UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

OR

 

Commission File Number I-4383

ESPEY MFG. & ELECTRONICS CORP.

 (Exact name of registrant as specified in its charter)

233 Ballston Avenue, Saratoga Springs, New York  12866

(Address of principal executive offices)

Note 1. Basis of Presentation

In the opinion of management the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation of the results for such periods.  The results for any interim period are not necessarily indicative of the results to be expected for the full fiscal year.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles have been condensed or omitted.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities.  On an ongoing basis, we evaluate our esti mates and judgments, including those related to revenue recognition, inventories, income taxes, and stock-based compensation.  Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.  These financial statements should be read in conjunction with the Company's most recent audited financial statements included in its report on Form 10-K for the year ended June 30, 2010.

Note 2. Net Income per Share

Basic net income per share excludes dilution and is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted net income per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the income of the Company.  As Unearned ESOP shares are released or committed-to-be-released the shares become outstanding for earnings-per-share computations.

The Company follows ASC 718 in establishing standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, as well as transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that maybe settled by the issuance of those equity instruments.  ASC 718 requires that the cost resulting from all share-based payment transactions be recognized in the financial statements based on the fair value of the share-based payment.  ASC 718 establishes fair value as the measurement objective in accounting for share-based payment transactions with employees, except for equity instruments held by employee share ownership plans.

Total stock-based compensation expense recognized in the Statement of Income for the three month period ended September 30,December 31, 2010 and 2009, was $16,040$21,599 and $25,304,$25,552, respectively, before income taxes.  The related total deferred tax benefit was approximately $1,328$1,834 and $2,477$2,183 for the same periods.three month period ended December 31, 2010 and 2009, respectively.  Total stock-based compensation expense recognized in the Statement of Income for the six month period ended December 31, 2010 and 2009, was $37,639 and $50,856, respectively, before income taxes.  The related total deferred tax benefit was approximately $3,162 and $4,660 for the six month period ended December 31, 2010 and 2009, respectively.  ASC 718 requires the tax benefits resulting from tax deductions in excess of the compensation cost recognizedre cognized for those options to be classified and reported as both an operating cash outflow and a financing cash inflow.

As of September 30,December 31, 2010, there was approximately $100,477$78,878 of unrecognized compensation cost related to stock option awards that is expected to be recognized as expense over the next 21.75 years.  The total deferred tax benefit related to these awards is approximately $8,831.$6,997.

The Company has one employee stock option plan under which options may be granted, the 2007 Stock Option and Restricted Stock Plan (the "2007 Plan"). The Board of Directors may grant options to acquire shares of common stock to employees of the Company at the fair market value of the common stock on the date of grant.  Generally, options granted have a two-year vesting period based on two years of continuous service and have a ten-year contractual life.  Option grants provide for accelerated vesting if there is a change in control.  Shares issued upon the exercise of options are from those held in Treasury.  The 2007 Plan was approved by the Company's shareholders at the Company's Annual Meeting on November 30, 2007 and supercedes the Company's 2000 Stock Option Plan (the "2000 Plan").   ;Options covering 400,000 shares arewere authorized for issuance under the 2007 Plan, of which 99,800 have been granted and 87,90087,100 are outstanding as of September 30,December 31, 2010.  While no further grants of options may be made under the 2000 Plan, as of September 30,December 31, 2010, 64,80061,000 options remain outstanding, vested and exercisable from the 2000 Plan.

ASC 718 requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the Black-Scholes option valuation model, which incorporates various assumptions including those for volatility, expected life and interest rates.

The table below outlines the weighted average assumptions that the Company used to calculate the fair value of each option award for the quartersix months ended:

The Company pays dividends quarterly and anticipates that it will be able to continue to pay comparable regular quarterly dividends in the foreseeable future. While the Company has paid a special cash dividend of $1.00 per share in each of December 20082009 and 2009,2010, there is no assurance that the Board of Directors will declare a comparable special dividend in 2010.2011.  Expected stock price volatility is based on the historical volatility of the Company’s stock. The risk-free interest rate is based on the implied yield available on U.S. Treasury issues with an equivalent term approximating the expected life of the options. The expected option life (in years) represents the estimated period of time until exercise and is based on actual historical experience.

