Note 1 - Basis of presentation

The interim consolidated financial statements of Perma-Pipe International Holdings, Inc., and subsidiaries ("PPIH", "Company", or "Registrant", or "we", or "us") are unaudited, but include all adjustments that the Company's management considers necessary to present fairly the financial position and results of operations for the periods presented. These adjustments consist of normal recurring adjustments. Information and footnote disclosures have been omitted pursuant to Securities and Exchange Commission ("SEC") rules and regulations. The consolidated balance sheet as of January 31, 2018 is derived from the audited consolidated balance sheet as of that date. The results of operations for any interim period are not necessarily indicative of future or annual results. Interim financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's latest Annual Report on Form 10-K. The Company's fiscal year ends on January 31. Years and balances described as 2018 and 2017 are for the three and nine months ended October 31, 2018 and 2017, respectively.

Note 2 - Business segment reporting

PPIH is engaged in the manufacture and sale of products in one segment: Piping Systems. Piping Systems engineers, designs, manufactures and sells specialty piping, leak detection and location systems. Specialty piping systems include (i) industrial and secondary containment piping systems for transporting chemicals, hazardous fluids and petroleum products, (ii) insulated and jacketed piping systems for district heating and cooling, municipal freeze protection, oil & gas, mining and industrial applications, and (iii) the coating and/or insulation of oil and gas gathering flow and long lines for oil and mineral transportation. The Company's leak detection and location systems are sold with its piping systems and on a stand-alone basis, to monitor areas where fluid intrusion may contaminate the environment, endanger personal safety, cause a fire hazard, impair essential services or damage equipment or property.

Note 3 - Accounts receivable

The majority of the Company's accounts receivable are due from geographically dispersed contractors and manufacturing companies. Credit is extended based on an evaluation of a customer's financial condition, including the availability of credit insurance. In the U.S., collateral is not generally required. In the U.A.E. and Saudi Arabia, letters of credit are usually obtained for significant orders. Accounts receivable are due within various time periods specified in the terms applicable to the specific customer and are stated at amounts due from customers net of an allowance for claims and doubtful accounts. The allowance for doubtful accounts is based on specifically identified amounts in customers' accounts, where future collectability is deemed uncertain. Management may exercise its judgment in adjusting the provision as a consequence of known items, such as current economic factors and credit trends. Past due trade accounts receivable balances are written off when the Company's collection efforts have been unsuccessful in collecting the amount due and the amount is deemed uncollectable. The write-off is recorded against the allowance for doubtful accounts.

One of the Company’s accounts receivable in the total amount of $5.4 million as of January 31, 2018 (inclusive of a retention receivable amount of $3.7 million, of which $3.2 million was included in the balance of other long-term assets as of October 31, 2018 and January 31, 2018, due to the long-term nature of the receivables) has been outstanding for several years as of October 31, 2018. The Company completed all of its deliverables in 2015, and has been engaged in ongoing active efforts to collect this amount. Since January 31, 2018, the Company has received payments of approximately $0.5 million, which reduced the balance of this receivable. As a result, the Company did not reserve any allowance against this receivable as of October 31, 2018. The Company continues to engage with the customer to ensure full payment of open balances. However, if the Company’s efforts to collect on this account are not successful in fiscal 2018, then the Company may recognize an allowance for all, or substantially all, of any such then uncollected amounts. As of October 31, 2018, this receivable balance, inclusive of a retention receivable amount, was $4.9 million. During November 2018, the Company received approximately $0.1 million, thus reducing this receivable balance to $4.8 million. 

For the three and nine month months ended October 31, 2018 and 2017, no individual customer accounted for 10% or more of the Company's consolidated net sales. 

At October 31, 2018, one customer accounted for 18% of the Company's accounts receivable. At January 31, 2018, three customers collectively accounted for 35% of the Company's accounts receivable. 

