Edgar Filing: ESPEY MFG & ELECTRONICS CORP

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-KSB

[X] Annual Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934 for the fiscal year ended June 30, 2006

[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934. For the transition period from to

Commission File No. 1-4383

ESPEY MFG. & ELECTRONICS CORP.
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(Exact name of registrant as specified in its charter)

NEW YORK 14-1387171
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(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

233 Ballston Avenue, Saratoga Springs, NY 12866
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(Address of principal executive offices including Zip Code)

(Registrant's telephone number including area code) (518)245-4400
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Name of Each Exchange
Title of Each class on Which Registered
------------------- -------------------
Common Stock $.33-1/3 par value American Stock Exchange
Common Stock Purchase Rights American Stock Exchange

Securities registered pursuant to Section 12 (g) of the Act: None

Indicate by check mark whether the registrant (1) has filed all reports required
to the filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days.
[X] Yes [ ] No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-B is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB.
[X] Yes [ ] No

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
[ ] Yes [X] No

Revenues for fiscal year ended June 30, 2006 were $20,851,570.

The aggregate market value of the voting stock held by non-affiliates of the
registrant was $23,397,251 based upon the closing sale price of $16.70 on the
American Stock Exchange on June 30, 2006.

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.

Class Outstanding at September 25, 2006
------- ---------------------------------
Common stock, $.33-1/3 par value 2,309,396 shares

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants definitive proxy statement relating to the 2006
Annual Meeting of Shareholders, to be filed with the Securities and Exchange
Commission, are incorporated by reference in Part III, Items 10 through 14 on
Form 10-KSB as indicated herein.

Forward-Looking Statements

This Annual Report on Form 10-KSB contains forward-looking statements that are
based on management's expectations, estimates, projections and assumptions.
Words such as "expects," "anticipates," "plans," "believes," "scheduled,"
"estimates" and variations of these words and similar expressions are intended
to identify forward-looking statements. Forward-looking statements are made
pursuant to the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995, as amended. These statements are not guarantees of future
performance and involve certain risks and uncertainties that are difficult to
predict. Therefore, actual future results and trends may differ materially from
what is forecast in forward-looking statements due to a variety of factors,
including, without limitation:
o Changing priorities in the U.S. government's defense budget (including
changes in priorities in response to terrorist threats or to improve
homeland security);
o Termination of government contracts due to unilateral government
action;
o Differences in anticipated and actual program performance, including
the ability to perform under long-term fixed-price contracts within
estimated costs, and performance issues with key suppliers and
subcontractors;
o Potential for changing prices for energy and raw materials.

All forward-looking statements speak only as of the date of this report or, in
the case of any document incorporated by reference, the date of that document.
All subsequent written and oral forward-looking statements attributable to the
Company or any person acting on the Company's behalf are qualified by the
cautionary statements in this section. The Company does not undertake any
obligation to update or publicly release any revisions to forward-looking
statements to reflect events, circumstances or changes in expectations after the
date of this report.

PART I
Item 1. Business

General

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. The
Company operates a one-segment business and was incorporated in 1928.

The electronic power supplies and components 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.

The Company's iron-core components include (i) transformers of the audio, power
and pulse types, (ii) magnetic amplifiers and (iii) audio filters. The
electronic system components manufactured by the Company include antenna systems
and high power radar transmitters. These system components utilize the Company's
own electronic power supplies, transformers and other iron-core components and
mechanical assemblies.

In the fiscal years ended June 30, 2006 and 2005, the Company's total sales were
$20,851,570 and $18,828,700, respectively. Sales to three domestic customers
accounted for 35%, 17% and 13% of total sales in 2006. Sales to two domestic
customers accounted for 32% and 14% of total sales in 2005.

Export sales in 2006 and 2005 were approximately $3,392,000 and $4,946,000,
respectively.

Sources of Raw Materials

The Company has never experienced any significant delay or shortage with respect
to the purchase of raw materials and components used in the manufacture of its
products, and has at least two potential sources of supply for a majority of its
raw materials. However, certain components used in our products are available
from only a limited number of sources, and other components are only available
from a single source. Despite the risk associated with limited or single source
suppliers, the benefits of higher quality goods and timely delivery minimize and
often limit any potential risk and can eliminate problems with part failures
during production.

Sales Backlog

At September 21, 2006, the Company's backlog was approximately $36.5 million.
The total backlog at June 30, 2006 was approximately $37.7 million as compared
to approximately $31.8 million at June 30, 2005. The Company's total backlog
represents the estimated remaining sales value of work to be performed under
firm contracts. The Company's backlog and risks associated with government
contracts is discussed in greater detail in Management's Discussion and Analysis
of Financial Condition and Results of Operations, contained in Item 7 below.

It is presently anticipated that a minimum of $24 million of orders comprising
the June 30, 2006 backlog will be filled during the fiscal year ending June 30,
2007. The minimum of $24 million does not include any shipments, which may be
made against orders subsequently received during the fiscal year ending June 30,
2007. The estimate of the June 30, 2006 backlog to be shipped in fiscal 2007 is
subject to future events, which may cause the amount of the backlog actually
shipped to differ from such estimate.

Marketing and Competition

The Company markets its products primarily through its own direct sales
organization. Business is solicited from large industrial manufacturers and
defense companies, the government of the United States and 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
many 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.

There is competition in all classes of products manufactured by the Company,
including 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 U.S. and
foreign government appropriations and program allocations, the competition for
available military business, and government termination of orders for
convenience.

The Company's business is not considered to be seasonal in nature.

Research and Development

The Company's expenditures for research and development were approximately
$121,000 and $187,000 in 2006 and 2005, respectively. Some of the Company's
engineers and technicians spend varying degrees of time on either development of
new products or improvement of existing products.

Employees

The Company had 175 employees as of September 21, 2006. Some of these employees
are represented by the International Brotherhood of Electrical Workers Local
#1799. The current collective bargaining agreement expires on June 30, 2008. The
contract includes a 3.75% annual pay increase in the fiscal period 2006 through
2007, and no increase for 2008. Relations with the Union are considered good.
Union membership at September 21, 2006 was 74 people.

Government Regulations

Compliance with federal, state and local provisions that have been enacted or
adopted to regulate the discharge of materials into the environment, or
otherwise relating to the protection of the environment, did not in fiscal 2006,
and the Company believes will not in fiscal year 2007, have a material effect
upon the capital expenditures, net income, or competitive position of the
Company.

The Company's U.S. government contract and subcontract orders are funded by
government budgets, which operate on an October-to-September fiscal year. In
February of each year, the President of the United States presents to the
Congress a proposed budget for the upcoming fiscal year. This budget includes
recommended appropriations for every federal agency and is the result of months
of policy and program reviews throughout the executive branch. From February
through September of each year, the appropriations and authorization committees
of Congress review the President's budget proposals and establish the funding
levels for the upcoming fiscal year in appropriations and authorization
legislation. Once these levels are enacted into law, the Executive Office of the
President administers the funds to the agencies.

There are two primary risks associated with this process. First, the process may
be delayed or disrupted because of congressional schedules, negotiations over
funding levels for programs or unforeseen world events, which could, in turn,
alter the funding for a program or contract. Second, funding for multi-year
contracts can be changed by future appropriations, which could affect the timing
of funds, schedules and program content.

