGE>
 
NOTE 8 -- LEASE INFORMATION

The following is an analysis of property under capitalized leases:

<TABLE>
<CAPTION>
 
     (In thousands)
                                                                  
                                                1997        1996 
                                               ------      ------
<S>                                            <C>         <C>    
     Land, building and improvements           $1,197      $  729
     Machinery and equipment                      322         207
                                                                 
     Furniture and office equipment               299         279
     Transportation equipment                   1,165       1,011
                                               ------      ------
                                                2,983       2,226 
     Less accumulated amortization              1,003         565
                                               ------      ------
                                               $1,980      $1,661
                                               ======      ====== 
</TABLE>

The Company leases the building and improvements from a partnership which is
owned by two significant management stockholders. The lease expires in November
2017.

The future minimum lease payments under the capitalized leases are as follows:


<TABLE>
<CAPTION>
     (In thousands)
<S>                                                         <C>    
     1998                                                   $  746
     1999                                                      488
     2000                                                      378
     2001                                                      316
     2002                                                      312
     Thereafter                                              4,627
                                                            ------
                                                            $6,867
Less amount representing interest                            4,256
                                                            ------ 
Present value of future minimum lease payments (Note 7)     $2,611
                                                            ======
</TABLE>

NOTE 9 -- INCOME TAXES

The following is a summary of domestic and foreign income before income taxes:

<TABLE>
<CAPTION>
 
     (In thousands)
                                                  1997      1996      1995
                                                 ------    ------    ------
<S>                                              <C>       <C>       <C>  
     Domestic                                    $4,303    $5,087    $3,712
     Foreign                                        281       317       101
                                                 ------    ------    ------
                                                 $4,584    $5,404    $3,813
                                                 ======    ======    ======
</TABLE>

                                      49
<PAGE>
 
Components of income tax expense are as follows:

<TABLE>
<CAPTION>
 
     (In thousands)

                                                    1997     1996     1995 
                                                   ------   ------   ------
<S>                                                <C>      <C>      <C>   
     Current:                                                              
        Federal                                    $1,441   $1,835   $1,270
        Foreign                                       (69)     218       30
        State and other                               178      310      192
                                                   ------   ------   ------
                                                    1,550    2,363    1,492 
        Deferred                                      276     (189)     (52)
                                                   ------   ------   ------
        Total                                      $1,826   $2,174   $1,440
                                                   ======   ======   ======
</TABLE>

The difference between the provision for income taxes and the amount computed by
applying the federal statutory rate is as follows:

<TABLE>  
<CAPTION> 

(In thousands)

                                                    1997     1996     1995
                                                   ------   ------   ------ 
<S>                                                <C>      <C>      <C>
Tax at federal statutory rate                      $1,559   $1,837   $1,296
Foreign rate tax differential                         -         86      -
State taxes, net of federal benefit                   116      170      107
Amortization of cost in excess of assets acquired      73       29      -
Other - net                                            78       52       37
                                                   ------   ------   ------
Total                                              $1,826   $2,174   $1,440
                                                   ======   ======   ======
</TABLE>

Components of the deferred income tax asset balance are as follows:

<TABLE>
<CAPTION>
 
 
(In thousands)

                                                             1997     1996
                                                            ------   ------
<S>                                                         <C>      <C>  
Accrued commissions                                         $1,317  $1,397
Foreign acquisition adjustments                                174     -
Insurance accruals                                             157     142
Sales reserve                                                  155     158
Vacation accruals                                              141     139
Inventory valuation allowance                                   93      92
Allowance for doubtful accounts                                 52      67
Inventory uniform capitalization                                36      89
Other                                                          183     109
                                                            ------  ------
Total                                                       $2,308  $2,193
                                                            ======  ====== 
</TABLE>

Components of the deferred income tax liability balance are as follows:

<TABLE>
<CAPTION>
 
     (In thousands)

                                                             1997      1996
                                                            ------    ------ 
<S>                                                         <C>       <C>  
Depreciation                                                $1,156    $  946
Foreign acquisition adjustments                                249       106
Other                                                           48         7
                                                            ------    ------
Total                                                       $1,453    $1,059
                                                            ======    ====== 
</TABLE> 

                                      50
<PAGE>
 
NOTE 10 -- EMPLOYEE RETIREMENT PLANS

Pension Plan

Midwesco Filter has a defined benefit plan covering its hourly rated employees.
The benefits are based on fixed amounts multiplied by years of service of
retired participants. The funding policy is to contribute such amounts as are
necessary to provide for benefits attributed to service to date and those
expected to be earned in the future. The amounts contributed to the plan are
sufficient to meet the minimum funding requirements set forth in the Employee
Retirement Income Security Act of 1974. Midwesco Filter may contribute
additional amounts at its discretion.

