Nortech Systems Incorporated — Form 10-Q Summary
Business context and reporting period
Nortech Systems Incorporated is a full-service electronics manufacturing services company producing wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds, with engineering and technical support services. Its principal markets are aerospace and defense, medical, and industrial equipment. This unaudited Form 10-Q covers the three and nine months ended September 30, 2018, compared with the same periods in 2017.
Key financial metrics
| Metric | Three months ended September 30 | Nine months ended September 30 | ||
|---|---|---|---|---|
| 2018 | 2017 | 2018 | 2017 | |
| Net sales | $29.6 million | $28.3 million | $84.5 million | $86.8 million |
| Gross profit | $3.4 million | $3.5 million | $10.2 million | $10.0 million |
| Gross margin | 11.5% | 12.4% | 12.1% | 11.5% |
| Operating income | $0.6 million | $0.3 million | $1.3 million | $0.5 million |
| Operating margin | 2.3% | 1.0% | 1.5% | 0.6% |
| Net income | $0.4 million | $43 thousand | $0.4 million | $13 thousand |
| Diluted EPS | $0.14 | $0.02 | $0.13 | $0.00 |
For the nine months, operating cash flow was $2.6 million, compared with $0.6 million in 2017. Investing cash flow was negative $1.0 million, primarily due to $1.0 million of property and equipment purchases. Financing cash flow was negative $1.7 million, including debt and capital lease repayments and $0.2 million of share repurchases. Cash and restricted cash totaled $0.6 million at September 30, 2018, compared with $1.1 million at September 30, 2017.
At September 30, 2018, total assets were $57.4 million and working capital was $20.2 million. Accounts receivable were $19.0 million, inventories were $15.2 million and contract assets were $7.1 million. Total liabilities were $36.1 million. Debt included $8.1 million outstanding under the line of credit, $4.6 million of net long-term debt, and $1.4 million of capital lease obligations.
The Bank of America credit facility provides a $16.0 million line of credit and includes a $5.0 million real estate term note. The line expires June 15, 2022, had a weighted-average interest rate of 4.3% at September 30, 2018, and had $4.8 million of unused borrowing-base availability. The facility is secured by substantially all company assets and contains financial and other covenants.
Material changes versus the prior comparable period
- Third-quarter sales increased 4.4%, while nine-month sales declined 2.6%.
- Third-quarter sales benefited from approximately $1.9 million attributable to the new revenue recognition policy; the nine-month benefit was approximately $4.2 million.
- Medical sales increased 12.0% in the quarter but declined 10.2% year to date. Aerospace and defense sales increased 3.9% in the quarter and 19.4% year to date. Industrial sales declined 3.8% in the quarter and 0.7% year to date.
- Third-quarter gross margin declined to 11.5% from 12.4%, primarily due to customer and product mix and $1.4 million of zero-margin noncash consideration. Nine-month gross margin improved to 12.1% from 11.5%, reflecting mix, operational efficiencies and cost improvements.
- Selling expense decreased to $0.7 million from $1.1 million in the quarter and to $2.8 million from $3.7 million year to date. Operating income and net income improved substantially in both comparison periods.
- The 90-day shipment backlog was $27.7 million at September 30, 2018, up 36.6% from the prior year and 16.0% from June 30, 2018.
Guidance, outlook, commentary, risks and unusual items
- Effective January 1, 2018, Nortech adopted ASC 606 using the modified retrospective method. The adoption shifted most revenue recognition from shipment to recognition over time and increased retained earnings by $1.4 million at adoption. Management states that approximately 91% of 2018 revenue was recognized over time.
- Management believes operating cash flow and available financing will be sufficient for future working capital needs. The credit agreement requires a fixed-charge coverage ratio of at least 1.0 to 1.0 beginning with the four-quarter period ending December 31, 2018 and includes a fiscal 2018 cumulative EBITDA requirement. The filing states the requirement as $1.97 million in Note 4 and approximately $2.0 million in MD&A; this should be verified.
- Management expects a 2018 effective tax rate of approximately 51%, compared with negative 18% for 2017, primarily due to tax reform effects and a higher expected tax rate in China.
- The company expects adoption of the new lease accounting standard beginning January 1, 2019 to materially increase reported assets and liabilities. It expects to apply the standard without retrospective adjustment.
- Matt Mahmood resigned as Chief Operating Officer effective October 5, 2018. The company expects to pay $235 thousand of severance over 12 months, to be fully expensed in the fourth quarter of 2018.
- Key risks include customer concentration, including one customer accounting for approximately 21% of sales in both 2018 comparison periods; foreign exchange and international operations; competition and outsourcing decisions by OEMs; labor availability; raw material and energy costs; FDA and regulatory compliance; ERP implementation difficulties; cybersecurity or information-system disruptions; and potential loss of a major customer.
- The company had no material change in previously disclosed risk factors other than the risks associated with implementing its new global ERP system. Management reported effective disclosure controls and no material change in internal control over financial reporting.
Important facts for investors to verify
- Reconcile reported 2018 results with comparable results under the prior revenue recognition method, particularly the effects on sales, contract assets, inventory, retained earnings and margins.
- Monitor compliance with the credit facility’s fixed-charge coverage and EBITDA covenants as of December 31, 2018, including the filing’s differing presentations of the EBITDA threshold.
- Assess the sustainability of the $27.7 million backlog and the degree to which revenue remains concentrated among major customers and markets.
- Evaluate liquidity given only $0.6 million of cash and restricted cash, $8.1 million of line borrowings, variable LIBOR-based interest rates and lender-controlled borrowing-base availability.
- Confirm the fourth-quarter impact of the $235 thousand COO severance obligation and the balance-sheet effects of ASC 842 lease adoption.
- Review execution of the ERP implementation and its potential effects on order processing, shipments, invoicing, collections and financial reporting.