Also, our international sales are denominated in United States currency.
Consequently, changes in exchange rates that strengthen the United States dollar
could increase the price in local currencies of our products in foreign markets
and make our products relatively more expensive than competitor's products.

U.S. Government Defense Contracts and Subcontracts

Generally, U.S. government contracts are subject to procurement laws and
regulations. Some of the Company's contracts are governed by the Federal
Acquisition Regulation (FAR), which lays out uniform policies and procedures for
acquiring goods and services by the U.S. government, and agency-specific
acquisition regulations that implement or supplement the FAR. For example, the
Department of Defense implements the FAR through the Defense Federal Acquisition
Regulation (DFAR).

The FAR also contains guidelines and regulations for managing a contract after
award, including conditions under which contracts may be terminated, in whole or
in part, at the government's convenience or for default. If a contract is
terminated for the convenience of the government, a contractor is entitled to
receive payments for its allowable costs and, in general, the proportionate
share of fees or earnings for the work done. If a contract is terminated for
default, the government generally pays for only the work it has accepted. These
regulations also subject the company to financial audits and other reviews by
the government of its costs, performance, accounting and general business
practices relating to its contracts, which may result in adjustment of the
company's contract-related costs and fees.

Item 2. Properties

The Company's manufacturing and engineering facilities are at its plant in
Saratoga Springs, New York.

The Saratoga Springs plant, which the Company owns, consists of various
adjoining one-story buildings on a 22 acre site. (Approximately 8% of this site
is unimproved) The property is not subject to mortgage indebtedness or any other
material encumbrance. The plant has a sprinkler system throughout and contains
approximately 151,000 square feet of floor space, of which 90,000 is used for
manufacturing, 24,000 for engineering, 33,000 for shipping and climatically
secured storage, and 4,000 for offices. The offices, engineering and some
manufacturing areas are air-conditioned. In addition to assembly and wiring
operations, the plant includes facilities for varnishing, potting, plating,
impregnation and spray-painting operations. The manufacturing operation also
includes a complete machine shop, with welding and sheet metal fabrication
facilities adequate for substantially all of the Company's current operations.
Besides normal test equipment, the Company maintains a sophisticated on-site
environmental test facility. In addition to meeting all of the Company's
in-house needs, the plating, machine shop and environmental facilities are
available to other companies on a contract basis.

Item 3. Legal Proceedings

None

Item 4. Submission of Matters to a Vote of Security Holders

None

PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters

Price Range of Common Stock

The table below shows the range of high and low prices for the Company's common
stock on the American Stock Exchange (ticker symbol "ESP"), the principal market
for trading in the common stock, for each quarterly period for the last two
fiscal years ended June 30:

2006 High Low
First Quarter 17.88 15.05
Second Quarter 20.45 17.31
Third Quarter 18.95 15.00
Fourth Quarter 19.45 15.90

2005 High Low
First Quarter 13.05 11.18
Second Quarter 14.45 12.80
Third Quarter 13.70 12.83
Fourth Quarter 15.88 12.38

As described in note 17 to the financial statements in Part II item 7, a stock
split in the form of a stock dividend of one share of common stock for each
share of common stock issued, was paid on December 30, 2005 (all per share and
share amounts have been adjusted to reflect this dividend).

Holders

The approximate number of holders of record of the common stock was 118 on
September 21, 2006 according to records of the Company's transfer agent.
Included in this number are shares held in "nominee" or "street" name and,
therefore, the number of beneficial owners of the common stock is believed to be
substantially in excess of the foregoing number.

Dividends

The Company paid cash dividends on the common stock of $.34 and $.30 per share
for the fiscal years ended June 30, 2006 and 2005, respectively. The Board of
Directors has authorized the payment of a fiscal 2007 first quarter dividend of
$.13 payable September 22, 2006.

During fiscal 2006 the Company sold common stock to certain employees as they
exercised existing stock options granted under a shareholder approved plan.
During the year, 23,200 shares were sold at prices that ranged from $6.63 a
share to $11.25 a share. The securities were sold for cash. Proceeds are used
for general working capital purposes.

There were no purchases of equity securities in the fiscal 2006 fourth quarter.

Securities Authorized For Issuance Under Equity Compensation Plans

Number of securities to Weighted-average Number of Securities remaining
be issued upon exercise exercise price of available for future issuance under
of outstanding options, outstanding options, equity compensation plan (excluding
Plan Category warrants and rights warrants and rights securities reflected in column (a))
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(a) (b) (c)

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Equity compensation
plans approved by
security holders 146,200 14.02 96,600
Equity compensation
plans not approved
by security holders -- -- --
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Total 146,200 96,600
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Item 6. Management's Discussion and Analysis of Financial Condition and Results
of Operations

Business Outlook

The business outlook for the Company is excellent. The order backlog remains
high, in terms of Company revenues in recent years, as sales continue to
increase. Also, expectations are for product mix and margins to remain favorable
for fiscal 2007. During fiscal 2006 new orders received by the Company were
approximately $26.9 million. The order backlog of approximately $37.7 million at
June 30, 2006 gives the Company a solid base of future sales and, therefore,
management expects a significant increase in sales during fiscal 2007, as
compared to fiscal 2006. In addition to the backlog, the Company currently has
outstanding quotations representing in excess of $26.6 million in the aggregate
for both repeat and new programs. Many potential orders are currently being
discussed and negotiated with existing and potential new customers.

The total order backlog was approximately $37.7 million at June 30, 2006, an
increase of $5.9 million over June 30, 2005. The backlog represents the
estimated remaining sales value of work to be performed under firm contracts.
The funded portion of this backlog at June 30, 2006 is approximately $29.2
million. This includes items that have been authorized and appropriated by
Congress and/or funded by the customer. The unfunded backlog is approximately
$8.5 million and represents firm multi-year orders for which funding has not yet
been appropriated by Congress. While there is no guarantee that future budgets
and appropriations will provide funding for a given program, management has
included in unfunded backlog only those programs that it believes are likely to
receive funding. The unfunded backlog at June 30, 2005 was approximately $8.7
million.

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.

Results of Operations

Net Sales for fiscal years ended June 30, 2006 and 2005, were $20,851,570 and
$18,828,700, respectively, a 10.7% increase. Generally, this increase can be
attributed to the contract specific nature of the Company's business and the
long-term nature of these contracts. The increase in order backlog that occurred
during the last two quarters of fiscal 2005 began to be recognized in net sales
in fiscal 2006. This trend is expected to continue into the next several
quarters. The sales backlog at June 30, 2006, as discussed above, includes
significant orders for military and industrial power supplies, and contracts to
manufacture certain customer products in accordance with pre-engineered
requirements.

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
than with respect to the 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.

For fiscal years ended June 30, 2006 and 2005 gross profits were $4,542,089 and
$3,381,357, respectively. Gross profit as a percentage of sales was 21.8% and
18.0%, for fiscal 2006 and 2005, respectively. A favorable product mix,
partially offset by higher ESOP compensation expense, caused the improved gross
profit percentage in fiscal 2006. ESOP compensation expense included in cost of
sales was $356,990 for the fiscal year ended June 30, 2006, and zero for the
fiscal year ended June 30, 2005 (see note 11 to the financial statements).
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 performed. Employment at June 30, 2006 was
169 people, the same number employed at June 30, 2005.

