GENERAL DISCUSSION
Frequency Electronics, Inc. (sometimes referred to as "Registrant", "Frequency Electronics" or the "Company") is a world leader in precision time and frequency technology which is employed in commercial, government, C4ISR and other military electronic systems. Its technology is used for a wide range of terrestrial and space applications.
Unless the context indicates otherwise, references to the Registrant or the Company are to Frequency Electronics, Inc. and its subsidiaries. References to “FEI” are to the parent company alone and do not refer to any of the subsidiaries. Frequency Electronics, a Delaware corporation, has its principal executive office at 55 Charles Lindbergh Boulevard, Mitchel Field, New York 11553. Its telephone number is 516-794-4500 and its website is www.frequencyelectronics.com.
Frequency Electronics was founded in 1961 as a research and development firm generating proprietary precision time and frequency technology primarily under contracts for U.S. Government end-use. In the mid-1990’s, the Company evolved into a designer, developer and manufacturer of state-of-the-art products for both commercial and government end-use. The Company’s present mission is to be the world leader in providing precision time and low phase noise frequency generation systems, from 1 Hz to 46 GHz for space and other challenging environments. The Company’s technology is the key element in enhancing the functionality and performance of many electronic systems.
MARKETS
The Company’s dominant business area is satellite payloads. It has a unique legacy of providing master timing systems, power converters, and frequency generation, synthesis and distribution systems. It is currently addressing new opportunities in frequency converters, transmitters and receivers, representing a significant increase in the potential revenue for FEI products on any one satellite. These products support primary and hosted payloads for both commercial and U.S. government end-use. Currently, approximately one thousand satellites with varying remaining years of useful life, are operating in High/Geostationary, Medium and Low Earth Orbits. This number of operational satellites is expected to continue to grow over the next ten years as many new satellites are added and older ones are replaced.
The Company’s products support multiple C4ISR (“Command, Control, Communication, Computer, Intelligence, Security and Reconnaissance”), counter measures and additional defense electronic applications for the U.S. government on land, sea and air-borne platforms.
Commercial markets include network infrastructure and other industrial uses. The Company’s products support precise signal synchronization in mobile communication networks to maintain quality of service. Its products support expanded bandwidth and security in public and enterprise networks. The vast world-wide wireline network infrastructure incorporates thousands of central offices which require synchronization upgrades and replacements to provide network integrity and interconnectivity. The Company provides remote terminal units (“RTU”) for management of networks such as power grids and gas lines as well as specialized timing technology for oil and gas exploration.
To address these markets, the Company has several corporate entities which operate under three reportable segments. (See also the section entitled REPORTABLE SEGMENTS below):
Frequency Electronics, Inc. Asia (“FEI-Asia”) was established in fiscal year 2002 to be the Company’s Asian-based low cost manufacturer of certain commercial communications products used primarily in the wireless and wireline markets. FEI-Asia is located in the Free-Trade Zone in Tianjin, China.
The Company’s subsidiary, FEI Government Systems, Inc. (“FEI-GSI”), was formed in fiscal year 2002 to focus on supplying the Company’s technology and legacy proprietary products to the United States military and other U.S. Government agencies.
In February 2012, the Company completed the acquisition of Elcom Technologies, Inc. (now FEI-Elcom Tech, Inc. or “FEI-Elcom”). FEI-Elcom designs and manufactures RF microwave devices and subsystems up to 46 GHz including fast switching, ultra low phase noise synthesizers, up-down converters, receivers, ceramic resonant oscillators and dielectric resonant oscillators. These instruments and components are critical for communication, surveillance, signal intelligence, automatic testing, satellite ground stations and satellite payloads.
In addition to its subsidiaries, the Company has a strategic investment in Morion, Inc. (“Morion”), a Russian crystal oscillator manufacturer located in St. Petersburg, Russia. The Company’s ownership of 4.6% of the outstanding shares of Morion’s common stock permits the Company to secure a cost-effective source for high precision quartz resonators and crystal oscillators. The Morion investment is accounted for under the cost method. (See Note 9 to the Consolidated Financial Statements)
FISCAL 2012 SIGNIFICANT MATTERS
Acquisition of FEI-Elcom Tech, Inc.
