Nortech Systems Incorporated: Q1 2016 Form 10-Q Summary
Business context and reporting period
Nortech Systems is an electronics manufacturing services provider producing wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds, with engineering and technical services. Its primary markets are aerospace and defense, medical, and industrial equipment. The filing covers the three months ended March 31, 2016, compared with the three months ended March 31, 2015. The financial statements are unaudited.
Financial performance and liquidity
| Metric | Q1 2016 | Q1 2015 | Change |
|---|---|---|---|
| Net sales | $29.0 million | $26.5 million | 9% increase |
| Gross profit | $3.4 million | $2.9 million | 18% increase |
| Gross margin | 11.7% | 10.8% | 90 basis-point increase |
| Income from operations | $221,000 | $(202,000) | $423,000 improvement |
| Net income | $63,000 | $(193,000) | Returned to profitability |
| Diluted EPS | $0.02 | $(0.07) | Improved |
| Operating cash flow | $1.3 million | $(240,000) | $1.6 million improvement |
Medical sales increased 31% to approximately $11.7 million, including $1.6 million attributable to the Devicix acquisition. Aerospace and defense sales increased 23% to approximately $3.8 million. Industrial sales declined 8% to approximately $13.4 million.
Cash was $741,000 at March 31, 2016, compared with $887 at December 31, 2015. Accounts receivable declined to $16.2 million from $18.4 million, while inventories increased to $21.2 million from $20.2 million. Working capital was approximately $20.7 million. The cash conversion cycle improved to 83 days from 96 days, primarily because of extended vendor payment terms.
Total liabilities were $33.8 million and shareholders’ equity was $22.3 million at March 31, 2016. The company had $8.2 million outstanding on its $15.0 million Wells Fargo revolving credit facility, with approximately $5.4 million of net unused availability. Long-term debt, including current maturities, was approximately $7.1 million, excluding the separate revolving credit balance. The facility is secured by substantially all assets and is subject to borrowing-base limitations and financial covenants. The fixed-charge coverage ratio was 1.55 to 1.00 versus a required minimum of 1.15 to 1.00.
Investing cash outflow was $785,000, primarily for property and equipment. Financing cash flow was $209,000, reflecting $532,000 of additional revolver borrowings partly offset by $323,000 of long-term debt repayments.
Material changes versus the prior comparable period
- Revenue growth and improved customer and product mix increased gross margin from 10.8% to 11.7%.
- The company moved from an operating loss and net loss to operating income and net income.
- Operating cash flow improved substantially, supported by collections of accounts receivable and other working-capital timing effects, partly offset by higher inventory and lower accounts payable.
- Selling expense declined to $1.3 million from $1.4 million, while general and administrative expense increased to $1.9 million from $1.7 million, primarily because of the Devicix acquisition.
- The 90-day backlog was $20.2 million, up 11% from March 31, 2015 but down 2% from December 31, 2015. Medical backlog increased, while industrial backlog declined.
- The Devicix acquisition increased medical revenue and contributed to margin performance; the acquisition also created seller notes and potential earnout obligations.
Guidance, outlook, risks, contingencies, and unusual items
Management stated that financing arrangements and expected operating cash flow should be sufficient for future working-capital needs and that it expected to comply with the fixed-charge coverage covenant. The filing does not provide formal revenue or earnings guidance. Management expected a 2016 effective tax rate of approximately 29% to 30%, compared with 36% for 2015, mainly because of the federal research and development credit.
Industrial demand remained soft, particularly in transportation, semiconductor equipment, and oil-and-gas-related markets. Key disclosed risks include market volatility, competition, facility reliability, labor availability, raw-material and copper costs, commodity and energy-price instability, general economic conditions, and component availability.
The Devicix purchase agreement provides for earnout consideration based on eligible engineering and production revenue, with a maximum payment of $2.5 million. The estimated fair value of the contingent consideration was $851,000. The company also had approximately $3.5 million of remaining minimum operating lease payments after March 31, 2016 and approximately $51,000 of uncertain tax benefit positions.
The company reported no material off-balance-sheet arrangements and stated that it is subject to legal proceedings and claims arising in the ordinary course of business. No events requiring a goodwill impairment test were identified during the quarter. The company was evaluating the future effects of new accounting standards for stock compensation, leases, and revenue recognition.
Important facts for investors to verify
- Whether medical and defense growth offsets continued weakness in industrial markets.
- The sustainability of the 11.7% gross margin and the contribution from Devicix and customer mix.
- Revolver availability, borrowing-base capacity, interest-rate exposure to LIBOR, and compliance with credit covenants.
- Working-capital requirements, particularly the $21.2 million inventory balance and reliance on extended vendor terms.
- The timing and potential amount of Devicix earnout payments and the effect of acquisition-related debt and amortization.
- Customer concentration: one customer’s divisions represented approximately 24% of Q1 2016 sales and approximately 17% of accounts receivable.
- The filing contains slightly different references to the expected 2016 effective tax rate, stating approximately 29% in MD&A and approximately 30% in the notes.