The following table sets forth the plan's funded status and amounts recognized
in the Company's consolidated balance sheet:

<TABLE>
<CAPTION>
 
 
(In thousands)

                                                             1997     1996
                                                            ------   ------
<S>                                                         <C>     <C>   
Actuarial present value of:                                               
  Vested benefit obligation                                 $  911  $   758
                                                            ======  =======
  Accumulated benefit obligation                            $  932  $   782
                                                            ======  =======
Projected benefit obligation                                $  985  $   782
Plan assets at fair value                                      972    1,004
                                                            ------  ------- 
Projected benefit obligation (less than)
  in excess of plan assets                                     (13)     222 
Unrecognized net transition obligation                           4        4 
Unrecognized prior service cost                                186      104 
Unrecognized net (gain) loss                                  (124)    (278)
                                                            ------  -------
PREPAID (ACCRUED) PENSION COST                              $   53  $    52 
                                                            ======  ======= 
</TABLE>

Net periodic pension expense for 1997, 1996 and 1995 includes the following
components:

<TABLE>
<CAPTION>
 
(In thousands)
                                                                        
                                                     1997    1996    1995 
                                                    -----   ------  ------
<S>                                                 <C>     <C>     <C>   
Service cost - benefits earned                                            
  during the year                                   $  42   $  39   $  32 
Interest cost on projected benefit obligation          57      53      48 
Actual return on plan assets                            9    (224)   (239)
Net amortization and deferral                         (92)    172     212 
                                                    -----   -----   ----- 
NET PENSION EXPENSE                                 $  16   $  40   $  53 
                                                    =====   =====   =====  
</TABLE>

Assumptions used in accounting for pension costs at January 31, 1998, 1997 and
1996, were: discount rate of 7.25%, 7.50% and 7.25%, respectively, and a rate of
return on plan assets of 8.0% for each year.

Approximately 94% and 91% of the plan assets at January 31, 1998 and 1997,
respectively, were invested in corporate common stocks and bonds, with the
remainder invested in money market and mutual funds.

                                      51
<PAGE>
 
401(k) Plan

The employees of the Company participate in the MFRI, Inc. Employee Savings and
Protection Plan, which is applicable to all employees except certain employees
who are covered by collective bargaining agreement benefits. The plan allows
employee pretax payroll contributions up to 16% of total compensation. Prior to
February 1, 1995, the Company made contributions to this 401(k) Plan in an
amount equal to 25% of each participant's contribution, up to a maximum of 1% of
their salaries. Beginning February 1, 1995, the Company contribution was
increased to 50% of each participant's contribution, up to a maximum of 2% of
their salaries.

Contributions to the 401(K) Plan and its predecessors were $243,000, $194,000,
and $180,000 for the years ended January 31, 1998, 1997 and 1996, respectively.

NOTE 11 -- BUSINESS SEGMENT INFORMATION

The Company has three business segments: the filtration product business, the
piping systems product business and the industrial process cooling equipment
business. The industrial process cooling business equipment segment was
established with the acquisition of Midwesco in December 1996. Intersegment
sales are not material. The following is information relevant to the Company's
business segments:

<TABLE>
<CAPTION>
 
SEGMENT INFORMATION:
(In thousands)
                                           1997      1996      1995
                                         --------   -------   -------
<S>                                      <C>        <C>       <C>

SALES:
  Filtration products                    $ 40,145   $37,563   $36,590
  Piping system products                   46,232    54,194    49,248
  Industrial process cooling equipment     24,863     1,816       -
                                         --------   -------   -------
TOTAL SALES                              $111,240   $93,573   $85,838
                                         ========   =======   =======

