FREQUENCY ELECTRONICS INC (FEIM) FY 2023 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. 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 Annual Report on Form 10-K 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, other supply chain related issues, increasing costs for materials, operating related expenses, competitive developments, changes in manufacturing and transportation costs, the availability of capital, the outcome of any litigation and arbitration proceedings, and failure to maintain an effective system of internal controls over financial reporting. The factors listed above are not exhaustive. Other sections of this Form 10-K 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-K 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, except as required by law.
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Critical Accounting Estimates
The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. 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 or the market value of its products. Changes in estimates can have a material impact on the Company’s financial position and results of operations.
Revenue Recognition
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 regarding labor, outside services, materials, overhead costs, and status of the contract. The effect of any change in the estimated gross margin 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.
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.
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.
Income Taxes
Our income tax expense, deferred tax asset and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. Significant judgments and estimates are required in the determination of the consolidated income tax expense.
Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover deferred tax assets in the jurisdiction from which they arise, we consider all positive and negative evidence, including the reversal of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. As of April 30, 2023 and 2022, we have a full valuation allowance against our U.S. deferred tax assets. If these estimates and assumptions change in the future, the Company may be required to reduce its existing valuation allowance resulting in less income tax expense. The Company evaluates the likelihood of realizing its deferred tax assets quarterly.
Tax benefits are recognized for an uncertain tax position when, in the Company’s judgment, it is more likely than not that the position will be sustained upon examination by a taxing authority. For a tax position that meets the more-likely-than-not recognition threshold, the tax benefit is measured as the largest amount that is judged to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. The liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances and when new information becomes available. Such adjustments are recognized entirely in the period in which they are identified. The effective tax rate includes the net impact of changes in the liability for unrecognized tax benefits and subsequent adjustments as considered appropriate by the Company. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, the Company believes its liability for unrecognized tax benefits is adequate.
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RESULTS OF OPERATIONS
Consolidated Results
The table below sets forth for the fiscal years ended April 30, 2023 and 2022, the percentage of consolidated net sales represented by certain items in the Company’s consolidated statements of operations:
| Fiscal Years Ended April 30, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2023 | 2022 | |||||||
| Revenues | ||||||||
| FEI-NY | 79.2 | % | 85.2 | % | ||||
| FEI-Zyfer | 24.4 | 16.2 | ||||||
| Less intersegment revenues | (3.6 | ) | (1.4 | ) | ||||
| 100.0 | 100.0 | |||||||
| Cost of revenues | 80.8 | 82.2 | ||||||
| Gross margin | 19.2 | 17.8 | ||||||
| Selling and administrative expenses | 23.0 | 24.1 | ||||||
| Research and development expenses | 7.7 | 10.3 | ||||||
| Operating loss | (11.5 | ) | (16.6 | ) | ||||
| Other (expense) income, net | (1.8 | ) | (1.3 | ) | ||||
| Provision from income taxes | 0.2 | - | ||||||
| Net loss | (13.5 | )% | (17.9 | )% |
Revenues
| Fiscal Years Ended April 30, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | ||||||||||||||||
| Segment | 2023 | 2022 | Change | |||||||||||||
| FEI-NY | $ | 32,314 | $ | 41,157 | $ | (8,843 | ) | (21.5 | )% | |||||||
| FEI-Zyfer | 9,932 | 7,827 | 2,105 | 26.9 | % | |||||||||||
| Intersegment revenues | (1,469 | ) | (688 | ) | (781 | ) | NM | |||||||||
| $ | 40,777 | $ | 48,296 | $ | (7,519 | ) | (15.6 | )% |
Fiscal year 2023 revenues from satellite programs, one of the Company’s largest business areas, decreased by $8.2 million, or 31%, compared to the prior fiscal year. Satellite program revenues for government end-use were 43% and 52% of total revenues for fiscal years 2023 and 2022, respectively. Satellite program revenues for commercial end-use were 1% and 2% of total revenue for fiscal year 2023 and 2022, respectively. Revenues on satellite program contracts are recorded in the FEI-NY segment and are recognized primarily under the Percentage-of-Completion (“POC”) method. Revenues from non-space U.S. Government/DOD customers increased by approximately $0.7 million, or 4%, in fiscal year 2023 compared to fiscal year 2022. These revenues are recorded in both the FEI-NY and FEI-Zyfer segments and accounted for approximately 50% and 41% of consolidated revenues for fiscal years 2023 and 2022, respectively. Other commercial and industrial sales accounted for approximately 6% and 5% of consolidated revenues for fiscal years 2023 and 2022, respectively. Sales in this business area were $2.6 million for both the fiscal year ended April 30, 2023 and the fiscal year ended April 30, 2022. The majority of the decrease in sales for fiscal year 2023 was in government satellite programs. This decrease is attributable in part to space programs which were delayed due to engineering issues, and in part to programs which were expected to start during fiscal year 2023 but have been delayed. The Company believes those engineering issues have largely been resolved, and the delayed programs are expected to start during fiscal year 2024 and contribute significantly to sales in fiscal year 2024.
