Espey MFG & Electronics Corp: Form 10-Q for the period ended Mar 31, 2017

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 is expected to 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 beyond 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 $38.7 million at March 31, 2017 which includes $20.4 million from two significant customers compared to $41.6 million at March 31, 2016 which included $26.2 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. There were no unfunded portions of the backlog at March 31, 2017 and 2016. In April, subsequent to the end of the third quarter we received a long-term contract for $8.4 million that brought our backlog over $47 million. The new contract award has been initially funded for $933,000 with additional funding expected to be released quarterly over the next 4 years.

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 nine months ended March 31, 2017, shipments to this significant customer declined by 43% as compared with the same period in 2016 and new orders received from this significant customer declined by 92% as compared with the same period in 2016. 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 for a resumption of business for the Company upon a rail industry recovery assuming we can remain competitive as a supplier.

The revenue stream decline from the locomotive industry may be offset in future periods by the shipment of a new product in the military market where the design development and qualification testing has been successfully completed. Full-rate production will commence during the fourth quarter with shipments expected to be released toward the end of such quarter. The Company is waiting on the approval, printing, and delivery of the product technical manual from our customer which is required to be included with each shipped unit. In addition, the Company has also launched two additional military power supply designs in fiscal 2016, each for a different customer. While both designs have proceeded into qualification testing, we are experiencing some delays in the qualification testing on one of these programs and expect future production orders to be delayed as a result. However, we expect both of these new products to have significant multi-year production runs post qualification, although the amount of revenues remains uncertain.

New orders received in the nine months of fiscal 2017 were approximately $16.8 million as compared to $26.0 million of new orders received in the first nine 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 has been qualified. 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.

It is presently anticipated that a minimum of $5.4 million of orders comprising the March 31, 2017 backlog will be filled during the last quarter of the fiscal year ending June 30, 2017. The minimum of $5.4 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 March 31, 2017 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 $53 million in the aggregate as of April 26, 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 40.7% of the Company's total sales for the three-month period ended March 31, 2017, and net sales to four significant customers represented 68.6% of the Company’s total sales for the three-month period ended March 31, 2016. Net sales to two significant customers represented 43.2% and 49.5% of the Company’s total sales for the nine-month periods ended March 31, 2017 and 2016, 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 March 31, 2017, to $5,324,104 as compared to $7,217,922 for the same period in 2016. Net sales for the nine months ended March 31, 2017, decreased to $17,060,411 as compared to $20,739,378 for the same period in 2016. For the three months ended March 31, 2017, the decrease in net sales is primarily due to the decrease in magnetic shipments and power supply shipments resulting from the completion of a customer contract and the scaled-back procurement by a significant customer, respectively. For the nine months ended March 31, 2017, 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.

For the three months ended March 31, 2017 and 2016, gross profits were $1,128,505 and $2,148,223, respectively. Gross profit as a percentage of sales was 21.2% and 29.8%, for the three months ended March 31, 2017 and 2016, respectively. For the nine months ended March 31, 2017 and 2016, gross profits were $3,552,397 and $5,704,586, respectively. Gross profit as a percentage of sales was 20.8% and 27.5%, for the nine months ended March 31, 2017 and 2016, respectively. The primary factors in determining the change in 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 nine months ended March 31, 2017 as compared to the same period in 2016 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 2.1% and 3.1% decline in the gross profit percentage for the three and nine months ended March 31, 2017, respectively.

Selling, general and administrative expenses were $784,589 for the three months ended March 31, 2017; an increase of $3,341, compared to the three months ended March 31, 2016. Selling, general and administrative expenses were $2,307,636 for the nine months ended March 31, 2017; an increase of $21,780 compared to the nine months ended March 31, 2016. The increase for the three months ended March 31, 2017 relates primarily to an increase in professional services and incurred travel offset by a decrease in compensations costs. The increase for the nine months ended March 31, 2017 relates primarily to increased compensation costs and incurred travel offset by a decrease in professional services and employee training expenditures.

Other income for the three months ended March 31, 2017 and 2016, was $47,399 and $16,952, respectively. Other income for the nine months ended March 31, 2017 and 2016, was $85,076 and $79,566, respectively. The increase is primarily due to an increase in interest income resulting from the increase in investment securities, partially offset by a reduction in scrap sales.

The Company’s effective tax rates for the three and nine months ended March 31, 2017, were 28.7% and 29.0%, respectively, compared to 29.7% and 29.5% for the three and nine months ended March 31, 2016. 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 March 31, 2017, was $279,173 or $0.12 per share both basic and diluted, respectively compared to $972,468 or $0.43 per share both basic and diluted, for the three months ended March 31, 2016. Net income for the nine months ended March 31, 2017, was $944,076 or $0.41 per share both basic and diluted compared to $2,465,425 or $1.08 per share both basic and diluted for the nine months ended March 31, 2016. The decrease in net income per share for the three and nine months ended March 31, 2017 compared to the same period in 2016 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 March 31, 2017 and June 30, 2016.

The Company's working capital as of March 31, 2017 and 2016 was approximately $29.7 million and $29.5 million, respectively. During the three and nine-months ended March 31, 2017 the Company repurchased 0 and 1,663 shares previously held in the ESOP for $0 and $44,336. During the three and nine months ended March 31, 2016 the Company repurchased 0 and 14,303 shares of its common stock from the ESOP for a purchase price of $0 and $355,418, respectively. Under existing authorizations from the Company's Board of Directors, as of March 31, 2017, 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 increase in cash provided by operating activities primarily relates to a decrease in net income offset by the reduction in payments for inventory purchases for the period and a decrease in accounts receivable. Net cash used by investing activities increased in the first nine 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 nine months ended March 31, 2017 compared with the same period in 2016. In addition, cash expended for the nine months ended March 31, 2016 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 nine months ended March 31, 2017 and 2016, the Company expended $331,686 and $140,340, 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.