INCOME FROM OPERATIONS:
  Filtration products                    $  4,140   $ 4,615   $ 4,086
  Piping system products                    2,347     4,033     2,585
  Industrial process cooling equipment      2,836       137       -
  Corporate                                (3,099)   (2,389)   (1,933)
                                         --------   -------   -------
TOTAL INCOME FROM OPERATIONS             $  6,224   $ 6,396   $ 4,738
                                         ========   =======   =======

IDENTIFIABLE ASSETS:
  Filtration products                    $ 36,116   $21,833   $18,538
  Piping system products                   38,701    36,415    37,051
  Industrial process cooling equipment     12,290    11,413       -
  Corporate                                 5,834     5,667     3,396
                                         --------   -------   -------
TOTAL IDENTIFIABLE ASSETS                $ 92,941   $75,328   $58,985
                                         ========   =======   =======
</TABLE>

                                      52
<PAGE>
 
<TABLE>
<CAPTION>
<S>                                                      <C>      <C>      <C>
CAPITAL EXPENDITURES:
  Filtration products                                    $   788  $ 1,371  $   937
  Piping system products                                   2,713    1,197    1,119
  Industrial process cooling equipment                       181       10       -
  Corporate                                                  703      148      203
                                                         -------  -------  -------
TOTAL CAPITAL EXPENDITURES                               $ 4,385  $ 2,726  $ 2,259
                                                         =======  =======  =======

DEPRECIATION AND AMORTIZATION:
  Filtration products                                    $   648  $   477  $   336
  Piping system products                                   1,236    1,049      880
  Industrial process cooling equipment                       155       14       -
  Corporate                                                  676      270      119
                                                         -------  -------  -------
TOTAL DEPRECIATION AND
  AMORTIZATION                                           $ 2,715  $ 1,810  $ 1,335
                                                         =======  =======  =======
</TABLE>

Export sales totaled $8,594,000 and $9,785,000 for the years 1997 and 1996,
respectively. Foreign net sales and identifiable assets were less than 10% of
consolidated net sales and total assets, respectively, for all years reported.

NOTE 12 -- SUPPLEMENTAL CASH FLOW INFORMATION

A summary of annual supplemental cash flow information follows:

<TABLE>
<CAPTION>
 
 
(In thousands)
                                                          1997     1996     1995
                                                         -------  -------  -------
<S>                                                      <C>      <C>      <C>
Cash paid for:
  Income taxes, net of refunds received                  $ 2,218  $ 2,225  $ 1,757
                                                         =======  =======  =======
  Interest, net of capitalized amounts                   $ 1,812  $ 1,076  $   928
                                                         =======  =======  =======

Noncash Financing and Investing Activities:

  Fixed assets acquired under capital leases             $   882  $   643  $   216
                                                         =======  =======  =======

  Settlement of Ricwil acquisition contingencies:     
     Fair value of assets acquired                                         $(1,476)
     Cost in excess of net assets acquired                                     889
     Common stock redeemed                                                     125
                                                                           -------
     Liabilities reduced                                                   $  (462)
                                                                           ======= 

  Purchase of businesses:
     Fair value of assets acquired
      (net of cash received)                             $ 7,250  $ 9,921  $ 1,140
     Cost in excess of (less than) net assets acquired     4,822    3,311     (110)
     Cash paid                                            (7,293)    (211)    (690)
     Fair value of stock options issued                     (369)
     Common stock issued                                      -    (3,418)      -
                                                         -------  -------  -------
     Liabilities assumed                                 $ 4,410  $ 9,603  $   340
                                                         =======  =======  =======

</TABLE>                                       53
<PAGE>
 
NOTE 13 -- STOCK OPTIONS

Under the 1989, 1993 and 1994 Stock Option Plans ("Option Plans"), 150,000,
100,000 and 250,000 shares of common stock, respectively, are reserved for
issuance to key employees of the Company and its affiliates as well as selected
advisors and consultants to the Company. In addition, under the 1994 Option
Plan, an additional one percent of shares of the Company's common stock
outstanding have been added to the shares reserved for issuance each February 1,
beginning February 1, 1995 and ending February 1, 1997, and an additional two
percent of shares of the Company's common stock outstanding are added to the
shares reserved for issuance each February 1, beginning February 1, 1998. Option
exercise prices will be no less than fair market value for the common stock on
the date of grant. The options granted under the Option Plans may be either non-
qualified options or incentive options. Such options vest ratably over 4 years
and are exercisable for up to ten years from the date of grant.

