Espey MFG & Electronics Corp: Form 10-Q for the period ended Mar 31, 2016

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. 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.

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 and testing process are subcontracted to vendors from time to time.

The Company markets its products primarily through its own direct sales organization and through outside sales representatives. 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.

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. However, the concentration of our business in equipment for industrial and military applications and our customer concentrations expose us to on-going associated risks including, without limitation, dependence on appropriations from the United States Government and the governments of foreign nations, program allocations of a single customer, and the potential of governmental termination of orders for convenience.

Uncertainty in federal defense spending and competition in our industrial customer base continues to be a concern. Based upon discussions during contract negotiations with our major customers over the past several years, we believe that many of our competitors have been 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 market place has put pressure on the pricing of our current products and will 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.

The Company's backlog was approximately $41.6 million at March 31, 2016, which includes $26.2 million from two significant customers, compared to $38.4 million at March 31, 2015, which included $24.4 million from two significant customers. The backlog at March 31, 2016, also includes a $10.1 million delivery order attributable to an award of a significant contract from the Federal Government. Revenues under this contract are not expected to be realized until fiscal year 2017. 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 March 31, 2016 and 2015, were $0 and $2.3 million, 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.

Management expects revenues in fiscal year 2016 to increase as compared with fiscal year 2015 revenues. Current expectations are for gross margins to be lower compared to prior year due to product mix, competitive pricing pressures, new program investments, and a one-time reduction to cost of sales in the prior year discussed within the Results of Operations, below. New orders received in the first nine months of fiscal 2016 were approximately $26.0 million as compared to $20.5 million of new orders received in the first nine months of fiscal 2015. It is presently anticipated that a minimum of $6 million of orders comprising the March 31, 2016, backlog will be filled during the fiscal year ending June 30, 2016. The minimum of $6 million does not include any shipments, which may be made against orders subsequently received during the fiscal year ending June 30, 2016.

In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $51 million in the aggregate as of May 11, 2016, for both repeat and new programs. The outstanding quotations encompass various new and previously manufactured power supplies, transformers, and subassemblies. 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 industrial locomotive power supply procurement of a single customer.

Management continues to evaluate our sales strategy including the professional and technical resources necessary to keep pace with the changing market conditions and needs of our customers. The Company has added to and re-aligned current sales and engineering resources, in order to focus on penetrating opportunities with new and existing customers. The Company continues quoting current and new customers for programs of varying sizes.

Net sales to four significant customers represented 68.6% of the Company's total sales for the three-month period ended March 31, 2016, and net sales to two significant customers represented 63.8% of the Company’s total sales for the three-month period ended March 31, 2015. Net sales to two significant customers represented 49.5% of the Company's total sales for the nine-month period ended March 31, 2016, and net sales to three significant customers represented 59.5% of the Company’s total sales for the nine-month period ended March 31, 2015. This high concentration level with these 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 and mitigating excessive reliance upon a single major product of a particular program or minimizing the impact of the loss of a single significant customer.

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 development and production contracts. Generally, revenues on 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 increased for the three months ended March 31, 2016, to $7,217,922 as compared to $6,470,286 for the same period in 2015. Net sales for the nine months ended March 31, 2016, increased to $20,739,378 as compared to $17,860,841 for the same period in 2015. For the three months ended March 31, 2016, the increase in net sales is primarily due to increased magnetics shipments offset by a decrease in power supplies shipped. For the nine months ended March 31, 2016, the increase in net sales is primarily due to increased shipments of magnetics and power supplies, offset by a decline in spare part sales.

For the three months ended March 31, 2016 and 2015, gross profits were $2,148,223 and $1,437,534, respectively. Gross profit as a percentage of sales was 29.8% and 22.2%, for the three months ended March 31, 2016 and 2015, respectively. For the nine months ended March 31, 2016 and 2015, gross profits were $5,704,586 and $5,506,348, respectively. Gross profit as a percentage of sales was 27.5% and 30.8%, for the nine months ended March 31, 2016 and 2015, 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 early stages of production. In the case of the latter, the Company incurs what it refers to as “loss contracts,” meaning engineering design contracts in which the Company invests with the objective of developing future product sales. In any given accounting period the mix of product shipments between higher margin programs and less mature programs, and expenditures associated with loss contracts, has a significant impact on gross profit and net income. The gross profit percentage increased in the three months ended March 31, 2016, as compared to the same period ended March 31, 2015 due to the impact of higher margins resulting from product mix. The gross profit percentage decreased for the nine months ended March 31, 2016, as compared to the nine months ended March 31, 2015 due to a favorable one-time reduction to cost of sales that occurred during the nine months ended March 31, 2015. The prior year reduction totaled $560,000 for a contract settlement related to a previously cancelled program.