Selling, general and administrative expenses were $2,636,458 for the fiscal year
ended June 30, 2006, an increase of $362,432, or 15.9% as compared to the prior
year. This increase is primarily due to an increase in the sales force and ESOP
compensation expense, offset partially by a decrease in professional fees.

Other income for fiscal 2006 increased as compared to fiscal 2005 due to
increased interest income on the Company's cash equivalents and short-term
investments due to higher interest rates. The Company does not believe that
there is significant risk associated with its investment policy, since at June
30, 2006 all of the investments were primarily represented by short-term liquid
investments including certificates of deposit and money market accounts.

The effective income tax rate was 34.2% in fiscal 2006 and 27.6% in fiscal 2005.
The effective tax rate was less than the statutory tax rate in fiscal 2005
mainly due to the foreign exportation benefit the Company received on its
international sales.

Net income for fiscal 2006, was $1,558,016 or $.77 and $.76 per share, basic and
diluted, respectively, compared to net income of $978,920 or $.48 per share, for
both basic and diluted, for fiscal 2005. The increase in net income per share
was due to increased sales and improved gross profit margins offset by the
increase in selling, general and administrative expenses.

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 two fiscal years. Management
has available a $3,000,000 line of credit to help fund further growth or working
capital needs, if necessary, but does not anticipate the need for any borrowed
funds in the foreseeable future.

The Company's working capital as of June 30, 2006 and 2005 was $26,316,971 and
$25,370,512, respectively. During 2006 and 2005 the Company repurchased 38,746
and 17,448 shares, respectively, of its common stock from the Company's Employee
Retirement Plan and Trust ("ESOP") and in other open market transactions, for a
total purchase price of $679,809 and $215,366, respectively. Under existing
authorizations from the Company's Board of Directors, as of June 30, 2006,
management is authorized to purchase an additional $320,191 of Company stock.

The table below presents the summary of cash flow information for the fiscal
year indicated:

2006 2005
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Net cash (used in) provided by operating activities.... $ (309,778) $ 710,049
Net cash (used in) provided by investing activities.... (5,667,338) 2,441,362
Net cash provided by financing activities ............. 3,246,224 776,152

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, receipt of progress payments, level
of sales and payments of accounts payable. Net cash used in investing activities
increased in fiscal 2006 due to the purchase of short-term investments and the
ESOP transaction described in note 11. The increase in cash provided by
financing activities is due primarily to the sale of treasury shares to the ESOP
in the first half of fiscal 2006.

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

Management believes that the Company's reserve for bad debts of $3,000 is
adequate given the customers with whom the Company does business. Historically,
bad debt expense has been minimal.

During fiscal year 2006 and fiscal 2005, the Company expended $468,868 and
$425,362, respectively, for plant improvements and new equipment. The Company
has budgeted approximately $400,000 for new equipment and plant improvements in
fiscal 2007. Management presently anticipates that the funds required will be
available from current operations.

The Company has entered 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 $246,625 at June 30, 2006. The Company does not
expect to fund any of the amounts under the standby letters of credit.

Critical Accounting Policies and Estimates

Our significant accounting policies are described in Note 2 to the financial
statements. We believe our most critical accounting policies include revenue
recognition and cost estimation on our contracts.

Revenue Recognition and Estimates

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 contract costs could be recorded if different
assumptions were used, based on changes in circumstances, in the estimation of
cost at completion. When a change in expected sales value or estimated cost is
determined, changes are reflected in current period earnings.

Other Matters

On July 15, 2005, pursuant to a Stock Purchase Agreement dated as of such date,
the Company sold 150,000 shares of its common stock, par value $0.33-1/3 per
share, to the Espey Mfg. & Electronics Corp. Employee Stock Ownership Plan Trust
(the "ESOP"). The ESOP paid $28.90 per share, for an aggregate purchase price of
$4,335,000. The determination of the purchase price was based on a fairness
opinion obtained by an independent valuation firm. The ESOP borrowed from the
Corporation an amount equal to the purchase price. The loan will be repaid in
fifteen (15) equal annual installments of principal and the unpaid balance will
bear interest at a fixed rate of 6.25% per annum, the "prime rate" as quoted in
The Wall Street Journal on the date of closing.

The Board of Directors of the Company approved a purchase price per share equal
to a 5% discount on the average trading price of the Company's common stock on
the American Stock Exchange on the date before closing, but in no event greater
than the fair market value as determined by an independent valuation firm
retained by the ESOP. The average trading price of the Company's common stock on
the American Stock Exchange on July 14, 2005 was $30.72.

In making the sale, the Company relied on the exemption from registration under
Section 4(2) of the Securities Act of 1933, as amended, because the shares sold
were offered only to the ESOP.

After giving effect to the transaction the ESOP owned 380,120 shares of the
Company's 1,158,294 outstanding shares of common stock as of July 15, 2005.

Item 7. Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firms

To the Board of Directors and Stockholders
Espey Mfg. & Electronics Corp.:

We have audited the accompanying balance sheet of Espey Mfg. & Electronics Corp.
as of June 30, 2006, and the related statements of income, changes in
stockholders' equity, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit. The financial statements of Espey Mfg. & Electronics Corp. as of June
30, 2005, were audited by other auditors whose report dated August 12, 2005,
expressed an unqualified opinion on those statements.

We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of the Company as of June 30,
2006, and the results of its operations and its cash flows for the year then
ended, in conformity with accounting principles generally accepted in the United
States of America.

/s/Rotenberg & Co., LLP
-----------------------
Rochester, New York
August 3, 2006

The Board of Directors and Stockholders
Espey Mfg. & Electronics Corp.:

We have audited the accompanying statements of income, changes in stockholders'
equity, and cash flows of Espey Mfg. & Electronics Corp. for the year ended June
30, 2005. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the results of operations and the cash flows of Espey
Mfg. & Electronics Corp. for the year ended June 30, 2005, in conformity with
U.S. generally accepted accounting principles.

/s/KPMG LLP
-----------
KPMG LLP
Albany, New York
August 12, 2005

Espey Mfg. & Electronics Corp.
Balance Sheet
June 30, 2006
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2006
----

ASSETS
Cash and cash equivalents .......................................... $ 7,072,615
Short term investments ............................................. 3,936,000
Trade accounts receivable, net ..................................... 4,213,228
Other receivables .................................................. 6,884

Inventories:
Raw materials and supplies ................................ 1,834,945
Work in Process ........................................... 2,268,357
Costs related to contracts in process, net of progress
payments of $234,154 .................................. 8,301,077
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Total inventories ......................................... 12,404,379

Deferred income taxes .............................................. 164,969
Prepaid expenses and other current assets .......................... 554,127
------------
Total current assets ...................................... 28,352,202
------------
Property, plant and equipment, net ................................. 2,882,452
------------

Total Assets .......................................... $ 31,234,654
============

LIABILITIES AND STOCKHOLDERS' EQUITY

Accounts payable ................................................... $ 615,586
Accrued expenses:
Salaries, wages and commissions ........................... 128,007
Vacation .................................................. 545,423
Other ..................................................... 51,400
Payroll and other taxes withheld and accrued ....................... 40,597
Income taxes payable ............................................... 654,218
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Total current liabilities ................................. 2,035,231
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Deferred income taxes .............................................. 226,653
------------
Total Liabilities ..................................... 2,261,884
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Common stock, par value $.33-1/3 per share
Authorized 10,000,000 shares; Issued 3,029,874 shares in
2006. Outstanding 2,304,562 (includes 274,167 Unearned
ESOP Shares) ......................................... 1,009,958
Capital in excess of par value ..................................... 12,506,749
Retained earnings .................................................. 25,651,945
------------
39,168,652

Less: Unearned ESOP Shares ...................................... (3,961,079)
Cost of 725,312 shares of common stock in treasury ........ (6,234,803)
------------
Total Stockholders' Equity ............................ 28,972,770
------------

Total Liabilities and Stockholders' Equity ............ $ 31,234,654
============

The accompanying notes are an integral part of the financial statements.

