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 technical 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, 2016, compared with the corresponding 2015 periods.
The company operates as a single Contract Manufacturing segment and had 2,747,831 common shares outstanding as of October 27, 2016.
Financial Performance and Position
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Net sales | $29.7 million | $30.4 million | $87.6 million | $83.8 million |
| Gross profit | $3.8 million | $2.9 million | $10.3 million | $8.2 million |
| Gross margin | 12.7% | 9.5% | 11.7% | 9.8% |
| Operating income (loss) | $190,000 | $(66,000) | $301,000 | $(751,000) |
| Net income (loss) | $63,000 | $(124,000) | $(54,000) | $(695,000) |
| Basic and diluted EPS | $0.02 | $(0.05) | $(0.02) | $(0.25) |
- Operating expenses were $3.6 million in the third quarter and $10.0 million for the first nine months. General and administrative expense increased primarily because of a $456,000 doubtful-account provision related to a customer bankruptcy, additional Devicix costs, and expenses associated with the new China facility.
- Net cash provided by operating activities was $1.9 million for the first nine months of 2016, versus $3.9 million in the prior-year period. Investing cash use was $1.7 million, principally for property and equipment purchases; financing cash use was $154,000.
- Cash increased to $61,000 at September 30, 2016, from $887,000 at December 31, 2015. Working capital was approximately $20.4 million.
- Accounts receivable were $17.7 million and inventory was $21.7 million at September 30, 2016. Inventory increased from $20.2 million at year-end, partly due to shipment delays, delayed product launches, safety stock, and customer design issues.
- Total liabilities were $35.0 million and shareholders’ equity was $22.2 million at September 30, 2016.
- Debt consisted of $8.2 million outstanding under the Wells Fargo line of credit and $6.8 million of long-term debt, including current maturities. The line had $6.1 million of net unused availability and bore approximately 3.1% interest at quarter-end.
- The fixed charge coverage ratio was 1.38 to 1.00 versus a required minimum of 1.15 to 1.00.
Material Changes Versus the Prior Comparable Period
- Third-quarter sales decreased 2%, while nine-month sales increased 4.6%.
- Medical sales increased 27% in the quarter and 34% for the first nine months, supported by manufacturing and Devicix engineering services. Aerospace and defense sales increased 6% in the quarter and 16% for the nine months.
- Industrial sales declined 25% in the quarter and 17% for the nine months, reflecting weaker demand in semiconductor, agriculture, transportation, energy, and related markets.
- Gross margin improved by 320 basis points in the quarter and 190 basis points for the nine months, driven by medical and engineering-services mix, selective pricing actions, and lower material costs.
- The company moved from an operating loss to operating income in both the quarter and nine-month period, and third-quarter net income was positive. The nine-month net loss narrowed substantially.
- Cash generation declined year over year despite improved earnings, primarily because of increased inventory and less favorable working-capital movements.
- The 90-day order backlog was $23.9 million at September 30, 2016, essentially flat year over year and up 5% from June 30. Medical backlog increased 35% year over year, while aerospace and defense backlog declined 35% year over year.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
- Management stated that financing arrangements and expected operating cash flows should be sufficient for future working-capital needs. No formal revenue or earnings guidance was provided.
- Management expects a 2016 effective tax rate of approximately 32%, compared with 36% for 2015, mainly because of the federal research and development credit.
- Cost of goods sold included $216,000 of China facility startup costs in the third quarter and $579,000 for the first nine months.
- The company announced closure of its Augusta, Wisconsin manufacturing operation by the end of 2016. Approximately 50 employees are affected. A $55,000 closure accrual was recorded; facility property and equipment had a net book value of $415,000 at September 30, 2016.
- The first Devicix revenue target was only partially met. The estimated contingent acquisition consideration was reduced by $45,000 to $806,000 at September 30, 2016.
- The largest customer accounted for approximately 22% of third-quarter sales and 23% of nine-month sales; its receivables represented approximately 17% of total accounts receivable. Customer concentration and the reported bankruptcy provision are significant credit risks.
- Other risks include market volatility, competition, labor availability, raw-material and energy costs, supply-chain availability, customer cancellations, economic weakness, and dependence on aerospace, defense, medical, and industrial demand.
- The company had operating leases with approximately $3.2 million of remaining minimum payments after September 30, 2016. Legal proceedings were described as ordinary-course matters.
- Management reported effective disclosure controls and no material changes in internal control over financial reporting.
Investor Verification Points
- Verify whether the medical-market growth and backlog conversion offset continuing weakness in industrial demand.
- Assess the collectibility of receivables following the customer bankruptcy and monitor the allowance for doubtful accounts.
- Review inventory levels, shipment delays, customer design issues, and their effects on cash conversion and working capital.
- Monitor compliance with Wells Fargo covenants, borrowing-base availability, LIBOR-linked interest costs, and the May 2018 credit-facility expiration.
- Evaluate the financial effect of the Augusta closure, including employee costs, asset disposition proceeds, and consolidation savings.
- Track China facility startup costs and whether the facility reaches planned utilization and profitability.
- Confirm the timing and amount of Devicix earnout payments and related revenue performance.
- Review the potential effects of pending accounting standards, particularly revenue recognition and lease accounting, on future reported results.