FREQUENCY ELECTRONICS INC (FEIM) FY 2024 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

“Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995:

The statements in this Annual Report on Form 10-K regarding future earnings and operations and other statements relating to the future constitute “forward-looking” statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements inherently involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. Factors that would cause or contribute to such differences include, but are not limited to, the risks associated with reliance on key customers, including the U.S. government, the Company’s use of estimates when accounting for contracts, actions by significant customers or competitors, competitive factors, new products and technological changes, continued acceptance of the Company’s products in the marketplace, dependence upon third-party vendors, product prices and raw material costs, the Company’s ability to attract and retain key employees, general domestic and international economic conditions, health epidemics and pandemics, external disruptions to the Company’s facilities or supply chain, the Company’s operations in a highly regulated industry, the outcome of any litigation and arbitration proceedings, cybersecurity attacks, volatility in the Company’s stock price, including due to the relatively low trading volume of its common stock, and failure to maintain an effective system of internal controls over financial reporting. The factors listed above are not exhaustive. Other sections of this Form 10-K include additional factors that could materially and adversely impact the Company’s business, financial condition and results of operations. Moreover, the Company operates in a very competitive and rapidly changing environment. New factors emerge from time to time and it is not possible for management to predict the impact of all these factors on the Company’s business, financial condition or results of operations or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not rely on forward-looking statements as a prediction of actual results. Any or all of the forward-looking statements contained in this Form 10-K and any other public statement made by the Company or its management may turn out to be incorrect. The Company expressly disclaims any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

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Critical Accounting Estimates

The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The Company believes its most critical accounting policies to be the recognition of revenue and costs on production contracts, income taxes and the valuation of inventory. Each of these areas requires the Company to make use of reasonable estimates, including estimating the cost to complete a contract, the realizable value of its inventory or the market value of its products. Changes in estimates can have a material impact on the Company’s financial position and results of operations.

Revenue Recognition

Revenues for most contracts are reported in operating results over time using the cost-to-cost method. Under this method, revenue is recorded based upon the ratio that incurred costs bear to total estimated contract costs with related cost of revenues recorded as the costs are incurred. Each month management reviews estimated contract costs through a process of aggregating actual costs incurred and estimating additional costs to completion based upon the current available information regarding labor, outside services, materials, overhead costs and status of the contract. The effect of any change in the estimated gross margin rate for a contract is reflected in revenues in the period in which the change is known. Provisions for the full amount of anticipated losses on contracts are made in the period in which they become determinable.

Significant judgment is used in evaluating the financial information for certain contracts to determine an appropriate budget and estimated cost. The Company evaluates this information continuously and bases its judgments on historical experience, design specifications, and expected costs for material and labor.

Inventory

In accordance with industry practice, inventoried costs contain amounts relating to contracts and programs with long production cycles, a portion of which will not be realized within one year. Inventory write downs are established for slow-moving materials based on percentage of usage over a ten-year period, obsolete items on a gradual basis over five years with no usage and costs incurred on programs for which production-level orders cannot be determined as probable. Such write-downs are based upon management’s experience and expectations for future business.

Income Taxes

Our income tax expense, deferred tax asset and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. Significant judgments and estimates are required in the determination of the consolidated income tax expense.

Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover deferred tax assets in the jurisdiction from which they arise, we consider all positive and negative evidence, including the reversal of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. As of April 30, 2024 and 2023, we have a full valuation allowance against our U.S. deferred tax assets. If these estimates and assumptions change in the future, the Company may be required to reduce its existing valuation allowance resulting in less income tax expense. The Company evaluates the likelihood of realizing its deferred tax assets quarterly.

Tax benefits are recognized for an uncertain tax position when, in the Company’s judgment, it is more likely than not that the position will be sustained upon examination by a taxing authority. For a tax position that meets the more-likely-than-not recognition threshold, the tax benefit is measured as the largest amount that is judged to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. The liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances and when new information becomes available. Such adjustments are recognized entirely in the period in which they are identified. The effective tax rate includes the net impact of changes in the liability for unrecognized tax benefits and subsequent adjustments as considered appropriate by the Company. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, the Company believes its liability for unrecognized tax benefits is adequate.

