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 2022 to be higher than revenues during fiscal year 2021 and expects to generate net income per share as compared to the net loss per share realized during fiscal year 2021. These expectations are driven by orders already in our sales backlog. Management continues to closely monitor the impact of evolving workforce and supplier constraints, primarily from the effects from the pandemic, to our planned delivery schedules. We continue to experience disruptions from workforce absences due to COVID-19 illnesses and direct contact exposures, resulting in self-isolating protocols to be followed to ensure the safety of company personnel. In addition, we are experiencing disruptions from workforce turnover, as local businesses emerging from the pandemic compete for personnel. Many of our positions require certain skillsets resulting in longer than average time to fill position vacancies. Some company suppliers continue to incur similar disruptions, in addition to incurring longer lead times on certain raw materials. 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 certain development programs. However, these delays are being resolved as they arise and we do not expect any negative impact on our customer order fulfillment projections for fiscal year 2022. In April 2021, we received qualification approval on a significant engineering design and production contract which allows us to begin the manufacturing of end units. Engineering programs in both the funded and unfunded portions of the current backlog aggregate $8.9 million. The Company currently expects new orders in fiscal 2022 to approximate those received in fiscal year 2021. 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 2021 the Company received $38.5 million in new orders. Our total backlog at June 30, 2021 was $65.6 million, as compared to $54.9 million at June 30, 2020. Currently, we expect a minimum of $38 million of orders comprising the June 30, 2021 backlog will be filled during the fiscal year ending June 30, 2022. This $38 million will be supplemented by shipments which may be made against orders received during the 2022 fiscal year. In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $75.3 million in the aggregate as of August 31, 2021, 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. Four significant customers represented approximately 59.4% of the Company’s total sales in fiscal year 2021 and two significant customers represented 38% of the Company’s total sales in fiscal year 2020. These sales are in connection with multiyear programs in which the Company is a significant contractor. The June 30, 2021 backlog of $65.6 million included orders from five customers that represent 15%, 15%, 14%, 13%, and 10%, respectively, of the total backlog. The June 30, 2020 backlog of $54.9 million includes orders from four customers that represent 19%, 13%, 10%, 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. 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 2022. 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, general operations of the business and dividend payments when applicable. 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. 7 Results of Operations Net sales for the years ended June 30, 2021 and 2020 were $27,734,598 and $31,526,231, respectively, a 12% decrease. The decrease in net sales in fiscal year 2021 is primarily due to a decrease in power supply and magnetics sales offset, in part, by an increase in build to print shipments. In general, sales fluctuations within product categories will occur during a comparable fiscal period as the direct result of product mix, influenced by the duration of specific programs and the contractual terms of firm orders placed for product and services under those programs including contract value, scope of work and duration. Deliverables within firm contracts are often subject to delivery schedules. Internal and external constraints, at times, impact our ability to ship. Sales results during the twelve months ended June 30, 2021 were impacted by our inability to manufacture and ship product during the third quarter due to an unplanned facility closure resulting from a significant workforce COVID-19 exposure. This closure lasted approximately 10 days with the facility re-opening at less than full capacity. These delays in production placed strain on an already aggressive production and shipment schedule in place for the fourth quarter. Also impacting sales during the fiscal year ended June 30, 2021, specific to power supply shipments, is the decline in procurement for product supporting the rail industry and the decrease in shipments against a single military contract which had no sales in the fiscal year when compared to the prior year. This decline was offset, in part, by an increase in build to print contracts of varying size, scope and duration. In addition, we continued to be constrained by (i) engineering design changes required to meet customer requirements, (ii) certain supplier product non-conformances, (iii) delays in obtaining timely resolutions on issues encompassing build to print customer-owned drawings, and (iv) 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 also experiencing an increase in delays with certain supplier deliveries resulting from effects of the COVID-19 pandemic. 