FREQUENCY ELECTRONICS INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations “Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995 : The statements in this quarterly report on Form 10-Q regarding future earnings and operations and other statements relating to the future constitute “forward-looking” statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements inherently involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. Factors that would cause or contribute to such differences include, but are not limited to, the risks associated with health epidemics and pandemics, including the COVID-19 pandemic and similar outbreaks, such as their impact on our financial condition and results of operations and on our ability to continue manufacturing and distributing our products, and the impact of health epidemics and pandemics on general economic conditions, including any resulting recession, our inability to integrate operations and personnel, actions by significant customers or competitors, general domestic and international economic conditions, reliance on key customers, continued acceptance of the Company’s products in the marketplace, competitive factors, new products and technological changes, product prices and raw material costs, dependence upon third-party vendors, competitive developments, changes in manufacturing and transportation costs, the availability of capital, and the outcome of any litigation and arbitration proceedings. The factors listed above are not exhaustive. Other sections of this Form 10-Q and in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2020, filed on July 29, 2020 with the Securities and Exchange Commission include additional factors that could materially and adversely impact the Company’s business, financial condition and results of operations. Moreover, the Company operates in a very competitive and rapidly changing environment. New factors emerge from time to time and it is not possible for management to predict the impact of all these factors on the Company’s business, financial condition or results of operations or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not rely on forward-looking statements as a prediction of actual results. Any or all of the forward-looking statements contained in this Form 10-Q and any other public statement made by the Company or its management may turn out to be incorrect. The Company expressly disclaims any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Critical Accounting Policies and Estimates The Company’s significant accounting policies are described in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2020, filed on July 29, 2020 with the Securities and Exchange Commission. The Company believes its most critical accounting policies to be the recognition of revenue and costs on production contracts, income taxes, and the valuation of inventory. Each of these areas requires the Company to make use of reasonable estimates including estimating the cost to complete a contract, the realizable value of its inventory and the market value of its products. Changes in estimates can have a material impact on the Company’s financial position and results of operations. The Company’s significant accounting policies did not change during the six and three months ended October 31, 2020. Revenue Recognition Revenue is recognized when a performance obligation is satisfied, which is when the expected goods or services are transferred to the customer, in an amount that reflects the consideration to which the Company expects to receive. A performance obligation is a distinct product or service that is transferred to the customer based on the contract. The transaction price is allocated to each performance obligation and is recognized as revenue upon satisfaction of that performance obligation. The Company derives revenue from contracts with customers by units sold with specific specifications and frequencies that are used by a specific customer and contracts where the end user is the government. The Company’s contracts typically include one performance obligation which is satisfied by shipped projects and completed services/reports required in the contract. Control over these performance obligations passes to the customer over time and therefore these revenues are reported in operating results over time using the cost-to-cost method. Under this method, revenue is recorded based upon the ratio that incurred costs bear to total estimated contract costs with related cost of revenues recorded as the costs are incurred. Each month management reviews estimated contract costs through a process of aggregating actual costs incurred and estimating additional costs to completion based upon the current available information and status of the contract. The effect of any change in the estimated gross margin rate (“GM Rate”) for a contract is reflected in revenues in the period in which the change is known. Provisions for the full amount of anticipated losses on contracts are made in the period in which they become determinable. 