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Gross Profit
| Fiscal Years Ended April 30, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | ||||||||||||||||
| 2023 | 2022 | Change | ||||||||||||||
| $ | 7,849 | $ | 8,599 | $ | (750 | ) | (8.7 | )% | ||||||||
| Gross Profit Percentage | 19.2 | % | 17.8 | % |
For the fiscal year ended April 30, 2023, the gross profit decreased and gross profit percentage increased as the result of several factors. The decrease in gross profit dollars was directly related to the decrease in revenues. Although the gross profit percentage increased slightly in fiscal year 2023 as compared to fiscal year 2022, it remains far below our targeted gross profit percentage range of 35%-40%. However, the Company is encouraged by the fact that the gross profit percentage for the third and fourth quarters of fiscal year 2023 were both over 30%, and the Company anticipates that this trend will continue in fiscal year 2024. The low gross profit percentage for fiscal 2022 and fiscal 2023 started in the fourth quarter of fiscal 2022, when we reported that several developmental stage programs experienced substantially higher than anticipated engineering costs. This continued into the first quarter and partially into second quarter of fiscal year 2023, however, the Company believes those issues have been largely resolved and the gross margin for the third and fourth quarters of fiscal year 2023 has increased to over 30%, as mentioned above.
Selling and Administrative Expenses
| Fiscal Years Ended April 30, | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | |||||||||||||||
| 2023 | 2022 | Change | |||||||||||||
| $ | 9,372 | $ | 11,662 | $ | (2,290 | ) | (19.6 | )% |
In fiscal years ended April 30, 2023 and 2022, selling and administrative expenses (“SG&A”) were 23% and 24% of consolidated revenues, respectively. The decrease in SG&A expenses was mainly due to the decrease in professional fees, deferred compensation expense, stock compensation expense and depreciation expense.
Research and Development Expenses
| Fiscal Years Ended April 30, | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | |||||||||||||||
| 2023 | 2022 | Change | |||||||||||||
| $ | 3,149 | $ | 4,975 | $ | (1,826 | ) | (36.7 | )% |
As a percentage of consolidated revenue, R&D expense for the fiscal years ended April 30, 2023 and 2022 were 8% and 10%, respectively. The $1.8 million decrease in R&D expense year over year was largely due to a renewed focus on correcting the program specific engineering issues identified above as part of an overall effort to return the Company to profitability. It should also be noted that FEI has dedicated resources and made substantial progress on two advanced technology development programs which are externally funded, and thus do not show up as internally funded R&D. That being said, FEI is committed to maintaining its technical excellence, and expects future R&D investment to be in line with, or even potentially above historical commitments.
The funds received in connection with customer funded R&D appears in revenues and the associated expenses are included in cost of revenues and are not included in the table above. The Company believes that internally generated cash and cash reserves are adequate to fund its future R&D activity.
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Operating Loss
| Fiscal Years Ended April 30, | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | |||||||||||||||
| 2023 | 2022 | Change | |||||||||||||
| $ | (4,672 | ) | $ | (8,038 | ) | $ | 3,366 | (41.9 | )% |
For the fiscal year ended April 30, 2023, the Company recorded an operating loss of $4.7 million compared to an operating loss of $8.1 million in the prior fiscal year. The decrease in operating loss was due to changes made affecting the second half of fiscal year 2023. The Company recorded approximately $614,000 of operating income in the second half of fiscal year 2023, a significant improvement from the $5.4 million operating loss for the first half of fiscal year 2023.
