Espey MFG & Electronics Corp: Form 10-K for the period ended Jun 30, 2016

General

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 industrial 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.

In fiscal years ended June 30, 2016 and 2015, the Company's total sales were $27,471,365 and $26,831,705, respectively. Sales to two domestic customers accounted for 37% and 12% of total sales in 2016. Sales to three domestic customers accounted for 36%, 15% and 10% of total sales in 2015. A loss of a significant customer would negatively impact the financial performance of the Company. One significant customer is experiencing a significant decline in sales due to falling demand in its core locomotive business. This is discussed further in Item. 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Export sales in 2016 and 2015 were approximately $2,125,000 and $2,384,000, respectively. This decrease is primarily due to the reduction in power supply shipments to specific customers.

Sources of Raw Materials

The Company has never experienced any significant delay or shortage with respect to the purchase of raw materials and components used in the manufacture of its products, and has at least two potential sources of supply for a majority of its raw materials. However, certain components used in its products are available from only a limited number of sources, and other components are only available from a single source. Despite the risk associated with limited or single source suppliers, the benefits of higher quality goods and timely delivery minimize and often limit any potential risk and can eliminate problems with part failures during production.

Sales Backlog

The total backlog at June 30, 2016 was approximately $39.1 million compared to approximately $36.4 million at June 30, 2015. The Company’s total backlog represents the estimated remaining sales value of work to be performed under firm contracts. The backlog was fully funded at June 30, 2016 and 2015. Funded backlog means items that have been authorized and appropriated by Congress and/or funded by the customer. There is no guarantee that future budgets and appropriations will provide funding for follow-on orders for a given program. The Company's backlog and risks associated with government contracts is discussed in greater detail in Management's Discussion and Analysis of Financial Condition and Results of Operations, contained in Item 7 below.

It is presently anticipated that a minimum of $23 million of orders comprising the June 30, 2016 backlog will be filled during the fiscal year ending June 30, 2017. The minimum of $23 million does not include any shipments, which may be made against orders subsequently received during the fiscal year ending June 30, 2017. The estimate of the June 30, 2016 backlog to be shipped in fiscal 2017 is subject to future events, which may cause the amount of the backlog actually shipped to differ from such estimate.

Marketing and Competition

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 military and industrial 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, and the potential of governmental termination of orders for convenience.

Uncertainty in federal defense spending and the current decline in the rail industry continues to drive competition. 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. This trend will continue into fiscal 2017 and we continue to invest in new programs and aggressively quote long-term programs in an effort to grow the business.

Moreover, to address current elements of competition and foster growth we have made targeted hires of experienced personnel to support enhanced sales, program fulfillment, engineering, quality control and supply chain management.

Research and Development

The Company's expenditures for research and development were approximately $49,236 and $234,812 in fiscal 2016 and 2015, respectively. Some of the Company's engineers and technicians spend varying degrees of time on either development of new products or improvements of existing products. A majority of these expenditures relate to research that is required by Espey engineers to support a request for a quotation from a customer having a product-specific custom need usually associated with stringent size and weight requirements. We do very little pure research as our business primarily is driven by customer product needs as opposed to new product development.

Employees

The Company had 145 employees as of September 12, 2016. Approximately 40% of these employees are represented by the International Brotherhood of Electrical Workers Local #1799. A new collective bargaining agreement was approved in July 2015. The three-year agreement expires on June 30, 2018. Relations with the Union are considered good.

Government Regulations

Compliance with federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, did not in fiscal year 2016, and the Company believes will not in fiscal year 2017, have a material effect upon the capital expenditures, net income, or competitive position of the Company.

The Company’s U.S. Government contract and subcontract orders are funded by government budgets, which operate on an October-to-September fiscal year. Normally, in February of each year, the President of the United States presents to Congress a proposed budget for the upcoming fiscal year. This budget includes recommended appropriations for every federal agency and is the result of months of policy and program reviews throughout the executive branch. From February through September of each year, the appropriations and authorization committees of Congress review the President’s budget proposals and establish the funding levels for the upcoming fiscal year in appropriations and authorization legislation. Once these levels are enacted into law, the Executive Office of the President administers the funds to the agencies.

There are two primary risks associated with this process. First, the process may be delayed or disrupted because of congressional schedules, negotiations over funding levels for programs or unforeseen world events, which could, in turn, alter the funding for a program or contract. Second, funding for multi-year contracts can be changed by future appropriations, which could affect the timing of funds, schedules and program content.