Note 4 - Revenue recognition

On February 1, 2018, the Company adopted Accounting Standards Codification Topic 606, "Revenue from Contracts with Customers," ("Topic 606"), using the modified retrospective method applied to contracts that were not completed as of that date. Under this methodology the effect, if any, of initially applying the new revenue standard was to be recorded as an adjustment to the opening balance of retained earnings, while periods prior to the adoption date were not to be adjusted and continue to be reported in accordance with the accounting policies in effect for those periods.

The Company conducted a complete and thorough analysis of each single element of the five-step model of Topic 606 and concluded that there was no material impact to the Company as a result of the adoption of the new standard. As such, the Company was not required to make a cumulative adjustment to the opening balances of retained earnings, contract assets or contract liabilities upon its initial application of the new revenue standard. 

Revenue from contracts with customers:

The Company defines a contract as an agreement that has approval and commitment from both parties, defined rights and identifiable payment terms, which ensures the contract has commercial substance and that collectability is reasonably assured.

The Company’s standard revenue transactions are classified in to two main categories:

The Systems revenue class has generally accounted for more than 90% of the Company’s total revenue and is recognized over time. The remaining revenue (Product class) is recognized when goods are shipped or services are performed. A breakdown of the Company's revenues by revenue class for the three and nine months ended October 31, 2018 and 2017 are as follows:

Most of the Company’s revenue is recognized over time as the manufacturing process progresses because one of the following conditions exist:

The U.S. operating entities measure revenue by the costs incurred to date relative to the estimated costs to satisfy the contract using the percentage-of-completion method (an input method). Generally, these contracts are considered a single performance obligation satisfied over time and due to the custom nature of the goods and services, the percentage-of-completion method is the most faithful depiction of the Company’s performance as it measures the value of the goods and services transferred to the customer. Costs include all material, labor, and direct costs incurred to satisfy the performance obligations of the contract. Revenue recognition begins when projects costs are incurred.

All other operating entities measure revenue by the direct measurement of the outputs produced relative to the remaining goods promised under the contract (output method). Due to the types of end customers, generally these contracts require formal inspection protocols or specific export documentation for units produced or produced and shipped, therefore, the output method is the most faithful depiction of the Company’s performance. Depending on the conditions of the contract, revenue may be recognized based on units produced, inspected and held by the Company prior to shipment or on units produced, inspected and shipped.

Contract modifications that occur prior to the start of the manufacturing process will supersede the original contract and revenue is recognized using the modified contract value. Contract modifications that occur during the manufacturing process (changes in scope of work, job performance, material costs, and/or final contract settlements) are recognized in the period in which the revisions are known. Provisions for losses on uncompleted contracts are made in contract liabilities account in the period such losses are identified.

Contract assets and liabilities:

Contract assets represent revenue recognized in excess of amounts billed (unbilled receivables) for contract work in progress for which the Company has a valid contract and an enforceable right to payment for work completed. Contract liabilities represent billings in excess of costs (unearned revenue) for contract work in progress for which the Company has a valid contract and an enforceable right to payment for work completed. Both customer billings and the satisfaction (or partial satisfaction) of the performance obligation(s) occur throughout the manufacturing process and impacts the period end balances in these accounts.

The Company anticipates that substantially all costs incurred for uncompleted contracts as of October 31, 2018 will be billed and collected within one year.

The following tables set forth the changes in the Company's contract assets and liabilities for the periods indicated. The Company expects to recognize the remaining balances as of October 31, 2018 within one year.

Practical expedients:

Costs to obtain a contract are not considered project costs as they are not usually incremental, nor does job duration span more than one year. The Company applies practical expedient for these types of costs and as such are expensed in the period incurred.

As the Company's contracts are less than one year, the Company has applied the practical expedient regarding disclosure of the aggregate amount and future timing of performance obligations that are unsatisfied or partially satisfied as of the end of the reporting period.

