NORTECH SYSTEMS INC annual report, FY2019

Nortech Systems Incorporated — FY2019 Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2019; filed March 19, 2020. The filing reports annual results rather than a standalone fourth-quarter income statement. Nortech is a single-segment electronic manufacturing services provider serving aerospace and defense, medical, and industrial customers, with operations in the United States, Mexico, and China.

Financial performance and condition

Metric	2019	2018	Change
Net sales	$116.3 million	$113.4 million	2.6% increase
Gross profit	$12.6 million	$13.3 million	5.5% decrease
Gross margin	10.8%	11.7%	Down 0.9 percentage points
Income from operations	$0.2 million	$1.2 million	Decrease of $1.0 million
Interest expense	$1.0 million	$0.8 million	Increase of $0.3 million
Net income (loss)	$(1.2) million	$0.2 million	Decline of $1.4 million
Diluted EPS	$(0.46)	$0.06	Decline
Operating cash flow	$1.0 million	$2.4 million	Decrease of $1.4 million

Medical sales increased 25.2% to $62.6 million, while industrial sales decreased 21.3% to $35.5 million. Aerospace and defense sales were approximately flat at $18.2 million.
Gross margin declined primarily because of product mix and operational inefficiencies associated with component shortages.
Selling expense fell to $2.7 million from $3.6 million, but general and administrative expense rose to $9.6 million from $8.4 million, reflecting ERP-related spending and one-time operational improvement costs.
Year-end total assets were $61.4 million, including $0.4 million of cash, $0.3 million of restricted cash, $18.6 million of accounts receivable, $14.3 million of inventory, and $7.7 million of contract assets.
Total liabilities were $41.4 million and shareholders’ equity was $20.0 million at December 31, 2019.
Accounts receivable declined to $18.6 million from $20.1 million, while inventory declined to $14.3 million from $17.0 million. The inventory reserve increased to $1.5 million from $1.1 million.

Liquidity, debt, and cash flow

Operating cash flow was $1.0 million, capital expenditures and other investing uses were $0.8 million, and financing activities used $0.5 million. Cash and restricted cash declined to $0.7 million from $0.9 million.
The Bank of America facility provides a $16.0 million line of credit and a $5.0 million real estate term note, both maturing June 15, 2022. Line-of-credit borrowings were $10.1 million at year-end, compared with $9.3 million in 2018.
Unused borrowing-base availability was $4.1 million at December 31, 2019, compared with $6.1 million in 2018. The facility is secured by substantially all company assets.
The weighted-average interest rate was 5.5% at year-end 2019 versus 4.8% in 2018. The company also had $3.6 million of long-term debt, net of debt issuance costs, and $2.0 million of finance lease obligations.
Operating and finance lease liabilities totaled $7.2 million following adoption of the new lease accounting standard. Management stated that existing financing arrangements and anticipated operating cash flows should meet working-capital, capital-expenditure, and debt-repayment needs for at least the next 12 months.
The company stated that it was in compliance with its credit covenants at December 31, 2019, including a minimum fixed-charge coverage ratio of 1.0 to 1.0.

Material changes versus 2018

Revenue grew modestly, driven by medical devices, but profitability deteriorated: gross margin fell from 11.7% to 10.8%, operating margin fell from 1.1% to 0.2%, and the company moved from net income to a net loss.
Interest expense increased because of higher borrowings and interest rates.
Operating cash generation weakened substantially, although working-capital reductions in accounts receivable and inventory provided cash.
90-day backlog was essentially unchanged at $27.3 million versus $27.4 million. Aerospace and defense backlog increased 16.7% and medical backlog increased 2.0%, offset by a 19.4% decline in industrial backlog. Total shipment backlog increased to $50.1 million from $47.1 million.
The company adopted ASC 842 on January 1, 2019, recognizing $5.7 million of operating lease assets and liabilities without an impact on earnings or cash flows at adoption.
The company repurchased 32,769 shares for approximately $0.1 million in 2019. The applicable repurchase program expired at year-end, and no remaining authorization was available.

Outlook, commentary, risks, and unusual items

Management emphasized expansion of medical capabilities, lean manufacturing, supply-chain management, early design engagement, and a shift toward higher-value solution-based services. No quantitative revenue or earnings guidance was provided.
COVID-19 had not materially affected the business as of the filing date, but management warned that the evolving pandemic could disrupt suppliers, customers, facilities, liquidity, capital resources, and workforce availability.
The largest customer’s two divisions represented 22.5% of 2019 sales, and the customer accounted for 35.6% of year-end accounts receivable, creating significant concentration risk.
Key operating risks include component shortages, customer cancellations or schedule changes, pricing and competitive pressure, dependence on outsourcing, foreign operations and currency movements, regulatory requirements for medical and defense products, labor availability, cybersecurity, environmental compliance, and economic weakness.
Goodwill of $2.4 million was not impaired in 2019 or 2018. The company recorded a $0.4 million inventory-reserve increase and maintained a $0.3 million allowance for doubtful accounts.
Income tax expense was $0.4 million despite a pretax loss, reflecting valuation allowances, GILTI provisions, and other tax adjustments. U.S. deferred tax assets were fully offset by a valuation allowance.
Litigation is described as ordinary-course and not expected to materially affect the financial statements. The remaining contingent consideration related to the Devicix acquisition was fully paid by year-end.
The independent auditor issued an unqualified opinion. Management reported effective disclosure controls and effective internal control over financial reporting; the company, as a smaller reporting company, was not required to obtain an auditor attestation on internal controls.

Important facts for investors to verify

Whether medical-market growth can offset the sharp decline in industrial revenue and whether backlog converts into sales at acceptable margins.
Whether component shortages, operational inefficiencies, and product mix continue to pressure gross margin.
Liquidity headroom under the borrowing-base facility, compliance with the fixed-charge coverage covenant, and refinancing requirements before the June 2022 maturities.
The financial impact of COVID-19 on supply-chain continuity, customer demand, workforce availability, and cash flow after the filing date.
Customer concentration, particularly the largest customer’s share of revenue and accounts receivable.
The adequacy of inventory reserves, doubtful-account allowances, and the valuation allowance against U.S. deferred tax assets.
Future capital expenditures, lease obligations, interest-rate exposure, and the absence of a dividend policy or active share-repurchase authorization.