Frequency Electronics - 10-Q quarterly report FY

During the second quarter of fiscal year 2009, the Company repurchased from Elcom 29,651 shares of the Company’s outstanding common stock at an aggregate cost of approximately $150,000.  The amount paid was at the market value of the Company’s common stock on the date of purchase.

The cost, gross unrealized gains, gross unrealized losses and fair market value of available-for-sale securities at October 31, 2009 and April 30, 2009 are as follows (in thousands):

The fair value accounting framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements).  The three levels of the fair value hierarchy are described below:

The asset’s or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.  Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.  All of the Company’s investments in marketable securities are Level 1 assets.

In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning May 1, 2010, with earlier adoption permitted.  Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance.  Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance.  Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method.  The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition.  In the event that early adoption is elected, the Company would be required to determine the relative selling price for all deliverables in a multiple element arrangement based on the hierarchy identified in the new standard.  The Company would also be required to apply the standard retrospectively to the beginning of the year and to the comparable prior period for disclosure purposes.  The Company is currently evaluating the impact this new guidance may have on its condensed consolidated financial statements.  Early adoption of the standard is unlikely.

In June 2009, the FASB issued authoritative guidance codifying a single source of authoritative nongovernmental U.S. GAAP.  This guidance does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all authoritative literature related to a particular topic in one place.  All existing accounting standard documents will be superseded and all other accounting literature not included in the FASB Codification will be considered non-authoritative.  These provisions were effective for interim and annual periods ending after September 15, 2009 and, accordingly, are effective for the Company in the current fiscal reporting period.  The adoption of this pronouncement did not have an impact on the Company’s condensed consolidated financial statements, but will impact its financial reporting process by eliminating all references to pre-codification standards.  On the effective date, the Codification superseded all then-existing non-SEC accounting and reporting standards, and all other non-grandfathered non-SEC accounting literature not included in the Codification became non-authoritative.

In May 2009, the FASB issued guidelines on subsequent event accounting which establishes general standards of accounting for, and requires disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  The Company adopted these amendments effective May 1, 2009 and has evaluated subsequent events through the date these financial statements were filed on December 15, 2009.

In April 2009, the FASB issued new guidance on the recognition of other-than-temporary impairments of investments in debt securities and provides new presentation and disclosure requirements for other-than-temporary impairments of investments in debt and equity securities.  The Company adopted these provisions during the first quarter of fiscal year 2010.  The adoption did not have a material effect on its consolidated financial statements.

In April 2009, the FASB issued guidance which requires disclosures about fair value of financial instruments in interim and annual financial statements.  The new requirements were effective for interim periods ending after June 15, 2009 and the Company adopted these requirements in the first quarter of fiscal year 2010.  The adoption did not have a material effect on its consolidated financial statements.

In September 2006, the FASB issued guidance which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  This guidance is contained in ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 820”).  In February 2008, the FASB deferred the effective date to January 1, 2009 for all nonfinancial assets and liabilities, except for those that are recognized or disclosed at fair value on a recurring basis (that is, at least annually).  The Company adopted the provisions of ASC Topic 820 in fiscal year 2009.  With the adoption of new accounting rules, fair value is now determined as an exit price, representing the price that would be received in an orderly transaction between market participants based on the highest and best use of the asset rather than as the result of an internally-generated cash flow analysis.  In April 2009, the FASB issued additional guidance for estimating fair value in accordance with ASC Topic 820.  The additional guidance addresses determining fair value when the volume and level of activity for an asset or liability have significantly decreased and identifying transactions that are not orderly.  The Company adopted the provision of this guidance during its first quarter of fiscal year 2010, ended July 31, 2009.  The adoption did not have a material effect on its consolidated financial statements.

In accordance with current accounting standards, the Company has evaluated subsequent events through the time of filing of this Form 10-Q, which was on December 15, 2009.

During the six month period ended October 31, 2009, the Company made a contribution of 40,434 shares of its common stock held in treasury to the Company’s profit sharing plan and trust under section 401(k) of the Internal Revenue Code.  Such contribution is in accordance with the Company’s discretionary match of employee voluntary contributions to this plan.

The Company’s significant accounting policies are described in Note 1 to the consolidated financial statements included in the Company’s April 30, 2009 Annual Report to Stockholders.  The Company believes its most critical accounting policies to be the recognition of revenue and costs on production contracts and the valuation of inventory.  Each of these areas requires the Company to make use of reasoned 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.

