Business Context and Reporting Period
Nortech Systems Incorporated is an electronics manufacturing services provider producing wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds, with engineering and supply-chain services. Its principal markets are aerospace and defense, medical, and industrial equipment. The unaudited Form 10-Q covers the three and six months ended June 30, 2019, compared with the corresponding 2018 periods.
Key Financial Metrics
| Metric | Three Months Ended June 30, 2019 | Three Months Ended June 30, 2018 | Six Months Ended June 30, 2019 | Six Months Ended June 30, 2018 |
|---|---|---|---|---|
| Net sales | $27.3 million | $28.5 million | $55.5 million | $55.0 million |
| Gross profit | $2.3 million | $3.8 million | $5.3 million | $6.8 million |
| Gross margin | 8.5% | 13.4% | 9.5% | 12.4% |
| Operating income (loss) | $(1.2) million | $0.7 million | $(1.3) million | $0.6 million |
| Net income (loss) | $(1.6) million | $0.4 million | $(1.9) million | $(0.0) million |
| Basic and diluted EPS | $(0.58) | $0.14 | $(0.72) | $(0.00) |
| Cash flow from operations | Not separately reported | Not separately reported | $(2.2) million | $2.7 million |
At June 30, 2019, cash was $0.4 million and restricted cash was $0.4 million. Working capital was $21.9 million, compared with $21.0 million at December 31, 2018. Accounts receivable were $20.7 million, inventories were $16.3 million, and contract assets were $7.2 million.
Borrowings included $12.3 million outstanding under the $16.0 million Bank of America line of credit, $4.3 million of long-term debt including current maturities, and $6.6 million of lease liabilities. Unused borrowing-base availability under the Bank of America line was $3.7 million. The line bore interest at a weighted-average rate of 5.8% at June 30, 2019.
Material Changes Versus the Prior Comparable Period
- Second-quarter sales declined 4.2%, while six-month sales increased 0.9%.
- Medical sales increased 11.6% in the quarter and 27.5% year to date; industrial sales decreased 25.8% and 23.3%, respectively. Aerospace and defense sales increased 7.3% in the quarter but declined 4.4% year to date.
- Gross margin declined 490 basis points in the quarter and 290 basis points year to date, primarily because of product mix and operational inefficiencies associated with component shortages.
- General and administrative expense increased 33.8% in the quarter and 21.3% year to date, driven by spending related to the newly implemented ERP system and one-time operational improvement expenditures.
- Operating results shifted from profit to loss in both comparable periods. Interest expense increased to $0.5 million year to date from $0.4 million.
- Operating cash flow changed from $2.7 million provided in the first six months of 2018 to $2.2 million used in the first six months of 2019, primarily due to increases in receivables and contract assets and a decrease in accounts payable.
- Total liabilities increased to $46.1 million from $38.9 million at December 31, 2018, largely reflecting increased line-of-credit borrowings and recognition of operating lease liabilities.
Guidance, Outlook, Commentary, Risks and Unusual Items
The filing does not provide formal quantitative earnings or revenue guidance. Management reported a 90-day shipment backlog of $31.4 million at June 30, 2019, up 31.4% from the prior year, and total shipment backlog of $58.7 million versus $40.1 million a year earlier. Management stated that financing arrangements and expected operating cash flows were believed sufficient for future working-capital needs, but this assessment depends on operating performance and continued access to bank financing.
The company did not meet the required 1.0-to-1.0 fixed-charge coverage ratio as of June 30, 2019. Bank of America waived the covenant violation in a second amendment received August 13, 2019. The line of credit is secured by substantially all company assets, and advances remain subject to borrowing-base requirements and lender discretion.
The company adopted ASC 842 on January 1, 2019, recognizing $5.7 million of operating lease assets and liabilities at adoption. No impairment expense was recorded. The Devicix acquisition notes were fully paid during the second quarter. China operations added a 6.0 million RMB line of credit and had borrowings of approximately $0.4 million at quarter-end.
Key risks include component shortages, operational inefficiencies, labor availability, commodity and energy cost volatility, competition, customer concentration, potential loss or reduction of major customer orders, foreign currency exposure, regulatory and quality requirements, debt-covenant compliance, and information-system or cybersecurity disruptions. One customer accounted for approximately 23% of second-quarter sales and 24% of six-month sales. Management stated that disclosure controls were effective as of June 30, 2019.
Investor Verification Priorities
- Verify the second amendment and waiver of the Bank of America fixed-charge coverage covenant and assess remaining covenant requirements and borrowing availability.
- Monitor whether component shortages and operational inefficiencies continue to pressure gross margin.
- Assess the sustainability of medical-market growth and the decline in industrial-market revenue.
- Reconcile operating cash outflows with receivables, contract assets, inventory, and accounts-payable trends.
- Evaluate liquidity relative to only $0.8 million of cash and $6.6 million of lease liabilities, including lender discretion over the secured credit line.
- Track customer concentration and backlog conversion, particularly the major customer representing approximately 23% to 24% of sales.
- Review ERP implementation and other one-time operational expenditures for additional effects on future earnings.