FEIM

Business Context and Reporting Period

Company: Frequency Electronics, Inc. (FEI)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: October 31, 2010 (Six and Three Months)
Business Overview: FEI designs and manufactures precision time and frequency control products for communication satellites, terrestrial cellular stations, and U.S. military applications. Operations are organized into three segments: FEI-NY (New York/China), Gillam-FEI (Belgium/France), and FEI-Zyfer (California).

Key Financial Metrics

Cash Flow (Six Months): Operating activities used $1.8 million (vs. $2.7 million provided in prior year). Investing activities used $1.7 million. Financing activities used $0.1 million.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated revenues increased 3% ($0.8 million) for the six months and 10% ($1.1 million) for the three months compared to the prior year. Growth was driven by U.S. Government/DOD satellite and non-space programs, which increased over 15% year-over-year.
• Profitability Improvement: Operating profit increased 78% for the six months and 236% for the three months. This was primarily due to improved gross margins (up to 38.7% from 36.5%) and the absence of a $200,000 impairment charge on an affiliate investment recorded in the prior year.
• Segment Performance: FEI-NY revenues grew 8% (six months). FEI-Zyfer revenues declined 17% (six months) but grew 22% (three months). Gillam-FEI revenues were relatively flat.
• Tax Provision: A provision for income taxes of $820,000 was recorded for the six months ended Oct 31, 2010, compared to zero in the prior year. This reflects the utilization of prior tax loss carryforwards and current earnings.

Guidance, Outlook, and Risks

• Outlook: Management expects to generate an operating profit for the full fiscal year 2011. Gross margin rates are expected to remain comparable to current levels. R&D spending is targeted at approximately 10% of revenues.
• Backlog: Consolidated backlog was approximately $31 million as of October 31, 2010, with 75% expected to be realized in the next twelve months. Approximately $5.5 million of this is under cost-plus-fee contracts pending full funding.
• Liquidity: The company maintains a strong liquidity position with $19.0 million in cash and marketable securities. Management believes liquidity is adequate through April 30, 2011.
• Internal Controls: The company disclosed that its disclosure controls and procedures were not effective as of October 31, 2010, due to material weaknesses in internal control over financial reporting identified in the previous fiscal year. No substantial changes were made to address these weaknesses during the quarter.
• Risks: Risks include dependence on U.S. Government programs, competitive factors, and the potential for inventory write-downs due to long production cycles.

Investor Verification Checklist

• Internal Control Weaknesses: Verify the specific nature of the material weaknesses in internal controls and the remediation plan, as controls were deemed ineffective.
• Government Contract Funding: Confirm the status of the $5.5 million in backlog under cost-plus-fee contracts that lacks full funding.
• Inventory Levels: Review the increase in inventory ($28.9 million) and the associated risk of obsolescence given the long production cycles.
• Tax Valuation Allowance: Monitor the $8.2 million deferred tax asset valuation allowance and the conditions required to reduce it in future periods.
• Segment Mix: Assess the sustainability of revenue growth in the FEI-NY segment versus the volatility in the FEI-Zyfer segment.