Espey Mfg. & Electronics Corp.
Statements of Income
Years Ended June 30, 2006 and 2005
--------------------------------------------------------------------------------
2006 2005
---- ----
Net sales ..................................... $ 20,851,570 $ 18,828,700
Cost of sales ................................. 16,309,481 15,447,343
------------ ------------
Gross Profit .................. 4,542,089 3,381,357

Selling, general and administrative expenses .. 2,636,458 2,274,026
------------ ------------
Operating income .............. 1,905,631 1,107,331

Other income (expense)
Interest and dividend income .. 464,143 228,159
Other ......................... (3,220) 16,365
------------ ------------
Total other income, net ....... 460,923 244,524
------------ ------------

Income before income taxes .................... 2,366,554 1,351,855

Provision for income taxes .................... 808,538 372,935
------------ ------------

Net income .................... $ 1,558,016 $ 978,920
============ ============

Net income per share:
Basic .................................... $ .77 $ .48
Diluted .................................. $ .76 $ .48
------------ ------------

Weighted average number of shares outstanding:
Basic .................................... 2,012,761 2,021,234
Diluted .................................. 2,049,455 2,043,208
============ ============

The accompanying notes are an integral part of the financial statements.

Espey Mfg. & Electronics Corp.
Statements of Changes in Stockholders' Equity
Years Ended June 30, 2006 and 2005
-------------------------------------------------------------------------------------------------------------------

Outstanding Capital in Unearned
Common Excess of ESOP Retained
Shares $ Amount Par Value Shares Earnings
------------ ------------ ------------ ------------ ------------

Balance as of June 30, 2004 2,029,236 $ 504,979 $ 10,411,915 $ -- $ 24,911,920
------------ ------------ ------------ ------------ ------------

Net income, 2005 978,920

Stock options exercised 4,800 (12,460)

Dividends paid on common stock
$.30 per share (606,286)

Tax effect of stock options exercised 12,618

Purchase of treasury stock (17,448)
------------ ------------ ------------ ------------ ------------

Balance as of June 30, 2005 2,016,588 504,979 10,412,073 -- 25,284,554
------------ ------------ ------------ ------------ ------------

Net income, 2006 1,558,016

Stock options exercised 23,200 48,578

Dividends paid on common stock
$.3425 per share (685,646)

Stock dividend paid on common stock 504,979 (504,979)

Sale of treasury stock to ESOP 303,520 1,973,781 (4,335,000)

Purchase of treasury stock (38,746)

Reduction of Unearned ESOP Shares 72,317 373,921
------------ ------------ ------------ ------------ ------------

Balance as of June 30, 2006 2,304,562 $ 1,009,958 $ 12,506,749 $ (3,961,079) $ 25,651,945
============ ============ ============ ============ ============

Treasury Stock Total
---------------------------- Stockholders'
Shares $ Amount Equity
------------ ------------ ------------

Balance as of June 30, 2004 1,000,638 $ (7,986,908) $ 27,841,906
------------ ------------ ------------

Net income, 2005 978,920

Stock options exercised (4,800) 57,960 45,500

Dividends paid on common stock
$.30 per share (606,286)

Tax effect on stock options exercised 12,618

Purchase of treasury stock 17,448 (215,366) (215,366)
------------ ------------ ------------

Balance as of June 30, 2005 1,013,286 (8,144,314) 28,057,292
------------ ------------ ------------

Net income, 2006 1,558,016

Stock options exercised (23,200) 166,677 215,255

Dividends paid on common stock (685,646)
$.3425 per share

Stock dividend paid on common stock --

Sale of treasury stock to ESOP (303,520) 2,422,642 61,423

Purchase of treasury stock 38,746 (679,808) (679,808)

Reduction of Unearned ESOP Shares 446,238
------------ ------------ ------------

Balance as of June 30, 2006 725,312 $ (6,234,803) $ 28,972,770
============ ============ ============

The accompanying notes are an integral part of the financial statements.

Espey Mfg. & Electronics Corp.
Statements of Cash Flows
Years Ended June 30, 2006 and 2005
--------------------------------------------------------------------------------

2006 2005
---- ----

Cash Flows From Operating Activities:
Net income $ 1,558,016 $ 978,920

Adjustments to reconcile net income to net cash
provided by operating activities:

Tax effect on stock options exercised -- 12,618

Depreciation 532,735 541,041

ESOP Compensation Expense 446,238 --

Loss on disposal of plant and equipment 37,988 --

Deferred income tax (benefit) (100,376) (85,380)

Changes in assets and liabilities:

(Increase) decrease in trade receivables (1,219,988) (852,843)

(Increase) decrease in other receivables (3,711) (1,364)

(Increase) decrease in inventories, net (2,036,827) (282,255)

(Increase) decrease in prepaid
expenses and other current assets (218,132) 23,398

Increase (decrease) in accounts payable 236,815 128,096

Increase (decrease) in accrued
salaries, wages and commissions 65,729 17,759

(Decrease) increase in accrued
employee insurance costs -- (7,487)

Increase (decrease) in vacation accrual 47,408 46,499

(Decrease) increase in other accrued expenses (2,383) 3,413

Increase (decrease) in payroll and
other taxes withheld and accrued 4,620 9,977

Increase (decrease) in income taxes payable 342,090 177,657
----------- -----------

Net cash (used in) provided by
operating activities $ (309,778) $ 710,049
----------- -----------

The accompanying notes are an integral part of the financial statements.

(Continued)

Cash Flows From Investing Activities:

Unearned ESOP Shares (4,335,000) --

Additions to property, plant and equipment (468,868) (425,362)

Purchase of short term investments (5,952,000) (2,688,000)

Proceeds from maturity of short term investments 5,088,000 672,000

Proceeds on sale of assets, net 530 --
------------ ------------

Net cash used in
investing activities (5,667,338) (2,441,362)
------------ ------------

Cash Flows From Financing Activities:

Sale of Treasury Stock 4,396,423 --

Dividends on common stock (685,646) (606,286)

Purchase of treasury stock (679,808) (215,366)

Proceeds from exercise of stock options 215,255 45,500
------------ ------------

Net cash provided by (used in)
financing activities 3,246,224 (776,152)
------------ ------------

Decrease in cash and cash equivalents (2,730,892) (2,507,465)

Cash and cash equivalents, beginning of the year 9,803,507 12,310,972
------------ ------------

Cash and cash equivalents, end of the year $ 7,072,615 $ 9,803,507
============ ============

Income Taxes Paid $ 591,345 $ 268,040
============ ============

The accompanying notes are an integral part of the financial statements.

