ESP Espey Manufacturing and Electronics Corp

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Espey Mfg. & Electronics Corp. (the "Company") located in Saratoga Springs, New York, is engaged principally in the development, design, production and sale of specialized electronic power supplies, a wide variety of transformers and other types of iron-core components, and electronic system components. In some cases, the Company manufactures such products in accordance with pre-developed mechanical and electrical requirements ("build to print"). In other cases, the Company is responsible for both the overall design and manufacture of the product. The Company does not generally manufacture standardized components and does not have a product line. The products manufactured by the Company find application principally in (i) shipboard and land based radar, (ii) locomotives,
(iii) aircraft, (iv) short and medium range communication systems, (v) navigation systems, and (vi) land-based military vehicles.

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. The Company is also on the eligible list of contractors of the United States Department of Defense and generally is automatically solicited by such agencies for procurement needs falling within the major classes of products produced by the Company. In addition, the Company directly solicits bids from the United States Department of Defense for prime contracts.

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. The Company, as well as other companies engaged in supplying equipment for military use, is subject to various risks, including, without limitation, dependence on United States and foreign government appropriations and program allocations, the competition for available military business, and government termination of orders for convenience.

In the first three months of fiscal 2008, the Company received approximately $4.2 million in new orders. These orders include both follow-on production quantities for mature products, and engineering development orders which will enable the Company to utilize its engineering expertise in developing new customer specific products. Some of these products, once developed, will be produced in the Company's manufacturing facility and are expected to provide large production order quantities over several years. These orders are in line with the Company's strategy of being involved in long-term high quantity military and industrial products.

The sales backlog of approximately $34.1 million at September 30, 2007 gives the Company a solid base of future sales and, therefore, management expects sales for fiscal 2008 to equal or exceed sales for fiscal 2007. In addition to the backlog, the Company currently has outstanding quotations and expected business representing approximately $42 million in the aggregate for both repeat and new programs.

Sales to two significant customers in the first quarter of fiscal 2008 and 2007 represented 56.9% and 56.8%, respectively, of the Company's total sales. While the Company has always had a small number of customers that account for a large percentage of its total sales in any given year, management is pursuing business opportunities involving significant product programs with new and current customers with an overall objective of lowering the concentration of sales and minimizing the impact of a significant customer or excessive reliance upon a single major product program of a particular customer. The current backlog of $34.1 million includes $23.5 million from these two customers at September 30, 2007.

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 or all 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 military procurement generally.

The total backlog for the Company of $34.1 million at September 30, 2007, down $1.5 million over September 30, 2006, represents the estimated remaining sales value of work to be performed under firm contracts. These contracts include significant orders for military and industrial power supplies, and contracts to manufacture certain customer products in accordance with pre-engineered requirements. The funded portion of this backlog at September 30, 2007 is approximately $33.8 million. This includes items that have been authorized and appropriated by Congress and/or funded by the customer. The unfunded backlog is approximately $316,000 and represents one order for which funding has not yet been received from the customer. While there is no guarantee that future budgets and appropriations will provide funding for a given program, management has included in unfunded backlog only those programs that it believes are likely to receive funding. The unfunded backlog at September 30, 2006 was $4.3 million.

Management, along with the Board of Directors, continues to evaluate the availability of and use of the Company's working capital. Expectations are that the working capital will be required to fund new orders over the next several quarters, dividend payments, and general operations of the business. Also, the Mergers and Acquisitions Committee of the Board of Directors continues to evaluate potential strategic options on a periodic basis.

Critical Accounting Policies and Estimates

Management believes our most critical accounting policies include revenue recognition and estimates to completion.

A significant portion of our business is comprised of development and production contracts. Generally, revenues on long-term fixed-price contracts are recorded on a percentage of completion basis using units of delivery as the measurement basis for progress toward completion.

Percentage of completion accounting requires judgment relative to expected sales, estimating costs and making assumptions related to technical issues and delivery schedule. Contract costs include material, subcontract costs, labor and an allocation of overhead costs. The estimation of cost at completion of a contract is subject to numerous variables involving contract costs and estimates as to the length of time to complete the contract. Given the significance of the estimation processes and judgments described above, it is possible that materially different amounts of expected sales and contract costs could be recorded if different assumptions were used, based on changes in circumstances, in the estimation process. When a change in expected sales value or estimated cost is determined, changes are reflected in current period earnings.