The following table summarizes stock option activity during the threesix months ended September 30,December 31, 2010:

The intrinsic value of stock options exercised was $3,563$26,324 and $0,$10,373, during the threesix months ended September 30,December 31, 2010 and 2009, respectively.  The intrinsic value of stock options outstanding and exercisable as of September 30,December 31, 2010 and 2009 was $270,576$443,108 and $42,948,$123,394, respectively.

The Company at certain times enters into standby letters of credit agreements with financial institutions primarily relating to the guarantee of future performance on certain contracts.  Contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at September 30,December 31, 2010.  As a government contractor, the Company is continually subject to audit by various agencies of the U.S. Government to determine compliance with various procurement laws and regulations.  As a result of such audits and as part of normal business operations of the Company, various claims and charges can be asserted against the Company.  It is not possible to predict the outcome of such actions.  Currently the Company has no claims or assertions pending or threatened against it.

Note 5.  Recently Issued Accounting Standards

In September 2009, the FASB issued ASC 605-25 for revenue recognition with multiple deliverables. These new standards impact the determination of when the individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting. Additionally, these new standards modify the manner in which the transaction consideration is allocated across the separately identified deliverables by no longer permitting the residual method of allocating arrangement consideration. These new standards areAdoption of ASC 605-25 had no effect on the Company's financial statements.

In July 2010, the FASB issued ASU 2010-20, “Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  The standard amends ASC Topic 310, “Receivables” to enhance disclosures about the credit quality of financing receivables and the allowance for credit losses by requiring an entity to provide a greater level of disaggregated information and to disclose credit quality indicators, past due information, and modifications of its financing receivables.  ASU 2010-20 was effective infor interim or annual fiscal years beginning on or after JuneDecember 15, 2010 however early adoption is permitted.  Adoption did notfor public entities and had no effect on the Company’s financial statements.

The Company sponsors a leveraged employee stock ownership plan (the "ESOP") that covers all nonunion employees who work 1,000 or more hours per year and are employed on June 30.  The Company makes annual contributions to the ESOP equal to the ESOP's debt service less dividends on unallocated shares received by the ESOP.  All dividends on unallocated shares received by the ESOP are used to pay debt service.  Dividends on allocated ESOP shares are recorded as a reduction of retained earnings.  As the debt is repaid, shares are released and allocated to active employees, based on the proportion of debt service paid in the year.  The Company accounts for its ESOP in accordance with FASB ASC 718-40.  Accordingly, the shares purchased by the ESOP are reported as Unearned ESOP Shares in the statement of financial position.  As shares are released or committed-to-be-released, the Company reports compensation expense equal to the current average market price of the shares, and the shares become outstanding for earnings-per-share (EPS) computations.   ESOP compensation expense was $107,033$128,375 and $108,843 for the three-month periodthree month periods ended September 30,December 31, 2010 and $90,8992009, respectively.  ESOP compensation expense was $235,408 and $199,742 for the three-month periodsix month periods ended September 30, 2009.December 31, 2010 and 2009, respectively.    The ESOP shares as of September 30,December 31, 2010 and 2009 were as follows:

Overview

Espey Mfg. & Electronics Corp. (“Espey”(the “Company”) is a power electronics design and original equipment manufacturing (OEM) company with a long history of developing and delivering highly reliable products for use in military and severe environment applications. All design, manufacturing, and testing is performed in our 150,000+ square foot facility located at 233 Ballston Ave, Saratoga Springs, New York. Espey is classified as a “smaller reporting company” for purposes of the reporting requirements under the Securities Exchange Act of 1934, as amended.  Espey’s common stock is publicly-traded on the NYSE-Amex under the symbol “ESP.”

Espey began operations after incorporation in New York in 1928.  We strive to remain competitive as a leader in high power energy conversion and transformer solutions through the design and manufacture of new and improved products by using advanced and “cutting edge” electronics technologies.

Espey is ISO 9001:2008 certified and our primary products are power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, ups systems, antennas and high power radar systems. The applications of these products include AC and DC locomotives, shipboard power, shipboard radar, airborne power, ground-based radar, and ground mobile power.