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 in the near future. As of April 2021, we received qualification approval on a significant engineering design and production contract which allows us to begin the manufacturing of end units. Gross profits for the twelve months ended June 30, 2021 and 2020 were $3,359,607 and $5,558,615, respectively. Gross profit as a percentage of sales was approximately 12.1% and 17.6%, for the same periods, respectively. The primary factors in determining the change in gross profit and net income (loss) 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. Impacting sales and gross profits in the current fiscal year, when compared to the prior year, was an unplanned facility shutdown during the third quarter which lasted approximately 10 days due to the COVID-19 pandemic. Several additional factors contributed to a decrease in the gross profit and the gross profit percentage in the twelve months ended June 30, 2021 as compared to the same period in 2020. Most significantly, the Company recognized as a reduction to income, increased costs on two specific engineering design and production contracts, one of which incurred an increase in both material and labor anticipated costs and the other primarily consisting of unforeseen material escalation costs to complete the production builds. Second, the Company wrote down the value of inventory pertaining to a certain design and production contract serving the airline industry which was cancelled by the customer during the second quarter of the fiscal year. Finally, sales on several build to print contracts and one specific large magnetics contract, which yielded lower margins, represented a higher volume of the overall product mix in fiscal 2021, thereby resulting in lower gross profit realized in the year. Selling, general and administrative expenses were $3,785,746 for the fiscal year ended June 30, 2021; a decrease of $600,561 compared to the fiscal year ended June 30, 2020. The decrease for the fiscal year ended June 30, 2021 as compared to the same period in 2020 relates primarily to the decrease in costs incurred for employee compensation, travel, board of director’s fees due to a reduction of one director, outside services supporting sales leads, outside selling costs for commissions paid on certain contracts, and outgoing freight costs due to a decrease in shipments. These decreases were offset in part by an increase in costs associated with recruiting for position vacancies. Employee compensation decreased due to a reduction in workforce and cost reduction measures implemented that included forgoing cost of living increases and the payment of bonuses during the current fiscal year. 8 Other income for the fiscal year ended June 30, 2021 and 2020 was $57,942 and $136,881, respectively. The decrease in the twelve months ended is primarily due to a decrease in interest income. Interest income is a function of the level of investments and investment strategies that generally tend to be conservative. The decrease in interest income in the current fiscal year resulted from the reduction and timing of investments made, offset in part, by a gradual decrease in overall current yield percentages earned on those investments. The Company’s effective tax rate was 50.7% in the fiscal year 2021 and 11.1% in fiscal year 2020. The effective tax rate in fiscal 2021 and 2020 varies from the statutory tax rate mainly due to the benefit derived from the ESOP dividends paid on allocated shares. The increase in the effective tax rate between periods is primarily due to the reduction in income before taxes and the benefits received in the current fiscal year on the ESOP dividends paid as well as the tax rate differential associated with the net operating loss carryback which resulted from the net loss incurred in the current fiscal year. The Company had a net loss for fiscal year 2021 of $(181,543) or $(0.08) per share, basic and diluted compared to net income of $1,163,668 or $0.49 per share, basic and diluted, for fiscal year 2020. The decrease in net income in the twelve months ended June 30, 2021 compared to the same period in 2020 is primarily attributable to lower sales, a lower gross profit margin percentage, and a decrease in other income offset, in part, by a decrease in selling, general, and administrative expenses and the benefit derived from the increase 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, 2021 and 2020. The line of credit is reviewed annually in November for renewal by December 1 st . The Company's working capital as of June 30, 2021 and 2020 was $27.5 million and approximately $28 million, respectively. The Company may at times be required to repurchase shares at the ESOP participants’ request at the fair market value. During the twelve months ended June 30, 2021 the Company did not repurchase any shares held by the ESOP. During the twelve months ended June 30, 2020 the Company repurchased 2,180 shares of its common stock previously held by the ESOP for a purchase price of $47,949. Under existing authorizations from the Company's Board of Directors, as of June 30, 2021, 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: 2021 2020 Net cash provided by operating activities $ 594,996 $ 5,968,511 Net cash provided by investing activities 2,006,910 326,010 Net cash used in financing activities (1,201,316 ) (2,355,160 ) 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 decrease in cash provided by operating activities compared to the prior year primarily relates to the decrease in net income, the increase in inventory purchases, the decrease in cash collected from customers as cash advances and an increase in payments to vendors offset, in part, by an increase in trade accounts receivables collected. Net cash provided by investing activities increased in the twelve months ended June 30, 2021 as compared to the same period in 2020 primarily due to maturing investments that were not reinvested during this period when compared to the same period last year. Cash used in financing activities decreased during the fiscal year ended June 30, 2021. The decrease is primarily due to the suspension and non-payment of the quarterly dividend during the last two quarters of the fiscal year and a decrease in cash proceeds collected from the exercise of stock options, offset by the decrease in the purchase of treasury stock as compared to the same period last year. 9 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, 2021 and 2020, the Company expended $43,554 and $214,421, respectively, for plant improvements and new equipment. The Company has budgeted approximately $200,000 for new equipment and plant improvements in fiscal year 2022. 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. 10