18 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) For smaller contracts or orders, sales of products and services to customers are reported in operating results based upon (i) shipment of the product or (ii) performance of the services pursuant to terms of the customer order. When payment is contingent upon customer acceptance of the installed system, revenue is deferred until such acceptance is received and installation completed. The Company’s products generally carry a one-year warranty, but may vary based on the contract terms. Significant judgment is used in evaluating the financial information for certain contracts to determine an appropriate budget and estimated cost. The Company evaluates this information continuously and bases its judgments on historical experience, design specifications, and expected costs for material and labor. Contract costs include all direct material, direct labor costs, manufacturing overhead and other direct costs related to contract performance. Selling, general and administrative costs are charged to expense as incurred. Inventory In accordance with industry practice, inventoried costs contain amounts relating to contracts and programs with long production cycles, a portion of which will not be realized within one year. Inventory write downs are established for slow-moving materials based on percentage of usage over a ten-year period, obsolete items on a gradual basis over five years with no usage and costs incurred on programs for which production-level orders cannot be determined as probable. Such write-downs are based upon management’s experience and expectations for future business. Any changes arising from revised expectations are reflected in cost of revenues in the period the revision is made. Marketable Securities Marketable securities consist of corporate debt securities, certificates-of-deposit, and debt securities of U.S. Government agencies. All marketable securities were held in the custody of one financial institution at October 31, 2020 and April 30, 2020. Investments in debt securities are categorized as available-for-sale and are carried at fair value, with unrealized gains and losses excluded from income and recorded directly to stockholders’ equity. The Company recognizes gains or losses when securities are sold using the specific identification method. COVID-19 Outbreak Update On January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus originating in Wuhan, China (the “COVID-19 outbreak”) and the risks to the international community as the virus spread globally beyond its point of origin. In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The Company’s priority during the COVID-19 outbreak has been to protect the health and safety of its employees while remaining operational. Within the limitations imposed by governmental health and safety procedures, the Company has continued to manufacture its full range of products at its facilities. The Company has educated employees about COVID-19 symptoms and hygiene best practices. The Company’s policies also include taking an employee’s temperature before entering facilities; mandating handwashing; requiring social distancing and, where social distancing is difficult, requiring face coverings; encouraging, and in some cases, requiring remote work for those employees who can work from home; and disinfecting facilities. As of December 11, 2020, the Company was aware of five employees that have had confirmed cases of COVID-19 since the COVID-19 outbreak began, with no fatalities. Additional employees have been absent or self-quarantined due to COVID-19; however, such absences have not had a significant impact on production. Additionally, since the COVID-19 outbreak began, facilities have remained open (other than temporary closures for disinfecting) and such measures to disinfect facilities have not had a significant impact on production. Certain of the Company’s vendors have been unable to deliver materials on time due to the COVID-19 outbreak. Such delays have negatively impacted the Company’s production, and the Company plans to continue to monitor these and its other vendors and, if necessary, seek alternative suppliers. 19 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) The full impact of the COVID-19 outbreak continues to evolve as of the date of this report. As such, it is uncertain as to the full magnitude that the pandemic may have on the Company’s financial condition, liquidity, and future results of operations. Management is actively monitoring the impact of the global situation on its financial condition, liquidity, operations, suppliers, industry, and workforce. Given the daily evolution of the COVID-19 outbreak and the global responses to curb its spread, the Company is not able to estimate the effects of the COVID-19 outbreak on its results of operations, financial condition, or liquidity for fiscal year 2021. On March 27, 2020, President Trump signed into law the “Coronavirus Aid, Relief, and Economic Security (CARES) Act.” The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations, increased limitations on qualified charitable contributions, and technical corrections to tax depreciation methods for qualified improvement property. The CARES Act also appropriated