Note 5 - Income taxes

The determination of the consolidated provision for income taxes, deferred tax assets and liabilities and related valuation allowances requires management to make judgments and estimates. As a company with subsidiaries in foreign jurisdictions, the process of calculating income taxes involves estimating current tax obligations and exposures in each jurisdiction as well as making judgments regarding the future recoverability of deferred tax assets. Income earned in the United Arab Emirates is not subject to local country income tax. Additionally, the relative proportion of taxable income earned domestically versus internationally can fluctuate significantly from period to period. Changes in the estimated level of annual pre-tax income, tax laws and the results of tax audits can affect the overall effective income tax rate, which impacts the level of income tax expense and net income. Judgments and estimates related to the Company's projections and assumptions are inherently uncertain; therefore, actual results could differ materially from projections.

The Company's effective tax rate ("ETR") from operations for the current third quarter and year-to-date was 116% and 122,166%, compared to 32.5% and 2.8% during the respective prior year periods. The change in the ETR from the prior year-to-date to the current year-to-date was in large part due to changes in the Company's net income by jurisdiction. Additional factors include the tax impact of a Canadian business combination which occurred in the prior year, the valuation allowance against the domestic deferred tax asset, and the fact that the Company's operating performance is close to break-even for the current year-to-date. Since the Company is near break-even, relatively small changes to ordinary income will have a large impact to the effective tax rate, which has occurred for PPIH this quarter resulting in the high ETR reflected above. The year-to-date tax expense is $1.5 million and the ordinary income before tax is less than $0.1 million which has produced an ETR of 122,166%. While consolidated ordinary income before tax is near break-even, the Company accrues taxes in various countries where they are generating income while applying a valuation allowance in the U.S. which attributes to the unusually large ETR.

The amount of unrecognized tax benefits, including interest and penalties, at October 31, 2018, recorded in other long-term liabilities was $0.1 million, all of which would impact the Company’s ETR if recognized.

The U.S. Tax Cuts and Jobs Act ("Tax Act") was enacted on December 22, 2017 and introduced significant changes to U.S. income tax law. The Tax Act reduced the U.S. statutory tax rate from 35% to 21%, effective January 1, 2018 and created new taxes on certain foreign-sourced earnings and certain related-party payments, which are referred to as the global intangible low-taxed income tax and the base erosion anti-abuse tax, respectively. In addition, in 2017 the Company was subject to the one-time transition tax on accumulated foreign subsidiary earnings not previously subject to U.S. income tax.

Due to the timing of the enactment and the complexity involved in applying the provisions of the Tax Act, the Company has made reasonable estimates of the effects and recorded provisional amounts in its financial statements as of January 31, 2018 and October 31, 2018. As the Company collects and prepares necessary data, and interprets the Tax Act and any additional guidance issued by the U.S. Treasury Department, the IRS, and other standard-setting bodies, the Company may make future adjustments to its provisional amounts. Furthermore, the Company considered the impact of the global intangible low-taxed income ("GILTI") provision during the third quarter and determined that there was an inclusion of $0.1 million based on year-to-date figures. The Company has elected to account for the impact of GILTI as a current period expense when incurred, however due to the net operating losses ("NOLs") available to the Company, along with the valuation allowance in the U.S. this had no impact on the current quarter tax expense, and no additional expense was recorded for this. The accounting for the tax effects of the Tax Act will be completed within the measurement period.

Provisional amounts for the foregoing income tax effects of the Tax Act have been recorded as of October 31, 2018 and are subject to change during the measurement period.

Note 6 - Impairment of long-lived assets

The Company's assessment of long-lived assets, and other identifiable intangibles is based upon factors that market participants would use in accordance with the accounting guidance for the fair value measurement of assets. The Company will continue testing for potential impairment at least annually or as otherwise required by applicable accounting standards. There was no impairment of long-lived assets for the three and nine months ended October 31, 2018 and 2017.

Goodwill. The purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual of the purchase price recorded as goodwill. All identifiable goodwill as of October 31, 2018 and January 31, 2018 was attributable to the purchase of Perma-Pipe Canada, Ltd.

The Company performs an impairment assessment of goodwill annually as of January 31, or more frequently if triggering events occur, based on the estimated fair value of the related reporting unit or intangible asset. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. There was no impairment of goodwill for the three and nine months ended October 31, 2018 and 2017.

