Espey MFG & Electronics Corp: Form 10-Q for the period ended Dec 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 the rail industry, and in equipment for military applications including 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, the potential of governmental termination of orders for convenience, and the general health of our largest customers.

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 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 adjust 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 in the current fiscal year as we continue to invest in new programs and aggressively quote long-term programs in an effort to grow the business.

In order to maintain a balanced business, we are continuing to place an emphasis on securing “build to print” opportunities, which will allow production work to go directly to the manufacturing floor, limiting the impact on our engineering staff. This effort will keep our manufacturing team busy while the products being developed transition to production. We have had some success with build to print opportunities. The selection of vendors by the potential customers to whom we have submitted quotations is taking longer than we originally anticipated. We will be unable to assess whether our initiative has been successful until the end of this fiscal year.

The Company's backlog was approximately $38.2 million at December 31, 2016 which includes $21.8 million from two significant customers compared to $43.0 million at December 31, 2015 which included $27.4 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. While there is no guarantee that future budgets and appropriations will provide funding for a given program, management includes in unfunded backlog only those programs that it believes are likely to receive funding based on discussions with customers and program status. The unfunded portions of the backlog at December 31, 2016 and 2015 were $0.

Management expects revenues in fiscal year 2017 to be less than revenues during fiscal 2016. This is primarily due to a decline we are experiencing in our industrial sector. As reported in our report on Form 10-K for the fiscal year ended June 30, 2016, a significant customer in the rail market advised us of its expectations for a scaled-back purchase plan due to falling demand for locomotives. For the six months ended December 31, 2016, shipments to this significant customer declined by 49% as compared with the same period in 2015 and new orders received from this significant customer declined by 87% as compared with the same period in 2015. We are working closely with our rail industry partners to secure long-term agreements that will allow us to support them through this downturn and provide a resumption of business for the Company upon a rail industry recovery. The anticipated sales decline in the rail industry may be offset, in part, by a new product for a customer in the military market 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 fourth quarter of the current fiscal year.

In order to address the downturn in the rail market and its impact on future sales and income, we also launched two additional military power supply designs in fiscal 2016, each for a different customer. All designs have progressed through critical design and have proceeded into qualification testing. We are experiencing some delays in qualification testing on one of these programs and expect future production orders to be delayed as well. We expect these new products to have significant multi-year production runs post qualification.

New orders received in the six months of fiscal 2017 were approximately $10.9 million as compared to $20.2 million of new orders received in the first six months of fiscal 2016, which included a $10.1 million initial production delivery order attributable to an award of a significant contract from the Federal Government for a power supply we have designed and is currently in the final stages of qualification. While we expect future procurements under this contract, due to the contract’s nature future procurements are not guaranteed and require the approval and allocation of funds by the Federal Government. The next procurement installment of the multi-year contract award is not expected until the product enters full-rate production, currently scheduled to commence in the fourth quarter of fiscal 2017. Each new order could be in the $10 million range. The orders received in the second quarter of fiscal 2017 include a power supply design and build contract from a new customer totaling approximately $3 million. If successful in design, this power supply could have a large volume of sales in future years, although currently we are unable to quantify the amount.

It is presently anticipated that a minimum of $11 million of orders comprising the December 31, 2016 backlog will be filled during the fiscal year ending June 30, 2017. The minimum of $11 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 December 31, 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.

In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $54 million in the aggregate as of January 31, 2017 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 generally.

Net sales to two significant customers represented 38.4% and 49.8% of the Company's total sales for the three-month period ended December 31, 2016 and 2015, respectively. Net sales to two significant customers represented 42.6% and 54.7% of the Company’s total sales for the six-month periods ended December 31, 2016 and 2015, respectively. 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 estimation on our contracts.