funds for the Small Business Administration (SBA) Paycheck Protection Program loans that are forgivable in certain situations to promote continued employment, as well as Economic Injury Disaster Loans to provide liquidity to small businesses harmed by the COVID-19 outbreak. The Company received a loan under the Paycheck Protection Program in April 2020, which it repaid in full in May 2020. For more detail regarding the Company’s PPP Loan, see Note K in Part I, Item I of this Quarterly Report on Form 10-Q. RESULTS OF OPERATIONS The table below sets forth for the six and three months ended October 31, 2020 and 2019, respectively, the percentage of consolidated revenues represented by certain items in the Company’s condensed consolidated statements of operations or notes to the condensed consolidated financial statements: Six months Three months Periods ended October 31, 2020 2019 2020 2019 Revenues FEI-NY 77.9 % 77.6 % 79.7 % 85.7 % FEI-Zyfer 27.3 26.3 24.5 22.0 Less intersegment revenues (5.2 ) (3.9 ) (4.2 ) (7.7 ) 100.0 100.0 100.0 100.0 Cost of revenues 65.1 87.2 62.0 113.0 Gross margin 34.9 12.8 38.0 (13.0 ) Selling and administrative expenses 27.3 21.9 29.5 25.2 Research and development expenses 8.1 17.3 7.0 16.0 Operating (loss) income (0.5 ) (26.4 ) 1.5 (54.2 ) Other income (loss), net 0.8 1.1 0.9 0.3 Provision (benefit) for income taxes 0.1 0.1 0.1 0.1 Net income (loss) 0.4 % (25.2 )% 2.5 % (54.0 )% Revenues Six months Three months Periods ended October 31, Segment 2020 2019 Change 2020 2019 Change FEI-NY $ 20,996 $ 16,794 $ 4,202 25.0 % $ 11,156 $ 7,784 $ 3,372 43.3 % FEI-Zyfer 7,353 5,701 1,652 29.0 3,430 2,000 1,430 71.5 Intersegment revenues (1,409 ) (854 ) (555 ) 65.0 (596 ) (697 ) 101 (14.5 ) $ 26,940 $ 21,641 $ 5,299 24.5 % $ 13,990 $ 9,087 $ 4,903 54.0 % 20 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) For the six months, ended October 31, 2020 revenues from commercial and U.S. Government satellite programs increased approximately $4.8 million, as compared to the same period of fiscal year 2020, and accounted for approximately 53% of consolidated revenues compared to approximately 44% of consolidated revenues during this same period in fiscal year 2020. The change in revenue is related to timing of contract awards. Revenues on these contracts are recognized primarily under the POC method. Revenues from the satellite market are recorded in the FEI-NY segment. Revenues from non-space U.S. Government/Department of Defense (“DOD”) customers, which are recorded in both the FEI-NY and FEI-Zyfer segments, increased $1.9 million as compared to the same period of fiscal year 2020, and accounted for approximately 40% of consolidated revenues compared to approximately 42% of consolidated revenues during this same period in fiscal year 2020. Other commercial and industrial revenues for the six months ended October 31, 2020 were $1.9 million and represented approximately 7% of consolidated revenues compared to $3.2 million, or 14% of consolidated revenues, in the same period of the prior fiscal year. For the three months ended October 31, 2020 revenues from commercial and U.S. Government satellite programs increased approximately $2.0 million, as compared to the same period of fiscal year 2020, and accounted for approximately 54% of consolidated revenues compared to approximately 61% of consolidated revenues during this same period in fiscal year 2020. The change in revenue is related to timing of contract awards. Revenues on these contracts are recognized primarily under the POC method. Revenues from the satellite market are recorded in the FEI-NY segment. Revenues from non-space U.S. Government/DOD customers, which are recorded in both the FEI-NY and FEI-Zyfer segments, increased $3.3 million as compared to the same period of fiscal year 2020, and accounted for approximately 39% of consolidated revenues compared to approximately 25% of consolidated revenues during this same period in fiscal year 2020. Other commercial and industrial revenues for the three months ended October 31, 2020 were $0.9 million and represented approximately 6% of consolidated revenues compared to $1.3 million, or 14% of consolidated revenues, in the same period of the prior fiscal year. Gross Margin (loss) Six months Three months Periods ended October 31, 2020 2019 Change 2020 2019 Change $ 9,410 $ 2,771 $ 6,639 NM $ 5,322 $ (1,182 ) $ 6,504 NM GM Rate 34.9 % 12.8 % 38.0 % (13.0 )% For the six and three-month periods ended October 31, 2020, gross margin and GM Rate increased significantly as compared to the same periods in fiscal year 2020. The increase in gross margin and GM Rate was due to several programs identified in prior periods that had higher engineering costs incurred that were in the development phase that have since been completed or are near completion. Selling and Administrative Expenses Six months Three months Periods ended October 31, 2020 2019 Change 2020 2019 Change $ 7,352 $ 4,743 $ 2,609 55.0 % $ 4,124 $ 2,290 $ 1,834 80.1 % For the six months ended October 31, 2020 and 2019, selling and administrative (“SG&A”) expenses were approximately 27% and 22%, respectively, of consolidated revenues. For the three months ended October 31, 2020 and 2019, SG&A expenses were approximately 30% and 25%, respectively, of consolidated revenues. The increase in SG&A expenses is mainly due to increase in professional fees (relating to litigation for which we expect insurance reimbursement for a portion of the legal fees) of $1.3M and $1.6M for the three and six month periods, respectively, and additional insurance costs. 