FEIM

Business Context and Reporting Period

Company: Frequency Electronics, Inc. (FEI)
Filing Type: Form 10-K (Annual Report)
Period Ended: April 30, 2011
Business Overview: FEI designs, develops, and manufactures high-technology frequency, timing, and synchronization products for satellite payloads, U.S. Government defense programs, and terrestrial network infrastructure. The company operates through three reportable segments: FEI-NY (New York/China), Gillam-FEI (Belgium/France), and FEI-Zyfer (California). Approximately 54% of sales are derived from U.S. Government contracts or subcontracts.

Key Financial Metrics

Debt & Liquidity: The company maintains a highly liquid position with no outstanding debt on its $7.4 million line of credit as of April 30, 2011. European subsidiaries have access to approximately $2.5 million in credit lines, none of which were utilized. Capital lease obligations totaled $0.46 million.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated revenues increased 8% ($3.8 million) driven primarily by the FEI-NY segment (+14%), which benefited from satellite payload programs and U.S. Government non-space products. FEI-Zyfer revenues declined 6% due to U.S. Government budgetary delays.
• Profitability Surge: Operating profit nearly doubled (99% increase) to $3.49 million, aided by improved gross margins and controlled operating expenses.
• Significant Tax Benefit: Net income was significantly boosted by a non-cash reduction of the deferred tax asset valuation allowance of $3.6 million. Management determined it was "more likely than not" that deferred tax assets would be realized due to recent profitability and a record backlog.
• Backlog Expansion: Backlog increased from $30 million to $71 million, the highest level in 20 years, with approximately 60% expected to be filled in fiscal 2012.

Guidance, Outlook, and Risks

Outlook: Management expects fiscal 2012 revenues to increase significantly, with satellite payload revenues growing to nearly half of consolidated revenues. Gross margins are projected to remain in the upper 30% to low 40% range. Operating expenses are targeted at less than 20% of revenues.

Management Commentary: The company anticipates continued growth in satellite and U.S. Government programs. R&D spending is targeted at approximately 10% of revenues ($4.5M - $5.5M) for fiscal 2012.

Risks & Contingencies:

• Customer Concentration: Five customers accounted for 68% of FEI-NY segment sales in 2011. Northrop Grumman alone accounted for over 10% of consolidated revenues. Loss of any major customer could have a material adverse effect.
• Government Funding: Approximately 54% of sales are tied to U.S. Government contracts, which are subject to budgetary constraints and potential termination for convenience.
• Internal Control Weakness: Management concluded that internal controls over financial reporting were not effective as of April 30, 2011, due to inadequate resources and incomplete documentation/testing of controls at Gillam-FEI and FEI-Zyfer subsidiaries. Remediation is planned for fiscal 2012.
• Foreign Operations: The company is exposed to currency risks in Belgium and China.

Investor Verification Checklist

• Tax Benefit Sustainability: Verify the assumptions regarding future taxable income that justified the $3.6 million reduction in the deferred tax valuation allowance.
• Backlog Realization: Confirm the funding status of the $71 million backlog, noting that $4 million of fixed-price contracts and $3.7 million of cost-plus contracts are currently unfunded.
• Internal Control Remediation: Monitor progress on the remediation of material weaknesses in internal controls at foreign subsidiaries (Gillam-FEI and FEI-Zyfer) to ensure future financial reporting reliability.
• Customer Dependency: Assess the stability of contracts with major customers (Northrop Grumman, Lockheed Martin, Motorola, Boeing, ITT) which drive the majority of segment revenues.
• Segment Performance: Review the specific drivers for the 6% revenue decline in the FEI-Zyfer segment to ensure it does not signal a broader trend in GPS-based government contracts.