During the fourth quarter of fiscal year 2012, the Company completed the purchase of all remaining capital stock of Elcom Technologies, Inc. (“Elcom” or after the acquisition, “FEI-Elcom”) that it did not previously own, resulting in 100% ownership. Prior to this transaction, the Company held a minority interest in Elcom. For the acquisition, the Company paid approximately $4.1 million to the shareholders of Elcom and an additional $910,000 to certain selling shareholders to settle their outstanding debt with Elcom. In addition, the Company held notes due from Elcom with a book value of approximately $1.7 million which was forgiven as an additional investment in Elcom. Based on the price paid to the shareholders, the Company valued Elcom at $7.9 million, which was allocated as $4.6 million of net tangible assets, deferred taxes of $2.6 million, and approximately $700,000 of intangible assets, including nonamortizing goodwill of approximately $400,000.
Reduction of Deferred Tax Asset Valuation Allowance
During the fourth quarters of fiscal years 2012 and 2011, the Company reduced its valuation allowance against deferred tax assets in the amount of $3.1 million and $3.6 million, respectively. This recognition was the result of a review of all available evidence as required by generally accepted accounting principles in the U.S., including the negative evidence of cumulative losses in prior years which required the recording of a substantial valuation allowance in fiscal year 2009. Management of the Company considered the profitable performance for fiscal years 2012 and 2011 as well as recent contract awards which have increased the Company’s long-term backlog to a higher level. Company management believes such contracts will enable the Company to continue to generate operating profits in fiscal year 2013 and beyond. These adjustments were made in the fourth quarters of fiscal 2012 and 2011 as the Company waited until it had results for the full year to make final its determination, given the existence of a loss in recent years, that it met the accounting threshold for determination that the recovery of the deferred tax asset was more likely than not and to estimate the appropriate balance of the valuation allowance, based on all available information. The amount of the non-cash valuation allowance reductions in the fourth quarters was based on management’s estimates of taxable income by reporting segment and taxing jurisdictions and the period over which the Company believes deferred tax assets will be realized.
REPORTABLE SEGMENTS AND PRODUCTS
The Company operates under three reportable segments, primarily aligned with the geographical locations of its subsidiaries: (1) FEI-NY, (2) Gillam-FEI; and (3) FEI-Zyfer. Within each segment the Company designs, develops, manufactures and markets precision time and frequency control products for different markets as described below. The Company’s Chief Executive Officer measures segment performance based on total revenues and profits generated by each geographic center rather than on the specific types of customers or end-users. Consequently, the Company determined that the segments indicated above appropriately reflect the way the Company’s management views the business. The FEI-NY segment, which operates out of the Company’s New York headquarters facility also includes the operations of the Company’s wholly-owned subsidiaries, FEI-Asia and FEI-Elcom. FEI-Asia functions as a manufacturing facility for the FEI-NY segment with minimal sales to outside customers. FEI-Elcom, in addition to its own product line, provides design and technical support for the FEI-NY segment’s satellite business.
The products for the FEI-NY segment are principally marketed to the commercial and U.S. Government satellite markets, to other U.S. Department of Defense programs and to wireless communications networks. The Gillam-FEI segment operates out of Belgium and France and designs, develops and manufactures products for wireline and network synchronization. Its products are currently sold to non-U.S. customers and its US5G product line has recently been introduced to the domestic U.S. market through the Company’s FEI-Zyfer segment which provides sales and support for the US5G family of products. The primary business of the FEI-Zyfer segment, which operates out of California, is the design and manufacture of products which incorporate GPS technologies. FEI-Zyfer sells its products to both commercial and U.S. Government customers and collaborates with other FEI segments on joint product development activities.