21 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) Research and Development Expense Six months Three months Periods ended October 31, 2020 2019 Change 2020 2019 Change $ 2,177 $ 3,731 $ (1,554 ) (41.7 )% $ 979 $ 1,450 $ (471 ) (32.5 )% Research and development (“R&D”) expenditures represent investments intended to keep the Company’s products at the leading edge of time and frequency technology and enhance future competitiveness. The R&D rate for the six-month period ended October 31, 2020 was 8% of sales compared to 17% of sales for the same period of the previous fiscal year. The R&D rate for the three-month period ended October 31, 2020 was 7% of sales compared to 16% of sales for the same period of the previous fiscal year. The Company’s R&D expense decreased year over year as previous R&D efforts have ended and turned into production; however, the Company plans to continue to invest in R&D to keep its products at the state of the art. Operating Profit ( Loss ) Six months Three months Periods ended October 31, 2020 2019 Change 2020 2019 Change $ (119 ) $ (5,703 ) $ 5,584 (97.9 )% $ 219 $ (4,922 ) $ 5,141 NM The Company’s results for the six and three-month periods ended October 31, 2020 reflect improvements in revenues, gross margin and GM rate. The Company is pleased with this trend. As referenced above by the percentages for the six and three-month periods ended October 31, 2020, operating profit (loss) has made a significant improvement from the same period of the prior fiscal year. Based upon our bookings and backlog we are expecting the improving trend to continue. Other Income (Expense), net Six months Three months Periods ended October 31, 2020 2019 Change 2020 2019 Change Investment income $ 157 $ 224 $ (67 ) (29.9 )% $ 50 $ 45 $ 5 11.1 % Interest expense (75 ) (50 ) (25 ) 50.0 % (36 ) (25 ) (11 ) 44.0 % Other income (expense), net 129 58 71 NM 113 2 111 NM $ 211 $ 232 $ (21 ) (9.1 )% $ 127 $ 22 $ 105 NM Investment income is derived primarily from the Company’s holdings of marketable securities. Earnings on securities may vary based on fluctuating interest rates, dividend payout levels, and the timing of purchases, sales, redemptions or maturities of securities. For the six-month period ended October 31, 2020 investment income includes a $105,000 dividend from Morion, compared to a $125,000 dividend from Morion in the same period in fiscal 2020. Income Tax Provision Six months Three months Periods ended October 31, 2020 2019 Change 2020 2019 Change $ 25 $ 29 $ (4 ) (13.8 )% $ 17 $ 9 $ 8 88.9 % Six months Three months Periods ended October 31, 2020 2019 2020 2019 Effective tax rate on pre-tax book income (loss): 27.2 % (0.5 )% 4.9 % (0.2 )% 22 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) The estimated annual effective tax rate for the fiscal year ending April 30, 2021 is 0%. This calculation reflects estimated income tax expense based on our current year annual pretax income forecast which is offset by the estimated change in the current year valuation allowance. The Company maintains a full valuation allowance against its deferred tax assets. For the six months ended October 31, 2020, the Company recorded a discrete income tax provision of $25,000, which primarily consisted of an accrual of interest for unrecognized tax benefits. For the six months ended October 31, 2019, the Company recorded a discrete income tax provision of $28,900, which primarily consisted of an accrual of interest for unrecognized tax benefits. For the three months ended October 31, 2020, the Company recorded an income tax provision of $17,000, which included a discrete income tax provision of $9,000 primarily related to an accrual of interest for unrecognized tax benefits. For the three months ended October 31, 2019, the Company recorded a discrete income tax provision of $9,000, which primarily consisted of an accrual of interest for unrecognized tax benefits. The effective tax rate for the six months ended October 31, 2020 is an income tax provision of 27.2% on pretax income of $92,000 compared to an income tax provision of (0.5)% on a pretax loss of $5,471,000 in the comparable prior fiscal year period. The effective tax rate for the six months ended October 31, 2020 differs from the U.S. statutory rate of 21% primarily due to state taxes, a discrete income tax provision related to the accrual of interest for unrecognized tax benefits, and domestic losses for which the Company is not recognizing an income tax benefit. The effective tax rate for the three months ended October 31, 2020 is an income tax provision of 4.9% on pretax income of $346,000 compared to an income tax provision of (0.2)% on a pretax loss of $4,900,000 in the comparable prior fiscal year period. The effective