FEIM

Business Context and Reporting Period

Company: Frequency Electronics, Inc. (FEI)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: October 31, 2008 (Six and Three Months)
Business Overview: FEI operates in three segments: FEI-NY (precision time/frequency control for satellites and military), Gillam-FEI (wireline synchronization in Belgium), and FEI-Zyfer (GPS technologies). The company is a smaller reporting company.

Key Financial Metrics

Note: Working Capital calculated as Total Current Assets ($66,790) minus Total Current Liabilities ($11,506).

Material Changes vs. Prior Period

• Revenue Decline: Consolidated revenues decreased 18% ($5.9M) for the six months and 20% ($3.5M) for the three months compared to the prior year. The primary driver was a 27-28% drop in the FEI-NY segment due to lower commercial satellite payload revenues.
• Margin Compression: Gross margin rates fell from 30.1% to 21.8% (six months) and 31.3% to 19.4% (three months). This was caused by higher engineering/manufacturing costs on satellite programs and increased inventory reserves for slow-moving items.
• Operating Loss: The company shifted from a small operating loss/profit in the prior year to significant operating losses of $2.3M (six months) and $1.0M (three months).
• Investment Income: Investment income dropped 90% ($3.4M) year-over-year. The prior year included a $3.0M gain from the sale of a portion of the company's investment in Morion, Inc., which did not recur.
• Share Repurchases: The company repurchased 677,651 shares for approximately $3.0M during the six-month period, utilizing a portion of its $5M authorization.

Outlook, Risks, and Management Commentary

• Outlook: Management expects U.S. Government satellite revenues to increase in the remainder of fiscal 2009 due to recent contract awards. However, commercial satellite revenue is expected to decline due to tight credit conditions. The company anticipates improved gross and operating margins in the second half of fiscal 2009 and expects to report a profit.
• Backlog: Consolidated backlog was approximately $36 million as of October 31, 2008, with 75% expected to be realized in the next 12 months.
• Material Weaknesses in Internal Controls: Management concluded that internal controls over financial reporting were not effective as of October 31, 2008. Material weaknesses include:
  • Insufficient resources and personnel to provide effective oversight.
  • Lack of documentation and testing of internal controls at subsidiaries Gillam-FEI and FEI-Zyfer.
  • Insufficient segregation of duties, as the CFO is actively involved in preparing financial statements and cannot provide independent review.
• Liquidity: The company maintains a strong working capital position ($55M) and a current ratio of 5.8 to 1. Cash flow from operations turned positive ($466k) due to collections on large satellite program milestones.

Investor Verification Checklist

• Internal Control Remediation: Verify the timeline and progress of remediation plans for the material weaknesses in internal controls, specifically regarding the subsidiaries and segregation of duties.
• Satellite Program Costs: Confirm the status of the "challenging" satellite programs causing margin compression and the expected timeline for their completion.
• Commercial Satellite Demand: Assess the impact of tight credit conditions on commercial satellite operators and the potential duration of the revenue decline in that sector.
• Inventory Reserves: Review the adequacy of inventory reserves ($6.74M) given the noted increase in slow-moving items.
• Government Contract Funding: Verify the funding status of the $7.3M in cost-plus-fee contracts included in the backlog, as these represent firm commitments but may not be fully funded.