Overview

Espey Mfg. & Electronics Corp. (the "Company") located in Saratoga Springs, New York, is engaged principally in the development, design, production and sale of specialized electronic power supplies, a wide variety of transformers and other types of iron-core components, and electronic system components. In some cases, the Company manufactures such products in accordance with pre-developed mechanical and electrical requirements ("build to print"). In other cases, the Company is responsible for both the overall design and manufacture of the product. The Company does not generally manufacture standardized components and does not have a product line. The products manufactured by the Company find application principally in (i) shipboard and land based radar, (ii) locomotives,
(iii) aircraft, (iv) short and medium range communication systems, (v) navigation systems, and (vi) land-based military vehicles artillery.

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.

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 nine months of fiscal 2009 were approximately $14.2 million, representing a 12.8% decrease from the amount of new orders received in the first nine months of fiscal 2008. These orders are predominately follow-on production quantities for mature products. These orders are in line with the Company's strategy of getting involved in long-term high quantity military and industrial products. The Company's backlog was $40.0 million at March 31, 2009 compared to $33 million at March 31, 2008, and is $38.9 million at May 10, 2009, which includes $19.1 million from two significant customers. The backlog for the Company represents the estimated remaining sales value of work to be performed under firm contracts. These contracts include significant orders for military and industrial power supplies, and contracts to manufacture certain customer products in accordance with pre-engineered requirements.

The sales backlog gives the Company a solid base of future sales. Based upon the backlog and the anticipated schedule for the fulfillment of orders, management expects sales for fiscal 2009 to be higher than fiscal 2008 sales. In addition to the backlog, the Company currently has outstanding quotations and potential business representing approximately $56 million in the aggregate for both repeat and new programs.

Net sales to two significant customers represented 59.0% and 58.4% of the Company's total sales for the three-month period ended March 31, 2009 and 2008, respectively. Sales to these two customers for the nine-month period ended March 31, 2009 and 2008 represented 65.7% and 57.9% of total sales, respectively. Historically, a small number of customers have accounted for a large percentage of the Company's total sales in any given fiscal year. For several years, management has pursued opportunities with current and new customers with an objective of lowering the concentration of sales, mitigating excessive reliance upon a single major product program of a particular program and minimizing the impact of the loss of a single significant customer. Management continues to evaluate its business development functions and potential revised courses of action.

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. Expectations are that the working capital will be required to fund any increase in orders over the next several quarters, dividend payments, and general operations of the business. Also, the Mergers and Acquisitions Committee of the Board of Directors continues to evaluate potential strategic options on an ongoing basis.

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, changes are reflected in current period earnings.

Results of Operations

Net sales for the three months ended March 31, 2009 were $6,709,880 as compared to $6,479,020 for the same period in 2008, representing an 3.6% increase. Net sales for the nine months ended March 31, 2009 were $18,957,576 as compared to $19,512,950 for the same period in 2008, representing a 2.8% decrease. Generally, the increases and decreases in net sales can be attributed to the contract specific nature of the Company's business. The increase for the three months ended March 31, 2009, was due to an overall increase in power supply shipments offset by a decrease in transmitter component shipments. The decrease for the nine months ended March 31, 2009 was due to a decrease in transmitter component and transformer shipments offset by an increase in power supply shipments.

For the three months ended March 31, 2009 and 2008 gross profits were $1,732,812 and $2,177,431, respectively. Gross profit as a percentage of sales was 25.8% and 33.6%, for the three months ended March 31, 2009 and 2008, respectively. For the nine months ended March 31, 2009 and 2008 gross profits were $3,510,017 and $5,209,126, respectively. Gross profit as a percentage of sales was 18.5% and 26.7%, for the nine months ended March 31, 2009 and 2008, respectively. The primary factor in determining gross profit and net income is 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 decreased gross profit and gross profit percentage in the three and nine months ended March 31, 2009, was primarily the result of unexpected losses incurred on two programs with significant engineering and production time required for design efforts. These two programs experienced significant cost overruns due to extended product qualification testing and difficulties moving the products from engineering design into full production. Currently, one program has completed qualification testing and has moved into full production. The other program is still in qualification testing and has made significant progress towards completion. There also is a third loss contract that had a negative impact on gross profit and net income in the 3 months ended March 31, 2009. This contract is near completion and should ship prior to June 30, 2009. Management continues to evaluate the Company's workforce to ensure that production and overall execution of the backlog orders and additional anticipated orders are successfully obtained and executed. Employment of full time equivalents at March 31, 2009 was 166 compared to 173 people at March 31, 2008.

