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 2026 to be higher than revenues recognized during fiscal year 2025. Net income per share is anticipated to fall below fiscal 2025 results driven primarily by orders already in our backlog that will be shipped in fiscal year 2026 with higher anticipated aggregate costs than the product mix shipped during fiscal 2025. 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 2026. 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. 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 can arise as a result of, among other reasons, design complexity, availability of personnel with the requisite expertise, requirements to obtain customer approval at various milestones, and extended delivery lead times on material required for prototypes. Cost overruns which can be caused 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 $13 million. The Company currently expects new orders in fiscal year 2026 to be lower than those received in fiscal year 2025. During fiscal year 2025, the Company received $86.4 million in new orders which included two significant, multi-year contract awards in an aggregate sum of $49.4 million. In addition to the backlog, the Company currently has outstanding opportunities representing approximately $163 million in the aggregate as of August 31, 2025, for both repeat and new programs. Outstanding opportunities encompass various new and previously manufactured power supplies, transformers, and subassemblies. The stated amount includes only those opportunities that 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 elements affecting the defense industry. Many solicitations we receive for the procurement of goods and services takes place by competitive bidding. Our sales strategy continues to focus on the long-standing relationships we have with many of the leading defense prime contractors. These relations yield growth opportunities from new product development and additional sales opportunities of existing products to these customers. The Company targets 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 $850,000 for fiscal year 2026. These upgrades would be in addition to those that are being funded by grants the Company was awarded. 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. Results of Operations Net sales for the years ended June 30, 2025 and 2024 were $43,950,872 and $38,736,319, respectively, an approximate 13.5% 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 2025 were higher when compared to the prior year primarily attributable to (i) several large multi-year contracts for shipboard transformers and power distribution panels, (ii) power systems for combat vehicles, and (iii) power systems for aircraft radar and missile platforms. Additionally, the Company saw increases on build to print sales. These increases were partially offset by a slight decrease in sales related to our magnetics programs where various contracts had 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, 2025 and 2024 were $12,684,631 and $10,653,060, respectively. Gross profit as a percentage of sales was 28.9% and 27.5%, 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, 2025 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 completed milestone sales, and (iii) non-recurring cost savings related to realized labor efficiencies and savings on material purchases. Moreover, the gross profit in fiscal year 2024 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. These factors did not impact the fiscal year 2025 gross profit. Finally, gross profit in fiscal year 2025 was increased by an improvement in the overhead rate on shipments. This is attributed to the recorded pension withdrawal obligation established in the last quarter of fiscal year 2024 that was paid in full during fiscal year 2025. See Financial Statement Note 7. Pension Expense for further details. Selling, general and administrative expenses were $4,557,945 for the fiscal year ended June 30, 2025, an increase of $444,337 compared to the fiscal year ended June 30, 2024. The increase in spending for the year ended June 30, 2025 compared to the same period in 2024 mainly arose from the temporary increase in employee compensation costs related to a brief overlap in a few positions requiring a training and transition period due to retirements that occurred during 2025. In addition, the Company had an increase in ESOP contributions, facility costs due to the completion of the new building, and travel and entertainment expenses . These increases were offset, in part, by a decrease in the cost of insurance, conference and training costs, and marketing and advertising costs. Other income for the fiscal years ended June 30, 2025 and 2024 was $1,601,978 and $755,562, respectively. The increase is due to the increase in interest income resulting from an increase in investment securities and an increase in fixed interest rates. The Company also received a one-time Capital Investment Grant in the amount of $300,000 related to the completion of the new building in fiscal 2025. Interest income is a function of the level of investments and investment strategies that generally tend to be conservative. 8 The Company’s effective tax rate was approximately 16.3% in fiscal year 2025 and approximately 20.3% in fiscal year 2024. The effective tax rate in fiscal 2025 is less than the statutory tax rate mainly due to the benefit received from stock option exercises, dividends paid on allocated ESOP 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 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 Company generated net income for fiscal year 2025 of $8,142,954 or $3.14 and $3.02 per share, basic and diluted, compared to net income of $5,815,140 or $2.34 and $2.29 per share, basic and diluted, for fiscal year 2024. The increase in net income in the year ended June 30, 2025 compared to the same period in 2024 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, 2025 and 2024. The existing line of credit was extended and expires February 28, 2026. The Company's working capital as of June 30, 2025 and 2024 was approximately $46.9 million and approximately $38 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, 2025 and 2024, 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, 2025, 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: 2025 2024 Net cash provided by operating activities $ 20,991,372 $ 10,595,200 Net cash used in investing activities (6,938,966 ) (7,840,277 ) Net cash used in financing activities 458,268 (1,151,708 ) 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 contract liabilities and a decrease in inventory, offset in part, by an increase in accounts receivable, increase in prepaid expenses and other current assets, and a decrease in accounts payable. Net cash used in investing activities decreased in the year ended June 30, 2025 as compared to the same period in 2024 due to a decrease in proceeds received from grant awards and a decrease in additions to property, plant and equipment. This was partially offset by a decrease in the purchase of investment securities net of proceeds from the sale and maturity of investment securities when compared to the same period last year. Cash used in financing activities for the year ended June 30, 2025 relates primarily to dividend payments on common stock, offset in full, 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, 2025 and 2024, the Company expended $4,365,404 and $5,164,165, respectively, for plant improvements and new equipment. Of the total expended amount, $3,260,000 was reimbursed in fiscal year 2025 and $4,228,722 was reimbursed in fiscal year 2024 under a not-to-exceed $7.4 million award received by the Company. Additionally, during the fiscal year ended June 30, 2025 there was $1,731,042 for plant improvements and new equipment eligible for reimbursement under a not-to-exceed $3.4 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 $850,000 for new equipment and plant improvements in fiscal year 2026, 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. 9 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. Critical Accounting Policies and Significant Estimates The preparation of our consolidated financial statements in accordance with generally accepted accounting principles requires management to make certain judgments, estimates, and assumptions that affect the reported amounts as presented on the face of the financial statements. These critical accounting policies and estimates are those that are most important to the portrayal of our financial condition and results of operations. We base our estimates on historical experience and other assumptions that we believe to be reasonable. Management continually reviews and evaluates these critical accounting policies and estimates in light of evolving business conditions, regulatory developments, and changes in the economic environment. As future events cannot be determined and their impact on the financial statements are uncertain, actual results may differ from our estimates and could be material to the consolidated financial statements. Historically, we have found our application of accounting policies to be appropriate, and actual results have not differed materially from established estimates. The critical accounting policies and estimates that we believe have the most significant effect on our financial statements are revenue recognition, inventory valuation, and deferred taxes. Revenue Recognition The majority of our sales are generated from military contracts from defense companies, the Department of Defense, other agencies of the government of the United States and foreign governments. 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, our generated profit will fluctuate or a loss could be incurred. 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. As the Company does not have standalone observable prices, a contract’s transaction price of each performance obligation is based on the standalone selling price, which is determined using an expected cost plus a margin approach. Valuation of Inventories 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 available information. Inventory balances are reduced based on this analysis. Inventory relating to contracts in process and work in process is valued at 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 variables including contract costs incurred and expected to be incurred as well as estimates regarding contract completion dates. Given the significance of the estimation processes and judgments described above, it is possible that materially different amounts of expected contract costs could be recorded if different assumptions were used, based on changes in circumstances, in the estimation process. When a change in expected estimated cost is determined, changes are reflected in current period earnings. Deferred Taxes The Company follows the provisions of the Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (ASC) Topic 740-10, “Accounting for Income Taxes." 10 Under the provisions of FASB ASC 740-10, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred taxes and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.