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. The filing covers the quarter and six months ended June 30, 2015; comparative periods are the quarter and six months ended June 30, 2014. The financial statements are unaudited.
Financial Results and Key Metrics
| Metric | Three Months Ended June 30, 2015 | Three Months Ended June 30, 2014 | Six Months Ended June 30, 2015 | Six Months Ended June 30, 2014 |
|---|---|---|---|---|
| Net sales | $26.8 million | $27.4 million | $53.3 million | $53.6 million |
| Gross profit | $2.4 million | $3.3 million | $5.3 million | $6.4 million |
| Gross margin | 9.1% | 12.0% | 9.9% | 11.9% |
| Operating income (loss) | $(0.5) million | $0.3 million | $(0.7) million | $0.6 million |
| Net income (loss) | $(0.4) million | $0.2 million | $(0.6) million | $0.3 million |
| Diluted EPS | $(0.14) | $0.09 | $(0.21) | $0.12 |
For the first six months, operating cash flow was $(0.1) million, compared with $1.3 million provided in the prior-year period. Investing cash flow was $(1.2) million, primarily for property and equipment purchases. Financing activities provided $1.4 million, principally from net borrowing activity.
At June 30, 2015, cash was $68,783. Accounts receivable were $16.7 million and inventories were $20.6 million, up from $18.5 million at December 31, 2014. Working capital was approximately $24.7 million.
Total debt, including current maturities and the line of credit, was approximately $15.0 million at June 30, 2015, consisting of $8.5 million outstanding under the operating line and $5.7 million of long-term debt. The company had approximately $5.5 million of unused borrowing availability, subject to borrowing-base requirements and lender discretion. The line of credit is secured by substantially all assets and bears interest at approximately 2.5% at quarter-end.
Material Changes Versus the Prior Comparable Period
- Second-quarter sales declined 2%; first-half sales were essentially flat year over year.
- Gross margin declined 290 basis points in the quarter and 200 basis points for the first half.
- The company moved from operating income and net income in 2014 to operating and net losses in 2015.
- Medical sales declined 16% in the quarter and 12% year to date, while industrial sales increased 9% and 14%, respectively. Aerospace and defense sales were flat in the quarter but down 17% year to date.
- Selling expense increased due to business-development activities and China manufacturing expansion. General and administrative expense decreased following cost reductions.
- Inventory increased approximately $2.1 million from year-end, contributing to negative operating cash flow.
- The May 2015 credit agreement amendment increased the line of credit to $15.0 million and added equipment and capital-expenditure borrowing facilities.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
Management attributed margin pressure to customer mix, reduced higher-margin medical revenue, lower-margin industrial revenue, depressed defense margins, Mexico startup costs, China and Asia expansion investments, and increased selling expense. Management is implementing lean initiatives and improvements to the new-product-introduction process and is considering capacity reductions or divestitures of non-profitable businesses.
The 90-day order backlog was approximately $19.4 million at June 30, 2015, up from $18.3 million at March 31, 2015. Management expected a major portion to convert to revenue in the following quarter, but noted that backlog varies with order timing, manufacturing delays, contract terms, and customer releases.
Management expected a 2015 effective tax rate of approximately 36%, compared with 8.4% in 2014. The 2014 rate benefited from a favorable Minnesota tax audit settlement and recognition of research and development credits.
On July 1, 2015, the company acquired substantially all assets of Devicix, LLC, a medical product design and engineering firm. The stated purchase price was $5.3 million, funded through $2.0 million of line-of-credit borrowings, $0.5 million of customer deposits, an assumed $0.5 million working-capital deficit, and seller notes totaling $2.3 million. The transaction includes a contingent earnout capped at $2.5 million. Purchase accounting valuations were not complete at the filing date.
Key risks include customer and market concentration, strong U.S. dollar effects, weak global economies, depressed oil and gas markets, competition, labor and component availability, raw-material and energy cost volatility, facility execution, LIBOR fluctuations, and compliance with debt covenants. General Electric represented 25% of second-quarter and first-half sales. The minimum fixed-charge coverage ratio was 1.71 to 1.00 versus a required 1.10 to 1.00 at June 30, 2015.
The company reported effective disclosure controls and no material change in internal control over financial reporting. It was subject to ordinary-course legal proceedings and claims; the filing does not identify a material specific proceeding.
Important Facts for Investors to Verify
- Whether margin recovery initiatives offset customer-mix pressure and Mexico, China, and Asia expansion costs.
- The conversion and quality of the $19.4 million 90-day backlog, particularly the decline in medical demand.
- Liquidity after the $2.0 million Devicix acquisition borrowing, including remaining borrowing-base availability and covenant compliance.
- The final purchase-price allocation, acquired assets and liabilities, goodwill, amortization, and contingent consideration for Devicix.
- Inventory levels, reserves, and working-capital requirements given negative operating cash flow.
- Customer concentration and exposure to General Electric, foreign markets, currency movements, and industrial and defense demand.
- The effect of the expected 36% tax rate and remaining uncertain tax positions on future earnings and cash taxes.