Revenues under larger, long-term contracts which generally require billings based on achievement of milestones rather than delivery of product, are reported in operating results using the percentage of completion method.  On fixed-price contracts, which are typical for commercial and U.S. Government satellite programs and other long-term U.S. Government projects, and which require initial design and development of the product, revenue is recognized on 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 sales recorded as the costs are incurred.  Each month management reviews estimated contract costs through a process of aggregating actual costs incurred and updating estimated costs to completion based upon the current available information and status of the contract.  The effect of any change in the estimated gross margin percentage for a contract is reflected in revenues in the period in which the change is known.  Provisions for anticipated losses on contracts are made in the period in which they become determinable.

On production-type orders, revenue is recorded as units are delivered with the related cost of sales recognized on each shipment based upon a percentage of estimated final program costs.  Changes in job performance may result in revisions to costs and income and are recognized in the period in which revisions are determined to be required.  Provisions for anticipated losses on contracts are made in the period in which they become determinable.

For customer orders in the Company’s Gillam-FEI and FEI-Zyfer segments or smaller contracts or orders in the FEI-NY segment, sales of products and services to customers are reported in operating results based upon (i) shipment of the product or (ii) performance of the services pursuant to terms of the customer order.  When payment is contingent upon customer acceptance of the installed system, revenue is deferred until such acceptance is received and installation completed.

Contract costs include all direct material, direct labor costs, manufacturing overhead and other direct costs related to contract performance.  Selling, general and administrative costs are charged to expense as incurred.

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.  The Company writes down the value of slow-moving and obsolete inventory items based upon management’s experience and expectations for future business.  Any write downs are reflected in cost of sales in the period the write downs are made.

The table below sets forth for the respective periods of fiscal years 2010 and 2009 the percentage of consolidated revenues represented by certain items in the Company’s consolidated statements of operations:

The improvement in gross margins for the six and three month periods ended October 31, 2009, are primarily due to increased gross margin rates.  The gross margin rates recorded in the fiscal year 2010 periods approach the Company’s targeted rates.  The rates recorded in the fiscal year 2009 periods were much lower than the Company’s targets due primarily to higher levels of engineering and manufacturing costs on certain satellite payload programs that were completed during fiscal year 2009.  During the quarter ended October 31, 2009, the Company reached an agreement with a customer to receive $650,000 representing a portion of the cost of certain unique inventory items that the customer no longer requires.  The Company recorded this amount as a reduction to cost of goods sold during the six and three month periods ended October 31, 2009.  During the same periods, the Company wrote down inventory, including the unique items, with an aggregate value of $800,000 and $650,000, respectively.  The Company anticipates that its gross margin rates for the remainder of fiscal year 2010 will be comparable to the current periods but will show significant improvement over the prior fiscal year.

For the six and three months ended October 31, 2009, selling and administrative expenses were 22% and 24%, respectively, of consolidated revenues.  This is compared to 22% and 20%, respectively, for the same periods of fiscal year 2009.  Although the Company’s target for such expenses is not to exceed 20% of revenues, since many of the costs are relatively fixed, lower revenues result in a higher ratio of expenses to revenues.  The decrease in expenses in the fiscal year 2010 periods compared to the same periods of fiscal year 2009 are primarily due to declines in personnel costs through a reduction in force and reduced deferred compensation expense.  These decreases were partially offset by higher professional fees and increased costs in the Gillam-FEI segment, including the impact of the rising value of the Euro to the U.S. dollar.  In subsequent quarters of fiscal year 2010, the Company expects selling and administrative expenses to be incurred at approximately the same rate in both dollars and as a percentage of revenues.

Research and development expenditures represent investments that keep the Company’s products at the leading edge of time and frequency technology and enhance competitiveness for future revenues.  Research and development spending for the six and three-month periods ended October 31, 2009 was 10% and 12% of revenues, respectively, compared to 8% and 6% of revenues for the same periods of fiscal year 2009, respectively.  The increased spending in fiscal year 2010, particularly in the second quarter of fiscal year 2010, resulted from intensive activities in the areas of satellite payload product development and improving the technology of the Company’s new wireline synchronization equipment.  In addition, the Company continues to conduct development activities on customer-funded programs the cost of which appears in cost of revenues, thus reducing the level of internal research and development spending.  The Company targets research and development spending at approximately 10% of revenues, but the rate of spending can increase or decrease from quarter to quarter as new projects are identified and others are concluded.  The Company will continue to devote significant resources to develop new products, enhance existing products and implement efficient manufacturing processes.  For the remainder of fiscal year 2010, the Company anticipates that internal research and development spending will be less than 10% of revenues.  Internally generated cash and cash reserves are adequate to fund these development efforts.

Investment income is derived primarily from the Company’s holdings of marketable securities.  Earnings on these securities may vary based on fluctuating interest rate levels and the timing of purchases or sales of securities.

