Nortech Systems Incorporated: FY2016 Form 10-K Summary
Business Context and Reporting Period
Nortech Systems Incorporated is a Minnesota-based electronic manufacturing services company serving aerospace and defense, medical, and industrial customers. It provides engineering, design, testing, prototyping, manufacturing, supply-chain management, and post-market services from facilities in the United States, Mexico, and China. The filing covers the fiscal year ended December 31, 2016, with comparison to fiscal 2015.
The company reports one operating segment: Contract Manufacturing. Its common stock trades on the NASDAQ Capital Market under the symbol NSYS.
Key Financial Metrics
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Net sales | $116.6 million | $115.2 million | 1.2% increase |
| Gross profit | $13.8 million | $12.1 million | 14.8% increase |
| Gross margin | 11.9% | 10.5% | 1.4 percentage-point increase |
| Income (loss) from operations | $629,000 | ($422,000) | Improved by $1.1 million |
| Net income (loss) | $44,000 | ($571,000) | Returned to profitability |
| Diluted EPS | $0.02 | ($0.21) | Improved |
| Cash flow from operating activities | $3.5 million | $3.4 million | Increase of $154,000 |
| Capital expenditures | $2.0 million | $1.7 million | Increase of $278,000 |
| Cash at year-end | $268,000 | $887 | Increase of $267,000 |
Sales by market were $53.8 million in medical, $46.7 million in industrial, and $16.1 million in aerospace and defense. Medical sales increased 30%, defense sales increased 11%, and industrial sales declined 21%.
At December 31, 2016, total assets were $55.5 million, total liabilities were $33.2 million, and shareholders’ equity was $22.3 million. Accounts receivable were $17.3 million, net of an $883,000 allowance, and inventories were $20.7 million, net of a $673,000 reserve.
Debt and Liquidity
- Outstanding borrowings under the Wells Fargo revolving credit facility were $7.3 million at year-end, compared with $7.7 million at year-end 2015.
- Net unused availability under the revolving facility was approximately $5.7 million, subject to borrowing-base requirements.
- Total long-term debt, including current maturities, was $6.5 million at December 31, 2016, compared with $7.5 million at December 31, 2015.
- The credit facility includes a $15.0 million line of credit and various term notes. The line of credit was scheduled to expire, if not renewed, on May 31, 2018.
- The company paid $499,000 of interest during 2016 and reported interest expense of $550,000.
- Management stated that existing financing arrangements and expected operating cash flows should fund working capital, capital expenditures, and debt repayments for the foreseeable future.
- The company was in compliance with its debt covenants at December 31, 2016. A January 2017 amendment reduced the required fixed-charge coverage ratio to 1.05 through June 30, 2017 and 1.10 thereafter.
Material Changes Versus the Prior Period
- Profitability improved substantially as gross margin benefited from a higher mix of medical products and engineering services, as well as selective pricing actions.
- General and administrative expense increased to $8.3 million from $7.2 million. Drivers included a $600,000 increase in doubtful-account expense related to a customer bankruptcy and settlement-related bad debt, $500,000 of additional full-year Devicix operating costs, and $200,000 of China facility costs. These increases were partly offset by a $300,000 reduction in contingent consideration related to the Devicix acquisition.
- China operations expanded during 2016. Start-up costs of $451,000 were included in cost of goods sold, while production revenue began in the second half of the year.
- The company announced the closure of its Augusta, Wisconsin facility. Production ceased in January 2017, approximately 50 employees were affected, and the facility was placed on the market in February 2017. The facility had $392,000 of net property and equipment at December 31, 2016.
- The 90-day backlog was $20.5 million, compared with $20.7 million in 2015. Medical backlog rose 35%, while defense backlog declined 36% and industrial backlog declined 15%.
- The cash conversion cycle increased to 81 days from 76 days, primarily because of higher inventory days associated with plant transfers and customer safety-stock requirements related to the Augusta closure.
Outlook, Risks, Contingencies, and Unusual Items
Management emphasized continued investment in medical-market growth, engineering services, supply-chain capabilities, lean manufacturing, and the global footprint. The company expects to consolidate Augusta operations into other facilities to improve asset utilization and cost leverage. It also intends to increase business-development and marketing investment.
- Customer concentration is significant: the largest customer’s two divisions represented approximately 24% of 2016 sales, and one division alone represented approximately 20%.
- Key risks include customer order cancellations and rescheduling, dependence on electronic-component suppliers, component shortages, pricing pressure, competition, customer credit losses, and exposure to industrial-market weakness.
- Foreign operations in Mexico and China expose the company to currency, trade, regulatory, political, labor, transportation, cybersecurity, and operational risks.
- Medical-device operations are subject to FDA Quality System Regulation requirements and periodic inspections.
- The company has variable-rate debt tied to LIBOR, creating interest-rate exposure.
- The Devicix acquisition includes contingent consideration. The estimated liability declined from $851,000 to $556,000 during 2016, producing a $294,000 reduction in general and administrative expense.
- Goodwill of $3.3 million was tested for impairment in the fourth quarter of 2016 and was not impaired.
- Operating lease commitments totaled approximately $3.1 million at year-end. Management stated that routine legal proceedings were not expected to materially affect the financial statements.
- No dividends were declared or paid in 2016 or 2015, and the company does not expect to pay dividends in the foreseeable future.
Important Facts for Investors to Verify
- Whether medical-market growth and the Devicix engineering business can offset continued weakness in industrial sales.
- Whether China start-up costs decline as production scales and whether the expanded global footprint improves margins.
- Progress and financial effects of the Augusta facility closure and operational consolidation.
- Compliance with fixed-charge coverage and other credit-agreement covenants after the January 2017 amendment.
- Availability under the asset-based revolver and the company’s ability to refinance or repay debt maturities, including $1.6 million due in 2017 and $2.7 million due in 2018.
- Changes in accounts receivable quality, the $883,000 doubtful-account allowance, inventory levels, and the 81-day cash conversion cycle.
- Customer concentration and the sustainability of the largest customer relationship.
- Actual realization of the reported backlog, particularly the decline in defense and industrial backlog.