FEIM

Business Context and Reporting Period

Company: Frequency Electronics, Inc. (FEI)
Filing Type: Form 10-K (Annual Report)
Period Ended: April 30, 2008
Business Overview: FEI designs, develops, and manufactures precision time and frequency control products for satellite payloads, terrestrial telecommunications (wireless and wireline), and U.S. Government defense applications. The company operates through three reportable segments: FEI-NY (headquarters and commercial/space products), Gillam-FEI (Belgian subsidiary for wireline synchronization), and FEI-Zyfer (GPS-based timing products).

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Consolidated net sales increased 15% to $64.4 million, driven by a 15% increase in the FEI-NY segment and a 21% increase in the FEI-Zyfer segment. Growth was primarily attributed to satellite payload programs (commercial and U.S. Government) and non-space U.S. Government programs, both of which saw over 40% revenue increases.
• Margin Compression: Gross margin percentage declined from 30.4% to 27.4%. This was caused by higher-than-anticipated engineering and manufacturing costs on satellite payload programs, including testing failures in the fourth quarter that required contract cost estimate revisions.
• Profitability: Despite an operating loss of $2.6 million, the company reported a net income of $0.9 million, compared to a net loss of $0.3 million in 2007. This turnaround was significantly aided by a $3.0 million pre-tax gain from the partial sale of its investment in Morion, Inc.
• Cash Flow: Net cash used in operating activities improved to $1.9 million (from $6.6 million used in 2007), though still negative due to operating losses and a 27% increase in accounts receivable. Investing activities provided $13.3 million, largely due to the Morion sale proceeds and marketable securities activity.

Guidance, Outlook, and Risks

Outlook and Guidance:

• Management expects substantial revenue growth in fiscal 2009 from commercial and U.S. Government satellite programs and new U.S. Government development contracts (secure radios, UAVs, guidance systems).
• The company anticipates improved gross margins in 2009 as challenging satellite programs conclude and are replaced by cost-plus programs.
• Research and Development spending is targeted at less than 10% of revenues for fiscal 2009.
• Dividends: The Board suspended the June 2008 cash dividend due to credit market uncertainties but intends to review the policy at subsequent meetings.

Risks and Contingencies:

• Customer Concentration: Three customers (Boeing, Motorola, Space Systems/Loral) accounted for 37% of consolidated sales in 2008. The loss of any single major customer would have a material adverse effect.
• Contract Risks: Fixed-price contracts expose the company to cost overrun risks. Recent testing failures on satellite payloads led to revenue reductions and loss provisions in Q4 2008.
• Internal Control Weaknesses: Management identified material weaknesses in internal controls over financial reporting, specifically regarding inadequate resources, insufficient segregation of duties (CFO involvement in preparation), and lack of documentation/testing at subsidiaries (Gillam-FEI and FEI-Zyfer).
• Foreign Operations: Exposure to currency fluctuations and potential tax liabilities in China (FEI-Asia) starting in calendar 2009.

Investor Verification Checklist

• Contract Cost Estimates: Verify the accuracy of revised cost-to-complete estimates for satellite payload programs to ensure future margin recovery.
• Internal Control Remediation: Monitor progress on the remediation plan for material weaknesses in internal controls, particularly at foreign subsidiaries.
• Customer Diversification: Assess the stability of relationships with top three customers (Boeing, Motorola, SS/L) which represent over one-third of revenue.
• Dividend Policy: Confirm the Board's decision regarding the resumption of cash dividends given the suspension in Q4 2008.
• Backlog Conversion: Track the conversion of the $39 million backlog into revenue, noting that $7 million is under cost-plus contracts with unfunded commitments.