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 1. Nature of operations

Espey Mfg. & Electronics Corp. (the Company) is a manufacturer of electronic
equipment used primarily in military and industrial applications. The principal
markets for the Company's products are companies that provide electronic support
to both military and industrial applications.

Note 2. Summary of Significant Accounting Policies

Inventory Valuation, Cost Estimation and Revenue Recognition
Raw materials are valued at weighted average cost.

Inventoried work relating to contracts in process and work in process is valued
at actual production cost, including factory overhead incurred to date. Work in
process represents spare units; parts and other inventory items acquired or
produced to service units previously sold or to meet anticipated future orders.
The cost elements of contracts in process and work in process consist of
production costs of goods and services currently in process and overhead.
Provision for losses on contracts is made when the existence of such losses
becomes probable and estimable. The costs attributed to units delivered under
contracts are based on the estimated average cost of all units expected to be
produced. Certain contracts are expected to extend beyond twelve months.

Revenue is recognized on contracts in the period in which the units are
delivered and billed (units-of-delivery method). 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.

Depreciation
Depreciation of plant and equipment is computed on a straight-line basis over
the estimated useful lives of the assets.

Estimated useful lives of depreciable assets are as follows:

Buildings and improvements 10 - 35 years
Machinery and equipment 3 - 25 years
Furniture, fixtures and office equipment 5 - 10 years

Income Taxes
The Company follows the provisions of Statement of Financial Accounting
Standards (SFAS) No. 109, "Accounting for Income Taxes."

Under the provisions of SFAS No. 109, deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect on deferred taxes and liabilities of a change in tax rates is recognized
in earnings in the period that includes the enactment date. In addition, SFAS
No. 109 requires that the tax benefit of tax-deductible dividends on unallocated
ESOP shares be recorded as a direct addition to retained earnings rather than as
a reduction of income tax expense.

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 2. Summary of Significant Accounting Policies, Continued

Cash and Cash Equivalents
Cash and cash equivalents consist of cash in banks, certificates of deposit, and
money market accounts. The Company considers all highly liquid investments with
original maturities of three months or less to be cash equivalents.

Short-term investments include certificates of deposit with maturities greater
than three months to a year.

Stock-Based Compensation
The intrinsic value method of accounting is used for stock-based compensation
plans. Under the intrinsic value method, compensation cost is measured as the
excess, if any, of the quoted market price of the stock at the grant date over
the amount an employee must pay to acquire the stock.

The Company has elected to account for its stock-based compensation plans under
the intrinsic value-based method of accounting as permitted by SFAS No. 123 and
as prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees", and related interpretations including FASB
Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation - An Interpretation of APB No. 25", in accounting for its fixed
stock option plans. Under this method, compensation expense would be recorded on
the date of grant only if the current market price of the underlying stock
exceeded the exercise price. In December 2003, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 148, "Accounting for Stock Based
Compensation". SFAS No. 148 provides alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based
employee compensation and amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock Based Compensation", to require more prominent disclosures
in both annual and interim financial statements about the method of accounting
for stock-based employee compensation and the effect of the method used on
reported results. The Company adopted the disclosure requirements of SFAS No.
123 and SFAS No. 148, as required.

The following table illustrates the effect on net income and net income per
share if the Company had applied the fair value recognition provisions of SFAS
No. 123, to stock-based employee compensation.

Years Ended June 30,
2006 2005
---- ----

Net income as reported $ 1,558,016 $ 978,920

Deduct: Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects (88,411) (43,470)
------------ ------------

Pro forma net income $ 1,469,605 $ 935,450
============ ============

Net income per share:

Basic-as reported $ 0.77 $ 0.48
============ ============
Basic-pro forma $ 0.73 $ 0.46
============ ============

Diluted-as reported $ 0.76 $ 0.48
============ ============
Diluted-pro forma $ 0.72 $ 0.46
============ ============

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 2. Summary of Significant Accounting Policies, Continued

Per Share Amounts
SFAS 128 "Earnings Per Share" requires the Company to calculate net income
(loss) per share based on basic and diluted net income (loss) per share, as
defined. Basic EPS excludes dilution and is computed by dividing net income
(loss) by the weighted average number of shares outstanding for the period.
Diluted EPS reflects the potential dilution that could occur if securities or
other contracts to issue common stock were exercised or converted into common
stock. The dilutive effect of outstanding options issued by the Company are
reflected in diluted EPS using the treasury stock method. Under the treasury
stock method, options will only have a dilutive effect when the average market
price of common stock during the period exceeds the exercise price of the
options.

Comprehensive Income
Comprehensive Income for the years ended June 30, 2006 and 2005 is equal to net
income.

Use of Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amount of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

Investment Tax Credits
Investment tax credits are accounted for as a reduction of income tax expense in
the year taxes payable are reduced.

Reclassifications
Certain reclassifications may have been made to the prior year financial
statements to conform to the current year presentation.

Recently Issued Accounting Standards
In November 2004, the FASB issued SFAS No. 151, "Accounting for Unexpected
Production Defects and Waste." SFAS No. 151 requires that "abnormal freight,
handling costs, and amounts of wasted materials (spoilage)" should be treated as
current-period costs. Under this concept, if the costs associated with the
actual level of spoilage or production defects are greater than the costs
associated with the range of normal spoilage or defects, the difference should
be charged to current-period expense. SFAS No. 151 is effective for annual
periods beginning after June 15, 2005. The adoption of SFAS No. 151 did not have
a material impact on the Company's results of operations and financial
condition.

In December 2004, the FASB issued SFAS No. 123R, "Share Based Payment". SFAS No.
123R requires companies to recognize in the income statement the grant-date fair
value of stock options and other equity-based compensation issued to employees.
SFAS No. 123R will be effective for the Company at the beginning of fiscal 2007.
Although the adoption of SFAS No. 123R will have no adverse impact on our
balance sheet or total cash flows, it will affect our net income and earnings
per share. The actual effects of adopting SFAS No. 123R will depend on numerous
factors including the amounts of share-based payments granted in the future, our
stock price volatility, estimated forfeiture rates and employee stock option
exercise behavior. See Note 2 for the effect on reported net income and earnings
per share if we had accounted for our stock option plan using the fair value
method. In March 2005, the U.S. Securities and Exchange Commission ("SEC")
issued Staff Accounting Bulletin No. 107 ("SAB 107"), which expresses views of
the SEC staff regarding the application of SFAS No. 123(R). Among other things,
SAB 107 provides interpretive guidance related to the interaction between SFAS
No. 123(R) and certain SEC rules and regulations, and provides the SEC staff's
views regarding the valuation of share-based payment arrangements for public
companies.

In December 2004, the FASB issued Staff Position FAS 109-1 regarding Income from
Domestic Production Activities which was effective immediately. Staff Position
FAS 109-1 clarifies SFAS No. 109's guidance that applies to the new deduction
for qualified domestic production activities. The staff position clarifies that
the deduction should be accounted for as a special deduction under SFAS No. 109.
The adoption of Staff Position FAS 109-1 did not have a material impact on the
Company's results of operations or financial condition.