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RESULTS OF OPERATIONS

Consolidated Results

The table below sets forth for the fiscal years ended April 30, 2024 and 2023, the percentage of consolidated net sales represented by certain items in the Company’s consolidated statements of operations:

Revenues

For the fiscal year ended April 30, 2024 revenue increased by approximately $14.5 million, or 36% compared to the prior fiscal year. The Company is encouraged by the significant revenue growth in both segments compared to the prior fiscal year. In fiscal year 2024, revenues from satellite programs, one of the Company’s largest business areas, increased by $5.3 million, or 30%, compared to the prior fiscal year. Satellite program revenues for government end-use were 40% and 43% of total revenues for fiscal years 2024 and 2023, respectively. Satellite program revenues for commercial end-use were 2% and 1% of total revenue for fiscal years 2024 and 2023, respectively. Revenues on satellite program contracts are recorded in the FEI-NY segment and are recognized primarily under the percentage-of-completion (“POC”) method. Revenues from non-space U.S. Government/DOD customers increased by approximately $8.7 million, or 43%, in fiscal year 2024 compared to fiscal year 2023. These revenues are recorded in both the FEI-NY and FEI-Zyfer segments and accounted for approximately 52% and 50% of consolidated revenues for fiscal years 2024 and 2023, respectively. Other commercial and industrial sales accounted for approximately 6% of consolidated revenues for both fiscal years 2024 and 2023. Sales in the other commercial and industrial sales area were $3.1 million and $2.6 million for the fiscal year ended April 30, 2024 and the fiscal year ended April 30, 2023, respectively. The majority of the increase in revenue for fiscal year 2024, as compared to fiscal year 2023, was as a result of an increase in sales in the non-space U.S. Government/DOD market.

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Gross Profit

For the fiscal year ended April 30, 2024, the gross profit and gross profit percentage increased as a result of several factors. The increase in gross profit dollars was directly related to the significant increase in revenues over the prior fiscal year period as well as the increase in gross margin. The majority of the increase in the gross profit percentage, as compared to the prior fiscal year, was in the FEI-NY segment and was attributed to the Company resolving technical issues on some developmental programs from the prior two fiscal years. The Company does not foresee significant additional technical issues regarding these programs as most of these programs have been completed. In addition, the Company has new programs that are progressing well, and the Company anticipates that they will add to the generation of additional revenue and profit.

Selling and Administrative Expenses

In fiscal years ended April 30, 2024 and 2023, selling and administrative expenses (“SG&A”) were 18% and 23% of consolidated revenues, respectively. While total SG&A expenses increased in fiscal year 2024, as compared to the prior fiscal year, SG&A expenses decreased as a percentage of revenue in fiscal year 2024, due to increased revenue as well as the Company successfully monitoring costs given the current economic conditions.

Research and Development Expenses

As a percentage of consolidated revenue, R&D expense for the fiscal years ended April 30, 2024 and 2023 were 6% and 8%, respectively. The Company funded R&D amount was slightly higher in fiscal year 2024 as compared to the previous fiscal year, reflecting the Company’s commitment to maintaining its technical excellence. The Company expects future R&D investment to be in line with, or even potentially above historical commitments.

The funds received in connection with customer funded R&D appears in revenues and the associated expenses are included in cost of revenues and are not included in the table above. The Company believes that internally generated cash and cash reserves are adequate to fund its future R&D activity.

Operating Income (Loss)

For the fiscal year ended April 30, 2024, the Company recorded operating income of $5.0 million compared to an operating loss of $4.7 million in the prior fiscal year. The change from an operating loss to operating income, year over year, is attributable to the Company’s significant increase in revenue and margin during fiscal year 2024, along with the positive effects of cost cutting measures instituted by management.

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Other Income (Expense), net

The change from the prior fiscal year was mainly caused by a loss on the sale of the Company’s available-for sale marketable securities in the previous fiscal year. Additionally, interest expense was approximately 30% lower in fiscal year 2024, as compared to the prior fiscal year.