The Company issued a stock purchase warrant to an investment banker in
connection with the Company's public sale of common stock. The warrant entitles
the holder to purchase 15,000 shares of common stock at $8.10 and may be
exercised through January 1999.

In connection with the purchase agreement relating to the acquisition of TDC,
the Company issued stock options to purchase 75,000 shares of common stock at
$9.60. These options may be exercised through November 2008.

Pursuant to the 1990 Independent Directors' Stock Option Plan ("Directors'
Plan") an option to purchase 10,000 shares of common stock is granted
automatically to each director who is not an employee of the Company
("Independent Director") on the date the individual is first elected as a
director of the Company. In addition, on June 20, 1995, options to purchase
1,000 shares were granted to each Independent Director and options to purchase
1,000 shares are to be granted to each Independent Director annually thereafter.
Option exercise prices will be at fair market value of the common stock on the
date of grant. Such options vest ratably over four years and are exercisable up
to ten years from the date of the grant.

The following summarizes the changes in options and warrants under the plans:
<TABLE>
<CAPTION>

                                              1997                      1996

                                    ------------------------  -----------------------
                                        Weighted Average          Weighted Average
                                     Shares   Exercise Price  Shares   Exercise Price
                                    --------  --------------  -------- --------------
<S>                                 <C>       <C>             <C>       <C>
Outstanding at beginning of year    479,550       $6.65       391,300       $6.60
Granted                             288,000        7.63        89,000        6.88
Exercised                           (18,550)       6.21          (750)       4.44
Cancelled                            (8,125)       7.02             -         -
                                    -------       -----       -------       -----
Outstanding at end of year          740,875       $7.04       479,550       $6.65
                                    =======       =====       =======       =====

Options exercisable at year-end     412,850                   271,525
</TABLE>
                                       54

<PAGE>

The following table summarizes information concerning outstanding and
exercisable options and warrants at January 31, 1998:
<TABLE>
<CAPTION>

                                 Options Outstanding                                   Options Outstanding
              ----------------------------------------------------------      ------------------------------------
 Range of         Number         Weighted Average       Weighted Average          Number           Weighted Average
 Exercise     Outstanding at        Remaining               Exercise          Exercisable at           Exercise
  Prices      Jan. 31, 1998      Contractual Life            Price             Jan. 31, 1998             Price
-----------   --------------     ----------------       ----------------      --------------       ----------------
<S>           <C>                <C>                    <C>                   <C>                  <C>
$4.00-$4.99       93,850            7.3 years                $4.45                44,050                $4.45
$6.00-$6.99      431,825            8.1 years                 6.87               157,075                 6.75
$7.00-$7.99       10,000            6.0 years                 7.25                10,000                 7.25
$8.00-$8.99      130,200            2.3 years                 8.00               126,725                 8.02
$9.00-$9.99       75,000            10.8 years                9.60                75,000                 9.60
                 -------            ----------               -----               -------                -----
                 740,875            7.0 years                $7.04               412,850                $7.41
                 =======            ==========               =====               =======                =====
</TABLE>

The weighted average fair value of options granted during 1997 and 1996 is
estimated at $4.04 and $3.83 per share, respectively, on the date of grant using
the Black-Scholes option-pricing model with the following weighted average
assumptions:
<TABLE>
<CAPTION>
                                                    1997    1996
                                                   ------  ------
<S>                                                <C>     <C>
Expected volatility                                 39.61%  43.00%
Expected life in years                                7.0     7.0
Risk-free interest rate                              6.44%   6.58%
Dividend yield                                        0.0%    0.0%
</TABLE>

Had compensation cost for the Company's 1997 and 1996 grants for stock-based
compensation plans been recognized consistent with SFAS 123, the Company's net
income and earnings per share for 1997 and 1996 would approximate the pro forma
amounts below:

<TABLE>
<CAPTION>

                                                    1997    1996
                                                   ------  ------
<S>                                                <C>     <C>
Net income - as reported (in thousands)            $2,758  $3,230
Net income - pro forma (in thousands)              $2,577  $3,153
Net income per common share - basic, as reported   $ 0.55  $ 0.71
Net income per common share - basic, pro forma     $ 0.51  $ 0.69
</TABLE>

For the purpose of pro forma disclosure, the estimated compensation costs are
amortized to expense over the options vesting period, four years. Therefore,
because SFAS 123 is applicable only to options granted subsequent to January 31,
1995, its pro forma effect will not be fully reflected until 1999.

                                       55
<PAGE>
 
NOTE 14 -- QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of the unaudited quarterly results of operations for
the years 1997 and 1996:

<TABLE>
<CAPTION>
 
                                        1997
                         -----------------------------------
 
                          First   Second   Third    Fourth
                         Quarter  Quarter  Quarter  Quarter
                         -------  -------  -------  -------
<S>                      <C>      <C>      <C>      <C> 
Net Sales                $25,764  $30,215  $28,518   $26,743
Gross Profit               6,250    8,245    7,324     6,116
Net Income                   588    1,251      911         8
Per Share Data:
 Net income - basic      $  0.12  $  0.25  $  0.18   $   -
 Net income - diluted    $  0.12  $  0.24  $  0.18   $   -

 
                                         1996
                         -----------------------------------
 
                          First   Second   Third    Fourth
                         Quarter  Quarter  Quarter  Quarter
                         -------  -------  -------  -------
Net Sales                $18,813  $26,142  $25,326   $23,292
Gross Profit               4,112    6,034    6,150     5,509
 
Net Income                   394    1,132    1,192       512
 
Per Share Data:
 
 Net income - basic      $  0.09  $  0.25  $  0.26   $  0.11
 
 Net income - diluted    $  0.08  $  0.25  $  0.26   $  0.11
 
</TABLE>

                                      56
<PAGE>
 

                                                                     Schedule II

                          MFRI, INC. AND SUBSIDIARIES

                       VALUATION AND QUALIFYING ACCOUNTS

              For the years ended January 31, 1998, 1997 and 1996

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------------------------
           COL. A                      COL. B                       COL. C                        COL. D               COL. E
---------------------------------------------------------------------------------------------------------------------------------
                                                                  ADDITIONS
                                                      ----------------------------------
                                                            (1)               (2)             Deductions From
                                Balance at beginning  Charged to Costs  Charged to Other         Reserves          Balance at End
         DESCRIPTION                 of period          and Expenses        Accounts                                 of Period
---------------------------------------------------------------------------------------------------------------------------------
<S>                             <C>                   <C>               <C>                   <C>                  <C>
Year ended January 31, 1998:
Allowance for possible losses
in collection of trade
receivables                                 $270,000          $108,000                               $169,000 (B)        $209,000
                                ========================================================      ===============      ==============

Year ended January 31, 1997:
Allowance for possible losses
in collection of trade
receivables                                 $199,000           $99,000           $10,000  (A)         $38,000 (B)        $270,000
                                ========================================================      ===============      ==============

Year ended January 31, 1996:
Allowance for possible losses
in collection of trade
receivables                                 $269,000           $84,000         ($137,000) (A)         $17,000 (B)        $199,000
                                ========================================================      ===============      ==============
</TABLE>

Note -- A  Acquired with purchase of business or (reversed) as part of
           settlement of purchase agreement

Note -- B  Uncollectible accounts written off.

                                      57
 
<PAGE>
 
                                  SIGNATURES


     Pursuant to the requirements of Section 13 or 15(d) 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.


Date: May 1, 1998                   By: /s/ David Unger
                                       ----------------
                                     David Unger,
                                     Chairman of the Board of Directors


     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following person on behalf of the registrant
and in the capacities and on the date indicated.