In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets
- Accounting Principles Board Opinion No. 29, Accounting for Nonmonetary
Transactions". SFAS No. 153 requires that exchanges should be recorded and
measured at the fair value of the assets exchanged, with certain exceptions.
SFAS No. 153 was

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 2. Summary of Significant Accounting Policies, Continued

effective for nonmonetary exchanges occurring in fiscal periods beginning after
June 15, 2005. The adoption of SFAS No. 153 did not have a significant impact on
the Company's results of operations or financial position.

In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3". SFAS
154 requires retrospective application to prior period financial statements of a
voluntary change in accounting principle and was effective in the first quarter
of 2006. The adoption of SFAS 154 did not have a material effect on results of
operations, financial condition or cash flows.

Impairment of Long-Lived Assets
Long-lived assets, including property, plant, and equipment, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to estimated undiscounted future cash flows expected to be generated by the
asset. If the carrying amount of an asset exceeds its estimated future cash
flows, an impairment charge is recognized by the amount by which the carrying
amount of the asset exceeds the fair value of the asset. Assets to be disposed
of are separately presented in the balance sheet and reported at the lower of
the carrying amount or fair value less costs to sell, and no longer depreciated.
The assets and liabilities of a disposed group classified as held for sale are
presented separately in the appropriate asset and liability sections of the
balance sheet.

Concentrations of Risk
The market for our defense electronics products is largely dependent on the
availability of new contracts from the United States and foreign governments to
prime contractors to which we provide components. Any decline in expenditures by
the United States or foreign governments may have an adverse effect on our
financial performance.

The FAR also contains guidelines and regulations for managing a contract after
award, including conditions under which contracts may be terminated, in whole or
in part, at the government's convenience or for default. If a contract is
terminated for the convenience of the government, a contractor is entitled to
receive payments for its allowable costs and, in general, the proportionate
share of fees or earnings for the work done. If a contract is terminated for
default, the government generally pays for only the work it has accepted. These
regulations also subject the Company to financial audits and other reviews by
the government of its costs, performance, accounting and general business
practices relating to its contracts, which may result in adjustment of the
Company's contract-related costs and fees.

Note 3. Contracts in Process

Contracts in process at June 30, 2006 and 2005 are as follows:

2006 2005
---- ----

Gross contract value $37,722,746 $31,757,086

Costs related to contracts in process, net of progress payments
of $234,154 in fiscal 2006 and $97,758 in fiscal 2005 $ 8,301,077 $ 6,056,290

Included in costs relating to contracts in process at June 30, 2006 and 2005 are
costs of $1,895,688 and $1,814,905, respectively, relative to contracts that may
not be completed within the ensuing year. Under the units-of-delivery method,
the related sale and cost of sales will not be reflected in the statement of
income until the units under contract are shipped.

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 4. Property, Plant and Equipment

A summary of the original cost of property, plant and equipment at June 30, 2006
and 2005 is as follows:

2006 2005
---- ----
Land $ 45,000 $ 45,000
Building and improvements 3,704,503 4,065,040
Machinery and equipment 7,143,329 7,831,278
Furniture, fixtures and office equipment 243,140 321,732
------------ ------------
11,135,972 12,263,050
Accumulated depreciation (8,253,520) (9,278,213)
------------ ------------
$ 2,882,452 $ 2,984,837
============ ============

Depreciation expense was $532,735 and $541,041, during the years ended June 30,
2006 and 2005, respectively.

Note 5. Line of credit

At June 30, 2006, the Company has an uncommitted and unused Line of Credit with
a financial institution. The agreement provides that the Company may borrow up
to $3,000,000. The line provides for interest at the borrower's choice of (I)
prime minus .75% or (II) LIBOR plus 1.80% for periods of 1, 2, or 3 months. Any
borrowing under the line of credit will be collateralized by accounts
receivable.

Note 6. Research and Development Costs

Research and development costs charged to cost of sales during the years ended
June 30, 2006 and 2005 were approximately $121,000 and $187,000, respectively.

Note 7. Pension Expense

Under terms of a negotiated union contract, the Company is obligated to make
contributions to a union-sponsored defined benefit pension plan covering
eligible employees. Such contributions and expenses are based upon hours worked
at a specified rate and amounted to $88,138 in fiscal 2006 and $86,876 in fiscal
2005.

The Company sponsors a 401(k) plan with employee and employer matching
contributions. The employer match is 10% of the employee contribution and was
$32,590 and $28,855, for fiscal years 2006 and 2005, respectively.

Note 8. Provision for Income Taxes

A summary of the components of the provision for income taxes for the years
ended June 30, 2006 and 2005 is as follows:

2006 2005
---- ----
Current tax expense - federal $ 823,564 $ 419,649
Current tax expense - state 85,351 38,666
Deferred tax (benefit) expense (100,376) (85,380)
--------- ---------
$ 808,539 $ 372,935
========= =========

Deferred income taxes reflect the impact of "temporary differences" between the
amount of assets and liabilities for financial reporting purposes and such
amounts measured by tax laws and regulations. These "temporary differences" are
determined in accordance with SFAS No. 109.

The combined U.S. federal and state effective income tax rates of 34.2% and
27.6%, for 2006 and 2005 respectively, differed from the statutory U.S. federal
income tax rate for the following reasons:

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 8. Provision for Income Taxes, Continued
2006 2005
---- ----
U.S. federal statutory income tax rate 34.0% 34.0%
Increase (reduction) in rate resulting from:
State franchise tax, net of federal income tax benefit 2.4 1.9
Foreign exportation benefit (0.8) (2.7)
ESOP cost versus Fair Market Value 1.0 --
Dividend on allocated ESOP shares (1.8) --
Qualified Production Activities (1.0) --
Adjustment of deferred tax accounts -- (5.2)
Other 0.4 (0.4)
------ ------
Effective tax rate 34.2% 27.6%
====== ======

For the years ended June 30, 2006 and 2005 deferred income tax benefit of
$(100,376) and $(85,380), respectively, result from the changes in temporary
differences for each year. Adjustments were made to the Company's deferred tax
assets and liabilities in fiscal 2005 based on an analysis completed in fiscal
2005. The tax effects of temporary differences that give rise to deferred tax
assets and deferred tax liabilities as of June 30, 2006 and 2005 are presented
as follows:
2006 2005
---- ----
Deferred tax assets:
Accrued expenses .............................. $142,269 $125,215
ESOP .......................................... 30,328 --
Other ......................................... 12,500 13,964
-------- --------
Total deferred tax assets ....... 185,097 139,179
-------- --------

Deferred tax liabilities:
Property, plant and equipment - principally due
to differences in depreciation methods ... 226,653 298,057
Inventory - effect on uniform capitalization .. 20,128 3,182
-------- --------
Total deferred tax liabilities .. 246,781 301,239
-------- --------
Net deferred tax liability ........................ $ 61,684 $162,060
======== ========

In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. Management considers the
scheduled reversal of deferred tax liabilities, projected future taxable income,
and tax planning strategies in making this assessment. Based upon the level of
historical taxable income and projection for future taxable income over the
period in which the deferred tax assets are deductible, management believes it
is more likely than not that the Company will realize the benefits of these
temporary differences without consideration of a valuation allowance.