Other Income (Expense), net
| Fiscal Years Ended April 30, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | ||||||||||||||||
| 2023 | 2022 | Change | ||||||||||||||
| (Loss) income on Investments | $ | (606 | ) | $ | 199 | $ | (805 | ) | NM | |||||||
| Loss on disposal of asset | - | (110 | ) | 110 | (100.0 | )% | ||||||||||
| Loss on impairment of Morion | - | (796 | ) | 796 | (100.0 | )% | ||||||||||
| Interest expense | (156 | ) | (77 | ) | (79 | ) | NM | |||||||||
| Other income (expense), net | 7 | 160 | (153 | ) | (95.6 | )% | ||||||||||
| $ | (755 | ) | $ | (624 | ) | $ | (131 | ) | 21.0 | % |
Losses on investment income was derived primarily from the sale of the Company’s available-for-sale marketable securities, which primarily consisted of fixed income securities, during the fiscal year ended April 30, 2023. Investment income was derived primarily from the Company’s holdings of marketable securities, which primarily consisted of fixed income securities for the fiscal year ended April 30, 2022.
Income Tax Provision
| Fiscal Years Ended April 30, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | ||||||||||||||
| 2023 | 2022 | Change | ||||||||||||
| $ | 74 | $ | 1 | $ | 73 | NM |
| Fiscal Years Ended April 30, | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in thousands) | ||||||||
| 2023 | 2022 | |||||||
| Effective tax rate on pre-tax book loss: | (1.3 | )% | (0.0 | )% |
For the fiscal year ended April 30, 2023, the Company recorded an income tax provision of $74,000. For the fiscal year ended April 30, 2022, the Company recorded an income tax provision of $1,000.
The Company’s effective tax rate of (1.3)% for fiscal year 2023 differs from the U.S. federal statutory rate of 21% primarily due to state taxes and domestic losses for which the Company is not recognizing an income tax benefit. (See Note 12 to the Consolidated Financial Statements for a reconciliation of the actual tax benefit to the expected tax provision at the federal statutory rate.)
As of April 30, 2023, the Company has U.S. federal net operating losses of $31.3 million of which $15.7 million begins to expire in fiscal year 2026 through fiscal year 2038, including $3.1 million which is subject to annual limitation under IRC Section 382. The remaining U.S. federal net operating losses of $15.6 million have an indefinite carry-forward period. The U.S. federal capital loss carry-forward of $0.9 million expires in fiscal years 2025 and 2027. U.S. federal R&D credits of $0.9 million begin to expire in fiscal year 2036 through fiscal year 2040. The Company also has state net operating loss carryforwards, and state tax credits that expire in various years and amounts.
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LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operations was $1.2 million in fiscal year 2023 compared to cash provided by operations of $4.0 million in fiscal year 2022. The Company’s balance sheet continues to reflect a highly liquid position with working capital of $21.0 million at April 30, 2023 as compared to $34.2 million at April 30, 2022. Included in working capital at April 30, 2023 was $12.0 million consisting of cash and cash equivalents. The Company’s current ratio at April 30, 2023 was 1.8 to 1 compared to 2.6 to 1, at the end of the prior fiscal year.
During fiscal years 2023 and 2022, the Company incurred $5.0 million and $5.4 million, respectively, in non-cash charges to earnings, including adjustments relating to net assets and liabilities for operating leases, loss provision accrual, loss on impairment of Morion, provision for a note receivable, depreciation and amortization expense, inventory adjustments, warranty and accounts receivable reserves and certain employee benefit plan expenses, including accounting for stock-based compensation. During fiscal year 2023, operating cash was increased by decreases in loss on provision accrual and other liabilities and increases in contract assets and inventory, offset by an increase in contract liabilities. During fiscal year 2022, operating cash was increased by a decrease in contract assets and inventory and increases in contract liabilities. Contract liabilities include amounts for programs that are pre-funded for long-lead materials required to be purchased.
Net cash provided by investing activities for the fiscal year ended April 30, 2023 was $8.7 million compared to $2.3 million used in investing activities for the fiscal year ended April 30, 2022. In fiscal year 2023, investing activities included the proceeds related to sales of marketable securities net of the purchases of marketable securities of $9.6 million and purchases of capital expenditures of $0.9 million. In fiscal year 2022, investing activities included the proceeds related to sales of marketable securities net of the purchases of marketable securities of $422,000 and purchases of capital expenditures of $1.9 million.
Net cash used in financing activities for the fiscal year ended April 30, 2023 was approximately $9.4 million related to a dividend payout. There was no cash used in financing activities for the fiscal year ended April 30, 2022.
The Company will continue to expend resources to develop, improve and acquire products for space and other applications, which management believes will result in future growth and profitability. During fiscal year 2023, the Company secured partial customer funding for a portion of its R&D efforts. The customer funds received in connection therewith appear in revenues and are not included in R&D expenses. For fiscal year 2024, 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 as in fiscal 2023. The Company expects internally generated cash will be adequate to fund these future 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.
