Espey MFG & Electronics Corp: Form 10-Q for the period ended Mar 31, 2019

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 American 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 9001:2015 and AS9100:2016 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. Espey is also on the eligible list of contractors with the United States Department of Defense. We pursue opportunities for prime contracts directly with the Department of Defense and are generally automatically solicited by Department of Defense procurement agencies for their needs falling within the major classes of products produced by the Company. 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, ranging from divisions of the largest electronic companies, to 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 and industrial applications, and our customer concentrations expose us to on-going associated risks. These risks include, without limitation, requirements for power supplies in the rail industry, 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 strength of the industry sectors in which our customers transact business.

In order to compete effectively for new business, in some cases we have invested in upfront design costs, thereby reducing initial profitability as a means of procuring new long-term programs. As part of our strategy, we adjust our pricing in order to achieve a balance which enables us both to retain repeat programs while being more competitive in bidding on new programs.

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 engineering development designs transition to production.

The total backlog at March 31, 2019 was approximately $45.4 million, which included $20.9 million from three significant customers, compared to $47.0 million at March 31, 2018, which included $21.0 million from three significant customers. The Company’s total backlog represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog at March 31, 2019 is approximately $41.9 million. This includes items that have been authorized and appropriated by Congress and/or funded by the customer. The unfunded backlog at March 31, 2019 is approximately $3.5 million and represents firm multi-year orders on two separate programs for which funding has 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 individual programs, 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. The unfunded backlog at March 31, 2018 was $4.5 million, comprised of one order from a single customer.

Successful conversion of engineering program backlog into sales is largely dependent on the execution and completion of our engineering design efforts. It is not uncommon to experience technical or scheduling delays which arise from time to time as a result of, among other reasons, design complexity, the availability of personnel with the requisite expertise, and the requirements to obtain customer approval at various milestones. Cost overruns which may arise from technical and schedule delays could negatively impact the timing of the conversion of backlog into sales, or the profitability of such sales. While recently, we have experienced technical and schedule delays with our major development programs, these delays have been resolved as they arise and we do not expect any negative impact on our customer order fulfillment projections for fiscal year 2019. Engineering programs in both the funded and unfunded portions of the current backlog aggregate $5.6 million.

Management expects revenues in fiscal year 2019 to be higher than revenues during fiscal year 2018, but expects the gross profit margin to be lower in fiscal year 2019 as compared to the gross profit margin during fiscal year 2018. This expectation is driven primarily by lower profit margin orders already in our backlog that will be shipped in the current fiscal year and investments in engineering development orders. As market factors including competition and product costs impact gross profit margins, management will continue to evaluate our sales strategy, employment levels, and facility costs.

New orders received in the first nine months of fiscal year 2019 were approximately $22.2 million as compared to $28.6 million of new orders received in the first nine months of fiscal 2018. It is presently anticipated that a minimum of $12.2 million of orders comprising the March 31, 2019 backlog will be filled during the fiscal year ending June 30, 2019. The minimum of $12.2 million does not include any shipments, which may be made against orders subsequently received during the fiscal year ending June 30, 2019. The estimate of the March 31, 2019 backlog to be shipped in fiscal year 2019 is subject to future events, which may cause the amount of the backlog actually shipped to differ from such estimate.

In addition to the backlog, the Company currently has outstanding opportunities representing approximately $58 million in the aggregate as of May 1, 2019 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.

A significant portion of the Company’s business is the production of military and industrial electronic equipment for use by the U.S. and foreign governments and certain industrial customers. Net sales to two significant customers represented 47.2% and 50.6% of the Company’s total sales for the three-month period ended March 31, 2019 and 2018, respectively. Net sales to three significant customers represented 58.1% of the Company’s total sales for the nine-month period ended March 31, 2019 and net sales to two significant customers represented 58.6% of the Company's total sales for the nine-month period ended March 31, 2018. 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.

Critical Accounting Policies and Estimates

Management believes our most critical accounting policies include revenue recognition and cost estimation on our contracts.

Revenue

The majority of our net sales is generated from contracts with industrial manufacturers and defense companies, the Department of Defense, other agencies of the government of the United States and foreign governments for the design, development and/or manufacture of products. Contracts may be long-term in nature. We provide our products and design and development services under fixed-price contracts. Under fixed-price contracts we agree to perform the specified work for a pre-determined price. To the extent our actual costs vary from the estimates upon which the price was negotiated, we will generate more or less profit or could incur a loss.