Espey services include design and development to specification, build to print, design services, design studies, environmental testing services, metal fabrication, plating and painting services, and development of automatic testing equipment. Espey manufacturing is vertically integrated, meaning that the Company produces individual components (including inductors), populates printed circuit boards, fabricates metalwork, paints, plates, wires, qualifies, and fully tests items, mechanically, electrically and environmentally, in house.

Business is solicited from large industrial manufacturers and defense companies, the government of the United States, foreign governments and major foreign electronic equipment companies.  In certain countries the Company has external sales representatives to help solicit and coordinate foreign contracts. The Company is also on the eligible list of contractors of agencies of the United States Department of Defense and generally is automatically solicited by such agencies for procurement needs falling within the major classes of products produced by the Company. In addition, the Company directly solicits bids from the United States Department of Defense for prime contracts.  Espey contracts with the Federal Governmentgovernment of the United States under cage code 20950 as Espey Mfg. & Electronics Corp. and cage code 98675 as EspeyEspe y Mfg. & Electronics Corp., Saratoga Industries Division.

There is competition in all classes of products manufactured by the Company from divisions of the largest electronic companies, as well as many small companies. The Company's sales do not represent a significant share of the industry's market for any class of its products. The principal methods of competition for electronic products of both a military and industrial nature include, among other factors, price, product performance, the experience of the particular company and history of its dealings in such products. The Company, as well as other companies engaged in supplying equipment for military use, is subject to various risks, including, without limitation, dependence on United States and foreign government appropriations and program allocations, the competition for available military business, and government termination of orders for convenience.

New orders received in the first threesix months of fiscal 2011 were approximately $6.8$24.6 million, representing a 42.6%224% increase fromover the amount of new orders received in the first threesix months of fiscal 2010.  These new orders are in line with the Company’s strategy of getting involved in long-term high quantity military and industrial products and are predominately for follow-on production of mature products.  The Company's backlog was $31.8$42.9 million at September 30,December 31, 2010 which includes $20.3$32.2 million from three significant customers, compared to $37.0$33.9 million at September 30,December 31, 2009 which included $19.1$23.0 million from two significant customers.  The backlog for the Company represents the estimated remaining sales value of work to be performed under firm contracts.

The outstanding quotations encompass various new and previously manufactured power supplies, transformers, and subassemblies.  However, there can be no assurance that the Company will acquire any or all of the anticipated orders described above, many of which are subject to allocations of the United States defense spending and factors affecting the defense industry and military procurement generally.

Management, along with the Board of Directors, continues to evaluate the need and use of the Company’s working capital.  Capital expenditures are expected to be approximately $500,000$800,000 for fiscal 2011.  Expectations are that the working capital will be required to fund orders, dividend payments, and general operations of the business.  From time to time, management along with the Mergers and Acquisitions Committee of the Board of Directors examine opportunities involving acquisitions or other strategic options, including buying certain products or product lines.  The criteria for consideration are synergies with the Company’s existing product base and accretion to earnings.

Critical Accounting Policies and Estimates

Management believes our most critical accounting policies include revenue recognition and estimates to completion.

A significant portion of our business is comprised of development and production contracts.  Generally, revenues on long-term fixed-price contracts are recorded on a percentage of completion basis using units of delivery as the measurement basis for progress toward completion.

Percentage of completion accounting requires judgment relative to expected sales, estimating costs and making assumptions related to technical issues and delivery schedule.  Contract costs include material, subcontract costs, labor and an allocation of overhead costs.  The estimation of cost at completion of a contract is subject to numerous variables involving contract costs and estimates as to the length of time to complete the contract.  Given the significance of the estimation processes and judgments described above, it is possible that materially different amounts of expected sales and contract costs could be recorded if different assumptions were used, based on changes in circumstances, in the estimation process.  When a change in expected sales value or estimated cost is determined, change s are reflected in current period earnings.

