Nortech Systems Incorporated — Q3 2014 Form 10-Q Summary
Business Context and Reporting Period
Unaudited quarterly report for the period ended September 30, 2014, filed November 5, 2014. Nortech is an electronics manufacturing services company providing wire and cable assemblies, printed circuit board assemblies, higher-level assemblies, box builds, engineering, testing, prototyping, and supply-chain services. Its primary markets are medical, industrial, and aerospace and defense.
Financial Results and Key Metrics
| Metric | Q3 2014 | Q3 2013 | Change |
|---|---|---|---|
| Net sales | $28.0 million | $27.4 million | Up 2% |
| Gross profit | $3.5 million | $3.0 million | Up 17% |
| Gross margin | 12.6% | 11.0% | Up 160 basis points |
| Operating income | $473,000 | $376,000 | Up 26% |
| Net income | $333,000 | $218,000 | Up 53% |
| Diluted EPS | $0.12 | $0.08 | Up $0.04 |
| Metric | Nine Months 2014 | Nine Months 2013 | Change |
|---|---|---|---|
| Net sales | $81.6 million | $81.8 million | Down less than 1% |
| Gross profit | $9.9 million | $9.6 million | Up 3% |
| Gross margin | 12.1% | 11.8% | Up 30 basis points |
| Operating income | $1.06 million | $973,000 | Up 9% |
| Net income | $666,000 | $546,000 | Up 22% |
| Diluted EPS | $0.24 | $0.20 | Up $0.04 |
For the nine months, operating cash flow was $1.4 million, compared with cash used of $21,000 in the prior-year period. Capital expenditures were $1.8 million, producing net cash used in investing activities of $1.8 million. Financing activities provided $599,000, and ending cash was $203,000.
At September 30, 2014, total assets were $49.4 million and working capital was approximately $24.0 million. Accounts receivable were $15.6 million and inventories were $20.4 million, with inventory up from $17.4 million at December 31, 2013 to support higher backlog.
Total debt was $12.7 million, consisting of $7.8 million drawn under the line of credit and $4.9 million of long-term debt, including current maturities. The $13.5 million line of credit expires, if not renewed, on May 31, 2018; approximately $4.3 million of borrowing-base availability remained at quarter-end. The facility is secured by substantially all company assets and includes financial, reporting, capital expenditure, and dividend-related covenants.
Material Changes Versus Prior Comparable Period
- Medical revenue increased 19% in the quarter and 24% year to date, partially offsetting aerospace and defense declines of 22% and 18%, respectively.
- Industrial revenue was essentially flat in the quarter and declined 8% year to date.
- Gross margin improved due to better leveraging and plant utilization and continued process improvements.
- General and administrative expense increased primarily because of infrastructure investments, reaching 6.2% of sales in the quarter versus 5.1% in the prior-year quarter.
- The effective tax rate declined to 10% from 29% for the quarter and to 10% from 23% year to date, primarily because of a favorable return-to-provision adjustment and recognition of research and development credits following a Minnesota tax audit settlement.
- The line of credit was extended in the second quarter and reclassified from current to long-term liabilities. December 31, 2013 line-of-credit borrowings were $7.2 million; September 30, 2014 borrowings were $7.8 million.
- The 90-day backlog rose to $20.9 million from $19.2 million at June 30, 2014 and $18.8 million at September 30, 2013, led by medical backlog growth.
Outlook, Commentary, Risks, and Unusual Items
Management reported improving third-quarter revenue and operating profit, rising backlog and pipeline activity, increased medical opportunities, and signs of recovery among industrial customers. Management also stated that aerospace and defense demand remains affected by lower Department of Defense funding, program cuts, and delays in government funding. A major portion of the firm 90-day backlog is expected to convert to revenue in the following quarter, although timing can vary.
Management believes financing arrangements and operating cash flows will be sufficient for future working capital needs. However, liquidity depends on operating cash generation, borrowing-base availability, lender discretion, and compliance with credit covenants. Borrowings carry variable LIBOR-based interest rates.
Key risks include market volatility, competition, facility or third-party operating disruptions, labor availability, raw material and copper costs, commodity and energy price instability, general economic conditions, and availability of raw material components. Customer concentration is significant: one customer's two divisions represented 30% of third-quarter sales and 29% of nine-month sales. Export sales represented 13% of sales.
Unusual items included the favorable tax true-up and $100,000 of previously reserved research and development credits accepted in the Minnesota tax audit settlement. The filing also reports approximately $199,000 accrued under the equity appreciation rights plan and $24,000 of unrecognized stock-option compensation at September 30, 2014. The company disclosed ordinary-course legal proceedings but no specific material proceeding. ASU 2014-09 revenue-recognition adoption was pending; the company had not selected a transition method or determined the impact.
Important Facts for Investors to Verify
- Whether medical and industrial backlog conversion offsets continuing aerospace and defense weakness.
- Whether the 12.6% quarterly gross margin improvement is sustainable and whether infrastructure investments drive further operating leverage.
- Inventory growth, accounts receivable collections, and the company’s ability to continue generating positive operating cash flow.
- Borrowing-base availability, covenant compliance, refinancing or renewal terms, and exposure to LIBOR rate changes.
- The durability of the 10% effective tax rate, given the tax settlement and discrete credits.
- Dependence on the largest customer, which represented 30% of third-quarter sales, and related accounts receivable exposure.
- The eventual impact and transition method for the pending revenue-recognition standard.