We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance, and collectability of consideration is probable. We assess each contract at its inception to determine whether it should be combined with other contracts. When making this determination, we consider factors such as whether two or more contracts were negotiated and executed at or near the same time, or were negotiated with an overall profit objective.

We evaluate the products or services promised in each contract at inception to determine whether the contract should be accounted for as having one or more performance obligation. Significant judgment is required in determining performance obligations. We determine the transaction price for each contract based on the consideration we expect to receive for the products or services being provided under the contract. The transaction price for each performance obligation is based on the estimated standalone selling price of the product or service underlying each performance obligation. Transaction prices on our contracts subject to the Federal Acquisition Regulations (FAR) are typically based on estimated costs plus a reasonable profit margin.

We recognize revenue using the output method based on the appraisal of results achieved and milestones reached or units delivered based on contractual shipment terms, typically shipping point.

Inventory

Inventoried work relating to contracts in process and work in process is valued at actual production cost, including factory overhead incurred to date. Contract costs include material, subcontract costs, labor, and an allocation of overhead costs. Work in process represents spare units and parts and other inventory items acquired or produced to service units previously sold or to meet anticipated future orders. Provision for losses on contracts is made when the existence of such losses becomes probable and estimable. The provision for losses on contracts is included in other accrued expenses on the Company’s balance sheet. The costs attributed to units delivered under contracts are based on the estimated average cost of all units expected to be produced. Certain contracts are expected to extend beyond twelve months.

The estimation of total 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.

Contract Liabilities

Contract liabilities include advance payments and billings in excess of revenue recognized.

Results of Operations

Net sales increased for the three months ended March 31, 2019 to $9,218,141 as compared to $5,663,161 for the same period in 2018. Net sales for the nine months ended March 31, 2019 increased to $24,858,649 as compared to $24,690,689 for the same period in 2018. For the three months ended March 31, 2019, the increase in net sales is primarily due to an increase in magnetic sales consisting of certain engineering deliverables and product shipments on a specific long-term program, as well as, an increase in power supply shipments supporting the rail industry. For the nine months ended March 31, 2019, the slight increase in net sales is primarily due to an increase in build to print sales for product which had no shipments in the prior fiscal year, an increase in magnetic sales for the reasons discussed above, offset, in part, by a decrease in power supply shipments. Although shipments supporting the rail industry remain strong, the overall decline in power supply shipments in the current fiscal year relates primarily to the timing of shipments related to a specific military contract which had significant shipments in the prior fiscal year.

Our ability to ship product continues to be constrained by engineering design changes required to meet customer requirements, certain supplier product non-conformances and an increase in lead times for many parts including certain electronic components due to industry shortages and volatility within the power electronics industry. We are currently working closely with our customers and suppliers to execute on our current past due deliveries and we do not expect this situation to impact future business.

Gross profits for the three months ended March 31, 2019 and 2018 were $2,150,439 and $1,255,204, respectively. Gross profit as a percentage of sales was 23.3% and 22.2%, for the same periods, respectively. For the nine months ended March 31, 2019 and 2018, gross profits were $4,659,608 and $5,791,956, respectively. Gross profit as a percentage of sales was 18.7% and 23.5%, for the same periods, 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 increased in the three months ended March 31, 2019 compared to the same period in 2018 primarily due to an increase in sales while expenditures incurred during the period related to engineering design investments remained comparable to those incurred in the same period in 2018 offset, in part, by a slight overall decline in the gross profit percentage on product shipments. The gross profit percentage decreased in the nine months ended March 31, 2019 as compared to the same period in 2018 primarily due to the increase in expenditures incurred related to engineering design investments primarily pertaining to a specific contract while sales for the period remained flat when compared to the same period in 2018. This increase in spending on the specific engineering design contract reduced the gross profit percentage by 5.9% for the nine months ended March 31, 2019. The gross profit percentage was further reduced by a slight overall decline in the gross profit percentage on product shipments.

Selling, general and administrative expenses were $1,069,070 for the three months ended March 31, 2019; an increase of $173,941, compared to the three months ended March 31, 2018. Selling, general and administrative expenses were $3,374,301 for the nine months ended March 31, 2019; an increase of $617,982 compared to the nine months ended March 31, 2018. The increase for the three months ended March 31, 2019 as compared to the same period in 2018 relates primarily to the increase in employee compensation costs associated with added program management personnel supporting the Company’s sales backlog and professional services. The increase for the nine months ended March 31, 2019 as compared to the same period in 2018 relates primarily to an increase in employee compensation costs, professional services, and other miscellaneous expenses offset, in part, by a reduction in travel and incurred marketing costs.