During fiscal year 2023, as in fiscal year 2022, the impact of inflation on the Company’s business was due to increases in costs for materials and services. The Company believes this may continue to impact expenses in fiscal year 2024 and future years.
As of April 30, 2023, the Company had an accumulated deficit of $25.6 million. The Company believes that its cash, as of April 30, 2023, and cash flows from operations will provide sufficient liquidity to meet its operating needs in the normal course of business in both the short-term (next twelve months from the date of issuance of these consolidated financial statements) and in the long-term (beyond the next twelve months).
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2017, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”), which simplifies how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Under ASU 2017-04, goodwill impairment will be tested by comparing the fair value of a reporting unit with its carrying amount, and recognizing an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The new guidance must be applied on a prospective basis and is effective for periods beginning after December 15, 2022, with early adoption permitted. The Company is evaluating the effect, if any, the update will have on its consolidated financial statements.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which replaces the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The new guidance is effective for fiscal years beginning after December 15, 2022. The Company is evaluating the effect, if any, the update will have on its consolidated financial statements when adopted in fiscal year 2024.
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OTHER MATTERS
The financial information reported herein is not necessarily indicative of future operating results or of the future financial condition of the Company.
Morion
The Company has an investment in Morion, a privately-held Russian company, which manufactures high precision quartz resonators and crystal oscillators. The Company has also licensed certain technology to Morion.
The Company’s investment consists of 4.6% of Morion’s outstanding shares, accordingly, the Company accounted for its investment in Morion on the cost basis. During the fiscal years ended April 30, 2023 and 2022, the Company acquired product from Morion in the aggregate amount of approximately $196,000 and $215,000, respectively. During the fiscal year ended April 30, 2022, the Company sold product and training services to Morion in the aggregate amount of approximately $23,000, included in revenues in the consolidated statements of operations as part of the FEI-NY segment. During the fiscal years ended April 30, 2022, the Company received dividends from Morion in the amount of approximately $123,000, which is included in other income, net in the consolidated statements of operations as part of the FEI-NY segment. During the fiscal year ended April 30, 2023, the Company sold no product and training services to Morion, and the Company received no dividends from Morion. Purchases of materials from Morion consist mainly of quartz crystal blanks which are used in the fabrication of quartz resonators. In the event that these items become unavailable from Morion, the Company is in the process of establishing alternate sources of supply. The Company is also capable of fabricating the crystal blanks in-house.
Morion is a less than wholly-owned subsidiary of Gazprombank, a state-owned Russian bank. The U.S. Ukraine-related sanctions regime has since 2014 included a list of sectoral sanctions identifications (“SSI”) pursuant to Executive Order 13662, which prohibits certain transactions, including certain extensions of credit, with an entity designated as an SSI or certain affiliates of an entity designated as an SSI. On July 16, 2014, after the Company’s investment in Morion, Gazprombank was designated as an SSI.
As previously disclosed, in light of Morion’s relationship with Gazprombank, in 2020, the Company evaluated, with the assistance of external legal counsel, certain sales to Morion and the timing of payments by Morion to the Company in connection with those sales to determine whether payments by Morion may have inadvertently constituted extensions of credit in violation of Directive 1 under Executive Order 13662. The Company determined that certain payments by Morion – the majority of which occurred more than five years ago – were not timely. Following the evaluation, on May 7, 2020, the Company voluntarily disclosed its findings to the Office of Foreign Assets Control (“OFAC”). The Company’s voluntary disclosure to OFAC related solely to delays in collection of accounts receivable that exceeded then-applicable payment windows set forth in sanctions regulations and did not relate to any other type of payment or transaction. On February 17, 2021, the Company received a Cautionary Letter from OFAC indicating that OFAC has completed its review of the matter. According to OFAC, the Cautionary Letter was issued instead of pursuing a civil monetary penalty or taking other enforcement action.
Due to the Russia-Ukraine conflict and resulting sanctions, the future status of FEI’s equity investment in Morion is uncertain. In response to these conditions, in connection with the preparation of the audited financial statements included in the 2022 Form 10-K, the Company impaired its investment in Morion in full. The impairment of $796,000 is included in other income (expense), net, in the Consolidated Statements of Operations for the fiscal year ended April 30, 2022. The likelihood of future sales to, purchases, and dividend payments from Morion is questionable.