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. (“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, fluctuating 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, 2020 was approximately $59.8 million, which included $32.7 million from four significant customers, compared to $45.4 million at March 31, 2019, which included $20.9 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, 2020 is approximately $58.6 million. This includes items that have been authorized and appropriated by Congress and/or funded by the customer. The unfunded backlog at March 31, 2020 is approximately $1.2 million and represents a firm multi-year order 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, 2019 was $3.5 million, comprised of firm multi-year orders on two separate programs, of which $2.7 million relates to the same multi-year order unfunded in the current fiscal period.

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.  We continue to experience technical and schedule delays with our major development programs. The issues causing the delays are being resolved as they arise. Engineering programs in both the funded and unfunded portions of the current backlog aggregate $4.7 million. 

The global outbreak of the novel strain of coronavirus COVID-19 disease was declared a pandemic by The World Health Organization (WHO) during March 2020. This resulted in country and state-wide mandated closures of non-essential businesses, some of which are still in effect. In certain instances, where mandates have been lifted, businesses have re-opened with limited or reduced capacity. We have remained open and fully operational, as we were authorized by the Department of Homeland Security as an essential business and member of the Defense Industrial Base Essential Critical Infrastructure Workforce. The Defense Industrial Base includes workers who support the essential products and services required to meet national security commitments to the Federal Government and the U.S. Military. Companies aligned with the essential critical infrastructure workforce are expected to maintain their normal work schedules and expected to follow guidance from the Centers for Disease Control and Prevention as well as state and local government officials regarding strategies to limit disease spread. Global supply chain disruptions from closures had a minor impact on our ability to ship product during the third quarter, however, because the effects of the pandemic continue, world-wide, we believe it is likely we will experience some trickle-down effects to our direct supply base which may impact our ability to ship certain scheduled deliveries during the fourth quarter and potentially could impact scheduled deliveries through the first half of fiscal 2021. Presently, we expect these disruptions to be minimal in nature and could result in our suppliers extending lead times for materials or, in some rare instances, require us to procure materials from an alternate supplier in order to meet contractual dates which could impact our anticipated materials costs. To date, we anticipate a slowdown in customer procurements and government contract awards which are expected to be temporary and minimal in nature. We continue to work with our customers and suppliers to best mitigate issues as they become known.

Management anticipates revenue and gross profit for the fiscal year ended June 30, 2020 to be lower when compared to the same period in 2019. The lowered revenue expectation is primarily driven by delays in several engineering design contract deliverables where on-going design changes and challenges to meet customer statement of work requirements continued to persist during the quarter ended March 31, 2020. These changes and challenges are typically identified during various phases of testing. The time and resources required to resolve these issues can vary, making the accuracy of revenue projections difficult. In addition, prior to the pandemic, we were made aware of certain supplier lead times which will impact our ability to ship certain planned commitments in the fourth quarter. As factors such as engineering delays, 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 2020 were $33.6 million as compared to approximately $22.2 million of new orders received in the first nine months of fiscal 2019. It is presently anticipated that a minimum of $14.6 million of orders comprising the March 31, 2020 backlog will be filled during the fiscal year ending June 30, 2020. The minimum of $14.6 million does not include any shipments, which may be made against orders subsequently received during the fiscal year ending June 30, 2020. The estimate of the March 31, 2020 backlog to be shipped in fiscal year 2020 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 $91 million in the aggregate as of May 1, 2020 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 one significant customer represented 33% of the Company’s total sales for the three-month period ended March 31, 2020. Net sales to two significant customers represented 49.4% of the Company’s total sales for the three-month period ended March 31, 2019. Net sales to one significant customer represented 27.7% of the Company’s total sales for the nine-month period ended March 31, 2020. Net sales to two significant customers represented 54.4% of the Company’s total sales for the nine-month period ended March 31, 2019. 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. 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 obligations. 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

Raw materials are valued at the lower of cost (average cost) or net realizable value. Balances for slow-moving and obsolete inventory are reviewed on a regular basis by analyzing estimated demand, inventory on hand, sales levels, market conditions, and other information and reduce inventory balances based on this analysis.

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, the change is reflected in current period earnings.

Contract Liabilities

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

Results of Operations

Net sales decreased for the three months ended March 31, 2020 to $6,191,300 as compared to $9,218,141 for the same period in 2019. Net sales for the nine months ended March 31, 2020 decreased to $19,401,793 as compared to $24,858,649 for the same period in 2019. For the three months ended March 31, 2020, the decrease in net sales is primarily due to a decrease in power supply, build to print, and magnetic sales. For the nine months ended March 31, 2020, the decrease in net sales is primarily due to a decrease in build to print and power supply sales offset, in part, by an increase in magnetic shipments.

Our ability to ship product or to meet contractual milestones 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 past due deliveries and we do not expect this situation to impact future business. We anticipate that many of these issues will be resolved in the fourth quarter and should not significantly impact results in fiscal year 2021.