Income Tax (Benefit) Provision

For the fiscal year ended April 30, 2024, the Company recorded an income tax benefit of $130,000. For the fiscal year ended April 30, 2023, the Company recorded an income tax provision of $74,000.

The Company’s effective tax rate of (2.4)% for fiscal year 2024 differs from the U.S. federal statutory rate of 21% primarily due to state taxes, an income tax benefit for a reduction in the uncertain tax position liability in connection with the expiration of the statute of limitations, and the reduction in the valuation allowance due to a decrease in the deferred tax asset for which no tax benefit was provided. (See Note 13 to the Consolidated Financial Statements for a reconciliation of the actual tax benefit to the expected tax provision at the federal statutory rate.)

As of April 30, 2024, the Company has U.S. federal net operating losses of $24.2 million of which $8.5 million begins to expire in fiscal year 2025 through fiscal year 2038, including $2.0 million which is subject to annual limitation under Internal Revenue Code Section 382. The remaining U.S. federal net operating losses of $15.7 million have an indefinite carry-forward period. The U.S. federal capital loss carry-forward of $0.8 million expires in fiscal years 2025 and 2028. U.S. federal R&D credits of $1.0 million begin to expire in fiscal year 2036 through fiscal year 2040. The Company also has state net operating loss carryforwards, and state tax credits that expire in various years and amounts.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operations was $8.7 million in fiscal year 2024 compared to cash provided by operations of $1.2 million in fiscal year 2023. The Company’s balance sheet continues to reflect a highly liquid position with working capital of $27.3 million at April 30, 2024 as compared to $21.0 million at April 30, 2023. Included in working capital at April 30, 2024 was $18.3 million consisting of cash and cash equivalents. The Company’s current ratio at April 30, 2024 was 1.9 to 1 compared to 1.8 to 1, at the end of prior fiscal year.

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During fiscal years 2024 and 2023, the Company incurred $4.4 million and $5.0 million, respectively, in non-cash charges to earnings, including adjustments relating to net assets and liabilities for operating leases, loss provision accrual, provision for a note receivable, depreciation and amortization expense, inventory adjustments, warranty and accounts receivable reserves and certain employee benefit plan expenses, including accounting for stock-based compensation. During fiscal year 2024, operating cash was increased as a result of decreases in loss on provision accrual and other liabilities and increases in contract assets and inventory, partially offset by an increase in contract liabilities and net income. During fiscal year 2023, operating cash was increased by decreases in loss on provision accrual and other liabilities and increases in contract assets and inventory, partially offset by an increase in contract liabilities.

Net cash used in investing activities for the fiscal year ended April 30, 2024 was $1.5 million compared to $8.7 million provided by investing activities for the fiscal year ended April 30, 2023. In fiscal year 2024, there were no investing activities related to sales of marketable securities net of the purchases of marketable securities and there were purchases of capital expenditures of $1.5 million. In fiscal year 2023, investing activities included the proceeds related to sales of marketable securities net of the purchases of marketable securities of $9.6 million and purchases of capital expenditures of $0.9 million.

There was no cash used in financing activities for the fiscal year ended April 30, 2024. Net cash used in financing activities for the fiscal year ended April 30, 2023 was approximately $9.4 million related to a special dividend payout.

The Company will continue to expend resources to develop, improve and acquire products for space and other applications, which management believes will result in future growth and profitability. During fiscal year 2024, the Company secured partial customer funding for a portion of its R&D efforts. The customer funds received in connection therewith appear in revenues and are not included in R&D expenses. For fiscal year 2025, the Company anticipates securing additional customer funding for a portion of its R&D activities and will allocate internal funds depending on market conditions and identification of new opportunities as in fiscal 2024. The Company expects internally generated cash will be adequate to fund these future R&D efforts. The Company may also pursue acquisitions to expand its range of products and may use internally generated cash and external funding in connection with such acquisitions.

During fiscal year 2024, as in fiscal year 2023, the impact of inflation on the Company’s business was due to increases in costs for materials and services. The Company believes this may continue to impact expenses in fiscal year 2025 and future years.

