Espey MFG & Electronics Corp: Form 10-Q for the period ended Dec 31, 2014

Overview

Espey Mfg. & Electronics Corp. (“Espey”) is a power electronics design and original equipment manufacturing (OEM) company with a long history of developing and delivering highly reliable products for use in military and severe environment applications. All design, manufacturing, and testing is performed in our 150,000+ square foot facility located at 233 Ballston Ave, Saratoga Springs, New York. Espey is classified as a “smaller reporting company” for purposes of the reporting requirements under the Securities Exchange Act of 1934, as amended. Espey’s common stock is publicly-traded on the NYSE MKT under the symbol “ESP.”

Espey began operations after incorporation in New York in 1928. We strive to remain competitive as a leader in high power energy conversion and transformer solutions through the design and manufacture of new and improved products by using advanced and “cutting edge” electronics technologies.

Espey is ISO 9001:2008 and AS9100:2009 certified. Our primary products are power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, ups systems, antennas and high power radar systems. The applications of these products include AC and DC locomotives, shipboard power, shipboard radar, airborne power, ground-based radar, and ground mobile power. The Company received AS9100:2009 certification, a quality management system specific to the aerospace industry, in fiscal 2014. Major aerospace manufacturers and suppliers worldwide require compliance to AS9100 as a condition of doing business with them. Obtaining certification will allow the Company to maintain current business and provides an opportunity to expand the Company’s qualification to bid on more work in the aerospace industry.

Espey services include design and development to specification, build to print, design services, design studies, environmental testing services, metal fabrication, painting services, and development of automatic testing equipment. Espey is vertically integrated, meaning that the Company produces individual components (including inductors), populates printed circuit boards, fabricates metalwork, paints, wires, qualifies, and fully tests items, mechanically, electrically and environmentally, in house. Portions of the manufacturing process are subcontracted to vendors from time to time.

The Company markets its products primarily through its own direct sales organization. Business is solicited from large industrial manufacturers and defense companies, the government of the United States, foreign governments and major foreign electronic equipment companies. In certain countries the Company has external sales representatives to help solicit and coordinate foreign contracts. Espey is also on the eligible list of contractors with the United States Department of Defense and generally is automatically solicited by Defense Department procurement agencies for their needs falling within the major classes of products produced by the Company. In addition, the Company directly pursues opportunities from the United States Department of Defense for prime contracts. Espey contracts with the Federal Government under cage code 20950 as Espey Mfg. & Electronics Corp. and cage code 98675 as Espey Mfg. & Electronics Corp., Saratoga Industries Division.

There is competition in all classes of products manufactured by the Company from divisions of the largest electronic companies, as well as many small companies. The Company's sales do not represent a significant share of the industry's market for any class of its products. The principal methods of competition for electronic products of both a military and industrial nature include, among other factors, price, product performance, the experience of the particular company and history of its dealings in such products. Our business is not seasonal. The Company, as well as other companies engaged in supplying equipment for military applications are exposed to on-going associated risks including, without limitation, dependence on appropriations from the United States Government and the governments of foreign nations, program allocations, and the potential of governmental termination of orders for convenience.

The Company's backlog was approximately $41.2 million at December 31, 2014, which includes $26.2 million from two significant customers, compared to $37.8 million at December 31, 2013, which included $25.7 million from two significant customers. The backlog for the Company represents the estimated remaining sales value of work to be performed under firm contracts. This includes items that have been authorized and appropriated by Congress and/or funded by the customer. The unfunded portions of the backlog at December 31, 2014 and 2013 were $2.3 million and zero, respectively, representing firm multi-year orders for which funding had not yet been appropriated by Congress or funded by our customer. While there is no guarantee that future budgets and appropriations will provide funding for a given program, management has included in unfunded backlog only those programs that it believes are likely to receive funding based on discussions with customers and program status.

