Nortech Systems Incorporated — Q3 2020 Form 10-Q Summary
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 primary markets are medical, industrial, and aerospace and defense. The filing covers the three and nine months ended September 30, 2020, compared with the same periods in 2019. The company operated manufacturing facilities in Minnesota, Mexico, and China and reported 2,657,530 common shares outstanding as of November 4, 2020.
Financial Performance and Liquidity
| Metric | Q3 2020 | Q3 2019 | 9M 2020 | 9M 2019 |
|---|---|---|---|---|
| Net sales | $26.4 million | $30.1 million | $80.3 million | $85.5 million |
| Gross profit | $1.6 million | $3.6 million | $7.1 million | $8.9 million |
| Gross margin | 6.2% | 12.1% | 8.8% | 10.4% |
| Operating income (loss) | $2.7 million | $0.7 million | $3.1 million | $(0.6) million |
| Net income (loss) | $2.0 million | $0.4 million | $2.0 million | $(1.5) million |
| Basic EPS | $0.74 | $0.16 | $0.75 | $(0.56) |
Operating and net income benefited materially from a $3.8 million gain on the sale of property and equipment in a sale-leaseback transaction. Excluding the gain, operating performance would have been substantially weaker year over year. Interest expense declined to $0.1 million in the quarter and $0.5 million year to date.
For the nine months, operating cash flow was negative $0.1 million compared with negative $0.2 million in 2019. Investing cash flow was positive $5.6 million, primarily from $6.0 million of sale-leaseback proceeds. Financing cash flow was negative $4.5 million, including a $7.5 million reduction in line-of-credit borrowings, $2.6 million of long-term debt principal payments, and $6.1 million of new PPP debt proceeds.
At September 30, 2020, cash was $0.3 million and restricted cash was $1.4 million. Working capital was $22.6 million, compared with $21.1 million at December 31, 2019. Accounts receivable were $16.0 million, inventories were $14.5 million, and contract assets were $7.3 million.
The company had $2.5 million outstanding under its $16.0 million line of credit and reported $8.6 million of unused borrowing-base-supported availability. Long-term debt, including the PPP promissory note and net of current maturities, was $6.7 million; current maturities were $0.4 million. Lease liabilities totaled $11.4 million, including $9.4 million of operating lease liabilities and $2.0 million of finance lease liabilities.
Material Changes Versus the Prior Comparable Period
- Q3 sales declined 12.3%, and nine-month sales declined 6.1%, primarily reflecting COVID-19-related demand and operating impacts.
- Medical sales declined 16.6% in Q3 and 7.1% year to date; industrial sales declined 31.1% and 16.3%, respectively.
- Aerospace and defense sales increased 41.3% in Q3 and 17.3% year to date, partially offsetting declines in the other markets.
- Gross margin fell 590 basis points in Q3 and 160 basis points year to date, driven by lower volume on a fixed-cost base and increased inventory reserves.
- General and administrative expense declined year to date to $5.8 million from $7.4 million, reflecting lower prior-year one-time operational improvement spending and cost-reduction benefits.
- The company completed a sale-leaseback of its Bemidji and Mankato facilities, receiving approximately $6.0 million and recording a $3.8 million gain, while entering into initial 15-year leases.
- Management approved closure of the Merrifield, Minnesota production facility, expected by December 31, 2020, affecting approximately 60 employees and shifting production to other Minnesota sites.
- September 30, 2020 90-day backlog was $23.1 million, down 27.8% from September 30, 2019. Total backlog was $45.7 million versus $58.1 million a year earlier.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
The filing does not provide quantitative revenue or earnings guidance. Management stated that it could continue operating its manufacturing facilities and providing essential services during the COVID-19 pandemic, but could not predict the pandemic’s future impact. Management believed cash flows, available credit, PPP proceeds, sale-leaseback proceeds, and cash on hand would be adequate for working capital, capital expenditures, and debt obligations.
The $6.1 million PPP promissory note bears interest at 1% and has a two-year term. Management expected all or a significant portion to be forgiven, but forgiveness remained subject to applicable requirements and review. The company could be required to repay up to the full amount if an SBA or Treasury review resulted in an adverse finding, potentially reducing liquidity and creating fines, penalties, legal costs, and reputational exposure.
The company met its required fixed-charge coverage covenant as of September 30, 2020. The credit facility is secured by substantially all company assets, advances are subject to borrowing-base requirements and lender discretion, and the facility expires June 15, 2022.
Key risks include continuing COVID-19 effects on demand, supply chains and workforce availability; customer concentration; competition and potential insourcing by original equipment manufacturers; labor and raw-material costs; regulatory and FDA compliance; cybersecurity or operational disruptions; foreign exchange exposure; and the loss of a major customer. One customer’s divisions represented approximately 23% of Q3 sales and 24% of nine-month sales and approximately 37% of accounts receivable at September 30, 2020.
The filing states that there were no material impairment charges, no material off-balance-sheet arrangements, no defaults on senior securities, and no material changes to previously disclosed risk factors other than COVID-19 and PPP-related risks. Disclosure controls were deemed effective.
Important Facts for Investors to Verify
- Whether the $6.1 million PPP loan was ultimately forgiven and the timing and accounting treatment of any forgiveness.
- Whether lower medical and industrial demand, backlog contraction, and COVID-19 effects continue into subsequent quarters.
- Underlying operating profitability excluding the $3.8 million sale-leaseback gain.
- Execution costs, savings, employee impacts, and operational effects from the Merrifield facility closure.
- Compliance with credit-facility covenants and continued availability under the borrowing base.
- Liquidity relative to negative operating cash flow, substantial lease obligations, debt maturities, and restricted cash.
- Customer concentration and collectability of the customer-related accounts receivable balance.