ESPEY MFG & ELECTRONICS CORP 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Business Outlook Management expects revenues in fiscal year 2021 to be higher than revenues during fiscal year 2020 and expects the net income per share to be higher in fiscal year 2021 than the net income per share during fiscal year 2020. This expectation is driven by orders already in our sales backlog. The Company currently expects new orders in fiscal 2021 to approximate those received in fiscal year 2020. 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. During fiscal year 2020 the Company received $40.9 million in new orders. Our total backlog at June 30, 2020 was $54.9 million, as compared to $45.6 million at June 30, 2019. Currently, we expect a minimum of $32 million of orders comprising the June 30, 2020 backlog will be filled during the fiscal year ending June 30, 2021. This $32 million will be supplemented by shipments which may be made against orders received during the 2021 fiscal year. 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 $5.1 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 initial country and state-wide mandated closures of non-essential businesses lasting various durations as determined under local jurisdictions. In most instances, businesses have since re-opened, some with limited or reduced capacity due to adherence and compliance with reopening and mitigation guidelines set in place to help prevent workplace exposures. Deemed an essential business, authorized by the Department of Homeland Security, we remained open and continue to be fully operational. Global supply chain disruptions from closures had a minor impact on our ability to ship product during the third and fourth quarters. However, because the effects of the pandemic continue, world-wide, we believe it is likely we will continue to experience some trickle-down effects to our direct supply base which may impact our ability to ship certain scheduled deliveries during 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 material costs. To date, we have experienced some slowdown in customer procurements and government contract awards. We continue to work with our customers and suppliers to mitigate issues as they become known. In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $84 million in the aggregate as of September 10, 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. Two significant customers represented approximately 38% of the Company’s total sales in fiscal year 2020 and three significant customers represented 54% of the Company’s total sales in fiscal year 2019. These sales are in connection with multiyear programs in which the Company is a significant contractor. The June 30, 2020 backlog of $54.9 million included orders from four customers that represent 19%, 13%, 10%, and 10%, respectively, of the total backlog. The June 30, 2019 backlog of $45.6 million includes orders from five customers that represent 16%, 13%, 11%, 11% and 10%, respectively, of the total backlog. Although improvement has been made in customer concentrations, this high customer concentration level continues to present significant risk. A loss of one of these customers or programs related to these customers, or customer requested deferrals of product delivery 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, mitigating excessive reliance upon a single major product of a particular program and minimizing the impact of the loss of a single significant customer. Given the nature of our business, we believe our existing sales order backlog is fairly diversified in terms of customers and the category of products on order. 7 Management, along with the Board of Directors, continues to evaluate the need and use of the Company’s working capital. Capital expenditures, primarily for machinery and equipment, are expected to be approximately $200,000 for fiscal year 2021. A majority of these expenditures will be made to stay competitive in the marketplace and to meet the needs of current contracts. Expectations are that the working capital will be required to fund orders, dividend payments, and general operations of the business. Management along with the Mergers and Acquisitions Committee of the Board of Directors will examine opportunities involving acquisitions or other strategic options, including buying certain products or product lines, provided that such opportunities demonstrate synergies with the Company’s existing product base and accretion to earnings. Results of Operations Net sales for the years ended June 30, 2020 and 2019 were $31,526,231 and $36,477,851, respectively, a 13.6% decrease. The decrease in net sales in fiscal year 2020 is primarily due to a decrease in power supply and build to print sales offset, in part, by an increase in magnetic shipments. The decrease in power supply sales is mainly due to reduced demand from one significant customer in the rail industry offset, in part, by an increase in shipments against a single military contract. The decline in build to print sales is primarily due to the timing of shipments across multiple contracts of varying size, scope and duration. The increase in magnetic shipments is primarily due to an increase in sales related to one major engineering development program, an increase in shipments on several repeat and new magnetic orders, offset, in part, by a decline in sales on another major engineering development program based on scheduled performance plans. In addition, sales were