The equity loss in the fiscal year 2010 and 2009 periods represent the Company’s share of the quarterly loss recorded by Elcom Technologies in which the Company owns a 25% interest.  In addition, during the three month period ended October 31, 2009, the Company measured the current market value of Elcom based on comparisons to comparable companies as well as Elcom’s forecasts of future financial results and determined that its investment was impaired.  Consequently, the Company recorded an impairment charge in the amount of $200,000 in addition to its equity share in Elcom’s quarterly loss.

The decrease in interest expense for the six and three month periods ended October 31, 2009, resulted from both a decrease in borrowings under the Company’s line of credit as well as a lower rate of interest charged on such borrowings compared to the same periods ended October 31, 2008.

Under the provisions of sale and leaseback accounting, a portion of the capital gain realized on a fiscal year 2005 real estate transaction is deferred and recognized in income over the initial lease term.  Under the caption “Other income, net” the Company recognized deferred gain of $177,000 and $88,000 for the six and three months ended October 31, 2008, respectively.  Since the gain was fully amortized during fiscal year 2009, comparable income was not recorded in the periods ended October 31, 2009. In the fiscal year 2010 periods, other expense included royalty expense and certain foreign currency exchange losses at the Company’s overseas subsidiaries.  Other insignificant income and expense items are also recorded under this caption.

During the six months ended October 31, 2009, the Company recorded an income tax provision of approximately $130,000, or approximately 25% of pre-tax income.  This provision was completely offset by a reduction in the valuation allowance on deferred tax assets that was established in prior years.  As of October 31, 2009, the valuation allowance is approximately $8.4 million and may continue to be reduced as the Company realizes pre-tax profits in future periods.

The Company is subject to taxation in several countries as well as the states of New York and California.  The statutory federal rates vary from 34% in the United States to 35% in Europe.  The effective rate is impacted by the income or loss of certain of the Company’s European and Asian subsidiaries which are currently not taxed.  In addition, the Company utilizes the availability of research and development tax credits in the United States to lower its tax rate.  As of April 30, 2009, the Company’s European subsidiaries had available net operating loss carryforwards of approximately $1.1 million, which will offset future taxable income.  The domestic U.S. tax loss carryforward, which expires in 2028, is approximately $3.0 million and the tax loss carryforward for state income tax purposes is approximately $7.3 million.

The Company’s balance sheet continues to reflect a strong working capital position of $51 million at October 31, 2009, compared to working capital of $48 million at April 30, 2009.  Included in working capital at October 31, 2009 is $16.5 million of cash, cash equivalents and marketable securities.  The Company’s current ratio at October 31, 2009 is 8.3 to 1.

For the six months ended October 31, 2009, the Company had positive cash flow from operating activities of $2.7 million compared to $466,000 provided by operations in the comparable fiscal year 2009 period.  The primary sources of cash in the fiscal year 2010 period were profitable operations and the collection of accounts receivable.  During the fiscal year 2010 period, the Company incurred over $2.5 million of non-cash operating expenses, such as depreciation and amortization and accruals for employee benefit programs.  These non-cash expenses are comparable to prior years.  In the six month period ended October 31, 2008, operating cash flow was diminished by the $1.7 million net loss for the period.  For the balance of fiscal year 2010, the Company expects to generate positive cash flow from operating activities.

Net cash used in investing activities for the six months ended October 31, 2009, was $280,000 compared to a $5.9 million use of cash for the same period of fiscal year 2009.  During the fiscal year 2010 period, cash was used solely to acquire capital equipment.  In the prior fiscal year, the Company invested $5.6 million in marketable securities, net of $1.0 million in proceeds from the sale of certain marketable securities, and acquired additional fixed assets for $293,000.  The Company may continue to acquire or sell marketable securities as dictated by its investment strategies as well as by the cash requirements for its development activities.  Capital equipment purchases for all of fiscal year 2010 are expected to be in the range of $1.0 million to $1.5 million.  Internally generated cash is adequate to acquire this level of capital equipment.

The Company will continue to expend resources to develop and improve products for space applications, guidance and targeting systems, and communication systems which management believes will result in future growth and continued profitability.  During fiscal year 2010, the Company intends to make a substantial investment of capital and technical resources to develop new products to meet the needs of the U.S. Government, commercial space and telecommunications infrastructure marketplaces and to invest in more efficient product designs and manufacturing procedures.  Where possible, the Company will secure partial customer funding for such development efforts but is targeting to spend its own funds at a rate less than 10% of revenues to achieve its development goals.  Internally generated cash will be adequate to fund these development efforts.

As of October 31, 2009, the Company's consolidated backlog amounted to approximately $37 million.  Approximately 70% of this backlog is expected to be realized in the next twelve months.  Included in the backlog at October 31, 2009 is approximately $7.5 million under cost-plus-fee contracts which the Company believes represent firm commitments from its customers for which the Company has not received full funding to date.  The Company excludes from backlog any contracts or awards for which it has not received authorization to proceed.

The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.