Nortech Systems Incorporated — Form 10-Q Summary
Business context and reporting period
Unaudited quarterly report for the period ended June 30, 2014, filed August 6, 2014. Nortech 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.
Financial performance and key metrics
| Metric | Three months ended June 30, 2014 | Three months ended June 30, 2013 | Six months ended June 30, 2014 | Six months ended June 30, 2013 |
|---|---|---|---|---|
| Net sales | $27.4 million | $28.5 million | $53.6 million | $54.4 million |
| Gross profit / margin | $3.3 million / 12.0% | $3.4 million / 11.8% | $6.4 million / 11.9% | $6.6 million / 12.1% |
| Income from operations | $347,000 | $373,000 | $583,000 | $597,000 |
| Net income | $247,000 | $187,000 | $333,000 | $328,000 |
| Diluted EPS | $0.09 | $0.07 | $0.12 | $0.12 |
| Operating cash flow | Not separately provided | Not separately provided | $1.3 million | $(1.4) million |
At June 30, 2014, cash was zero; accounts receivable were $15.2 million, inventories were $19.4 million, and total assets were $47.2 million. Total liabilities were $24.9 million and shareholders’ equity was $22.3 million.
Debt included $7.2 million drawn on the line of credit, $4.7 million of long-term debt including current maturities, and approximately $4.2 million of unused line availability. The line of credit was reclassified from current to long-term because management stated it had the ability and intent to refinance it on a long-term basis. The line is secured by substantially all company assets and is subject to borrowing-base requirements and financial covenants.
Six-month investing cash usage was $1.1 million, primarily for property and equipment purchases. Financing activities used $200,000, including $361,000 of long-term debt principal payments net of $230,000 of new borrowings. Working capital was $23.0 million at June 30, 2014, compared with $15.5 million at December 31, 2013, primarily because of the debt reclassification.
Material changes versus the prior comparable period
- Second-quarter sales declined approximately 4% year over year, while six-month sales declined approximately 2%.
- Second-quarter gross margin improved to 12.0% from 11.8%, attributed to favorable product mix and process improvements. Six-month gross margin decreased to 11.9% from 12.1%.
- Second-quarter operating income declined to $347,000 from $373,000; six-month operating income declined to $583,000 from $597,000.
- Second-quarter net income increased to $247,000 from $187,000, primarily because of a $15,000 tax benefit versus $98,000 of tax expense in the prior-year quarter. Six-month net income was broadly stable.
- Medical sales increased 33% in the quarter and 30% for the first six months. Aerospace and defense sales decreased 28% and 17%, respectively, while industrial sales decreased 15% and 14%.
- Operating cash flow improved to $1.3 million from $1.4 million used in the first six months of 2013, reflecting improved collections and accounts payable timing, partly offset by higher inventories.
- The 90-day backlog was $19.2 million at June 30, 2014, up 13% from March 31, 2014 and approximately flat with June 30, 2013. Medical and industrial backlog increased from the beginning of the quarter, while aerospace and defense backlog remained below the prior year.
Outlook, commentary, risks and unusual items
Management described the second quarter as stronger than the first in revenue and net income and reported increased quoting and pipeline activity among industrial customers. Management expects a major portion of the 90-day backlog to convert to revenue in the following quarter, but the filing provides no formal revenue or earnings guidance.
Defense demand remains pressured by Department of Defense funding delays, program cancellations and reduced contract size. Industrial demand continues to be affected by a sluggish economic recovery. Gross margin may vary with product mix, component costs and availability, pricing, product life cycles, new-product start-up costs, capacity utilization and overhead absorption.
The second-quarter tax benefit resulted from a favorable Minnesota Department of Revenue audit settlement recognizing $100,000 of previously reserved research and development credits. Management expected a full-year 2014 effective tax rate of approximately 30%, compared with 28% for 2013. Approximately $41,000 of uncertain tax benefit positions remained at June 30, 2014.
Key risks include customer and market concentration, competition, economic conditions, labor availability, raw-material and energy costs, component availability, facility reliability, LIBOR-related interest-rate exposure, borrowing-base and covenant compliance, and reliance on a major customer. Two divisions of the largest customer represented 30% of second-quarter sales and 29% of six-month sales. Legal proceedings were described as ordinary-course matters. Management reported effective disclosure controls and no material change in internal control over financial reporting.
The company is evaluating ASU 2014-09, Revenue from Contracts with Customers, effective for annual reporting periods beginning after December 15, 2016. It had not selected a transition method or determined the accounting impact as of the filing date.
Investor verification checklist
- Verify the sustainability of the $1.3 million of operating cash flow and whether inventory growth is supported by firm customer demand.
- Review the line-of-credit agreement, borrowing-base availability, covenants, maturity classification and refinancing assumptions.
- Assess customer concentration and the effect of continued defense funding reductions or industrial demand weakness.
- Determine how much of the $19.2 million backlog converts to third-quarter sales and at what gross margin.
- Separate recurring earnings from the $100,000 tax benefit and confirm the full-year effective tax-rate outlook.
- Monitor component costs, labor availability, capacity utilization and customer pricing pressure because reported operating margins remain near 1%.