During fiscal years 2012 and 2011, approximately 70% and 62%, respectively, of the Company’s consolidated revenues were from products sold by the FEI-NY segment. Sales by Gillam-FEI were approximately 20% and 25% of consolidated revenues for fiscal years 2012 and 2011, respectively. In fiscal years 2012 and 2011, sales for the FEI-Zyfer segment were 18% and 20% of consolidated revenues, respectively. (The sum of annual sales percentages exceeds 100% due to intersegment sales.)
Consolidated revenues include sales to end-users in countries located outside of the United States. During fiscal years 2012 and 2011, foreign sales comprised 33% and 28%, respectively, of consolidated revenues. Segment information regarding revenues, including foreign sales, operating profits, depreciation and assets is more fully disclosed in Note 15 to the accompanying financial statements.
FEI-NY segment:
The Company provides precision time, frequency generation and synchronization products and subsystems that are found in ground-based communication stations, on-board satellites and imbedded in moving platforms operated by the U.S. military. The Company has made a substantial investment in research and development to apply its core technologies to satellite payloads, non-space Department of Defense (“DOD”) programs and network infrastructure markets. Revenues from satellite payloads, both for commercial and U.S. Government applications, have increased in recent years while the portion of network infrastructure sales was reduced. The Company expects to continue to generate substantial revenues from deployment of new and replacement satellites and U.S. Government/DOD applications including sales of ruggedized subsystems for moving platforms of the U.S. military.
Satellite Payloads
The use of satellites launched for communications, navigation, weather forecasting, video and data transmissions and Internet access has expanded the need to transmit increasing amounts of voice, video, and data to earth-based receivers. This requires more precise timing and frequency control at the satellite. The Company manufactures the master clocks (quartz, rubidium and cesium) and other significant timing and frequency generation products for many satellite communication systems, and many of the Company’s other space assemblies are used onboard spacecraft for command, control and power distribution. Efficient and reliable DC-DC power converters are also manufactured for the Company’s own assemblies and as stand-alone products for space applications. The Company’s oven-controlled quartz crystal oscillators are cost-effective precision clocks suited for high-end performance required in satellite transmissions, airborne telephony and geophysical survey positioning systems. Newly developed and upgraded frequency generators, synthesizers, and up/down converters and receivers have augmented the Company’s product offerings and positioned the Company to provide a greater share of a typical satellite’s payload. Commercial satellite programs which utilize the Company’s space-qualified products include Iridium NEXT, MexSat, MSV, ICO, TerreStar, GlobalStar, Intelsat, Inmarsat and numerous others.
In the years ahead, the Company expects that the U.S. DOD will require more secure communication capabilities, more assets in space and greater bandwidth. The Global Positioning Satellite System, the MILSTAR Satellite System and the AEHF Satellite System are examples of the programs in which the Company participates - programs which management believes are important to the success of the U.S. Government’s security, communication and intelligence needs. The Company has manufactured the master clock for the Trident missile, the basic timing system for the Voyager I and Voyager II deep space exploratory missions and the quartz timing system for the Space Shuttle. The Company’s product offerings for U.S. Government satellite programs are similar in design and function to those used on commercial satellites, as described above.
U.S. Government- non-space:
In addition to space-based programs, the Company’s proprietary products have been used in airborne and ground-based guidance, navigation, communications, radar, sonar surveillance and electronic countermeasure and timing systems. The Company has developed and patented a low g-sensitivity (gravity) technology which offers a 100-fold improvement in performance under shock, vibration and other environmental effects. Products are built in accordance with DOD standards and are in use on many of the United States’ important military applications. The Company anticipates that adequate funds will be provided by the U.S. Government to ensure that these programs are sustained.
FEI-Elcom designs and manufactures RF microwave devices and subsystems up to 46 GHz including fast switching, ultra low phase noise synthesizers, up-down converters, receivers, ceramic resonant oscillators and dielectric resonant oscillators. These instruments and components are important for communication, surveillance, signal intelligence, automatic testing, satellite ground stations and satellite payloads.
The Company’s sales on U.S. Government programs for both space and non-space applications are generally made under fixed price contracts either directly with U.S. Government agencies or indirectly through subcontracts intended for government end-use. The price paid to the Company is not subject to adjustment by reason of the costs incurred by the Company in the performance of the contract, except for costs incurred due to contract changes ordered by the customer. These contracts are negotiated on terms under which the Company bears the risk of cost overruns and derives the benefit from cost savings.