Declining federal defense spending continues to cause new incidents of competition in the industry. Based upon discussions during contract negotiations with our major customers, we believe that many of our competitors are aggressively investing in upfront product design costs and lowering profit margins as a strategic means of maintaining existing business and enhancing market share at the expense of short term profit. This change in the marketplace has put pressure on the pricing of our current products and will likely result in lower margins on new business and some of our legacy business. In order to compete effectively for new business, in some cases we invest in upfront design costs, thereby reducing initial profitability as a means of procuring new long-term programs. Accordingly, we have adjusted our pricing strategy in order to achieve a balance which enables us both to retain repeat programs while being more competitive in bidding on new programs. We continue to refine this strategy based upon our discussions with existing and prospective customers.

Moreover, engineering development contracts frequently have an element of uncertainty associated with the status of the applicable defense program, whether it will be approved for ultimate production and the timing of production, and whether the particular program will be funded by Congress. It is not uncommon for there to be a lapse of several years or more between engineering development work and production work. Or, as we have recently observed, production work may be delayed indefinitely or never occur.

New orders received in the first six months of fiscal 2015 were approximately $16.8 million, as compared to $9.3 million of new orders received in the first six months of fiscal 2014. Due to the uncertain timing of receipt of new orders, particularly large orders, period to period comparisons, including short-term fluctuations in backlog, are not necessarily indicative of business trends. We continue to quote a large volume of opportunities and are reviewing our cost components and cost structure to become more cost competitive in an attempt to replace business which had been anticipated but ultimately was either deferred indefinitely or lost.

While the sales backlog gives the Company a solid base of future sales, based upon the composition of the backlog and our anticipated schedule for the fulfillment of orders, management expects net sales in fiscal year 2015 to be less than net sales in fiscal year 2014. It is presently anticipated that a minimum of $14 million of orders comprising the December 31, 2014 backlog will be filled during the fiscal year ending June 30, 2015. The minimum of $14 million does not include any shipments, which may be made against orders subsequently received during the fiscal year ending June 30, 2015. The estimate of the December 31, 2014 backlog to be shipped in fiscal 2015 is subject to future events, which may cause the amount of the backlog actually shipped to differ from such estimate.

In addition to the backlog, the Company currently has outstanding opportunities representing approximately $20 million in the aggregate for both repeat and new programs. The outstanding quotations encompass various new and previously manufactured standard and specialized military and industrial power electronics, power supplies, transformers as well as contract manufacturing. However, there can be no assurance that the Company will acquire any of the anticipated orders described above, many of which are subject to allocations of the United States defense spending and factors affecting the defense industry and military procurement generally.

Management continues to evaluate our sales strategy including professional and technical resources necessary to keep pace with the changing market conditions and needs of our customers. Recently, the company revamped its sales organization and refocused its efforts to concentrate on our core competencies of designing and delivering to customer specification highly reliable power supplies, power magnetics and power distribution electronics for use in military and severe environment applications. In addition, we intend to design and produce some of our own products when we identify a potential need in the marketplace. We are starting to see some benefits from these organizational changes including the identification of new program opportunities including program awards in some instances.

Net sales to three significant customers represented 62.9% of the Company's total sales for the three-month period ended December 31, 2014 and net sales to two significant customers represented 47.3% of the Company's total sales for the three-month period ended December 31, 2013. Net sales to two significant customers represented 50.7% and 59.2% of the Company’s total sales for the six-month periods ended December 31, 2014 and 2013, respectively. This high concentration level with two customers presents significant risk. A loss of one of these customers or programs related to these customers could significantly impact the Company. Historically, a small number of customers have accounted for a large percentage of the Company’s total sales in any given fiscal year. Management continues to pursue opportunities with current and new customers with an overall objective of lowering the concentration of sales, mitigating excessive reliance upon a single major product of a particular program and minimizing the impact of the loss of a single significant customer. Management continues to evaluate its business development functions and potential revised courses of action in order to diversify its customer base.

