Nortech Systems Incorporated — FY2018 Form 10-K Summary
Business Context and Reporting Period
Nortech Systems Incorporated is a global electronic manufacturing services provider serving Aerospace and Defense, Medical, and Industrial customers. It provides engineering, prototyping, testing, contract 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, 2018, with comparisons to fiscal 2017; it is an annual filing rather than a standalone fourth-quarter report.
- Single reportable segment: Contract Manufacturing.
- Employees at December 31, 2018: 728 full-time and 91 part-time or temporary.
- Largest customer represented 23.2% of 2018 net sales, compared with 24.9% in 2017.
Financial Performance and Position
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Net sales | $113.4 million | $112.3 million | 0.9% increase |
| Gross profit | $13.3 million | $12.1 million | 9.8% increase |
| Gross margin | 11.7% | 10.8% | 90 basis-point increase |
| Operating income (loss) | $1.2 million | $(1.3) million | Improved by $2.5 million |
| Income (loss) before taxes | $0.5 million | $(2.1) million | Improved by $2.6 million |
| Net income (loss) | $0.2 million | $(2.4) million | Improved by $2.6 million |
| Diluted EPS | $0.06 | $(0.89) | Improved |
| Cash flow from operations | $2.4 million | $0.8 million | Increase of $1.6 million |
- Net sales by market: Aerospace and Defense $18.3 million, Medical $45.1 million, and Industrial $50.0 million. Aerospace and Defense increased 16.6%, Industrial increased 10.6%, and Medical declined 12.3%.
- Selling expenses declined to $3.6 million from $4.7 million, while general and administrative expenses increased to $8.4 million from $8.1 million.
- Interest expense increased to $0.8 million from $0.6 million. The effective tax rate was 66.3%, primarily affected by a $0.3 million GILTI tax expense and other tax adjustments.
- Cash and restricted cash totaled $0.9 million at year-end, including $0.5 million of unrestricted cash and $0.5 million of restricted cash.
- Total assets were $60.0 million and total shareholders’ equity was $21.1 million at December 31, 2018.
- Accounts receivable were $20.1 million, inventories were $17.0 million, and contract assets were $6.4 million.
- The cash conversion cycle improved to 61 days from 86 days, primarily reflecting the revenue-recognition change and payment timing.
Debt, Liquidity, and Capital Resources
- The Bank of America facility provides a $16.0 million line of credit expiring June 15, 2022, plus a $5.0 million real-estate term note. Borrowings under the line were $9.3 million at December 31, 2018, compared with $8.5 million in 2017.
- Unused borrowing-base-supported availability was $6.1 million at December 31, 2018, compared with $4.2 million at the prior year-end.
- The weighted-average interest rate on the Bank of America facility was 4.80% at year-end, versus 3.74% in 2017, and varies with LIBOR.
- Total long-term debt, before current maturities, was $4.4 million; capital lease obligations totaled $1.3 million.
- Management stated that financing arrangements and expected operating cash flows should be sufficient for working capital, capital expenditures, and debt repayments for at least the next 12 months.
- The company was in compliance with its credit agreement covenants at December 31, 2018, including the fixed-charge coverage and cumulative EBITDA requirements.
- 2018 investing cash outflows were $1.4 million, primarily for property and equipment. Financing cash outflows were $0.9 million, including debt, lease, and share-repurchase payments.
Material Changes and Unusual Items
- Effective January 1, 2018, the company adopted ASC 606 using the modified retrospective method. The adoption shifted most revenue recognition from shipment to over-time recognition and increased beginning retained earnings by $1.4 million.
- ASC 606 added $4.8 million to reported 2018 sales versus the prior revenue-recognition guidance. Reported 2018 net sales were $113.4 million versus $108.5 million on a pro forma prior-guidance basis.
- Approximately 91% of 2018 revenue under contract manufacturing agreements was recognized over time. Noncash customer-provided materials contributed $4.9 million of revenue at zero margin.
- 2017 results included a $0.9 million goodwill impairment and a $0.4 million gain on the sale of the Augusta, Wisconsin facility; neither item recurred in 2018.
- The company entered a ten-year lease for a 77,000-square-foot manufacturing facility in Nuevo Leon, Mexico, which replaced an expiring Monterrey lease.
- The company repurchased 76,201 shares for approximately $0.3 million during 2018 under two $250,000 repurchase programs. The August 2018 program had $0.2 million remaining at year-end.
- A former chief operating officer’s separation agreement resulted in approximately $0.2 million of 2018 expense, with approximately $0.2 million payable in 2019.
- The company adopted the new lease standard on January 1, 2019 and estimated that right-of-use assets and lease liabilities would increase by approximately $5.5 million to $6.5 million, with no material effect expected on earnings or cash flows.
Guidance, Outlook, Commentary, and Risks
The filing does not provide formal revenue or earnings guidance. Management’s strategy emphasizes value-added services, early design engagement, lean manufacturing, supply-chain management, medical-market growth, and improved asset utilization in Industrial and Defense markets.
- 90-day backlog increased to $27.4 million from $19.4 million. Medical backlog increased 126.7%, Aerospace and Defense backlog increased 20.6%, and Industrial backlog declined 13.2%.
- Management cited customer and product mix, operational efficiencies, and cost improvements as drivers of the higher gross margin.
- Key risks include customer concentration, dependence on OEM outsourcing, EMS competition, component shortages and cost inflation, foreign operations and currency movements, labor availability, FDA and ITAR compliance, product liability, customer credit risk, and customer order cancellations or rescheduling.
- The company is exposed to variable interest rates, foreign currency losses, tariffs, supply-chain disruptions, environmental requirements, cyber incidents, natural disasters, and implementation risks associated with its global ERP system.
- Operating leases had approximately $7.4 million of future commitments at year-end, excluding capital leases. The filing states that ordinary-course legal proceedings are not expected to materially affect results.
Important Facts for Investors to Verify
- Separate the underlying operating trend from the $4.8 million revenue increase attributable to ASC 606 adoption and the $4.9 million of zero-margin noncash consideration.
- Assess whether the Medical-market sales decline is temporary in light of the significant increase in Medical backlog.
- Monitor the largest customer’s 23.2% sales concentration and the related accounts-receivable exposure.
- Review borrowing-base availability, covenant compliance, variable-rate debt, and 2019 debt maturities.
- Evaluate whether the improved 11.7% gross margin and positive operating income are sustainable without the benefit of nonrecurring comparisons to 2017 impairment and facility-sale items.
- Confirm the impact of ASC 842 lease adoption and the company’s ability to manage approximately $7.4 million of operating-lease commitments.
- Review the effectiveness of the ERP implementation, regulatory compliance status, component availability, and customer order changes.
- Consider the company’s limited liquidity, lack of dividends, ongoing repurchases, and continued reliance on operating cash flow to fund obligations.