significantly impacted by our ability to meet contractual milestones on certain engineering design contracts and delays on several build to print orders. We continued to be constrained by engineering design changes required to meet customer requirements, certain supplier product non-conformances, obtaining timely resolutions on issues encompassing build to print customer-owned drawings and an increase in lead times for many parts, including certain electronic components due to industry shortages and volatility within the power electronics industry. Engineering, program management, and supply chain personnel are working closely with our customers and suppliers to execute on our past due deliveries and we do not expect this situation to affect future business opportunities. We anticipate that many of these issues will be resolved during fiscal 2021. Gross profits for the fiscal years ended June 30, 2020 and 2019 were $5,558,615 and $7,063,173, respectively. Gross profit as a percentage of sales was 17.6% and 19.4%, 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 twelve months ended June 30, 2020 compared to the same period in 2019. This decrease resulted from product mix, specifically related to the decrease in power supply shipments. This portfolio of products consists of many mature products which typically yield higher margins. The Company also incurred an increase in cost on a specific power supply contract due to the replacement cost associated with a recurring product failure stemming from an engineering design issue. In addition, the Company incurred specific program losses on several large build to print contracts due to higher than expected material costs and first time build and quality control inspections costs, as well as, a large engineering contract due to engineering delays, third-party supplier issues and additional testing required. These decreases were offset, in part, by an improved gross profit percentage on a separate large engineering design contract when compared to the same period in 2019. The improvement on the engineering contract resulted from reduced spending on the program and from additional funded and anticipated funding for required testing. Selling, general and administrative expenses were $4,386,307 for the fiscal year ended June 30, 2020; a decrease of $23,927 compared to the fiscal year ended June 30, 2019. The decrease for the fiscal year ended June 30, 2020 as compared to the same period in 2019 relates primarily to the decrease in bad debt expense, conferences and training costs, travel and entertainment expenses and product shipment costs. This decrease was offset, in part, by an increase in employee compensation costs. Other income for the fiscal year ended June 30, 2020 and 2019 was $136,881 and $228,694, respectively. The decrease in the twelve months ended is primarily due to a decrease in interest income on investments and income received from the sale of scrap metal. The decrease in interest income resulted from the gradual decrease 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 decrease in income from scrap metal sales is primarily due to a decrease in saleable metal remnants resulting from the overall decrease in material purchases during the current year when compared to the prior year. 8 The Company’s effective tax rate was 11.1% in the fiscal year 2020 and 18.7% in fiscal year 2019. 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 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 and the benefit derived from the ESOP special cash dividend paid on the allocated shares. Net income for fiscal year 2020 was $1,163,668 or $0.49 per share, basic and diluted compared to $2,342,694 or $0.99 and $0.98 per share, basic and diluted, respectively for fiscal year 2019. The decrease in net income in the twelve months ended June 30, 2020 compared to the same period in 2019 is primarily attributable to lower sales, a lower gross profit margin percentage, a decrease in other income offset, in part, by a decrease in selling, general, and administrative expenses and 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 June 30, 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 June 30, 2020 and 2019 was $27,993,023 and $28,377,168, respectively. During the twelve months ended June 30, 2020, the Company repurchased 2,180 shares of its common stock from the ESOP for a purchase price of $47,949. During the twelve months ended June 30, 2019 the Company repurchased 1,810 shares of its common stock from the ESOP for a purchase price of $44,888. Under existing authorizations from the Company's Board of Directors, as of June 30, 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: 2020 2019 Net cash provided (used in) by operating activities $ 5,968,511 $ (3,604,406 ) Net cash provided by investing activities 326,010 5,234,540 Net cash used in financing activities (2,355,160 ) (4,466,169 ) 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 an increase in prepaid expenses and other current assets and the decline in net income. Net cash provided by investing activities decreased in the twelve months ended June 30, 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 fiscal years ended June 30, 2020 and 2019, the Company expended $214,421 and $608,318, respectively, for plant improvements and new equipment. The Company has budgeted approximately $200,000 for new equipment and plant improvements in fiscal year 2021. 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. 9