As of April 30, 2024, the Company had an accumulated deficit of $20.0 million. The Company believes that its cash, as of April 30, 2024, and cash flows from operations will provide sufficient liquidity to meet its operating needs in the normal course of business in both the short-term (next twelve months from the date of issuance of these consolidated financial statements) and in the long-term (beyond the next twelve months).

RECENT ACCOUNTING PRONOUNCEMENTS

In November 2023, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2023-07, Segment Reporting (Topic 280): Improvements to Reportable Segment Disclosures (“ASU 2023-07”), which expands on the required disclosure of incremental segment information. The new guidance is effective for fiscal years beginning after December 15, 2023, and interim periods within fiscal years beginning after December 15, 2024, with early adoption permitted. The Company is evaluating the effect on its consolidated financial statements when adopted in fiscal year 2025 but does not expect the effect to be material.

In December 2023, the FASB issued ASU No. 2023-09, Income Taxes (Topic 740): Improvements to Income Tax Disclosures (“ASU 2023-09”), which requires companies to annually disclose categories in the effective tax rate reconciliation and additional information about income taxes paid. The new guidance is effective for annual periods beginning after December 15, 2024, and interim periods within fiscal years beginning after December 15, 2024, with early adoption permitted. The Company is in the process of evaluating the impact that the adoption of ASU No. 2023-09 will have to the financial statements and related disclosures.

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OTHER MATTERS

The financial information reported herein is not necessarily indicative of future operating results or of the future financial condition of the Company.

Morion

The Company has an investment in Morion, a privately-held Russian company, which manufactures high precision quartz resonators and crystal oscillators. The Company has also licensed certain technology to Morion.

The Company’s investment consists of 4.6% of Morion’s outstanding shares, accordingly, the Company accounts for its investment in Morion on the cost basis. During the fiscal years ended April 30, 2024 and 2023, the Company acquired product from Morion in the aggregate amount of approximately $89,000 and $196,000, respectively. During the fiscal years ended April 30, 2024 and 2023, the Company sold no product and no training services to Morion, and the Company received no dividends from Morion.

Purchases of materials from Morion consist mainly of quartz crystal blanks which are used in the fabrication of quartz resonators. In the event that these items become unavailable from Morion, the Company is in the process of establishing alternate sources of supply. The Company is also capable of fabricating the crystal blanks in-house.

Morion is a less than wholly-owned subsidiary of Gazprombank, a state-owned Russian bank. The U.S. Ukraine-related sanctions regime has since 2014 included a list of sectoral sanctions identifications (“SSI”) pursuant to Executive Order 13662, which prohibits certain transactions, including certain extensions of credit, with an entity designated as an SSI or certain affiliates of an entity designated as an SSI. On July 16, 2014, after the Company’s investment in Morion, Gazprombank was designated as an SSI.

As previously disclosed, in light of Morion’s relationship with Gazprombank, in 2020, the Company evaluated, with the assistance of external legal counsel, certain sales to Morion and the timing of payments by Morion to the Company in connection with those sales to determine whether payments by Morion may have inadvertently constituted extensions of credit in violation of Directive 1 under Executive Order 13662. The Company determined that certain payments by Morion – the majority of which occurred more than five years ago – were not timely. Following the evaluation, on May 7, 2020, the Company voluntarily disclosed its findings to the Office of Foreign Assets Control (“OFAC”). The Company’s voluntary disclosure to OFAC related solely to delays in collection of accounts receivable that exceeded then-applicable payment windows set forth in sanctions regulations and did not relate to any other type of payment or transaction. On February 17, 2021, the Company received a Cautionary Letter from OFAC indicating that OFAC has completed its review of the matter. According to OFAC, the Cautionary Letter was issued instead of pursuing a civil monetary penalty or taking other enforcement action.

Due to the Russia-Ukraine conflict and resulting sanctions, the future status of FEI’s equity investment in Morion is uncertain. In response to these conditions, in connection with the preparation of the audited financial statements included in the 2022 Form 10-K, the Company impaired its investment in Morion in full. The likelihood of future sales to, purchases, and dividend payments from Morion is questionable.