Other income for the three months ended March 31, 2019 and 2018 was $45,254 and $56,112, respectively. Other income for the nine months ended March 31, 2019 and 2018 was $174,686 and $140,797, respectively. The decrease for the three months ended is primarily due to the reduction in investment securities offset, in part, by the gradual increase in the current yield percentages earned on the investment securities. The increase in the nine months ended is primarily due an increase in interest income resulting from the gradual increase in current yield percentages earned on investment securities offset, in part, by a reduction in investment securities. Interest income is a function of the level of investments and investment strategies which generally tend to be conservative.

The Company’s effective tax rates for the three and nine months ended March 31, 2019, were 18.1% and 17.7%, respectively, compared to 23.6% and 25.2% for the three and nine months ended March 31, 2018. The statutory tax rate was reduced from 34% to 21% under the Tax Cuts and Jobs Act (the “Tax Act’) effective on January 1, 2018. The effective tax rate in fiscal 2019 is less than the statutory tax rate mainly due to the benefit derived from the ESOP dividends paid on allocated shares and for the tax benefit received in the first nine months of fiscal 2019 from the exercise of stock options. The effective tax rate in fiscal 2018 is less than the statutory tax rate mainly due to the benefit the Company received on its “qualified production activities” under The American Jobs Creation Act of 2004 which expired after the end of fiscal 2018 and the benefit derived from the ESOP dividends paid on allocated shares.

Net income for the three months ended March 31, 2019, was $922,456 or $0.39 per share, basic and diluted, compared to $317,764 or $0.14 per share, basic and diluted, for the three months ended March 31, 2018. Net income for the nine months ended March 31, 2019, was $1,201,886 or $0.51 and $0.50 per share, basic and diluted, respectively compared to $2,375,399 or $1.02 per share, basic and diluted, for the nine months ended March 31, 2018. The increase in net income per share for the three months ended March 31, 2019 was due to higher gross profit resulting primarily from an increase in sales offset, in part, by an increase in selling, general and administrative expenses when compared to the same periods in 2018. In addition, the company received a benefit in the current period from the reduction in the Company’s effective tax rate discussed above. The decrease in net income per share for the nine months ended March 31, 2019 was primarily due to a lower gross profit percentage resulting from an increase in expenditures related to engineering design investments made by the company when compared to the prior year and an increase in selling, general and administrative expenses when compared to the same periods in 2018 as discussed above. These increases were offset, in part, by a reduction in the Company’s effective tax rate discussed 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. Contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at March 31, 2019 and 2018. The line of credit is reviewed annually in November for renewal by December 1st.

The Company's working capital as of March 31, 2019 and 2018 was approximately $27.2 million and $30.0 million, respectively. During the three and nine-month period ended March 31, 2019, the Company did not repurchase any shares of its common stock from the Company’s Employee Retirement Plan and Trust (“ESOP”). During the three and nine months ended March 31, 2018 the Company repurchased 0 and 4,798 shares of its common stock from the ESOP for a purchase price of $0 and $109,694. Under existing authorizations from the Company's Board of Directors, as of March 31, 2019, management is authorized to purchase an additional $876,297 of Company stock.

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

Net cash used in operating activities fluctuates between periods primarily as a result of differences in sales and net income, provision for income taxes, the timing of the collection of accounts receivable, purchase of inventory, and payment of accounts payable. The increase in cash used in operating activities compared to the prior year primarily relates to a decrease in net income, an increase in accounts receivable and inventories attributed to the sales volume and backlog increases offset, in part, by a decrease in prepaid expenses and other current assets and an increase in accounts payable. Net cash provided by investing activities increased in the nine months ended March 31, 2019 as compared to the same period in 2018 is primarily due to an increase in maturing investments and a decrease in spending for the purchase of property, plant and equipment. The increase in cash used in financing activities in the current period is primarily related to the cash expended for the special dividend totaling $1.00 per share declared and paid in fiscal 2019 offset, in part, by proceeds received from the exercise of stock options during the current fiscal year.

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, 2019 and 2018, the Company expended $538,550 and $632,023, respectively, for plant improvements and new equipment. The Company has budgeted approximately $750,000 for new equipment and plant improvements in fiscal year 2019. Management anticipates that the funds required will be available from current operations.

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.

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, the impact of cyber or other security threats or other disruptions to our business, 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.