Nortech Systems Incorporated: Q3 2019 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 supply-chain services. Its primary markets are medical, industrial, and aerospace and defense. The unaudited filing covers the three and nine months ended September 30, 2019, compared with the corresponding 2018 periods.
Financial performance and liquidity
| Metric | Q3 2019 | Q3 2018 | 9M 2019 | 9M 2018 |
|---|---|---|---|---|
| Net sales | $30.1 million | $29.6 million | $85.5 million | $84.5 million |
| Gross profit | $3.6 million | $3.4 million | $8.9 million | $10.2 million |
| Gross margin | 12.1% | 11.5% | 10.4% | 12.1% |
| Income from operations | $0.7 million | $0.6 million | $(0.6) million | $1.3 million |
| Net income (loss) | $0.4 million | $0.4 million | $(1.5) million | $0.4 million |
| Basic and diluted EPS | $0.16 | $0.14 | $(0.56) | $0.13 |
| Cash flow from operations | Not provided for quarter | Not provided for quarter | $(0.2) million | $2.6 million |
- Q3 sales increased 1.7%, while nine-month sales increased 1.1% year over year.
- Q3 gross margin improved because of favorable product mix. Nine-month gross margin declined because of product mix and operational inefficiencies associated with component shortages.
- Q3 general and administrative expense increased to $2.3 million from $2.0 million, driven by spending related to the ERP implementation and one-time operational improvement expenditures. Nine-month G&A expense increased to $7.4 million from $6.2 million.
- At September 30, 2019, cash was $0.2 million and restricted cash was $1.8 million. Total cash and restricted cash used in the cash-flow statement was $2.0 million.
- Working capital was $22.7 million at September 30, 2019, compared with $20.7 million at December 31, 2018.
- Accounts receivable were $20.1 million, inventories were $16.9 million, and contract assets were $7.2 million at September 30, 2019.
- Total liabilities were $47.1 million and shareholders’ equity was $19.6 million at September 30, 2019.
Debt, leases, and financing
- The Bank of America facility includes a $16.0 million line of credit and a real estate term note, with stated maturity dates in June 2022. Line-of-credit borrowings were $12.4 million at September 30, 2019, with $3.5 million of unused borrowing-base availability.
- The line of credit had a weighted-average interest rate of 5.4% at September 30, 2019 and is secured by substantially all company assets. Interest rates vary with LIBOR.
- Nortech did not meet the required 1.0-to-1.0 fixed charge coverage ratio as of September 30, 2019. Bank of America waived the covenant violation in a third amendment received on November 8, 2019.
- Devicix acquisition notes were fully repaid during the first half of 2019. The company also had no borrowings under its China Construction Bank line at quarter-end.
- Operating lease assets were $5.0 million and total lease liabilities were $7.0 million, primarily reflecting adoption of ASC 842 on January 1, 2019.
Material changes versus the prior comparable period
- Medical sales increased 19.3% in Q3 and 24.9% for the first nine months, while industrial sales declined 22.3% and 23.3%, respectively. Aerospace and defense sales increased 5.0% in Q3 and declined 1.7% year to date.
- Q3 operating income and net income modestly improved, but the nine-month period changed from operating income of $1.3 million and net income of $0.4 million in 2018 to an operating loss of $0.6 million and net loss of $1.5 million in 2019.
- Operating cash flow declined from $2.6 million provided in the first nine months of 2018 to $0.2 million used in 2019, while financing activities provided $2.1 million, primarily through increased line-of-credit borrowings.
- Interest expense increased to $0.8 million from $0.6 million for the first nine months, reflecting higher borrowings and rates.
- The 90-day shipment backlog was $32.0 million, up 15.6% from September 2018. Total backlog was $58.1 million versus $43.1 million a year earlier.
- Customer concentration increased in significance: one customer’s divisions represented approximately 22% of Q3 sales and 24% of nine-month sales, and approximately 28% of accounts receivable at September 30, 2019.
Outlook, commentary, risks, and unusual items
- The filing provides no specific earnings or revenue guidance. Management stated that financing arrangements and expected operating cash flows were believed sufficient for future working capital needs.
- Management identified component shortages, operational inefficiencies, ERP implementation costs, and one-time operational improvement spending as factors affecting year-to-date profitability.
- Approximately 91% of revenue was recognized over time under contract manufacturing arrangements. Estimates of total contract revenue and costs could affect the timing and amount of reported revenue and profit.
- Management cited risks involving economic conditions, competition, outsourcing decisions by original equipment manufacturers, labor availability, raw-material and energy costs, customer concentration, quality and regulatory requirements, debt covenant compliance, foreign currency, cybersecurity, and facility or supply-chain disruptions.
- The filing reports ordinary-course legal proceedings and claims, with no specific material proceeding described. No material changes to previously disclosed risk factors were reported.
- No goodwill or long-lived-asset impairment expense was recorded during the periods presented. The share repurchase program expired on September 30, 2019 after $0.1 million of 2019 repurchases.
Important facts for investors to verify
- Review the third amendment and waiver to the Bank of America credit agreement, including any revised covenant requirements, borrowing-base limitations, and lender discretion over advances.
- Assess whether operating cash flow can improve sufficiently to reduce reliance on the line of credit, particularly given low unrestricted cash.
- Monitor the sustainability of medical-market growth and the recovery or further deterioration of industrial-market sales.
- Evaluate the effect of component shortages, ERP-related costs, and operational improvements on future gross margins and operating expenses.
- Analyze the concentration of revenue and receivables with the largest customer and the potential effect of order changes or lost business.
- Verify backlog conversion, since backlog is subject to customer schedules, manufacturing delays, contract terms, and other variables and is not a guarantee of future revenue.