Note 7 - Stock-based compensation

At October 31, 2018, the Company had one incentive stock plan under which new equity incentive awards may be granted:

The Company has prior incentive plans under which previously granted awards remain outstanding, but under which no new awards may be granted. At October 31, 2018, the Company had reserved a total of 921,314 shares for grants and issuances under these incentive stock plans, which includes a reserve for issuances pursuant to unvested or unexercised prior awards, and shares for new grants or issuances pursuant to the 2017 Plan.

While the 2017 Plan provides for the grant of deferred shares, non-qualified stock options, incentive stock options, restricted shares, restricted stock units, and performance-based restricted stock units intended to qualify under section 422 of the Internal Revenue Code, to date the Company has issued only restricted shares and restricted stock units under the 2017 Plan and currently intends to continue this practice. The 2017 Plan authorizes awards to officers, employees, consultants, and directors.

The Company has stock-based compensation awards that can be granted to eligible employees, officers or directors. The following is the stock-based compensation expense:

Stock Options

The following tables summarize the Company's stock option activity:

As of October 31, 2018, there was less than $0.1 million of total unrecognized compensation expense related to unvested stock options. The expense is expected to be recognized over a weighted average period of 1.4 years.

Restricted stock

The following table summarizes the Company's restricted stock activity for the year:

As of October 31, 2018, there was $1.3 million of unrecognized compensation expense related to unvested restricted stock granted under the plans. The expense is expected to be recognized over a weighted average period of 2.4 years.

As a result of certain events that occurred during second quarter of fiscal 2018, including a settlement of stock-based award previously granted to a retiring member of the Company's Board of Directors, the Company changed its method of accounting for deferred stock compensation arrangements granted to the Company's directors from liability accounting treatment to equity accounting treatment and, as such, reclassified $0.7 million from a liability to additional paid in capital.

Note 8 - Earnings per share

Note 9 - Debt

Debt totaled $21.6 million at October 31, 2018, a net increase of $5.8 million since January 31, 2018.

Revolving lines North America. On September 20, 2018, the Company and certain of its U.S. and Canadian subsidiaries (collectively, together with the Company, the “North American Loan Parties”) entered into a new Revolving Credit and Security Agreement (the “Credit Agreement”) with PNC Bank, National Association, as administrative agent and lender (“PNC”), providing for a new three-year $18 million Senior Secured Revolving Credit Facility, subject to a borrowing base including various reserves (the “Senior Credit Facility”). The Senior Credit Facility replaced the Company’s then existing $15 million Credit and Security Agreement, dated September 24, 2014, among various subsidiaries of the Company and Bank of Montreal, as successor by assignment to BMO Harris Bank N.A., as amended (the “Prior Credit Agreement”).

The Company initially used borrowings under the new Senior Credit Facility to pay off outstanding amounts under the Prior Credit Agreement (which totaled approximately USD $3,773,823 plus CAD 4,794,528) and cash collateralize a letter of credit (USD $154,500). The Company expects to use additional borrowings under the new Senior Credit Agreement to fund future capital expenditures and on-going working capital needs, and for other corporate purposes. Borrowings under the Senior Credit Facility bear interest at a rate equal to an alternate base rate or London Interbank Offered Rate ("LIBOR"), plus, in each case, an applicable margin.  The applicable margin is based on average quarterly undrawn availability with respect to the Senior Credit Facility.  Interest on alternate base rate borrowings are generally payable monthly in arrears and interest on LIBOR borrowings are generally be payable in arrears on the last day of each interest period.  Additionally, the Company is required to pay a 0.375% per annum facility fee on the unused portion of the Senior Credit Facility.  The facility fee is payable quarterly in arrears.

