FEIM

Business Context and Reporting Period

Company: Frequency Electronics, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: July 31, 2008 (First Quarter of Fiscal Year 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). The Company is a smaller reporting company.

Key Financial Metrics

Note: Working Capital calculated as Total Current Assets ($71,794) minus Total Current Liabilities ($13,203).

Material Changes vs. Prior Period

• Revenue Decline: Net sales decreased 16% year-over-year, primarily driven by a 25% drop in the FEI-NY segment due to lower satellite payload revenues. This was caused by higher-than-anticipated engineering and manufacturing costs recognized under the percentage-of-completion method.
• Margin Compression: Gross margin rate fell to 24.4% from 28.7%. Management attributes this to the satellite program costs, though the rate represents a sequential improvement from the previous quarter's 16%.
• Investment Income Volatility: Investment income plummeted 95% to $158,000. The prior year period included a $3.0 million gain from the sale of a portion of the Company's investment in Morion, Inc., which did not recur.
• Operating Loss Expansion: Operating loss widened to $1.29 million from $0.79 million due to lower sales and continued engineering costs on satellite programs.
• Cash Flow: Operating cash flow used $2.1 million (improved from $4.4 million used in the prior year), while investing activities used $6.7 million due to the purchase of $6.6 million in marketable securities.

Outlook, Risks, and Management Commentary

• Future Outlook: Management expects revenues from U.S. Government and commercial satellite programs to increase in the remainder of Fiscal 2009 due to recent contract awards. Gross and operating margins are anticipated to improve as engineering efforts on current satellite programs conclude.
• Backlog: Consolidated backlog stood at approximately $36 million as of July 31, 2008, with 80% expected to be filled by April 30, 2009. This includes $7 million in cost-plus-fee contracts not yet fully funded.
• Stock Repurchases: The Company has repurchased approximately $4 million of its common stock out of a $5 million authorization. Subsequent to the quarter-end, an additional 659,651 shares were acquired at an average price of $4.34.
• Material Weaknesses in Internal Controls: Management concluded that internal controls over financial reporting were not effective as of July 31, 2008. Material weaknesses include:
  • Insufficient resources and personnel to oversee internal controls.
  • Lack of documentation and testing of internal controls at subsidiaries Gillam-FEI and FEI-Zyfer.
  • Insufficient segregation of duties, as the CFO is involved in the preparation of financial statements and cannot provide independent review.
• Risks: Dependence on third-party vendors, competitive factors, and the impact of foreign currency exchange rates (specifically the Euro vs. USD) on operating expenses.

Investor Verification Checklist

• Internal Control Remediation: Verify the progress of the plan to document and test controls at Gillam-FEI and FEI-Zyfer, and the hiring of third-party advisors to address segregation of duties.
• Satellite Program Margins: Monitor the completion of current satellite payload programs to confirm the anticipated improvement in gross margins.
• Backlog Funding: Confirm the funding status of the $7 million in cost-plus-fee contracts included in the backlog.
• Debt Utilization: Track the utilization of the bank line of credit, which increased to $6.7 million during the quarter.
• Segment Performance: Watch for the expected recovery in the FEI-NY segment, which drives the majority of consolidated revenue.