Selling, general and administrative expenses were $658,115 for the three months ended March 31, 2009; an increase of $10,117, compared to the three months ended March 31, 2008. Selling, general and administrative expenses were $2,125,927 for the nine months ended March 31, 2009, an increase of $108,557 compared to the nine months ended March 31, 2008. The increase for the three and nine months ended March 31, 2009, relates primarily to an increase in salaries and an increase in legal and consulting fees.

Other income for the three and nine months ended March 31, 2009 decreased as compared to the three and nine months ended March 31, 2008 due to decreased interest rates and related interest income on the Company's cash and cash equivalents and short-term investments. The Company does not believe that there is a significant risk associated with its investment policy, since at March 31, 2009 all of the investments were primarily represented by short-term liquid investments including certificates of deposit and money market funds.

The effective income tax rate at March 31, 2009 and 2008 was 31.8% and 34.4%, 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 and the benefit derived from the ESOP dividends paid on allocated shares.

Net income for the three months ended March 31, 2009, was $ 781,272 or $.37 per share, both basic and diluted, compared to $1,099,205 or $.53 per share, both basic and diluted, for the three months ended March 31, 2008. Net income for the nine months ended March 31, 2009, was $1,137,155 or $.54 per share, both basic and diluted, compared to $2,487,874 or $1.20 and $1.18 per share, basic and diluted, respectively, for the nine months ended March 31, 2008. The decrease in net income per share was primarily due to the loss programs explained above and decreased interest income.

Liquidity and Capital Resources

The Company's working capital is an appropriate indicator of the liquidity of its business, and during the past three 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 three fiscal years.

The Company's working capital as of March 31, 2009 and 2008 was approximately $24.1 million and $26.4 million, respectively. During the three months ended March 31, 2009 and 2008 the Company repurchased 14,350 and 7,500 shares, respectively, of its common stock for a total purchase price of $209,035 and $144,600, respectively. Of the total purchases, 10,699 shares and 7,500 shares, respectively, were purchased from the Company's Employee Retirement Plan and Trust ("ESOP") for a purchase price of $157,222 and $144,600, respectively. All remaining shares were purchased on the open market. During the nine months ended March 31, 2009 and 2008 the Company repurchased 19,899 and 33,220 shares, respectively, of its common stock for a total purchase price of $311,545 and $716,363, respectively. Of the total purchases, 11,499 shares and 33,220 shares, respectively, were purchased from the Company's Employee Retirement Plan and Trust ("ESOP") for a purchase price of $171,662 and $716,363, respectively. All remaining shares were purchased on the open market. Under existing authorizations from the Company's Board of Directors, as of March 31, 2009, management is authorized to purchase an additional $1,688,454 million of Company stock.

                                                     Nine Months Ended March 31,
                                                          2009         2008
                                                     ------------  ------------
Net cash (used in) provided by operating activities  $  (554,444)  $ 2,910,999
Net cash used in investing activities                   (722,280)   (3,023,736)
Net cash used in financing activities                 (4,722,830)   (4,394,594)

Net cash provided by operating activities fluctuates between periods primarily as a result of differences in net income, the timing of the collection of accounts receivable, purchase of inventory, level of sales and payment of accounts payable. Net cash used in investing activities decreased in the first nine months of fiscal 2009 primarily due to more short-term investments maturing during the current period. The increase in cash used in financing activities is due primarily to increased dividends paid on common stock, decreased purchase of treasury shares, and a decrease in the proceeds from the exercise of stock options.

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 nine months ended March 31, 2009 and 2008, the Company expended $211,952 and $423,131, respectively, for plant improvements and new equipment. The Company has budgeted approximately $350,000 for new equipment and plant improvements in fiscal 2009. 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. Contingent liabilities on outstanding standby letters of credit agreements aggregated to zero at March 31, 2009 and March 31, 2008.

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 and 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.