Last year, the U.S. Congress passed the Budget Control Act of 2011 putting a process in place to reduce the federal deficit. Unless Congress passes a subsequent law to offset it, the potential exists for significant reductions in future expenditures by the Department of Defense based on a process known as sequestration. As indicated above, many of the programs and platforms for which Frequency supplies products and systems, are used by the U.S. Government for maintaining secure communications world-wide, for obtaining vital intelligence and enabling precision targeting capabilities. It is the belief of management that the future success of the mission of the U.S. military and intelligence gathering community is heavily dependent on successful and timely deployment of these systems. Thus, the Company anticipates that adequate funds will be provided by the U.S. Government to ensure that the programs are completed.
Recently the Company has also received several cost-plus-fee contracts. Under these contracts, the Company may be able to recover all of its direct and indirect costs related to the programs plus a pre-determined fee. In the event of substantial cost overruns, the fee may be reduced.
Negotiations on U.S. Government contracts are sometimes based in part on Certificates of Current Costs. An inaccuracy in such certificates may entitle the government to an appropriate recovery. From time to time, the Defense Contracts Audit Agency ("DCAA") audits the Company's accounts with respect to these contracts.
All U.S. Government end-use contracts are subject to termination by the purchaser for the convenience of the U.S. Government and are subject to various other provisions for the protection of the U.S. Government. In the event of such termination, the Company is entitled to receive compensation as provided under such contracts and in the applicable U.S. Government regulations.
Network Infrastructure
The development of new and enhanced technologies brings expanded and more reliable telecommunications and Internet services to the public. As digital cellular systems and Personal Communication Systems (“PCS”) networks grow they require more base stations to meet the demand for better connectivity, higher data rates and dependable high quality for cell phone service. Cellular infrastructure integrators and original equipment manufacturers, consisting of some of the world’s largest telecommunications companies, are building out existing networks even as they develop new technologies for future systems.
In conjunction with its European subsidiary, Gillam-FEI, the Company has developed state-of-the-art carrier network synchronization equipment identified as the US5G product line. These products are intended to provide synchronization and timing references for wireline networks within the United States where approximately 35,000 “shelves” are located in 25,000 Central Offices around the country. The Company expects to realize increasing sales of this product line and derivative products in fiscal year 2013 and beyond.
Gillam-FEI segment:
Gillam-FEI extends the Company’s competencies into wireline synchronization, network management, and specialized test equipment. With the advent of new digital broadband transmission technologies, reliable synchronization has become the warranty to quality of service for telecommunications operators. Gillam-FEI is among the world leaders in the field of wireline synchronization technology, and its products are targeted for telecommunication operators and network equipment manufacturers that utilize modular and flexible platforms to build reliable digital-network-systems worldwide. Telecommunications operators such as Belgacom, France Telecom, Telefonica and other service providers are among Gillam-FEI’s major customers. With the development of the US5G unit for the FEI-Zyfer segment and the U.S. market, Gillam-FEI also developed a state-of-the-art US5Ge unit and ancillary products intended for deployment in the European, Middle Eastern, Asian and African markets.
FEI-Zyfer segment:
FEI-Zyfer designs, develops and manufactures products for precision time and frequency generation and synchronization, primarily incorporating GPS technology. FEI-Zyfer’s products make use of both “in-the-clear” civil and “crypto-secured” military signals from GPS. In most cases, FEI-Zyfer’s products are integrated into communications systems, computer networks, test equipment, and military command and control terminals for ground and satellite link applications. More than 60% of revenues are derived from sales where the end user is the U.S. Government. FEI-Zyfer’s products are an important extension of FEI’s core product line, specifically in the area of GPS capabilities. In addition, FEI-Zyfer provides sales and support for the Company’s family of wireline telecommunications US5G and derivative products.
