Frequency Electronics, Inc. — Q2 FY2019 Form 10-Q
Reporting period: Quarter and six months ended October 31, 2018. The company develops precision time and frequency control products and systems through FEI-NY and FEI-Zyfer. Amounts below are in U.S. dollars; financial statement amounts are in millions unless otherwise noted.
Financial performance
- Quarter: Revenue was $12.1 million, up 30.0% year over year. Gross profit was $4.0 million, with a 33.1% gross margin versus 23.6%. Operating loss narrowed to $0.23 million from $1.87 million. Net income was $0.12 million, or $0.01 per diluted share, versus a net loss of $1.48 million, or $0.17 per share.
- Six months: Revenue was $23.2 million, up 8.4%. Gross profit was $8.3 million, with a 35.8% gross margin versus 31.5%. Operating loss narrowed to $0.15 million from $1.69 million. Net income was $0.15 million, or $0.02 per diluted share, versus a net loss of $0.87 million, or $0.10 per share.
- Revenue mix: For the six months, satellite revenue was $11.3 million and government non-space revenue was $10.4 million; other commercial and industrial revenue was $1.4 million, down from $4.7 million. FEI-NY revenue increased 16.4% to $18.3 million, while FEI-Zyfer revenue declined 35.1% to $5.1 million.
- Expenses and other income: Six-month selling and administrative expense rose 2.7% to $5.2 million; R&D declined 3.2% to $3.3 million. Six-month investment income fell to $0.19 million from $1.17 million, largely because the prior-year period included approximately $1.0 million of realized gains on equity securities. Other income included proceeds from a life-insurance policy on a retired key employee.
- Cash flow: Operating activities used $1.1 million in the six months, compared with $2.8 million provided a year earlier. Investing activities used $2.6 million, including $1.3 million of property and equipment purchases and $2.2 million of marketable-security purchases. Cash and equivalents fell by $4.0 million to $3.9 million.
- Liquidity and debt: Working capital was $47.4 million and the current ratio was 12.1:1. Cash, equivalents, and marketable securities totaled $11.3 million. The company reported no outstanding borrowings; it had terminated its bank credit facility, though it said credit was available under an advisory arrangement based on securities holdings.
- Balance sheet: Total assets were $83.7 million and stockholders’ equity was $64.2 million. Inventory was $25.6 million; costs and estimated earnings in excess of billings, net, were $7.0 million. Deferred compensation liabilities were $13.7 million.
Material changes and accounting comparability
- The company adopted ASC 606 and related contract-cost guidance (ASC 340-40) on May 1, 2018 using the modified-retrospective method. Adoption increased opening retained earnings by a net $0.484 million.
- ASC 606 changed the timing of revenue recognition for certain U.S. government production contracts from point-in-time recognition to percentage-of-completion recognition. Reported six-month revenue was $2.052 million higher and reported net income was $0.988 million higher than it would have been without adoption. For the quarter, the corresponding increases were $1.242 million and $0.413 million. Thus, reported year-over-year comparisons are affected by the new accounting.
- Approximately $20.4 million of six-month revenue was recognized over time using percentage of completion. Management’s estimates of contract costs and completion affect recognized revenue and margins.
- Gillam, sold in April 2018 for $1.0 million cash plus a $1.0 million note due in three years, was reported as discontinued operations in the prior-year comparisons. The sale resulted in an approximately $0.359 million loss.
Outlook, risks, and contingencies
- Funded backlog was approximately $38 million at October 31, 2018, up from $30 million at April 30, 2018; about 80% was expected to be realized within 12 months. Backlog included approximately $8.5 million under cost-plus-fee contracts and excludes awards without authorization to proceed and associated funding.
- Management said significant additional customer funding had been secured for FY2019 R&D and expected internally generated cash to fund development efforts. It believed liquidity was adequate through at least December 14, 2019. No specific earnings or revenue guidance was provided.
- Management attributed improved gross margin to increased revenue, lower repair costs, and product mix. It expected customer-funded R&D to add substantially to overall R&D activity for the full fiscal year.
- Key uncertainties include contract cost and completion estimates, inventory valuation, customer acceptance and funding, competition and technology changes, vendor dependence, and currency movements, particularly the Chinese renminbi. The company had a full valuation allowance against U.S. deferred tax assets based notably on cumulative losses.
- The company reported unrealized losses on available-for-sale securities but did not consider them other-than-temporary, citing market volatility and its ability to hold the securities. Its Morion investment and dealings also carry geopolitical considerations: Morion operates as a subsidiary of a Russian state-owned bank subject to U.S. restrictions on new financing.
- Management reported effective disclosure controls as of October 31, 2018 and no material changes in internal control over financial reporting during the quarter.
Important facts for investors to verify
- How much of reported revenue and earnings growth reflects ASC 606 timing changes rather than underlying operating improvement.
- Whether the $38 million funded backlog converts on schedule, and the assumptions and margins embedded in long-term contract estimates.
- Drivers of the cash decline and operating cash use, including receivables, payables, and investment spending.
- FEI-Zyfer’s revenue decline and the ongoing shift toward satellite and government non-space revenue.
- Progress in achieving sustainable operating profitability, given the six-month operating loss and U.S. deferred-tax valuation allowance.