Nortech Systems Incorporated — 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 principal markets are aerospace and defense, medical and industrial equipment. This unaudited Form 10-Q covers the three and six months ended June 30, 2018, compared with the corresponding 2017 periods.
Financial Performance and Position
| Metric | Three Months Ended June 30, 2018 | Three Months Ended June 30, 2017 | Six Months Ended June 30, 2018 | Six Months Ended June 30, 2017 |
|---|---|---|---|---|
| Net sales | $28.5 million | $30.1 million | $55.0 million | $58.5 million |
| Gross profit | $3.8 million | $3.4 million | $6.8 million | $6.5 million |
| Gross margin | 13.4% | 11.2% | 12.4% | 11.0% |
| Income from operations | $0.7 million | $0.1 million | $0.6 million | $0.2 million |
| Net income (loss) | $0.4 million | $(0.02) million | $(0.002) million | $(0.03) million |
| Basic and diluted EPS | $0.14 | $(0.01) | $(0.00) | $(0.01) |
Six-month operating cash flow was $2.7 million, compared with $1.3 million in the prior-year period. Investing cash flow was $(0.6) million, primarily for $0.6 million of property and equipment purchases. Financing cash flow was $(2.2) million, including $1.4 million of line-of-credit repayments, $0.5 million of long-term debt repayments, $0.2 million of share repurchases and $0.2 million of capital-lease principal payments. Ending cash and restricted cash was $0.7 million, including $0.2 million of restricted cash.
At June 30, 2018, total assets were $55.9 million and total liabilities were $34.9 million. Current assets were $41.8 million versus current liabilities of $22.7 million, producing working capital of approximately $19.1 million. Accounts receivable were $19.3 million, inventories were $14.0 million and contract assets were $6.5 million.
Debt included $7.1 million outstanding under the revolving line of credit, $4.5 million of real-estate term notes before related adjustments, $0.6 million of Devicix acquisition notes before related adjustments, and capital-lease obligations totaling approximately $1.5 million. The $16.0 million secured credit facility expires June 15, 2022; reported unused availability was $6.3 million. The line of credit carried a weighted-average interest rate of 4.5% at June 30, 2018.
Material Changes Versus the Prior Comparable Period
- Second-quarter sales declined 5.3%, and six-month sales declined 5.9%. Medical sales decreased 12.7% in the quarter and 19.6% year to date, while aerospace and defense sales increased 9.8% and 27.5%, respectively. Industrial sales were essentially flat.
- Gross margin improved by 220 basis points in the quarter and 140 basis points year to date, attributed to customer and product mix, operating efficiencies and cost improvements.
- Operating income increased to $0.7 million in the quarter and $0.6 million year to date, compared with $0.1 million and $0.2 million, respectively, in 2017.
- Second-quarter 2017 included a $0.2 million loss on extinguishment of debt. The six-month 2017 results also benefited from a $0.4 million gain on the sale of the Augusta facility.
- Selling expense decreased, while general and administrative expense increased modestly. The cash conversion cycle improved to 56 days for the first six months from 76 days in the prior-year period, although management states that the comparison was significantly affected by the new revenue-recognition standard.
Guidance, Outlook, Risks and Unusual Items
Effective January 1, 2018, the company adopted ASC 606 using the modified retrospective method. The adoption resulted in a $1.4 million increase to beginning retained earnings and shifted much of the company’s revenue recognition from shipment to over-time recognition. Approximately 91% of 2018 revenue was recognized over time. Reported 2018 sales were $1.6 million higher in the second quarter and $2.3 million higher year to date than they would have been under the previous guidance, while the company stated that the change had a significant effect on reported assets, inventory, contract assets and cash-flow presentation.
Management reported a 90-day shipment backlog of $23.9 million at June 30, 2018, up 8.9% from March 31 and 9.0% from June 30, 2017. Aerospace and defense backlog increased 30.9% year over year, industrial backlog increased 9.5%, and medical backlog was approximately flat.
The company expected a 2018 effective tax rate of approximately 65%, compared with a negative 18% rate in 2017, primarily because of the Tax Cuts and Jobs Act and a higher expected tax rate in China. 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 specified minimum cumulative EBITDA targets, including approximately $2.0 million for the twelve months ending December 31, 2018. The filing states that financing arrangements and operating cash flows are expected to satisfy future working-capital needs.
Key risks include customer concentration, loss of a major customer, medical and FDA compliance, competition and reduced outsourcing by original equipment manufacturers, labor availability, raw-material and energy costs, currency and market volatility, facility or supply-chain disruptions, cybersecurity incidents, and implementation difficulties with the company’s new global ERP system. The company also has approximately $6.8 million of future minimum operating-lease payments and various ordinary-course legal claims. No material changes to previously disclosed risk factors were reported other than the ERP implementation risk.
Investor Verification Checklist
- Verify the effect of ASC 606 on recurring revenue, margins, inventory, contract assets, receivables and period-to-period comparability.
- Monitor medical-market demand and the company’s reliance on a major customer that represented approximately 21% of six-month sales and 19% of accounts receivable at June 30, 2018.
- Assess compliance with the credit agreement’s EBITDA and fixed-charge coverage covenants as the December 31, 2018 testing dates approach.
- Reconcile reported backlog conversion with shipments, receivables and cash collections, particularly because contract assets totaled $6.5 million.
- Evaluate whether the improved gross margin and operating income are sustainable without the benefit of noncash consideration recognized at zero margin.
- Review ERP implementation progress, potential operating disruptions and the company’s limited cash balance relative to debt and lease obligations.