BACKLOG
As of April 30, 2012, the Company's consolidated backlog amounted to approximately $57 million. During the prior fiscal year, reported consolidated backlog rose from approximately $30 million to approximately $71 million which included one $24 million multi-year contract which was fully included in backlog at its outset consistent with the Company’s policy respecting contract funding and authorization to proceed. (See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations). Approximately 65% of the current backlog is expected to be filled during the Company’s fiscal year ending April 30, 2013. Included in the backlog at April 30, 2012 is approximately $800,000 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. On fixed price contracts, the Company excludes any unfunded portion which, as of April 30, 2012, was approximately $2 million. The Company expects these contracts to become fully funded over time and will be added to its backlog at that time. The backlog is subject to change by reason of several factors including possible cancellation of orders, change orders, terms of the contracts and other factors beyond the Company's control. Accordingly, the backlog is not necessarily indicative of the revenues or profits (losses) which may be realized when the results of such contracts are reported.
CUSTOMERS AND SUPPLIERS
The Company markets its products both directly and through approximately 30 independent sales representative organizations located in the United States, Europe and Asia. Sales to non-U.S. end-users, including the revenues of its overseas subsidiaries, totaled approximately 33% and 28% of net revenues in fiscal years 2012 and 2011, respectively.
The Company's products are sold to both commercial and governmental customers. For the years ended April 30, 2012 and 2011, approximately 46% and 54%, respectively, of the Company's sales were made under contracts to the U.S. Government or subcontracts for U.S. Government end-use.
During fiscal year 2012, Northrop Grumman Corporation (“Northrop”), Boeing Corporation (“Boeing”) and Thales Alenia Space each accounted for more than 10% of consolidated and FEI-NY segment revenues. During fiscal year 2011, Northrop accounted for more than 10% of consolidated and FEI-segment revenues. In addition, Lockheed Martin Corporation, Motorola Corporation, Boeing and ITT each accounted for more than 10% of the FEI-NY segment’s sales in fiscal year 2011.
During fiscal years 2012 and 2011, Belgacom was a major customer of the Gillam-FEI segment, accounting for more than 10% of that segment’s revenues each year.
During fiscal year 2012, AT&T was a major customer of the FEI-Zyfer segment accounting for more than 10% of that segment’s revenues. During fiscal year 2011, AT&T and Spiral Solutions and Technologies each accounted for more than 10% of that segment’s revenues.
The loss by the Company of any one of these customers could have a material adverse effect on the Company’s business. The Company believes its relationship with these companies to be mutually satisfactory and is not aware of any prospect for the cancellation or significant reduction of any of its commercial or existing U.S. Government contracts.
The Company purchases a variety of components such as transistors, resistors, capacitors, connectors and diodes for use in the manufacture of its products. The Company is not dependent upon any one supplier or source of supply for any of its component part purchases and maintains alternative sources of supply for all of its purchased components. The Company has found its suppliers generally to be reliable and price-competitive.
RESEARCH AND DEVELOPMENT
The Company's technological leadership continues to be an important factor to support future growth in revenues and earnings. The Company has focused its internal research and development efforts on improving the core physics and electronic packages in its time and frequency products, conducting research to develop new time and frequency technologies, improving product manufacturability by seeking to reduce its production costs through product redesign and process improvements and other measures to take advantage of lower cost components.
The Company continues to focus a significant portion of its own resources and efforts on developing hardware for satellite (commercial and U.S. Government) and terrestrial commercial communications systems, including wireless, wireline and GPS-related systems. During fiscal years 2012 and 2011, the Company expended $3.9 million and $5.1 million of its own funds, respectively, on such research and development activity. (See also Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.) During fiscal years 2012 and 2011, many of the Company’s development resources were applied to certain cost-plus-fee contracts and the design-stage of fixed-price satellite payload programs. As a result, some of the Company’s development efforts were customer-funded and the costs appear in cost of revenues resulting in reduced internal research and development spending. For fiscal year 2013, the Company is targeting to spend between $4.5 million and $5.5 million on internal research and development projects. The actual amount spent in fiscal year 2013 will depend on market conditions and identification of new opportunities.