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 schedules. 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, 2016, to $5,667,624 as compared to $7,242,020 for the same period in 2015. Net sales for the six months ended December 31, 2016, decreased to $11,736,308 as compared to $13,521,456 for the same period in 2015. For the three and six months ended December 31, 2016, the decrease in net sales is primarily due to the decrease in shipments in power supplies resulting from the scaled-back procurement by a significant customer due to falling demand offset by an increase in magnetic shipments.

For the three months ended December 31, 2016 and 2015, gross profits were $1,080,145 and $1,588,043, respectively. Gross profit as a percentage of sales was 19.1% and 21.9%, for the three months ended December 31, 2016 and 2015, respectively. For the six months ended December 31, 2016 and 2015, gross profits were $2,423,892 and $3,556,363, respectively. Gross profit as a percentage of sales was 20.7% and 26.3%, for the six months ended December 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 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. The gross profit percentage decreased in the three and six months ended December 31, 2016 as compared to the same period in 2015 due to product mix and an increase in expenditures related to engineering design investments, specifically, one of the military power supplies discussed above. The design investment resulted in a 4.1% and 3.6% decline in the gross profit percentage for the three and six months ended December 31, 2016, respectively.

Selling, general and administrative expenses were $750,381 for the three months ended December 31, 2016; a decrease of $4,577, compared to the three months ended December 31, 2015. Selling, general and administrative expenses were $1,523,047 for the six months ended December 31, 2016; an increase of $18,439 compared to the six months ended December 31, 2015. The decrease for the three months ended December 31, 2016 relates primarily to a decrease in professional services. The increase for the six months ended December 31, 2016 relates primarily to increased compensation costs offset by a decrease in professional services.

Other income for the three months ended December 31, 2016 and 2015, was $18,655 and $37,173, respectively. Other income for the six months ended December 31, 2016 and 2015, was $37,678 and $62,614, respectively. The decrease is primarily due to a reduction in scrap sales partially offset by an increase in interest income.

The Company’s effective tax rates for the three and six months ended December 31, 2016, were 29.9% and 29.2%, respectively, compared to 29.4% for the three and six months ended December 31, 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 ESOP dividends paid on allocated shares.

Net income for the three months ended December 31, 2016, was $244,079 or $0.11 per share both basic and diluted, respectively compared to $614,427 or $0.27 per share both basic and diluted, for the three months ended December 31, 2015. Net income for the six months ended December 31, 2016, was $664,904 or $0.29 per share both basic and diluted compared to $1,492,957 or $0.65 per share both basic and diluted for the six months ended December 31, 2015. The decrease in net income per share for the three and six months ended December 31, 2016 compared to the same period in 2015 was mainly due to lower gross profit resulting from lower sales and lower gross profit percentage resulting from product mix and the increase in expenditures related to engineering design investments made by the company.

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 December 31, 2016 and 2015.

The Company's working capital as of December 31, 2016 and 2015 was approximately $29.9 million and $28.9 million, respectively. During the three and six-months ended December 31, 2016 the Company repurchased 1,663 shares of its common stock from the Company’s Employee Retirement Plan and Trust (“ESOP”) for a purchase price of $44,335. During the three and six months ended December 31, 2015 the Company repurchased 14,303 shares of its common stock from the ESOP for a purchase price of $355,418. Under existing authorizations from the Company's Board of Directors, as of December 31, 2016, management is authorized to purchase an additional $985,991 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 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 decrease in cash provided by operating activities primarily relates to a decrease in net income and the decrease in cash collections on accounts receivable offset by the reduction in payments for inventory purchases for the period. Net cash used by investing activities increased in the first six months of fiscal 2017 due to an increase in the purchase of investment securities. The decrease in cash used in financing activities is due primarily to the fact that fewer shares were purchased from the Company’s ESOP during the six months ended December 31, 2016 compared with the same period in 2015. In addition, cash expended for the six months ended December 31, 2015 included the dividend payable at June 30, 2015.

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, 2016 and 2015, the Company expended $223,211 and $82,341, 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.

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.