Subject to certain exceptions, borrowings under the Senior Credit Facility are secured by substantially all of the assets of the Company and certain of its North American subsidiaries. The North American Loan Parties’ obligations under the Senior Credit Facility are guaranteed by Perma-Pipe Canada, Inc. The Senior Credit Facility will mature on September 20, 2021. Subject to certain qualifications and exceptions, the Senior Credit Facility contains covenants that, among other things, restrict the North American Loan Parties’ ability to create liens, merge or consolidate, consummate acquisitions, make investments, dispose of assets, incur debt, and pay dividends and other distributions. In addition, the North American Loan Parties cannot allow capital expenditures to exceed $3 million annually (plus a limited carryover of unused amounts).

The Senior Credit Facility also contains financial covenants requiring (i) the North America Loan Parties to achieve consolidated net income (excluding the financial performance of the Company’s foreign subsidiaries not party to the Credit Agreement) before interest, taxes, depreciation, amortization and certain other adjustments (“EBITDA”) of at least $1,807,000 for the period from August 1, 2018 through October 31, 2018; (ii) the North America Loan Parties to achieve EBITDA of at least $2,462,000 for the period from August 1, 2018 through January 31, 2019; (iii) the North America Loan Parties to achieve a ratio of its EBITDA (with certain additional adjustments) to the sum of scheduled cash principal payments on indebtedness for borrowed money and interest payments on the advances under the Senior Credit Facility (excluding from the calculation items related to the financial performance of the Company’s foreign subsidiaries not party to the Credit Agreement) to be not less than 1.10 to 1.00 for the nine-month period ending April 30, 2019 and for the quarter ending July 31, 2019 and each quarter end thereafter on a trailing four-quarter basis; and (iv) the Company and its subsidiaries (including the Company’s foreign subsidiaries not party to the Credit Agreement) to achieve a ratio of its EBITDA (with certain additional adjustments) to the sum of scheduled cash principal payments on indebtedness for borrowed money and interest payments on the advances under the Senior Credit Facility of not less than 1.10 to 1.00 for the nine-month period ending October 31, 2018 and for the quarter ending January 31, 2019 and each quarter end thereafter on a trailing four-quarter basis. The Company was in compliance with this requirement as of  October 31, 2018.

The Senior Credit Facility contains customary events of default. If an event of default occurs and is continuing, then PNC may terminate all commitments to extend further credit and declare all amounts outstanding under the Senior Credit Facility due and payable immediately. In addition, if any of the North American Loan Parties or certain of their subsidiaries become the subject of voluntary or involuntary proceedings under any bankruptcy, insolvency or similar law, then any outstanding obligations under the Senior Credit Facility will automatically become immediately due and payable. Borrowings under the Senior Credit Facility will bear interest at a rate of 2.00% per annum in excess of the otherwise applicable rate while a bankruptcy event of default exists or, upon the lenders’ request, during the continuance of any other event of default.

Revolving lines foreign. The Company also has credit arrangements used by its Middle Eastern subsidiaries. These credit arrangements are in the form of overdraft facilities and project financing at rates competitive in the countries in which the Company operates. The lines are secured by certain equipment, certain assets (such as accounts receivable and inventory), and a guarantee by the Company. Some credit arrangement covenants require a minimum tangible net worth to be maintained, including maintaining certain levels of intercompany subordinated debt. In addition, some of the revolving credit facilities restrict payment of dividends. On October 31, 2018, the Company was in compliance with the covenants under the credit arrangements. On October 31, 2018, interest rates were based on the Emirates Inter Bank Offered Rate (EIBOR) plus 3.5% per annum, with a minimum interest rate of 4.5% per annum. On October 31, 2018, the Company's interest rates ranged from 6.11% to 6.14%, with a weighted average rate of 6.14%, and the Company could borrow $9.1 million under these credit arrangements. On October 31, 2018, $6.6 million of availability was used to support letters of credit to guarantee amounts committed for inventory purchases and for performance guarantees. On October 31, 2018, the Company had borrowed $0.5 million, and had an additional $2.1 million available. The foreign revolving lines balances as of October 31, 2018 and January 31, 2018, were included as current maturities of long-term debt in the Company's consolidated balance sheets. 