Management, along with the Board of Directors, continues to evaluate the need and use of the Company’s working capital. Capital expenditures are expected to be approximately $200,000 for fiscal 2015, of which $54,050 was expended through December 31, 2014. These expenditures are primarily being made to expand the production capability for transformers. Expectations are that working capital will be adequate to fund orders, regular quarterly dividend payments, and general operations of the business consistent with past practice. There is no guarantee that the Board of Directors will either maintain the amount of the regular cash dividend or declare a special dividend during the fiscal year ending June 30, 2015 or any future years.

Critical Accounting Policies and Estimates

Management believes our most critical accounting policies include revenue recognition and cost estimates to completion.

A significant portion of our business is comprised of engineering design and production contracts. Generally, revenues on these long-term fixed-price contracts are recorded on a percentage of completion basis using units of delivery as the measurement basis for progress toward completion.

Percentage of completion accounting requires judgment relative to expected sales, estimating costs and making assumptions related to technical issues and delivery schedule. Contract costs include material, subcontract costs, labor and an allocation of overhead costs. The estimation of cost at completion of a contract is subject to numerous variables involving contract costs and estimates as to the length of time to complete the contract. Given the significance of the estimation processes and judgments described above, it is possible that materially different amounts of expected sales and contract costs could be recorded if different assumptions were used, based on changes in circumstances, in the estimation process. When a change in expected sales value or estimated cost is determined, changes are reflected in current period earnings.

Results of Operations

Net sales decreased for the three months ended December 31, 2014 to $5,697,083 as compared to $6,569,641 for the same period in 2013. Net sales for the six months ended December 31, 2014 decreased to $11,390,555 as compared to $13,490,596 for the same period in 2013. The decrease in net sales for both the three and six months ended December 31, 2014 is primarily due to lower sales from engineering design contracts followed by a slight decline in electromechanical and transformer shipments.

For the three months ended December 31, 2014 and 2013 gross profits were $2,258,735 and $896,014, respectively. Gross profit as a percentage of sales was 39.6% and 13.7%, for the three months ended December 31, 2014 and 2013, respectively. For the six months ended December 31, 2014 and 2013, gross profits were $4,068,814 and $3,091,150, respectively. Gross profit as a percentage of sales was 35.7% and 22.9%, for the six months ended December 31, 2014 and 2013, respectively. The primary factors in determining gross profit and net income are overall sales levels and product mix. The gross profits on mature products and build to print contracts are higher as compared to products which are still in the engineering development stage or in the early stages of production. In any given accounting period the mix of product shipments between higher margin mature programs and less mature programs, including loss contracts, has a significant impact on gross profit and net income. The increase in gross profit in the three and six months ended December 31, 2014 was due to several factors. First, the Company yielded higher margins as a result of product mix as compared to the prior year where gross profits were negatively impacted by losses incurred on two engineering design contracts where the Company had been investing with an objective of developing future sales for follow-on production orders. Those programs were subsequently cancelled during the balance of fiscal 2014. In addition, the Company agreed to a final contract settlement in December 2014, relating to one of the cancelled programs, resulting in a reduction in cost of sales totaling $560,000.

Selling, general and administrative expenses were $633,177 for the three months ended December 31, 2014; a decrease of $153,383, compared to the three months ended December 31, 2013. Selling, general and administrative expenses were $1,231,379 for the six months ended December 31, 2014; a decrease of $323,156 compared to the six months ended December 31, 2013. The decrease for the three and six months ended December 31, 2014 relates primarily to a reduction in salary expense due to reductions in the number of employees.

Interest and other income for the three months ended December 31, 2014 and 2013 was $19,998 and $41,071, respectively. Interest and other income for the six months ended December 31, 2014 and 2013 was $37,648 and $66,552, respectively. Interest and dividend income is a function of the level of investments and investment strategies which generally tend to be conservative.

The effective income tax rate at December 31, 2014 and 2013 was 25.9%. The effective tax rate is less than the statutory tax rate mainly due to the benefit the Company receives on its “qualified production activities” under The American Jobs Creation Act of 2004 and the benefit derived from the ESOP dividends paid on allocated shares.