Results of Operations

For the three months ended September 30,December 31, 2010 and 2009 gross profits were $1,650,532$1,624,799 and $2,058,202,$1,462,093, respectively.  Gross profit as a percentage of sales was 27.4%24.7% and 29.9%24.9%, for the three months ended September 30,December 31, 2010 and 2009, respectively.  For the six months ended December 31, 2010 and 2009 gross profits were $3,275,331 and $3,520,295, respectively.  Gross profit as a percentage of sales was 26.0% and 27.6%, for the six months ended December 31, 2010 and 2009, respectively.  The primary factorsfactor in determining gross profit and net income are overall sales levels andis product mix.  The gross profits on mature products and build to print contracts are higher as compared to products which are still in the engineering development stage or in the early stages of production.  In any given accounting period the mix of product shipments between higher margin mature programs and less mature programs, including loss contracts, has a significant impact on gross profit and net income.  The increased gross profit in the three months ended December 31, 2010, was primarily the result of higher net sales with only minor cost overruns related to loss contracts.  The decreased gross profit and gross profit percentage in the threesix months ended September 30,December 31, 2010, as compared to September 30, 2009, was primarily the result of decreased sales, product mix and minor cost overruns related to certain products.

Interest income for the three and six months ended September 30,December 31, 2010 decreased as compared to the three and six months ended September 30,December 31, 2009 due to decreased interest rates and related interest income on the Company’s cash and cash equivalents and short-term investments. Other income increased for the six-months ended December 31, 2010 due to an increase in scrap sales and funds received related to an insurance claim.  The Company does not believe there is significant risk associated with its investment policy, since at September 30,December 31, 2010 all of the investments were primarily represented by short-term liquid investments.

The effective income tax rate at September 30,December 31, 2010 and 2009 was 28.2% and 26.8%, respectively.  The effective tax rate is less than the statutory tax rate mainly due to the benefit the Company receives on its “qualified production activities” under The American Jobs Creation Act of 2004 and the benefit derived from the ESOP dividends paid on allocated shares.

Liquidity and Capital Resources

The Company's working capital is an appropriate indicator of the liquidity of its business, and during the past two fiscal years, the Company, when possible, has funded all of its operations with cash flows resulting from operating activities and when necessary from its existing cash and investments. The Company did not borrow any funds during the last threetwo fiscal years.

The Company's working capital as of September 30,December 31, 2010 and 2009 was approximately $26.2 million.$24.0 million and $24.1 million, respectively.  During the three and six months ended September 30,December 31, 2010 and 2009 the Company did not repurchase anyrepurchased 3,548 and 23,513 shares, respectively, of its common stock.stock from the Company's Employee Retirement Plan and Trust ("ESOP") for a purchase price of $83,662 and $452,155, respectively.  Under existing authorizations from the Company's Board of Directors, as of September 30,December 31, 2010, management is authorized to purchase an additional $1,236,300$1,152,638 million of Company stock.

The Company currently believes that the cash flow generated from operations and when necessary, from cash and cash equivalents, will be sufficient to meet its long-term funding requirements for the foreseeable future.

During the threesix months ended September 30,December 31, 2010 and 2009, the Company expended $107,247$543,613 and $147,308,$290,965, respectively, for plant improvements and new equipment. The Company hashad budgeted approximately $500,000 for new equipment and plant improvements in fiscal 2011.  Currently total expenditures are expected to be approximately $800,000.   Management anticipates that the funds required will be available from current operations.

The Company at certain times enters into standby letters of credit agreements with financial institutions primarily relating to the guarantee of future performance on certain contracts.  ContingentThe Company had no contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at September 30, 2010.

This report contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995.  The terms "believe," "anticipate," "intend," "goal," "expect," and similar expressions may identify forward-looking statements.  These forward-looking statements represent the Company's current expectations or beliefs concerning future events.  The matters covered by these statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statements, including the Company's dependence on timely development, introduction and customer acceptance of new products, the impact of competition and price erosion, supply and manufacturing constraints, potential new orders from customers and other risks an d uncertainties.  The foregoing list should not be construed as exhaustive, and the Company disclaims any obligation subsequently to revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.

The Company is a smaller reporting company as defined under Securities and Exchange Commission Rule 12b-2. Pursuant to the exemption available to smaller reporting company issuers under Item 305 of Regulation S-K, quantitative and qualitative disclosures about market risk, the Company is not required to provide the information for this item.

(a) The Company's management, with the participation of the Company's chief executive officer and chief financial officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

(b) There have been no changes in our internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.