Note 9. Significant Customers

A significant portion of the Company's business is the production of military
and industrial electronic equipment for use by the U.S. and foreign governments
and certain industrial customers. Sales to three domestic customers accounted
for 35%, 17%, and 13% of total sales in fiscal 2006. Sales to two domestic
customers accounted for 32% and 14% of total sales in fiscal 2005, respectively.

Export sales in fiscal 2006 and fiscal 2005 were approximately $3,392,000 and
$4,946,000, respectively.

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 10. Stock Rights Plan

The Company has a Shareholder Rights Plan that expires on December 31, 2009.
Under this plan, common stock purchase rights were distributed as a dividend at
the rate of one right for each share of common stock outstanding as of or issued
subsequent to April 14, 1989. Each right entitles the holder thereof to buy
one-half share of common stock of the Company at an exercise price of $25 per
share (after giving effect to the stock split described in Note 17) subject to
adjustment. The rights are exercisable only if a person or group acquires
beneficial ownership of 15% or more of the Company's common stock or commences a
tender or exchange offer which, if consummated, would result in the offeror
individually or, together with all affiliates and associates thereof, being the
beneficial owner of 15% or more of the Company's common stock.

If a 15% or larger shareholder should engage in certain self-dealing
transactions or a merger with the Company in which the Company is the surviving
corporation and its shares of common stock are not changed or converted into
equity securities of any other person, or if any person were to become the
beneficial owner of 15% or more of the Company's common stock, then each right
not owned by such shareholder or related parties of such shareholder (all of
which will be void) will entitle its holder to purchase, at the right's then
current exercise price, shares of the Company's common stock having a value of
twice the right's exercise price. In addition, if the Company is involved in any
other merger or consolidation with, or sells 50% or more of its assets or
earning power to another person, each right will entitle its holder to purchase,
at the right's then current exercise price, shares of common stock of such other
person having a value of twice the right's exercise price.

The Company generally is entitled to redeem the rights at one cent per right at
any time until the 15th day (or 25th day if extended by the Company's Board of
Directors) following public announcement that a 15% position has been acquired
or the commencement of a tender or exchange offer which, if consummated, would
result in the offer or, together with all affiliates and associates thereof,
being the beneficial owner of 15% or more of the Company's common stock.

Note 11. Employee Stock Ownership Plan

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. Prior to July 15, 2005, the ESOP owned 230,120 shares, all
of which were allocated to employees. On July 15, 2005, pursuant to a Stock
Purchase Agreement dated as of such date, the Company, by selling 150,000 shares
of its common stock, par value $0.33-1/3 per share, to the Espey Mfg. &
Electronics Corp. Employee Stock Ownership Plan Trust, provided more shares to
be allocated to employees for services rendered over the next 15 years. The ESOP
paid $28.90 per share, for an aggregate purchase price of $4,335,000. The
determination of the purchase price was based on a fairness opinion obtained by
an independent valuation firm. The ESOP borrowed from the Corporation an amount
equal to the purchase price. The loan will be repaid in fifteen (15) equal
annual installments of principal and the unpaid balance will bear interest at a
fixed rate of 6.25% per annum, the "prime rate" as quoted in The Wall Street
Journal on the date of closing. The above ESOP information has not been adjusted
for the stock split completed December 30, 2006.

The Board of Directors of the Company had approved a purchase price per share
equal to a 5% discount on the average trading price of the Company's common
stock on the American Stock Exchange on the date before closing, but in no event
greater than the fair market value as determined by an independent valuation
firm retained by the ESOP. The average trading price of the Company's common
stock on the American Stock Exchange on July 14, 2005 was $30.72.

In making the sale, the Company relied on the exemption from registration under
Section 4(2) of the Securities Act of 1933, as amended, because the shares sold
were offered only to the ESOP.

After giving effect to the transaction, the ESOP owned 380,120 shares of the
Company's 1,158,294 outstanding shares of common stock as of July 15, 2005.

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

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 11. Employee Stock Ownership Plan, Continued

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 Statement of Position 93-6. 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 $446,238 for the year ended June 30,
2006. The ESOP shares as of June 30, 2006, after the stock split referred to in
Note 17, were as follows:

Allocated Shares 446,418
Committed-to-be-released shares --
Unreleased shares 274,167
----------

Total shares held by the ESOP 720,585
==========

Fair value of unreleased shares at June 30, 2006 $4,578,589
==========

Note 12. Stock Based Compensation

During fiscal 2000, the Board of Directors and shareholders approved the 2000
Stock Option Plan (the Plan). Under the Plan, incentive and non-qualified stock
options may be granted to purchase shares of common stock of the Company.
Options authorized for issuance under the Plan totaled 300,000. As of June 30,
2006, the Plan was authorized to grant options to purchase 96,600 shares of the
Company's common stock.

Options under the Plan have been granted with exercise prices at fair market
value at the grant date and vest over a period of two years. All options must be
exercised within 10 years from the date of grant and are exercisable anytime
after the two-year vesting period.

Information concerning the plans incentive and non-qualified stock options is as
follows:

Option Option Price
Shares Per Share
---------------------------------------------------------------
June 30, 2004 74,000 $6.63 - 9.93
---------------------------------------------------------------
Options granted 31,000 $11.25
Options canceled (3,000) $8.98 - 11.25
Options exercised (4,800) $8.98 - 9.93
---------------------------------------------------------------
June 30, 2005 97,200 $6.63 - 11.25
---------------------------------------------------------------
Options granted 76,200 $17.36 - 17.80
Options canceled (4,000) $6.63 - 11.25
Options exercised (23,200) $6.63 - 9.93
---------------------------------------------------------------
June 30, 2006 146,200
===============================================================

The table below summarizes information with respect to stock options outstanding
as of June 30, 2006:

Remaining Exercise Price of
Exercise Options Contractual Options Exercisable
Prices Outstanding Life Exercisable Options
----------------------------------------------------------------------
$ 6.63 1,400 4 1,400 $ 6.63
$ 8.98 4,600 5 4,600 $ 8.98
$ 9.93 14,200 6 14,200 $ 9.93
$ 9.25 21,400 7 21,400 $ 9.25
$11.25 28,400 8 -- --
$17.36 37,000 9 -- --
$17.80 39,200 10 -- --
----------------------------------------------------------------------
Total 146,200 41,600
======================================================================

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 12. Stock Based Compensation, Continued

The weighted average fair value of options granted under the plans during fiscal
years 2006 and 2005 was $4.11 and $3.89, respectively. The assumptions used for
the Black-Scholes model are as follows:

2006 2005
---- ----
Risk-free interest rate..................... 4.5% 4.0%
Expected term............................... 5.5 years 5 years
Company's expected volatility............... 22.5% 20.0%
Dividend yield.............................. 2.1% 3.0%

As described in note 17, a stock split in the form of a stock dividend of one
share of common stock for each share of common stock issued, was paid on
December 30, 2005 (all per share and share amounts have been adjusted to reflect
this dividend).

