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 2023 to be higher than revenues during fiscal year 2022 and expects net income per share to be higher in fiscal 2023 as compared to the net income per share realized during fiscal year 2022. These expectations are driven by orders already in our sales backlog. Creating consistency in our quarter to quarter financial performance will remain a challenge as we navigate a current difficult environment of inflation and parts shortages. We saw improvement to our operations in the second half of fiscal year 2022 and expect continued improvement in fiscal year 2023. However, we continue to be constrained by (i) engineering design changes required to meet customer requirements, (ii) delays in obtaining timely resolutions on issues encompassing build to print customer-owned drawings, and (iii) 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. Effects from global events and the resulting supply chain disruptions continue to place pressure on the cost of raw materials, freight, utility, labor and other production and administrative costs. These inflationary cost challenges are expected to continue to have a negative impact on operating income in fiscal year 2023. Volatile raw material indexes and shortages have led to wide-spread vendor price increases. For our executed fixed-priced contracts, we will continue to either singularly or combined be 1) required to absorb the increased costs 2) continue to mitigate costs down through the identification of additional supply chain buying strategies or 3) submit for price remediation assistance from our customers. To minimize exposure on future fixed-priced contracts, we continue to incorporate inflationary increases to product quotations provided to our customers, some of which have resulted in significant price increases. Additionally, to minimize our exposure, we have, in many instances, reduced the time in which certain product quotations remain valid and have also extended lead times for product deliveries. We continue to work with our customers to mitigate any adverse impact upon our ability to service their requirements. Management continues to closely monitor the impact of evolving workforce labor constraints, primarily from the effects from the pandemic, on our planned delivery schedules. Although declining, we continue to experience periodic 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. Disruptions from workforce turnover has stabilized. Combined, with supply chain constraints, future unforeseen labor disruptions could delay shipments and result in missing our backlog fulfillment projections and recognizing lower operating income. 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 and increased raw material costs 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 major development programs. To date, we have been able to resolve various technical and scheduling delays and continue to work with our customers on newly arising delays. Engineering programs in both the funded and unfunded portions of the current backlog aggregate $7.3 million. The Company currently expects new orders in fiscal 2023 to be greater than those received in fiscal year 2022. 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 2022 the Company received $43.2 million in new orders. Our total backlog at June 30, 2022 was approximately $76.8 million, as compared to $65.6 million at June 30, 2021. Currently, we expect a minimum of $35 million of orders comprising the June 30, 2022 backlog will be filled during the fiscal year ending June 30, 2023. This $35 million will be supplemented by shipments which may be made against orders received during the 2023 fiscal year. 7 In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $74.6 million in the aggregate as of August 31, 2022, 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 57.2% of the Company’s total sales in fiscal year 2022 and four significant customers represented approximately 59.4% of the Company’s total sales in fiscal year 2021. These sales are in connection with multiyear programs in which the Company is a significant contractor. The June 30, 2022 backlog of $76.8 million included orders from five customers that represent approximately 16%, 16%, 15%, 13%, and 12%, respectively, of the total backlog. The June 30, 2021 backlog of $65.6 million included orders from five customers that represented approximately 15%, 15%, 14%, 13%, and 10%, respectively, of the total backlog. 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 and for a building roof restoration project not completed in fiscal 2022 due to the backorder of materials, are expected to approximate $500,000 for fiscal year 2023. 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. Results of Operations Net sales for the years ended June 30, 2022 and 2021 were $32,104,774 and $27,734,598, respectively, an approximate 16% increase. The increase in net sales in fiscal year 2022 is primarily due to an increase in magnetic and power supply 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 which also contributes to sales fluctuations between comparable periods. We saw improvement to our operations in the second half of the year which eased our previous inability to ship on specific contracts. We processed and converted certain past due supply chain deliveries into product shipments and completed certain past due engineering milestone deliverables. We expect continued improvement on current engineering delays as new employees come up to speed on contracts and related statement of work specifications and material delays. In addition, contracts impeded by actions required from our customers have been resolved or are moving forward towards resolution. However, the impact of ongoing global events, most notably the COVID-19 pandemic, is expected to continue to impact operational instability primarily in our supply chain, with increased lead times and increased costs from inflationary pricing. Unplanned employee absences due to sickness and self-isolating protocols continues, but have been significantly less when compared to the prior year. Disruptions from workforce turnover has stabilized. Our focus remains to work with our customers and suppliers to identify alternative strategies to reduce lead times and maximize sales and operating income. Specific to net sales for the twelve month periods discussed above, the sales fluctuations when compared to the same periods last year were primarily the direct result of an unplanned facility closure which occurred in March 2021 due to a significant workforce COVID-19 exposure. The closure lasted approximately 10 days with the facility re-opening at less than full capacity. In addition, the increase in sales in the current fiscal year was influenced by product mix, contractual due dates, and our ability to deliver on certain past due customer orders which had been delayed due to extended raw material lead times. Specific to magnetic shipments, sales increased from more shipments on specific contracts related to a family of power distribution transformers for a single customer when compared to the prior year. In addition, an increase in magnetic sales is attributable to increased deliveries against a large magnetics contract for transformers originally designed in-house and an increase in milestone deliveries on a large on-going development program for a power distribution panel. Specific to power supply shipments, the increase in sales is primarily attributable to product supporting the rail industry when compared to a year ago, also attributable to the timing of deliveries on existing contracts and additional follow-on orders received. 