Nortech Systems Incorporated — Form 10-K Summary
Business context and reporting period
Nortech Systems Incorporated is a contract manufacturer serving the Medical, Aerospace and Defense, and Industrial markets. It provides engineering, prototyping, testing, supply-chain, manufacturing, and post-market services for complex electromedical and electromechanical products. Operations are located in Minnesota, Mexico, and China. The filing covers the fiscal year ended December 31, 2022, with comparison to fiscal 2021. The company reports one operating segment: Contract Manufacturing within the EMS industry.
Financial performance and condition
| Metric | 2022 | 2021 | Change |
|---|---|---|---|
| Net sales | $134.1 million | $115.2 million | +16.4% |
| Gross profit | $20.5 million | $15.9 million | +29.1% |
| Gross margin | 15.3% | 13.8% | +150 bps |
| Operating income | $3.9 million | $2.3 million | +$1.6 million |
| Operating margin | 2.9% | 2.0% | +90 bps |
| Income before taxes | $3.5 million | $8.0 million | Declined due to prior-year PPP gain |
| Net income | $2.0 million | $7.2 million | Declined 71.9% |
| Diluted EPS | $0.70 | $2.54 | Declined |
| Cash provided by operating activities | $5.4 million | $(4.5) million | Improved by $9.9 million |
Revenue grew across all markets: Medical revenue increased 20.3% to $75.9 million, Aerospace and Defense increased 17.5% to $19.5 million, and Industrial increased 9.0% to $38.7 million. Management attributed growth to higher demand, pricing actions to offset material and labor inflation, increased production volume, and stronger plant utilization.
Selling expense increased to $3.7 million from $2.4 million, primarily due to higher sales engineering costs. General and administrative expense increased to $11.4 million from $10.0 million. Research and development expense increased to $1.5 million from $0.5 million. There were no restructuring or intangible-asset abandonment charges in 2022.
The 2021 results included a $6.2 million gain from forgiveness of the company’s PPP loan and approximately $5.2 million of Employee Retention Credits. These unusual items materially increased 2021 earnings and explain why 2022 net income fell despite higher sales and operating income.
Liquidity, debt, and cash flow
- Cash was $1.0 million at December 31, 2022, compared with $0.6 million at year-end 2021. Cash plus restricted cash totaled $2.5 million, compared with $2.2 million.
- Accounts receivable were $16.0 million, inventories were $22.4 million, and contract assets were $10.0 million. Inventory increased from $19.4 million, reflecting supply-chain actions and higher production requirements.
- The Bank of America revolving credit facility provides up to $16.0 million and expires June 15, 2026. Borrowings were $6.9 million at year-end 2022 versus $9.0 million in 2021.
- Unused borrowing availability was $8.4 million at year-end 2022 versus $3.5 million in 2021. The facility is secured by substantially all company assets.
- The weighted-average interest rate on the revolving facility was 5.2% at year-end 2022 versus 3.5% in 2021.
- The company reported compliance with its debt covenants, including the required fixed-charge coverage ratio.
- 2022 investing cash outflows were $2.4 million, primarily for $2.4 million of property and equipment purchases. Financing cash outflows were $2.7 million, principally revolving-credit repayments and finance-lease payments.
- Management believes existing financing arrangements, expected operating cash flow, cash on hand, and anticipated Employee Retention Credit receipts will meet working-capital, capital-expenditure, and debt-repayment needs for the next twelve months.
Material changes versus the prior comparable period
- Sales increased 16.4%, led by Medical and Aerospace and Defense growth.
- Gross margin improved to 15.3% from 13.8%, primarily from pricing actions and higher production volume.
- Operating income increased despite higher selling, administrative, and R&D expenses.
- Net income declined sharply because 2021 benefited from $6.2 million of PPP loan forgiveness and Employee Retention Credits, while 2022 did not receive comparable benefits.
- Operating cash flow turned positive, increasing to $5.4 million from a $4.5 million use of cash, although inventory increased by approximately $3.0 million during 2022.
- Total backlog increased 9.6% to $104.1 million, while 90-day backlog decreased 2.7% to $35.9 million.
- The remaining Employee Retention Credit receivable was $2.7 million at year-end 2022; $2.6 million was collected during the year.
- The company revised the presentation of 2021 revolving-credit cash flows from net to gross. Management concluded the correction was immaterial and said it did not affect total cash flows, earnings, or the balance sheet.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide formal revenue, earnings, or margin guidance. Management expects continued opportunities from medical-market growth, increased customer outsourcing, value-added engineering, supply-chain services, and its U.S., Mexico, and China footprint. Total backlog was described as strong because major customers are placing orders further into the future to secure critical components.
- Supply-chain disruptions, component shortages, extended lead times, freight costs, material inflation, and labor costs remain significant risks. Higher inventory levels used to protect customer deliveries have reduced available cash and could result in write-downs if demand changes.
- The largest customer represented 26.9% of net sales in both 2022 and 2021. One customer also represented 21.1% of accounts receivable at year-end 2022.
- Medical-device operations are subject to FDA Quality System Regulation requirements and inspections; U.S. facilities supporting defense customers are ITAR compliant.
- Operations in Mexico and China expose the company to geopolitical, trade, regulatory, currency, labor, transportation, and intellectual-property risks.
- The company is majority owned by the Kunin family group, which can control director elections and significant corporate decisions. The company does not expect to pay dividends in the foreseeable future.
- The Bank of America facility carries variable-rate exposure. Failure to comply with covenants could restrict borrowing or accelerate repayment obligations, although the company was compliant at year-end.
- R&D spending rose to $1.5 million, including work on active optical cables and expanded beam connectors. The filing states that these investments are inherently risky and differ from the company’s historical customer-designed manufacturing model.
- Related-party revenue included $0.2 million from Abilitech Medical and $0.4 million from Marpe Technologies in 2022. The company fully reserved its $0.1 million of accounts receivable and inventory exposure to Abilitech.
- Management reported no material litigation exposure, no long-lived-asset impairment, effective disclosure controls, and effective internal control over financial reporting. The audit report contained no critical audit matters.
Most important facts for investors to verify
- Whether the $104.1 million total backlog converts to revenue and cash at expected timing, particularly given the lower 90-day backlog.
- The collectability and timing of the remaining $2.7 million Employee Retention Credit receivable.
- Inventory aging, customer-specific exposure, and potential excess or obsolete inventory charges.
- Customer concentration and the effect of any reduction in orders from the largest customer.
- Progress in restoring or expanding margins after material, labor, freight, and supply-chain inflation.
- Variable-rate debt costs, borrowing-base availability, covenant compliance, and the status of the credit agreement after the January 15, 2023 expiration of a collateral-related amendment.
- Execution and commercial prospects for the company’s R&D initiatives and related product-liability or warranty exposure.
- Renewal or replacement of China facility leases expiring in 2023 and 2024, and other lease obligations totaling $9.7 million at year-end 2022.