<TABLE>
 
<S>                      <C>                               <C> 
DAVID UNGER*             Director and Chairman of the       )
                           Board of Directors (Principal    )
                           Executive Officer)               )
                                                            )
HENRY M. MAUTNER*        Director                           ) May 1, 1998
                                                            )
GENE K. OGILVIE*         Director                           )
                                                            )
FATI A. ELGENDY*         Director                           )
                                                            )
BRADLEY E. MAUTNER*      Director                           )
                                                            )
DON GRUENBERG*           Director                           )
                                                            )
MICHAEL D. BENNETT*      Vice President, Secretary and      )
                           Treasurer (Principal Financial   )
                           and Accounting Officer)          )
                                                            )
ARNOLD F. BROOKSTONE*    Director                           )
                                                            )
EUGENE MILLER*           Director                           )
                                                            )
STEPHEN B. SCHWARTZ*     Director                           )
                                                            )
*By:/s/ David Unger      Individually and as Attorney-in-   )
    -----------------    Fact                               )
    David Unger          
</TABLE>

                                       58
<PAGE>
 
                                 EXHIBIT INDEX
                                 -------------

<TABLE>
<CAPTION>

Exhibit No.                       Description                                           Page No. +
-----------                       -----------                                           ----------
<S>      <C>                                                                           <C> 
2.1      Stock Purchase Agreement, dated December 3, 1997, by and between Roy E.
         Greenlees, Lorie Greenlees, Janet Marshall (collectively "Sellers") and
         MFRI, Inc. ("Buyer") [Incorporated by reference to Exhibit 2.1 to the
         Company's current report on Form 8-K dated December 12, 1997 (SEC File
         No. 0-18370)]

3(a)     Certificate of Incorporation of MFRI, Inc. [Incorporated by reference
         to Exhibit 3.3 to Registration Statement No. 33-70298]

3(b)     By-Laws of MFRI, Inc. [Incorporated by reference to Exhibit 3.4 to
         Registration Statement No. 33-70298]

4(a)     Specimen Common Stock Certificate [Incorporated by reference to Exhibit
         4 to Registration Statement No. 33-70794]

10(a)    Management Services Agreement dated December 30, 1996 by and between
         MFRI, Inc. and Midwesco, Inc. (formerly known as Midwesco-Illinois,
         Inc.) [Incorporated by reference to Exhibit 10(a) to the Company's
         Annual Report on Form 10-K for the fiscal year ended January 31,
         1997**]

10(b)    1989 Stock Option Plan, as amended [Incorporated by reference to
         Exhibit 10(c) to the Company's Annual Report on Form 10-K for the
         fiscal year ended January 31, 1990*]

10(c)    1993 Stock Option Plan [Incorporated by reference to Exhibit 10.4 of
         Registration Statement No. 33-70794]

10(d)    1994 Stock Option Plan [Incorporated by reference to Exhibit 10(c) to
         the Company's Annual Report on Form 10-K for the fiscal year ended
         January 31, 1994 (SEC File No. 0-18370)]

-------------------------
+    Included only in manually signed original
*    SEC File No. 33-31850
**   SEC File No. 0-18370

</TABLE> 
                                      59

<PAGE>
 
<TABLE>
<CAPTION>

Exhibit No.                       Description                                           Page No. +
-----------                       -----------                                           ----------
<S>      <C>                                                                           <C> 
10(e)     1990 Independent Directors Stock Option Plan, as amended
          [Incorporated by reference to Exhibit 10.8 to Registration
          Statement No. 33-70794)]

10(f)     Form of Directors Indemnification Agreement [Incorporated by
          reference to Exhibit 10.7 to Registration Statement No. 33-70298]

10(g)     Asset Purchase Agreement dated as of September 30, 1994 by and among
          Ricwil Piping Systems Limited Partnership, The Ricwil Piping systems
          Company and MFRI, Inc. [Incorporated by reference to Exhibit 2.1 to
          the Company's current report on Form 8-K dated September 30, 1994 (SEC
          File No. 0-18370)]

21        Subsidiaries of MFRI, Inc.

23        Consent of Deloitte & Touche LLP

24        Power of Attorney executed by directors and officers of the Company

-------------------------
+    Included only in manually signed original
*    SEC File No. 33-31850
**   SEC File No. 0-18370
</TABLE> 

                                      60