Results of Operations

Net sales for the three months ended September 30, 2007 were $6,301,786 as compared to $6,071,906 for the same period in 2006, representing a 3.8% increase. Generally, this increase can be attributed to the contract specific nature of the Company's business. The Company continues to deliver product on its single largest order for power supplies and the increase in sales for the quarter is largely attributable to an increase in shipments on this order. New orders received in the first three months of fiscal 2008 were approximately $4.2 million compared to approximately $3.9 million in the first three months of fiscal 2007. The sales order backlog has been over $30 million for ten quarters in a row and expectations are this trend will continue.

The primary factor in determining gross profit and net income is product mix. The gross profits on mature products and build to print contracts are higher than with respect to the products, which are still in the engineering development stage or in the early stages of production. In any given accounting period the mix of product shipments between higher margin mature programs and less mature programs including loss contracts, has a significant impact on gross profit and net income.

For the three months ended September 30, 2007 and 2006 gross profits were $ 1,349,110 and $1,397,308, respectively. Gross profit as a percentage of sales was 21.4% and 23%, for the three months ended September 30, 2007 and 2006, respectively. The reduced gross profit percentage in the three months ended September 30, 2007, was the result of higher overhead expenses including supervisory labor for quality control and production, ESOP contribution, production supplies and maintenance. Management continues to evaluate the Company's workforce to ensure that production and overall execution of the backlog orders and additional anticipated orders are successfully performed. Employment at September 30, 2007 was 182 compared to 173 people at September 30, 2006.

Selling, general and administrative expenses were $667,553 for the three months ended September 30, 2007, a decrease of $59,427 compared to the three months ended September 30, 2006. The decrease is primarily due to the decreased labor for administrative purposes and lower selling costs due to reduced headcount.

Other income for three months ended September 30, 2007 increased as compared to the three months ended September 30, 2006, due to increased interest income on the Company's cash and cash equivalents and short-term investments due to higher interest rates. The Company does not believe that there is a significant risk associated with its investment policy, since at September 30, 2007 all of the investments are primarily represented by short-term liquid investments including certificates of deposit and money market funds.

The effective income tax rate at September 30, 2007 and 2006 was 34.1% and 33.7% respectively. The effective tax rate for September 30, 2006 is less than the statutory tax rate mainly due to the foreign exportation benefit the Company receives on its international sales, the Qualified Production Activities benefit, and the benefit derived from the ESOP dividends paid on allocated shares.

Net income for the three months ended September 30, 2007, was $591,583 or $.29 and $.28 per share, basic and diluted, respectively, compared to $543,050 or $.27 and $.26 per share, basic and diluted, respectively, for the three months ended September 30, 2006. The increase in net income per share was due to the decrease in selling, general and administrative expenses, increased interest income, offset partially by reduced gross profit as a percentage of sales.

Liquidity and Capital Resources

The Company's working capital is an appropriate indicator of the liquidity of its business, and during the past three 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 three 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. This line of credit expires on November 30, 2007.

The Company's working capital as of September 30, 2007 was approximately $28.5 million. During the three months ended September 30, 2007 and 2006 the Company repurchased 16,743 and 1,766 shares, respectively, of its common stock from the Company's ESOP, for a total purchase price of $370,857 and $31,126, respectively. Under existing authorizations from the Company's Board of Directors, as of September 30, 2007, management is authorized to purchase an additional $1,629,143 of Company stock.

 Three Months Ended September 30,
 2007 2006
 ------------ ------------
Net cash provided by operating activities $ 533,506 $ 1,560,125
Net cash used in investing activities (72,359) (397,933)
Net cash used in financing activities (521,179) (170,456)

Net cash provided by operating activities fluctuates between periods primarily as a result of differences in net income, the timing of the collection of accounts receivable, purchase of inventory, level of sales and payment of accounts payable. Net cash used in investing activities decreased in the first three months of fiscal 2008 due to the increase in maturities of short-term investments. The increase in cash used in financing activities is due primarily to the purchases of treasury stock during the current quarter.

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 three months ended September 30, 2007 and 2006, the Company expended $72,359 and $109,933, respectively, for plant improvements and new equipment. The Company has budgeted approximately $400,000 for new equipment and plant improvements in fiscal 2008. Management presently anticipates that the funds required will be available from current operations.

The Company at certain times enters into standby letters of credit agreements with financial institutions primarily relating to the guarantee of future performance on certain contracts. Contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at September 30, 2007.

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, maintenance and potential increase of the Company's backlog, 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.