Also, our international sales are denominated in United States dollars. Consequently, changes in exchange rates that strengthen the United States dollar could increase the price in local currencies of our products in foreign markets and make our products relatively more expensive than competitors’ products.

U.S. Government Defense Contracts and Subcontracts

Generally, U.S. Government contracts are subject to procurement laws and regulations. Some of the Company’s contracts are governed by the Federal Acquisition Regulation (FAR), which lays out uniform policies and procedures for acquiring goods and services by the U.S. Government, and agency-specific acquisition regulations that implement or supplement the FAR. For example, the Department of Defense implements the FAR through the Defense Federal Acquisition Regulation (DFAR).

The FAR also contains guidelines and regulations for managing a contract after award, including conditions under which contracts may be terminated, in whole or in part, at the government’s convenience or for default. If a contract is terminated for the convenience of the government, a contractor is entitled to receive payments for its allowable costs and, in general, the proportionate share of fees or earnings for the work done. If a contract is terminated for default, the government generally pays for only the work it has accepted. These regulations also subject the Company to financial audits and other reviews by the government of its costs, performance, accounting and general business practices relating to its contracts, which may result in adjustment of the Company’s contract-related costs and fees.

The Company's entire operation, including administrative, manufacturing and engineering facilities, is located in Saratoga Springs, New York.

The Saratoga Springs plant, which the Company owns, consists of various adjoining buildings on a 22 acre site, approximately eight acres of which is unimproved. The property is not subject to mortgage indebtedness or any other material encumbrance. The plant has a sprinkler system throughout and contains approximately 151,000 square feet of floor space, of which 90,000 is used for manufacturing, 24,000 for engineering, 33,000 for shipping and climatically secured storage, and 4,000 for offices. The offices, engineering and some manufacturing areas are air-conditioned. In addition to assembly and wiring operations, the plant includes facilities for varnishing, potting, impregnation and spray-painting operations. The manufacturing operation also includes a complete machine shop, with welding and sheet metal fabrication facilities adequate for substantially all of the Company's current operations. Besides normal test equipment, the Company maintains a sophisticated on-site environmental test facility. In addition to meeting all of the Company's in-house needs, the machine shop and environmental facilities are available to other companies on a contract basis.

Business Outlook

Management expects revenues in fiscal year 2017 to be less than revenues during fiscal year 2016. This expectation is driven primarily by recent communications with a significant customer in the industrial sector who has advised us of a significantly scaled-back purchase plan resulting from falling demand in the rail industry. This negative development may be offset, in part, by a new product for another customer which is currently in the final stages of design development and qualification testing. If the testing is successful, shipments of the product are expected to begin in the third quarter of the fiscal year.

During fiscal 2016 the Company received approximately $30.2 million in new orders. Our total backlog at June 30, 2016 was approximately $39.1 million, as compared to $36.4 million at June 30, 2015. Currently, we expect a minimum of $23 million of orders comprising the June 30, 2016 backlog will be filled during the fiscal year ending June 30, 2017. This $23 million will be supplemented by shipments which may be made against orders received during the fiscal year.

In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $50 million in the aggregate as of September 8, 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.

Two significant customers including the one which advised us of the intent to reduce orders during fiscal year 2017, represented 49% of the Company’s total sales in fiscal 2016 and three significant customers represented 61% of the Company’s total sales in fiscal 2015. These sales are in connection with multiyear programs in which the Company is a significant contractor. The June 30, 2016 backlog of $39.1 million includes orders from two customers that represent 35% and 27%, respectively, of the total backlog. This high customer concentration level presents significant risk. A loss of one of these customers or programs related to these customers, or customer requested deferrals of product delivery 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. We continue to evaluate the Company’s business development functions and the implementation of potential alternative courses of action in order to diversity the Company’s customer base. The quotations for non-repeat programs referred to above include several new customers.

As market factors impact revenues, management will continue to evaluate our sales strategy, employment levels, and facility costs. Management is currently participating in a plant layout optimization review with an objective to improve capacity and maximum cost savings as product moves through the facility. Recommendations from the review are currently being implemented and expect to be completed in fiscal 2017 and 2018.

