Nortech Systems Incorporated — Q3 2015 Form 10-Q Summary
Business Context and Reporting Period
Nortech Systems Incorporated is a Minnesota-based 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 principal markets are aerospace and defense, medical and industrial equipment. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2015, with comparisons to the corresponding 2014 periods.
Financial Performance and Position
| Metric | Q3 2015 | Q3 2014 | 9M 2015 | 9M 2014 |
|---|---|---|---|---|
| Net sales | $30.4 million | $28.0 million | $83.8 million | $81.6 million |
| Gross profit | $2.9 million | $3.5 million | $8.2 million | $9.9 million |
| Gross margin | 9.5% | 12.6% | 9.8% | 12.1% |
| Operating income (loss) | $22,543 | $473,490 | $(662,418) | $1.1 million |
| Net income (loss) | $(123,606) | $332,697 | $(694,755) | $665,555 |
| Diluted EPS | $(0.05) | $0.12 | $(0.25) | $0.24 |
| Cash flow from operations | Not separately provided | Not separately provided | $3.9 million | $1.4 million |
September 30, 2015 total assets were $58.3 million, compared with $48.7 million at December 31, 2014. Cash was only $12,234, while accounts receivable were $19.2 million and inventory was $20.3 million. Working capital was approximately $20.1 million, down from $24.3 million at year-end.
Total debt, including the line of credit and current maturities, was approximately $14.4 million at September 30, 2015, compared with approximately $12.8 million at December 31, 2014. The company had $6.9 million outstanding under its $15.0 million revolving credit facility and approximately $7.5 million of net unused availability. The facility expires, if not renewed, on May 31, 2018, is secured by substantially all company assets, and is subject to borrowing-base and financial covenants. The fixed-charge coverage ratio was 1.22 to 1.00 versus a required minimum of 1.20 to 1.00 for the period.
Operating cash flow benefited from depreciation and amortization and favorable payment timing, particularly an increase in accounts payable. Investing cash use was $3.4 million, including $2.0 million for the Devicix acquisition and $1.5 million for property and equipment. Financing activities used $535,380, and ending cash declined by $54,137 from the beginning of the year.
Material Changes Versus the Prior Comparable Period
- Third-quarter sales increased 8% to $30.4 million; nine-month sales increased 3% to $83.8 million.
- Industrial sales increased 14% in both the quarter and nine-month period. Aerospace and defense sales increased 10% in the quarter but declined 9% year to date. Medical sales were approximately flat in the quarter and declined 8% year to date.
- Gross margin fell 310 basis points in the quarter and 230 basis points year to date, primarily due to customer and market mix, new-part startup costs, Mexico ramp-up costs and approximately $700,000 of low-margin excess-material sales.
- Third-quarter operating results improved from losses in the first two quarters of 2015, but operating income declined substantially from the 2014 quarter. The nine-month period moved from operating income of $1.1 million to an operating loss of $662,418.
- Interest expense increased to $341,148 for the first nine months from $271,661, reflecting higher debt levels and acquisition-related financing.
- General and administrative expense declined 6% year to date, while selling expense increased 10% year to date as the company supported growth initiatives.
- On July 1, 2015, the company acquired substantially all assets of Devicix, a medical product design and engineering firm. Consideration had a preliminary fair value of $5.1 million, including cash, customer deposits, assumed working capital deficit, seller notes and contingent consideration. The acquisition added $1.1 million of third-quarter revenue and resulted in approximately $3.2 million of preliminary goodwill and $2.1 million of finite-life intangible assets.
- 90-day backlog increased to approximately $24.0 million at September 30, 2015 from $19.4 million at June 30, 2015 and $20.9 million at September 30, 2014.
Guidance, Outlook, Risks and Unusual Items
Management did not provide formal revenue or earnings guidance. Management stated that gross-margin improvement initiatives were showing some progress but had not reached levels necessary to achieve expected profitability. Planned or ongoing actions include lean initiatives by work order, improvements to new-product-introduction processes, revised pipeline qualification and quoting procedures, reductions in excess capacity, and possible divestitures of non-profitable businesses.
Management expects a 2015 effective tax rate of approximately 36%, compared with 8.4% in 2014. The lower 2014 rate was largely attributable to a favorable Minnesota tax audit settlement and recognition of research and development credits.
Key risks include customer and market concentration, dependence on General Electric, competition, demand volatility, labor availability, raw-material and energy-cost increases, component availability, facility reliability, execution of the Mexico expansion and Devicix integration, and compliance with debt covenants. General Electric represented 27% of nine-month 2015 sales, while its two divisions represented 22% of accounts receivable at September 30, 2015.
The Devicix purchase agreement includes contingent earnout consideration based on eligible engineering and production revenue, with a maximum of $2.5 million; the preliminary recorded fair value was $851,000. The acquisition accounting remained subject to finalization in the fourth quarter. The company also entered into a new headquarters lease and reported $2.8 million of future minimum lease payments after September 30, 2015.
Management concluded that disclosure controls were effective and reported no material change in internal control over financial reporting. The filing states that the company had no reportable off-balance-sheet arrangements and was subject to ordinary-course legal proceedings and claims.
Important Facts for Investors to Verify
- Whether the company can sustain the improved quarterly revenue and backlog without further deterioration in gross margin.
- Progress integrating Devicix, realizing expected synergies and determining final goodwill, intangible assets and earnout obligations.
- Compliance with the fixed-charge coverage covenant and continued availability under the asset-based credit facility.
- Cash conversion, inventory growth, receivables collection and reliance on extended accounts-payable terms.
- Exposure to General Electric and changes in aerospace, medical and industrial customer demand.
- Execution and profitability of Mexico PCB assembly operations and other growth initiatives.
- The effect of the higher expected 2015 tax rate and remaining uncertain tax positions.
- The eventual impact and transition method for the revenue-recognition standard effective January 1, 2018.