Net income for the three months ended December 31, 2014, was $1,219,082 or $0.54 per share both basic and diluted, respectively compared to $111,152 or $0.05 per share both basic and diluted, for the three months ended December 31, 2013. Net income for the six months ended December 31, 2014, was $2,130,303 or $0.94 and $0.93 per share, basic and diluted, respectively compared to $1,160,060 or $0.52 and $0.51 per share, basic and diluted, respectively, for the six months ended December 31, 2013. The increase in net income per share was mainly due to higher gross profits due to product mix and lower selling, general and administrative expenses, offset by lower sales.

Liquidity and Capital Resources

The Company's working capital is an appropriate indicator of the liquidity of its business, and during the past two fiscal years, the Company, when possible, has funded all of its operations with cash flows resulting from operating activities and when necessary from its existing cash and investments. The Company did not borrow any funds during the last two fiscal years. Management has available a $3,000,000 line of credit to help fund further growth or working capital needs, if necessary, but does not anticipate the need for any borrowed funds in the foreseeable future.

The Company's working capital as of December 31, 2014 and 2013 was approximately $28.1 million and $27.3 million, respectively. During the three and six months ended December 31, 2014 the Company repurchased 3,644 and 13,553 shares of its common stock, respectively, from the Company's Employee Retirement Plan and Trust ("ESOP") for a purchase price of $85,671 and $320,504 respectively. During the three and six months ended December 31, 2013 the Company did not repurchase any shares of its common stock. Under existing authorizations from the Company's Board of Directors, as of December 31, 2014, management is authorized to purchase an additional $1,385,744 million of Company stock.

The table below presents the summary of cash flow information for the fiscal years indicated:

Net cash provided by operating activities fluctuates between periods primarily as a result of differences in net income, provisions for income taxes, the timing of the collection of accounts receivable, purchase of inventory, level of sales and payment of accounts payable. Net cash provided by investing activities increased in the first six months of fiscal 2015 primarily due to a reduction in capital expenditures and the timing of the re-investment of matured securities. Net cash used in financing activities decreased primarily due to the reduction of dividends paid on common stock, related to a special dividend pain in the prior fiscal year, offset in part by the purchase of treasury stock.

The Company currently believes that the cash flow generated from operations and when necessary, from cash and cash equivalents will be sufficient to meet its long-term funding requirements for the foreseeable future.

During the six months ended December 31, 2014 and 2013, the Company expended $54,050 and $624,785, respectively, for plant improvements and new equipment. The Company has budgeted approximately $200,000 for new equipment and plant improvements in fiscal 2015. Management anticipates that the funds required will be available from current operations.

The Company at certain times enters into standby letters of credit agreements with financial institutions primarily relating to the guarantee of future performance on certain contracts. The Company had no contingent liabilities on outstanding standby letters of credit agreements at each of December 31, 2014 and December 31, 2013.

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE

SECURITIES LITIGATION REFORM ACT OF 1995

This report contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The terms "believe," "anticipate," "intend," "goal," "expect," and similar expressions may identify forward-looking statements. These forward-looking statements represent the Company's current expectations or beliefs concerning future events. The matters covered by these statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statements, including the Company's dependence on timely development, introduction and customer acceptance of new products, the impact of competition and price erosion, supply and manufacturing constraints, potential new orders from customers and other risks and uncertainties. The foregoing list should not be construed as exhaustive, and the Company disclaims any obligation subsequently to revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.

The Company is a smaller reporting company as defined under Securities and Exchange Commission Rule 12b-2. Pursuant to the exemption available to smaller reporting company issuers under Item 305 of Regulation S-K, quantitative and qualitative disclosures about market risk, the Company is not required to provide the information for this item.

(a) The Company's management, with the participation of the Company's chief executive officer and chief financial officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

(b) There have been no changes in our internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.