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 2025 to be higher than revenues recognized during fiscal year 2024 and expects net income per share to exceed fiscal 2023 reported results, however net income per share is anticipated to fall below fiscal 2024 results. This expectation is driven primarily by orders already in our backlog that will be shipped in fiscal year 2025 with higher anticipated aggregate costs than the product mix shipped during fiscal 2024. Gross profit on fiscal 2025 shipments will be reduced by the increase in overhead costs incurred specific to the pension withdrawal obligation recorded in fiscal 2024, explained in greater detail in Financial Statement Note 7. Pension Expense. Overhead costs will be reduced, in future years, from the Company’s withdrawal from the plan, as recurring annual contribution payments to the plan will no longer be required. 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. Ongoing demand in the power electronics industry across multiple manufacturing sectors continues to create shortages and extended lead times. In some instances, waiting times for certain components approach a year or more. We adequately factor supplier-provided lead times into internal planning schedules and new customer quotations. From time to time, we encounter part obsolescence which requires us to identify an alternate part suitable for use. We continue to work with our customers on strategies to mitigate any adverse impact upon our ability to service their requirements. Factors which may arise after the placement of the customer’s order may cause us to miss projected delivery dates. Inflationary costs are expected to continue but are not expected to have a significant impact on operating income in fiscal year 2025. The labor workforce remains stable. Management continues to closely monitor workforce labor requirements to support our sales backlog and planned delivery schedules. Longer time-to-hire challenges remain for certain positions due to specific skillsets required for those positions and the fact fewer workers, in general, are seeking employment. Unemployment rates in the local geographic region trend lower than the national average which has created a competitive recruiting environment. Where possible, the Company continues to offer on-the-job training and when necessary continues to recruit personnel outside the local region. Combined with supply chain constraints, 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, the requirements to obtain customer approval at various milestones, and extended delivery lead times on material required for prototypes. 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. Engineering programs in both the funded and unfunded portions of the current backlog aggregate $10.2 million. The Company currently expects new orders in fiscal 2025 to be greater than those received in fiscal year 2024. During fiscal year 2024, the Company received approximately $52.4 million in new orders. Included in new order bookings are repeat production orders for multi-year purchases with deliveries expected to extend for several years. In addition to the backlog, the Company currently has outstanding opportunities representing in excess of $130 million in the aggregate as of August 31, 2024, for both repeat and new programs. Included in outstanding opportunities is a large multi-year purchase from a single customer for several products currently being manufactured by the Company, expected to be formalized prior to December 31, 2024. Outstanding opportunities encompass various new and previously manufactured power supplies, transformers, and subassemblies. We consider the value of those opportunities we believe are likely to be awarded based on factors which include: quotation status, communicated award dates, historical ordering, public information on defense programs and program funding, discussion with customers, and our cost competitiveness. However, there can be no assurance that the Company will acquire any of the outstanding opportunities described above, many of which are subject to allocations of the United States defense spending and factors affecting the defense industry, as well as, the fact many solicitations we receive for the procurement of goods and services takes place by competitive bidding. Our sales strategy includes identifying and obtaining multiple new engineering design and development contracts in any given fiscal year to ensure optimal utilization of our engineering personnel in addition to securing follow-on production awards for product previously designed in-house, as well as, build to print opportunities. The Company targets those programs and opportunities which will generate future longer-term production tails in ensuing years. From time to time, we accept work associated with engineering design studies. While unlikely to result in near-term follow-on orders, this positions us competitively on future awards and expands our engineering team’s skillset. 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 and facility upgrades, are not expected to exceed $500,000 for fiscal year 2025. 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. Management along with the Legal Affairs, Strategic Planning, and M&A 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. The Company was awarded $7.4 million in funding during the second quarter of fiscal year 2023 in support of facility and capital equipment upgrades for testing and qualification for the United States Navy. The funding is part of the Navy’s investment to improve and sustain the Surface Combatant Industrial Base. The work is being conducted on the Company’s property in Saratoga Springs, NY, with completion slated for the end of calendar year 2024. The Company expects to be paid within 30 days after the submission of three milestone invoices, but will not be paid for expenses incurred in excess of the specified milestone payment limits. The Company will record the receipt of milestone payments received as a reduction from the cost of the assets. As of June 30, 2024 milestone reimbursements received totaled $4,228,722. Included in property, plant, and equipment at June 30, 2024 was $965,392 not yet reimbursed under the funding award. As of June 30, 2024, the Company anticipates spending the remaining $2.3 million, allowable under the award, during fiscal 2025. Results of Operations Net sales for the years ended June 30, 2024 and 2023 were $38,736,319 and $35,592,323, respectively, an approximate 8.8% increase. 