Selling, general and administrative expenses were $781,248 for the three months ended March 31, 2016; an increase of $15,348, compared to the three months ended March 31, 2015. Selling, general and administrative expenses were $2,285,856 for the nine months ended March 31, 2016; an increase of $288,577 compared to the nine months ended March 31, 2015. The increase for the three and nine months ended March 31, 2015 relates primarily to an increase in compensation costs due to pay increases and an increase in the number of employees.

Other income for the three months ended March 31, 2016 and 2015, was $16,952 and $14,386, respectively. Other income for the nine months ended March 31, 2016 and 2015, was $79,566 and $52,034, respectively. The increase is primarily due to an increase in scrap metal sales.

The Company’s effective tax rates for the three and nine months ended March 31, 2016, were 29.7% and 29.5%, respectively, compared to 26.2% and 26.0% for the three and nine months ended March 31, 2015, respectively. 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. The increase in the effective tax rate for March 31, 2016, is primarily due to a reduced benefit caused by the reduction in dividends deductible for income tax purposes.

Net income for the three months ended March 31, 2016, was $972,468 or $0.43 per share both basic and diluted, respectively compared to $506,369 or $0.22 per share both basic and diluted, for the three months ended March 31, 2015. Net income for the nine months ended March 31, 2016, was $2,465,425 or $1.08 per share both basic and diluted compared to $2,636,672 or $1.16 and $1.15 per share, basic and diluted, respectively, for the nine months ended March 31, 2015. The increase in net income per share for the three months ended March 31, 2016, was primarily due to higher sales and higher margins resulting from product mix. The decrease in net income per share for the nine months ended March 31, 2016, was mainly due to higher selling, general and administrative expenses and a higher effective income tax rate offset by an increase in sales. Also, impacting the comparison is a prior year favorable one-time $560,000 reduction to cost of sales referred to above.

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 and letter of credit needs, if necessary, but does not anticipate the need for any borrowed funds in the foreseeable future. Contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at March 31, 2016 and 2015.

The Company's working capital as of March 31, 2016 and 2015, was approximately $29.5 million and $28.1 million, respectively. During the three and nine months ended March 31, 2016, the Company repurchased 0 and 14,303 shares of its common stock from the Company’s Employee Retirement Plan and Trust (”ESOP”) for a purchased price of $0 and $355,418, respectively. During the three and nine months ended March 31, 2015 the Company repurchased 0 and 13,553 shares of its common stock, respectively, from the ESOP for a purchase price of $0 and $320,504, respectively. Under existing authorizations from the Company’s Board of Directors, as of March 31, 2016, management is authorized to purchase an additional $1,030,326 of Company Stock.

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

Net cash provided by operating activities fluctuates between periods primarily as a result of differences in sales and net income, provisions for income taxes, the timing of the collection of accounts receivable, purchase of inventory, and payment of accounts payable. The increase in net cash provided by operating activities primarily relates to an increase in trade receivable collections and a decline in inventory purchases due to the timing of production jobs, offset by an increase in cash paid for both federal income tax deposits and payments to vendors. Net cash provided by investing activities decreased in the nine months of fiscal 2016 due to the timing and reinvestment of matured investment securities. The increase in cash used in financing activities is due primarily to the dividend payable at June 30, 2015, paid in the nine months ended March 31, 2016.

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 nine months ended March 31, 2016 and 2015, the Company expended $140,340 and $162,822, respectively, for plant improvements and new equipment. The Company has budgeted approximately $250,000 for new equipment and plant improvements in fiscal 2016. Management anticipates that the funds required will be available from current operations.

Management also believes that the Company's reserve for bad debts of $3,000 is adequate given the customers with whom the Company does business. Historically, bad debt expense has been minimal.

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.