8 Gross profits for the twelve months ended June 30, 2022 and 2021 were $5,472,158 and $3,359,607, respectively. Gross profit as a percentage of sales was 17% and 12.1%, 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. The improvement in gross profit in the twelve months ended June 30, 2022 as compared to the same period in 2021 resulted from an increase in sales and overall product mix comprising shipments. In addition, gross profit for the twelve month period improved when compared to the prior year as specific items which negatively impacted prior year results did not have a negative impact on gross profit recognized in the current year. Reductions to gross profit in the prior year included lower sales as the result of an unplanned facility shutdown in the third quarter of last year and the costs incurred for an inventory write-down for a design and production contract serving the airline industry which was cancelled by the customer during the prior fiscal year and with respect to which the Company was unsuccessful in being awarded restitution. Last year, two specific engineering design and production contracts, on which we incurred increased costs, had a larger negative impact on gross profit when compared to the current year. Specific to the current fiscal year, the Company recognized higher gross profit on increased sales, primarily from mature power supply, magnetic and build to print shipments when compared to the same period last year. Additionally, the Company showed an improvement to gross profit on a specific power supply contract resulting from adjustments recovered from the customer for costs previously incurred. Finally, the Company was successful in securing several additional equitable adjustments on other contracts in the second half of the fiscal year which had a favorable impact on gross profit. These improvements to gross profit were offset, in part, by increased costs, primarily labor, incurred on a power supply engineering design and production contract and a build to print power supply contract requiring engineering efforts, both of which contracts had no adverse impact on the prior year results. Finally, gross profit was reduced by an unforeseen significant increase in material costs on a large production contract, a direct result of inflationary and volatile pricing for certain raw materials and components. We have submitted a formal request to the customer for an equitable adjustment to this long-term fixed price contract supporting the US military. There is no guaranty that the customer will agree to a pricing adjustment. Selling, general and administrative expenses were $3,942,991 for the fiscal year ended June 30, 2022; an increase of $157,245 compared to the fiscal year ended June 30, 2021. The increase is attributable to costs incurred as the result of a change in senior management which occurred in the second quarter of fiscal 2022, higher costs incurred to recruit and fill company-wide position vacancies, an increase in professional service expenses, an increase in travel costs, and an increase in utility expenses. These increases were offset, in part, by a decrease in overall employee compensation costs for program management personnel due to a reduction in headcount when compared to the same period last year, and a decrease in board of director’s fees due to a reduction of two non-employee directors. Other income for the fiscal year ended June 30, 2022 and 2021 was $63,914 and $57,942, respectively. The increase is primarily due to an increase in other income primarily composed of income from scrap sales, offset, in part, by 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 Company’s effective tax rate was a provision of 20.6% in the fiscal year 2022 and a benefit of 50.7% in fiscal year 2021. The effective tax rate in fiscal 2022 and 2021 varies from 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 periods is the direct result of higher income before taxes in the current fiscal year and a decreased benefit derived from fewer ESOP dividends paid on allocated shares. In the prior fiscal year, the higher effective tax rates was primarily due to the incurred net operating loss before taxes, in addition to the benefits received in the prior fiscal year on higher ESOP dividends paid as well as a benefit received on the tax rate differential associated with the net operating loss carryback which resulted from the net loss incurred in the prior fiscal year. The Company generated net income for fiscal year 2022 of $1,265,127 or $0.52 per share, basic and diluted, compared to net loss of $(181,543) or $(0.08) per share, basic and diluted, for fiscal year 2021. The increase in net income in the twelve months ended June 30, 2022 compared to the same period in 2021 is primarily attributable to higher sales, a higher gross profit margin percentage, a slight increase in other income offset, in part, by an increase in selling, general, and administrative expenses and an increase in tax expense, all discussed above. 9 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, 2022 and 2021. The existing line of credit was extended and expires February 28, 2023. The Company's working capital as of June 30, 2022 and 2021 was approximately $29.5 million and $27.5 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, 2022 and 2021, the Company did not repurchase any shares held by the ESOP. Under existing authorizations from the Company's Board of Directors, as of June 30, 2022, 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: 2022 2021 Net cash provided by operating activities $ 2,219,687 $ 594,996 Net cash (used in) provided by investing activities (918,339 ) 2,006,910 Net cash used in financing activities — (1,201,316 ) 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 increase in net income, the decrease in inventory purchases offset, in part, by a decrease in trade accounts receivables collected and the decrease in cash collected from customers as cash advances. Net cash used in investing activities increased in the twelve months ended June 30, 2022 as compared to the same period in 2021 primarily due to the reinvestment of matured securities when compared to the same period last year. During the twelve months ended June 30, 2022, there was no cash used for financing activities primarily resulting from the suspension of dividend payments. In the prior year, cash used in financing activities resulted from the payment of regular dividends for the first two fiscal quarters. 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, 2022 and 2021, the Company expended $303,561 and $43,554, respectively, for plant improvements and new equipment. The Company has budgeted approximately $500,000 for new equipment and plant improvements in fiscal year 2023. 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