Note 13. Financial Instruments/Concentration of Credit Risk

The carrying amounts of financial instruments, including cash and cash
equivalents, short term investments, accounts receivable, accounts payable and
accrued expenses, approximated fair value as of June 30, 2006 and 2005 because
of the relatively short maturities of these instruments.

Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of cash and cash equivalents, short-term
investments and accounts receivable. The Company maintains cash and cash
equivalents with various financial institutions. At times such investments may
be in excess of FDIC insurance limits. As disclosed in Note 9, a significant
portion of the Company's business is the production of military and industrial
electronic equipment for use by the U.S. and foreign governments and certain
industrial customers. The related accounts receivable balance of the Company's
total trade accounts receivable balance, represented at June 30, 2006 by three
customers, was 63% and by two customers at June 30, 2005 was 57%.

Although the Company's exposure to credit risk associated with nonpayment of
these balances is affected by the conditions or occurrences within the U.S. and
foreign governments, the Company believes that its trade accounts receivable
credit risk exposure is limited. The Company performs ongoing credit evaluations
of its customer's financial conditions and requires collateral, such as progress
payments, in certain circumstances. The Company establishes an allowance for
doubtful accounts based upon factors surrounding the credit risk of specific
customers, historical trends and other information.

Note 14. Related Parties

The Company paid a law firm in which a director of the Company is a partner, a
total of $19,658 and $72,979, for legal services during fiscal years ended June
30, 2006 and 2005, respectively. Included in the payment of $19,658 and $72,979
for fiscal year ended June 30, 2006 and 2005, was $9,085 and $23,750,
respectively, held in trust and paid to other service providers relating to the
ESOP transaction described in Note 11.

The shares of common stock owned by the ESOP Trust are voted by the Trustees in
the manner directed by the ESOP Committee. The Trustees, Howard Pinsley and
Peggy A. Murphy, are the Chairman of the Board, Chief Executive Officer and
President of the Company and Secretary of the Company, respectfully. See Note 11
for additional information regarding the ESOP.

Note 15. Commitments and Contingencies

Espey Mfg. & Electronics Corp.
Notes to Financial Statements
--------------------------------------------------------------------------------

Note 16. Quarterly Financial Information (Unaudited)

First Second Third Fourth
2006 Quarter Quarter Quarter Quarter
---------- ---------- ---------- ----------
Net Sales................. $4,560,574 $5,056,083 $4,677,808 $6,557,105
Gross profit .......... 880,290 947,360 1,042,265 1,672,174
Net income............. 217,744 274,260 365,057 700,955

Net income per share -
Basic..................... 0.11 0.14 0.18 0.34
Diluted................... 0.11 0.13 0.18 0.34

2005
Net Sales................. $4,730,327 $4,896,741 $4,219,861 $4,981,771
Gross profit .......... 649,142 772,387 650,890 1,308,938
Net income............. 60,585 167,032 111,987 639,316

Net income per share -
Basic..................... 0.03 0.08 0.06 0.31
Diluted................... 0.03 0.08 0.06 0.31

Note 17. Stock Split

On December 30, 2005, the Company effected a one-for-one stock split in the form
of a dividend of one share of common stock for each share of common stock
outstanding. The Company also allocated to treasury an additional share for each
share being held as a treasury share. All references to the number of common
shares, shares related to the Company's stock option plan, as well as per share
data in the accompanying financial statements, have been adjusted to reflect the
stock split on a retroactive basis with the exception of the details describing
the Company's ESOP transaction which became executed on July 15, 2005 described
in note 6 and "Other Matters". As a result of the stock split, common stock was
increased and retained earnings was decreased by $504,979.

Item 8. Changes in and disagreements with accountants on accounting and
financial disclosure

None

Item 8A. Controls and Procedures

(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 Annual Report on Form 10-KSB. 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.

Item 8B. Other information

None.

PART III

The information called for by "Item 9. Directors, Executive Officers, Promoters
and Control Persons; Compliance with Section 16(a) of the Registrant", "Item 10.
Executive Compensation", "Item 11. Security Ownership of Certain Beneficial
Owners and Management and Related Stockholder Matters", "Item 12. Certain
Relationships and Related Transactions" and "Item 14. Principal Accountant Fees
and Services", is hereby incorporated by reference to the Company's Proxy
Statement for its Annual Meeting of Shareholders, (scheduled to be held on
November 17, 2006) to be filed with the SEC pursuant to Regulation 14A under the
Securities Exchange Act of 1934, as amended.

Item 13. Exhibits

3.1 Certificate of incorporation and all amendments thereto
(incorporated by reference to Exhibit 3.1 to Espey's Report on
Form 10-K for the year ended June 30, 2004 and Report on Form
10-Q for the quarter ended December 31, 2004)

3.2 By-laws (incorporated by reference to Exhibit 3.2 to Espey's
Report on Form 10-Q for the quarter ended March 31, 2004)

4.1 Amended and Restated Rights Agreement, dated March 31, 1989,
as amended February 12, 1999 and December 31, 1999, between
Espey Mfg. & Electronics Corp. and Registrar and Transfer
Company (incorporated by reference to Espey's Form 8-K dated
December 20, 1999)

4.2 Description of Capital Stock (Incorporated by reference to
Espey's Report on Form 8-K dated October 7, 2005)

10.1 2000 Stock Option Plan (incorporated by reference to Espey's
Definitive Proxy Statement dated December 6, 1999 for the
January 4, 2000 annual meeting)

10.2 Executive Officer contract (filed herewith)

11.1 Statement re: Computation of Per Share Net income (filed
herewith)

14.1 Code of ethics (incorporated by reference to Espey's website
www.espey.com)
-------------

23.1 Consent of Rotenberg & Co., LLP (filed herewith)

23.2 Consent of KPMG LLP (filed herewith)

31.1 Certification of the Chief Executive Officer pursuant to Rules
13a-14(a) and 15d-14(a) under the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 (filed herewith)

31.2 Certification of the Principal Financial Officer pursuant to
Rules 13a-14(a) and 15d-14(a) under the Securities Exchange
Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (filed herewith)

32.1 Certification of the Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed herewith)

32.2 Certification of the Principal Financial Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 (filed herewith)

S I G N A T U R E S

Pursuant to the requirements of Section 13 and 15 (d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

ESPEY MFG. & ELECTRONICS CORP.

/s/Howard Pinsley
------------------------------
Howard Pinsley
President and
Chief Executive Officer

/s/Howard Pinsley President
--------------------------- (Chief Executive Officer)
Howard Pinsley September 25, 2006

/s/David O'Neil Treasurer
--------------------------- (Principal Financial Officer)
David O'Neil September 25, 2006

/s/Katrina Sparano Assistant Treasurer
--------------------------- (Principal Accounting Officer)
Katrina Sparano September 25, 2006

/s/Barry Pinsley Director
--------------------------- September 25, 2006
Barry Pinsley

/s/Seymour Saslow Director
--------------------------- September 25, 2006
Seymour Saslow

/s/Michael W. Wool Director
--------------------------- September 25, 2006
Michael W. Wool

/s/Paul J. Corr Director
--------------------------- September 25, 2006
Paul J. Corr

/s/Alvin O. Sabo Director
--------------------------- September 25, 2006
Alvin O. Sabo

/s/Carl Helmetag Director
--------------------------- September 25, 2006
Carl Helmetag