FEIM

Business Context and Reporting Period

Company: Frequency Electronics, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: July 31, 2009
Business Overview: The Company 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 for secure communications). The Company is classified as a smaller reporting company.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Turnaround: The Company returned to profitability with a net income of $654,000, compared to a net loss of $773,000 in the prior year. Operating profit improved by $1.95 million.
• Revenue Mix: Consolidated revenues decreased 5% year-over-year. This was driven by a 20% decline in the FEI-NY segment (commercial satellite programs) and a 6% decline in Gillam-FEI. Conversely, the FEI-Zyfer segment grew 84% due to increased sales of the US5G product line and non-space U.S. Government programs.
• Margin Expansion: Gross margin rate improved significantly from 24.4% to 34.6%. Management attributes this to a shift toward cost-plus-fee contracts for satellite programs and the completion of high-cost engineering projects from the prior year.
• Expense Reduction: Selling and administrative expenses dropped 18% due to workforce reductions and lower professional fees. R&D expenses decreased 21% as some development costs were funded by customers on cost-plus contracts.
• Cash Flow: Operating cash flow turned positive ($1.2 million) from a negative $2.1 million in the prior year, driven by profitable operations.

Outlook, Risks, and Contingencies

• Guidance: Management anticipates sustaining operating profits at current levels and expects to generate a profit for the full fiscal year 2010. Gross margins are expected to remain comparable to the current quarter. R&D spending is targeted at less than 10% of revenues.
• Backlog: Consolidated backlog stood at approximately $31 million as of July 31, 2009, with 70% expected to be realized in the next 12 months. Approximately $9 million of this is under cost-plus-fee contracts where full funding has not yet been received.
• Internal Control Material Weaknesses: Management concluded that disclosure controls and internal controls over financial reporting were not effective as of July 31, 2009. Material weaknesses include:
  • Lack of documentation and testing of internal controls at Gillam-FEI and FEI-Zyfer subsidiaries.
  • Insufficient accounting personnel to provide independent review of financial entries (the CFO is involved in preparation).
• Risks: Uncertainty regarding funding for commercial satellite programs due to economic conditions. Dependence on U.S. Government contracts and third-party vendors.

Investor Verification Checklist

• Internal Control Remediation: Verify the progress of documenting and testing controls at the Gillam-FEI and FEI-Zyfer subsidiaries to address the material weakness.
• Revenue Sustainability: Assess the durability of the FEI-Zyfer growth (84% increase) and the stability of the cost-plus-fee contracts driving the improved gross margin.
• Commercial Satellite Exposure: Monitor the status of commercial satellite programs in the FEI-NY segment, which saw a 20% revenue decline and remains subject to funding uncertainty.
• Inventory Valuation: Review inventory levels ($26.6 million) and reserves ($4.7 million) given the Company's reliance on long-term contracts and the critical accounting policy regarding inventory valuation.
• Debt Covenants: Confirm compliance with the $7.4 million line of credit, which is secured by marketable securities.