Mortgages. On July 28, 2016, the Company borrowed 8.0 million CAD (approximately $6.1 million at the prevailing exchange rate on the transaction date) from a bank in Canada under a mortgage note secured by the Company's manufacturing facility located in Alberta, Canada, that matures on December 23, 2042. The interest rate is variable, currently at 6.1%, with monthly payments of 37 thousand CAD (approximately $28 thousand) for interest; and monthly payments of 27 thousand CAD (approximately $20 thousand) for principal. Principal payments began January 2018.

On June 19, 2012, the Company borrowed $1.8 million under a mortgage note secured by its manufacturing facility in Lebanon, Tennessee. The proceeds were used for payment of amounts borrowed. The loan bears interest at 4.5% with monthly payments of $13 thousand for both principal and interest and matures July 1, 2027. On June 19, 2022, and on the same day of each year thereafter, the interest rate shall adjust to the prime rate, provided that the applicable interest rate shall not adjust more than 2.0% per annum and shall be subject to a ceiling of 18.0% and a floor of 4.5%.

Capital Leases. In 2017, the Company obtained three capital leases for 1.1 million CAD (approximately $0.8 million at the prevailing exchange rates on the transaction dates) to finance vehicle equipment. The interest rates for these capital leases were from 4.0% to 7.8% per annum with monthly principal and interest payments of less than $0.1 million. These leases mature from April 30, 2021 to September 29, 2022.

Note 10 - Restricted cash

Restricted cash held by foreign subsidiaries was $1.0 million as of October 31, 2018 and $1.2 million as of January 31, 2018. Restricted cash held by foreign subsidiaries is related to fixed deposits that also serve as security deposits and guarantees. Restricted cash held in the U.S. on October 31, 2018 was $1.5 million, and is a cash collateral held by PNC Bank in relation to the new credit agreement.  

Note 11 - Fair value

The carrying values of cash and cash equivalents, accounts receivable and accounts payable are reasonable estimates of their fair value due to their short-term nature. The carrying amount of the Company's short-term debt, revolving line of credit and long-term debt approximate fair value, because the majority of the amounts outstanding accrue interest at variable market rates.

Note 12 - Recent accounting pronouncements

In June 2018, the FASB issued an update to Topic 718, which is intended to reduce costs and complexity, and improve financial reporting for share-based payments issued to non-employees. ASU No. 2018-07 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted.  The Company has evaluated the effect that this ASU will have on its consolidated financial statements and related disclosures, and has determined that this ASU does not have a material impact on the Company's results of operations or financial position.

In March 2017, the FASB issued authoritative guidance which changes the income statement presentation of the components of net periodic benefit cost related to defined benefit pension and other post-retirement plans. The primary change under the new guidance is that only the service cost component of net periodic benefit cost should be included in operating income and is eligible for capitalization as an asset. The other components of net periodic benefit cost, such as interest cost, the expected return on assets, and amortization of actuarial gains and losses and prior service cost, should be presented below operating income. The guidance was effective for the Company starting February 1, 2018 and has been applied retrospectively to the presentation of net periodic benefit cost and prospectively to the capitalization of service cost. The adoption of this guidance did not have a material impact on the Company's results of operations or financial position.

In October 2016, the FASB issued authoritative guidance requiring the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs rather than when transferred to a third party as required under the current guidance. The new guidance was effective for the Company beginning February 1, 2018. The adoption of this guidance did not have a material impact on the Company's results of operations or financial position.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This ASU requires entities to recognize assets and liabilities for most leases on their balance sheets. It also requires additional qualitative and quantitative disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases. ASU No. 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted.  The Company is currently evaluating the effect that this standard will have on its consolidated financial statements and related disclosures.

In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers ("Topic 606")", with several clarifying updates issued during 2016. This ASU was effective for the Company beginning February 1, 2018. The adoption of this ASU did not have a material impact on the Company's results of operations or financial position. Refer to Note 4 - Revenue recognition - for more detail.

The Company evaluated other recent accounting pronouncements and does not expect them to have a material impact on its consolidated financial statements or related disclosures.