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 contract delivery schedules. Deliverables within firm contracts are often subject to delivery schedules which also contributes to sales fluctuations between comparable periods. Sales in fiscal year 2024 were higher when compared to the prior year primarily from (i) increased shipments on several large multi-year contracts for transformers and power distribution panels, and (ii) increased shipments on several power supply contracts primarily supporting AESA radar programs and off-highway vehicle production builds. These increases were offset, in part, by a decrease in overall build to print sales which, in several instances, had specific contracts with significantly fewer or no sales in the current reporting period as compared to the same period last year due to order completion or planned customer delivery schedules. Gross profits for the years ended June 30, 2024 and 2023 were $10,653,060 and $8,050,538, respectively. Gross profit as a percentage of sales was 27.5% and 22.6%, 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 increase in gross profit for the year ended June 30, 2024 when compared to the same period last year resulted primarily from (i) sales levels and general product mix, (ii) higher than average profit margins on one-time sales to certain customers, and (iii) higher sales on a large follow-on order for power distribution panels which had fewer sales and higher costs in the prior year related to engineering design efforts. Moreover, the gross profit in fiscal year 2023 had been negatively impacted by significant unanticipated costs incurred on several fixed-priced engineering design contracts and a specific build to print contract, all for power supplies, due to unforeseen complexities of the designs. The improvement in the gross profit in fiscal year 2024 was offset, in part, by increased costs incurred on a recurring production job and a new engineering development job. Finally, gross profit in the current year was reduced by an increase in the overhead costs on shipments, resulting from the recorded pension withdrawal obligation established in the last quarter of the current fiscal period, explained in greater detail in Financial Statement Note 7. Pension Expense. 8 Selling, general and administrative expenses were $4,113,608 for the fiscal year ended June 30, 2024; an increase of $363,084 compared to the fiscal year ended June 30, 2023. The increase in spending for the year ended June 30, 2024 compared to the same period in 2023 mainly relates to the increase in employee compensation costs which includes a new business development employee. In addition, and to a lesser extent, expenses increased related to travel expenses, recruiting expenses, and freight costs incurred on outgoing shipments. These increases were offset, in part, by a decrease in utility and outside selling costs related to non-employee sales representatives. Other income for the fiscal years ended June 30, 2024 and 2023 was $755,562 and $406,453, respectively. The increase is primarily due to the increase in interest income resulting from an increase in investment securities and an increase in fixed interest rates. 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 approximately 20.3% in the fiscal year 2024 and approximately 21.9% in fiscal year 2023. The effective tax rate in fiscal 2024 is less than the statutory tax rate mainly due to the benefit received from ESOP dividends paid on allocated shares and a benefit from foreign derived intangible income, offset in part by permanent differences related to incentive stock options. The effective tax rate in fiscal 2023 is greater than the statutory tax rate mainly due to the permanent difference for incentive stock option expense recorded for book purposes which is not deductible for tax purposes. During fiscal 2023, there was no benefit received from ESOP dividends paid on allocated shares due to the suspension of the company dividend through February 2023. The effective tax rate in the year ended June 30, 2024 was lower than the comparable prior year primarily from the benefit derived from ESOP dividends paid on allocated shares, greater benefit derived from foreign derived intangible income and a benefit derived from the exercise of incentive stock options in the current period when compared to same period in the prior year. The Company generated net income for fiscal year 2024 of $5,815,140 or $2.34 and $2.29 per share, basic and diluted, compared to net income of $3,677,131 or $1.50 and $1.49 per share, basic and diluted, for fiscal year 2023. The increase in net income in the year ended June 30, 2024 compared to the same period in 2023 is primarily attributable to higher sales, a higher gross profit margin percentage, an increase in other income, offset in part, by an increase in selling, general, and administrative expenses and an increase in the provision for income taxes. 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, 2024 and 2023. The existing line of credit was extended and expires February 28, 2025. The Company's working capital as of June 30, 2024 and 2023 was approximately $38 million and $33.2 million, respectively. The Company may at times be required to repurchase shares at the ESOP participants’ request at the fair market value. During the years ended June 30, 2024 and 2023, 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, 2024, 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: 2024 2023 Net cash provided by operating activities $ 10,595,200 $ 3,899,870 Net cash used in investing activities (7,840,277 ) (8,765,907 ) Net cash used in financing activities (1,151,708 ) (489,268 ) 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 an increase in net income, a decrease in prepaid expenses and other current assets, a decrease in inventory, an increase in accounts payable and other accrued expenses, offset in part, by a decrease in contract liabilities, and an increase in trade accounts receivable. 9 Net cash used in investing activities increased in the year ended June 30, 2024 as compared to the same period in 2023 due to an increase in investment securities when compared to the same period last year, in addition to additions to property, plant and equipment, partially offset by proceeds received from the grant award. Cash used in financing activities for the year ended June 30, 2024 relates primarily to dividend payments on common stock, offset in part, by proceeds from the exercise of stock options. 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, 2024 and 2023, the Company expended $5,164,165 and $512,016, respectively, for plant improvements and new equipment, of which $4,886,113 and $249,705, respectively, was either reimbursed or eligible to be reimbursed under a not to exceed $7.4 million award received by the Company. The award received by the Company is in support of facility and capital equipment upgrades for testing and qualification for the United States Navy. This funding award is part of the Navy’s investment to improve and sustain the Surface Combatant Industrial Base. Separately, the Company has budgeted approximately $500,000 for new equipment and plant improvements in fiscal year 2025, not reimbursable under the funding award. A majority of these expenditures will be made to stay competitive in the marketplace and to meet the needs of current contracts. Management believes that the Company's allowance for credit losses of $3,000 is adequate given the customers with whom the Company does business based on historical experience, current economic market conditions, performance of specific account reviews, and other factored considerations to include, but not limited to, contracts covered by government funding and the overall health of the industry. Historically, bad debt expense has been minimal.