tax rate for the three months ended October 31, 2020 differs from the U.S. statutory rate of 21% primarily due to state taxes, a discrete income tax provision related to the accrual of interest for unrecognized tax benefits, and domestic losses for which the Company is not recognizing an income tax benefit. LIQUIDITY AND CAPITAL RESOURCES The Company’s consolidated balance sheet continues to reflect a strong working capital position of $39.7 million at October 31, 2020 and $38.3 million at April 30, 2020. Included in working capital at October 31, 2020 and April 30 2020 is $13.6 million and $14.4 million, respectively, consisting of cash, cash equivalents, and marketable securities. The Company’s current ratio at October 31, 2020 was 4.5 to 1 compared to 3.9 to 1 as of April 30, 2020. Net cash provided by operating activities for the six months ended October 31, 2020 was $1.9 million compared to $180,000 in the comparable prior fiscal 2020 period. The increase cash flow in the fiscal 2021 period resulted mainly due to the net income in the current fiscal year period as compared to a net loss in the prior fiscal year, as well as an increase in accounts receivable balances offset by a decrease in inventory amounts. For the six-month periods ended October 31, 2020 and 2019, the Company incurred approximately $2.6 million and $3.9 million, respectively, of non-cash operating expenses including ROU assets and liabilities for leases, loss provision accrual, depreciation and amortization, inventory reserve adjustments, and accruals for employee benefit programs. Net cash used in investing activities for the six months ended October 31, 2020 was $200,000 compared to $1.3 million for the six months ended October 31, 2019. During the six months ended October 31, 2020 approximately $900,000 of marketable securities were purchased compared to $2.5 million for the same period of fiscal 2020. The Company acquired property, plant and equipment in the amount of approximately $800,000 for the six-month period ended October 31, 2020 compared to $1.3 million for the six-month period ended October 31, 2019. The Company may continue to invest in cash equivalents as dictated by its investment strategy. Net cash used in financing activities for the six months ended October 31, 2020 was approximately $2.0 million related to the repayment of the PPP Loan and the amounts borrowed against the Company’s line of credit with UBS Bank USA. There was no cash used in financing activities for the six months ended October 31, 2019. The Company has been authorized by its Board to repurchase up to $5 million worth of shares of its common stock when appropriate opportunities arise. As of October 31, 2020, the Company has repurchased approximately $4 million of its common stock out of the $5 million authorization. For the six months ended October 31, 2020 and 2019 there were no repurchases of shares. 23 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) The Company will continue to expend resources to develop, improve and acquire products for space applications, guidance and targeting systems, and communication systems which management believes will result in future growth and profitability. The Company anticipates securing additional customer funding for a portion of its R&D activities and will allocate internal funds depending on market conditions and identification of new opportunities. The Company expects internally generated cash will be adequate to fund these R&D efforts. The Company may also pursue acquisitions to expand its range of products and may use internally generated cash and external funding in connection with such acquisitions. As of October 31, 2020, the Company’s consolidated funded backlog was approximately $42 million compared to $36 million at April 30, 2020, the end of fiscal 2020. Approximately 79% of this backlog is expected to be realized in the next twelve months. As of October 31, 2020, there are no amounts included in backlog under cost-plus fixed-fee (“CPFF”) contracts that have not been funded. The Company excludes from backlog any contracts or awards for which it has not received authorization to proceed. On fixed price contracts, the Company excludes any unfunded portion. Over time, as partially funded contracts become fully funded, the Company will add the additional funding to its backlog. The backlog is subject to change for various reasons, including possible cancellation of orders, change orders, terms of the contracts and other factors beyond the Company’s control. Accordingly, the backlog is not necessarily indicative of the revenues or profits (losses) which may be realized when the results of such contracts are reported. The Company believes that its liquidity is adequate to meet its operating and investment needs through at least December 11, 2021 and the foreseeable future. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements, that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. 24 Table of Contents FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES (Continued) Item 3. Quantitative and Qualitative Disclosures about Market Risk Not applicable to smaller reporting companies.