Gross profits for the three months ended March 31, 2020 and 2019 were $910,933 and $2,150,439, respectively. Gross profit as a percentage of sales was 14.7% and 23.3%, for the same periods, respectively. For the nine months ended March 31, 2020 and 2019, gross profits were $3,527,429 and $4,659,608, respectively. Gross profit as a percentage of sales was 18.2% and 18.7%, 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,” primarily on 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 months ended March 31, 2020 as compared to the same period in 2019, primarily resulting from product mix and margin erosion on two specific build to print contracts resulting from an increase in material costs and first time build and quality control inspection costs. In addition, due to a recurring product failure relating to an engineering design issue, the company incurred a current quarter charge on a power supply contract. This issue has been resolved and is not anticipated to impact future results. These decreases were offset, in part, by an improved gross profit percentage related to a specific engineering design contract when compared to the same period in 2019. This improvement resulted from reduced spending on the program and from additional anticipated funding for required testing. The gross profit percentage decreased slightly in the nine months ended March 31, 2020 compared to the same period in 2019 resulting primarily from a decline related to product mix and increased costs on three specific production contracts incurred in the current quarter offset, in part, by an improved gross profit percentage on two specific engineering design contract when compared to the same period in 2019. The improvement on the larger engineering contract resulted from reduced spending on the program and from additional anticipated funding for required testing.

Selling, general and administrative expenses were $1,057,034 for the three months ended March 31, 2020, a decrease of $12,036, compared to the three months ended March 31, 2019. Selling, general and administrative expenses were $3,390,988 for the nine months ended March 31, 2020, an increase of $16,687 compared to the nine months ended March 31, 2019. The decrease for the three months ended March 31, 2020 as compared to the same period in 2019 relates primarily to the decrease in professional services, travel and entertainment costs, and a reduction in director fees due to a board member retirement effective in December 2019. This decrease was offset, in part, by an increase in employee compensation costs. The increase for the nine months ended March 31, 2020 as compared to the same period in 2019 relates primarily to an increase in compensation costs offset, in part, by the decrease in bad debt expense, conferences and training and professional service costs.

Other income for the three months ended March 31, 2020 and 2019 was $23,518 and $45,254, respectively. Other income for the nine months ended March 31, 2020 and 2019 was $109,771 and $174,686, respectively. The decrease for the three and nine 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. 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, 2020, were 15.4% and 15.9%, respectively, compared to 18.1% and 17.7% for the three and nine months ended March 31, 2019, respectively. The effective tax rate in fiscal 2020 and 2019 is less than the statutory tax rate mainly due to the benefit derived from the ESOP dividends paid on allocated shares. The decrease in the effective tax rate between fiscal years is primarily due to a decrease in income before taxes.    

The net loss for the three months ended March 31, 2020, was $(103,765) or $(0.04) per share, basic and diluted, compared to net income of $922,456 or $0.39 per share, basic and diluted, for the three months ended March 31, 2019. Net income for the nine months ended March 31, 2020, was $206,975 or $0.09 per share, basic and diluted, compared to $1,201,886 or $0.51 and $0.50 per share, basic and diluted, for the nine months ended March 31, 2019. The decrease in net income in the current quarter resulted from lower sales and a decrease in the gross profit percentage offset, in part, by the benefit received from a lower effective tax rate, all discussed above. The decrease in net income in the nine months ended March 31, 2020 compared to the same period in 2019 is primarily attributable to lower sales, a lower gross profit margin percentage, an increase in selling, general, and administrative expenses, a decrease in other income offset, in part, by the benefit derived from the decrease in the effective tax rate, all 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, 2020 and 2019. The line of credit is reviewed annually in November for renewal by December 1^st.

The Company's working capital as of March 31, 2020 and 2019 was approximately $27.2 million. The Company may at times be required to repurchase shares at the ESOP participants’ request at the fair market value. During the three and nine months ended March 31, 2020 the Company repurchased 0 and 2,180 shares previously held by the ESOP for $0 and $47,949, respectively. During the three and nine months ended March 31, 2019 the Company did not repurchase any shares held by the ESOP. Under existing authorizations from the Company's Board of Directors, as of March 31, 2020, management is authorized to purchase an additional $783,460 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, provision 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 compared to the prior year primarily relates to the collection of trade receivables and the increase in contract liabilities for the collection of customer advances offset, in part, by a decrease in accounts payable, an increase in prepaids and other current assets, and the decline in net income. Net cash provided by investing activities decreased in the nine months ended March 31, 2020 as compared to the same period in 2019 primarily due to the reinvestment of maturing investments when compared to the same period in 2019. In the prior period, cash received from maturing investments was used, in part, for the payment of the special dividend. The decrease in cash used in financing activities in the current period when compared to the prior period is primarily due to the fact that a special dividend totaling $1.00 per share was declared and paid in the prior period.

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, 2020 and 2019, the Company expended $210,527 and $538,550, respectively, for plant improvements and new equipment. The Company has budgeted approximately $300,000 for new equipment and plant improvements in fiscal year 2020. 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 from the coronavirus (COVID-19) pandemic, 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.