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 $750,000 for fiscal 2017. A majority of these expenditures will be made to optimize the production flow as noted above and to upgrade existing equipment and add needed technology to stay competitive in the marketplace. Expectations are that the working capital will be required to fund orders, dividend payments, and general operations of the business. From time to time, management along with the Mergers and Acquisitions Committee of the Board of Directors examine opportunities involving acquisitions or other strategic options, including buying certain products or product lines. The criteria for consideration are synergies with the Company’s existing product base and accretion to earnings.

Results of Operations

Net sales for fiscal years ended June 30, 2016 and 2015, were $27,471,365 and $26,831,705, respectively, a 2.4% increase. The slight increase in sales can be attributed to the contract specific nature of the Company’s business and the timing of deliveries on these contracts. Specifically, the increase in net sales is primarily due to an increase in magnetic shipments of $1.1 million, offset by a decrease in build-to-print sales.

For the fiscal years ended June 30, 2016 and 2015 gross profits were $7,371,682 and $7,141,573, respectively. Gross profit as a percentage of sales increased slightly to 26.8% for fiscal 2016, up from 26.6% in fiscal 2015. 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 typically 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 can incur 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. In total, the gross profit percentage remained consistent for the twelve months ended June 30, 2016, as compared to the twelve months ended June 30, 2015. Fiscal 2016 profit margins on shipments were up slightly due to product mix and less incidents of “loss contracts” as compared to the prior fiscal year. In addition, fiscal 2015 included a favorable one-time reduction to cost of sales of $560,000 for a contract settlement related to a previously cancelled program.

Selling, general, and administrative expenses were $3,028,449 for the fiscal year ended June 30, 2016, an increase of $316,642, or 11.7% as compared to the prior year. The increase for fiscal 2016 relates primarily to an increase in compensation costs due to an increase in the number of employees supporting sales and program management.

Employment of full time equivalents at June 30, 2016 was 149 people compared with 145 people at June 30, 2015. Employees were hired in sales, engineering, quality control and program management both to support the Company’s current backlog and to build a team that can augment and diversify our business and effectively manage the Company.

Other income for the fiscal years ended June 30, 2016 and 2015 was $119,274 and $68,050, respectively. The increase is due to an increase in scrap sales offset by a slight decrease in interest income. Interest income is a function of the level of investments and investment strategies which generally tend to be conservative.

The effective income tax rate has remained consistent with the prior year and was 28.8% in fiscal 2016 and 29.2% in fiscal 2015. 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 dividends paid on allocated ESOP shares.

Net income for fiscal 2016, was $3,175,801 or $1.39 and $1.38 per share, basic and diluted, respectively, compared to net income of $3,183,127 or $1.40 and $1.39 per share, basic and diluted, respectively, for fiscal 2015. The decrease in net income per share for the twelve months ended June 30, 2016, was primarily due to higher selling, general and administrative expenses offset by an increase in sales and the gross profit percentage resulting from product mix. 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 needs, if necessary, but does not anticipate the need for any borrowed funds in the foreseeable future.

The Company's working capital as of June 30, 2016 and 2015 was $30,242,950 and $28,656,762, respectively. During the three and twelve months ended June 30, 2016 the Company repurchased 0 and 14,303 shares of its common stock, respectively, from the Company’s Employee Retirement Plan and Trust (“ESOP”) for a purchase price of $0 and $355,418, respectively. During the three and twelve months ended June 30, 2015 the Company repurchased 0 and 13,553 shares of its common stock, respectively, from the Company’s ESOP for a purchase price of $0 and $320,504, respectively. Under existing authorizations from the Company's Board of Directors, as of June 30, 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 fiscal year 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 twelve 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 twelve months ended June 30, 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.

Management 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.

During fiscal years 2016 and 2015, the Company expended $284,210 and $266,029, respectively, for plant improvements and new equipment. The Company has budgeted approximately $750,000 for new equipment and plant improvements in fiscal 2017. Management anticipates that the funds required will be available from current operations.

Evaluation of Controls and Procedures

(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 Annual Report on Form 10-K. 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.

Management’s Report on Internal Control over Financial Reporting

Management of our Company is responsible for establishing and maintaining adequate internal control over financial reporting, as that term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Under the supervision and with the participation of our management, including the principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. Based on our evaluation using the criteria set forth in Internal Control-Integrated Framework, management has concluded that our internal control over financial reporting was effective as of June 30, 2016.

This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Our report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit us to provide only management’s report in this annual report.