Nortech Systems Incorporated — Q3 2022 Form 10-Q Summary
Business Context and Reporting Period
Nortech Systems is a global electronics manufacturing services provider serving the medical, industrial, and aerospace and defense markets. It provides engineering, prototyping, manufacturing, supply-chain, testing, and post-market services from facilities in the United States, Mexico, and China. The filing covers the three and nine months ended September 30, 2022. The financial statements are unaudited and presented in thousands, except per-share data.
Key Financial Metrics
| Metric | Q3 2022 | Q3 2021 | 9M 2022 | 9M 2021 |
|---|---|---|---|---|
| Net sales | $35.3 million | $29.5 million | $98.5 million | $81.7 million |
| Gross profit | $6.3 million | $8.0 million | $15.4 million | $13.2 million |
| Gross margin | 17.9% | 27.3% | 15.6% | 16.1% |
| Income from operations | $1.9 million | $4.9 million | $3.1 million | $3.1 million |
| Net income | $1.5 million | $3.6 million | $2.4 million | $2.2 million |
| Diluted earnings per share | $0.53 | $1.24 | $0.83 | $0.78 |
| Net cash provided by operating activities | Not separately provided | Not separately provided | $1.0 million | $(2.9) million |
Q3 sales increased 19.7% year over year, while nine-month sales increased 20.6%. Growth reflected higher demand and price increases intended to offset material and labor inflation. Medical sales were $20.5 million in Q3 and $54.3 million for the nine months; industrial sales were $10.9 million and $29.0 million; aerospace and defense sales were $3.9 million and $15.2 million, respectively.
Operating expenses were $4.4 million in Q3 and $12.2 million for the nine months. Selling, general and administrative, and research and development expenses increased in Q3, while 2021 included restructuring charges and gains related to the Merrifield facility closure. The effective tax rate was 16% for Q3 and 15% for the nine months, compared with 26% and 23%, respectively, in the prior-year periods.
At September 30, 2022, cash was $1.3 million and restricted cash was $0.8 million. Total current assets were $58.1 million, including $23.6 million of inventory, $15.5 million of accounts receivable, $9.9 million of contract assets, and a $5.2 million employee retention credit receivable. Total assets were $73.1 million and shareholders’ equity was $28.2 million.
Borrowings under the Bank of America line of credit were $9.9 million, with $5.8 million of unused availability supported by the borrowing base. The facility has a $16.0 million commitment and expires June 15, 2026. The weighted-average interest rate was 4.1% at September 30, 2022. The company was in compliance with its debt covenants. Lease liabilities totaled approximately $9.9 million on a present-value basis.
Material Changes Versus the Prior Comparable Period
- Revenue increased $5.8 million, or 19.7%, in Q3 and $16.8 million, or 20.6%, for the nine months.
- Q3 gross margin declined to 17.9% from 27.3%, primarily because the prior-year period benefited from approximately $5.2 million of payroll and medical expense reductions associated with the employee retention credit. Price increases and higher production volume partially offset inflationary pressures.
- Q3 operating income fell to $1.9 million from $4.9 million, and net income fell to $1.5 million from $3.6 million, principally due to the prior-year employee retention credit benefit.
- Nine-month operating income was essentially unchanged at $3.1 million, while nine-month net income increased to $2.4 million from $2.2 million, aided in part by a lower effective tax rate.
- Operating cash flow improved to $1.0 million from an operating cash outflow of $2.9 million. Working capital remained a significant use of cash, including $4.4 million invested in inventory and $1.2 million in contract assets.
- Inventory increased to $23.6 million from $19.4 million at December 31, 2021, while the line-of-credit balance increased to $9.9 million from $9.0 million.
- The 90-day backlog was $36.9 million, down 5.1% from September 30, 2021. Total backlog was $103.3 million, up 31.4% year over year but down 2.7% from June 30, 2022.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
Management did not provide specific quantitative revenue or earnings guidance. Management stated that existing financing arrangements, anticipated operating cash flows, expected employee retention credit proceeds, and cash on hand should be sufficient for working capital, capital expenditures, and debt repayments over the next twelve months.
- COVID-19 continued to affect the company primarily through supply-chain disruptions and delays. Management is actively managing cash and working capital.
- The company identified risks from supply-chain unreliability, labor shortages, inflation in materials and energy, commodity and currency volatility, competition, loss of major customers, facility or information-system disruptions, cybersecurity incidents, FDA compliance, and economic conditions.
- One customer represented 28% of Q3 sales and 26% of nine-month sales. Two customers represented approximately 43% of accounts receivable at September 30, 2022.
- The $5.2 million employee retention credit receivable remained outstanding at September 30, 2022 and was included as collateral under the credit agreement through December 31, 2022.
- There were no 2022 restructuring charges. The company recorded $319 thousand of restructuring charges and $176 thousand of gains on asset sales during the first nine months of 2021.
- The company disclosed related-party activity involving entities associated with Chairman David Kunin, including $217 thousand of 2022 nine-month revenue from Abilitech Medical and $182 thousand of revenue from Marpe Technologies.
- The company expects substantially all contract assets of $9.9 million to transfer to receivables within 90 days, with most remaining amounts within 180 days.
- No material changes were reported to the risk factors in the 2021 Form 10-K. Management concluded that disclosure controls and procedures were effective.
Important Facts for Investors to Verify
- Timing and collectability of the $5.2 million employee retention credit receivable.
- Whether price increases and operating improvements can offset material, labor, energy, and supply-chain costs without further margin erosion.
- Customer concentration, particularly the customer representing 28% of Q3 sales and the two customers comprising 43% of receivables.
- Inventory growth, contract-asset conversion, and the company’s ability to sustain positive operating cash flow.
- Availability and covenant compliance under the secured Bank of America credit facility, including the impact of variable interest rates.
- Conversion of the $103.3 million total backlog into revenue and the effect of the lower 90-day backlog on near-term shipments.
- Potential effects of COVID-19, supply-chain interruptions, labor availability, currency movements, and customer demand changes.