Business Context and Reporting Period
Nortech Systems Incorporated, a smaller reporting company, filed this unaudited Form 10-Q for the quarter ended March 31, 2014. The company is an Electronics Manufacturing Services provider producing wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for aerospace and defense, medical, and industrial customers. Operations are conducted in Minnesota, Wisconsin and Monterrey, Mexico.
Key Financial Metrics
| Metric | Q1 2014 | Q1 2013 |
|---|---|---|
| Net sales | $26.149 million | $25.925 million |
| Gross profit | $3.074 million; 11.8% margin | $3.237 million; 12.5% margin |
| Income from operations | $236,221; 0.9% margin | $223,622; 0.9% margin |
| Income before taxes | $136,157 | $120,089 |
| Net income | $86,157 | $141,089 |
| Diluted earnings per share | $0.03 | $0.05 |
| Cash provided by operating activities | $523,417 | Cash used of $418,522 |
| Capital expenditures | $669,663 | $201,573 |
- Cash was $336,195 at March 31, 2014, compared with no reported cash balance at December 31, 2013.
- Working capital was approximately $15.7 million at March 31, 2014, compared with $15.5 million at year-end 2013.
- Accounts receivable were $15.409 million and inventories were $18.794 million at March 31, 2014.
- The company had $7.625 million outstanding on its revolving line of credit, approximately $4.971 million of long-term debt including current maturities, and approximately $5.9 million of unused line availability.
- The line of credit expires, if not renewed, on May 31, 2015; a $1.7 million real estate term note is due, if not renewed, on May 15, 2015.
Material Changes Versus the Prior Comparable Period
- Sales increased approximately 1%, led by a 20% increase in medical sales to $9.568 million. Aerospace and defense sales declined 7% to $4.241 million, and industrial sales declined 8% to $12.340 million.
- Gross profit declined approximately 5%, and gross margin decreased 70 basis points to 11.8%, primarily because of product mix and launch costs for new assemblies.
- Operating income increased approximately 6% despite lower gross profit, as selling expense declined to $1.121 million from $1.197 million and general and administrative expense declined to $1.717 million from $1.817 million.
- Net income declined approximately 39%, primarily because Q1 2013 benefited from a $21,000 tax benefit, while Q1 2014 recorded $50,000 of tax expense. The effective tax rate was 37% in Q1 2014 versus negative 17% in Q1 2013.
- Operating cash flow improved by approximately $942,000 year over year, but increased inventory consumed $1.367 million of cash. Capital expenditures increased by approximately $468,000.
- Revolving credit borrowings increased by $390,485, while Q1 2013 reflected net repayments of $923,508. Q1 2014 also included $230,000 of long-term debt proceeds.
- 90-day backlog was $17.019 million at March 31, 2014, up from $16.113 million at December 31, 2013 but down from $20.347 million at March 31, 2013. Aerospace and defense backlog declined to $2.921 million, while medical backlog increased to $8.014 million.
Guidance, Outlook, Risks and Unusual Items
- Management expects 2014 full-year tax expense to reflect an effective tax rate of approximately 37%, compared with 28% in 2013, primarily because the federal research and development credit was not extended for 2014.
- Management stated that existing financing arrangements and expected operating cash flows should be sufficient for future working capital needs. No revenue or earnings guidance was provided.
- Management expects a major portion of the March 31, 2014 90-day backlog to convert to revenue in the following quarter, but noted that backlog varies with order size, manufacturing delays, contract terms and customer delivery schedules.
- Customer concentration is significant: two divisions of the largest customer represented 29% of Q1 2014 sales and 21% of accounts receivable at March 31, 2014.
- Export sales represented 13% of Q1 2014 sales, compared with 11% in Q1 2013.
- Key stated risks include market volatility, competition, facility reliability, labor availability, raw-material and energy costs, economic conditions, and availability of components.
- Impairment charges were $1,150 in Q1 2014 versus $74,003 in Q1 2013. Equity appreciation-right compensation expense increased to approximately $43,000 from $14,000.
- The company adopted ASU 2013-11 in Q1 2014 without a material financial statement impact. Management reported effective disclosure controls and no material change in internal control over financial reporting.
- The filing states that the company is subject to legal proceedings and claims arising in the ordinary course of business, without identifying a material matter.
Investor Verification Checklist
- Verify whether the medical-market sales and backlog increases offset continued weakness in industrial and aerospace and defense demand.
- Monitor gross-margin recovery as new assembly launches mature and product mix changes.
- Assess inventory growth, working-capital requirements and the company’s reliance on its revolving credit facility.
- Review renewal and covenant compliance risks for the credit facilities maturing or subject to renewal in 2015.
- Evaluate customer concentration and the potential impact of changes in orders from the largest customer.
- Confirm the effect of the higher projected 2014 tax rate and the absence of the research and development credit.
- Track backlog conversion, capital expenditures and operating cash flow in subsequent quarters.