Nortech Systems Incorporated — 2018 First-Quarter Form 10-Q Summary
Business Context and Reporting Period
Nortech Systems 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 aerospace and defense, medical, and industrial equipment. The filing covers the three months ended March 31, 2018, and was filed May 11, 2018. Dollar amounts are in thousands unless otherwise noted.
Financial Performance and Position
| Metric | Q1 2018 | Q1 2017 |
|---|---|---|
| Net sales | $26,447 | $28,318 |
| Gross profit | $3,028 | $3,092 |
| Gross margin | 11.5% | 10.9% |
| Income (loss) from operations | $(120) | $121 |
| Net loss | $(391) | $(15) |
| Loss per diluted share | $(0.14) | $(0.01) |
| Cash provided by operating activities | $542 | $(255) |
- Selling expense declined to $1,039 from $1,205, while general and administrative expense was broadly stable at $2,109 versus $2,120.
- Net loss included $172 of interest expense and $99 of income tax expense. The reported effective tax rate was negative 34%, compared with 23% in Q1 2017.
- Cash used in investing activities was $292, primarily for $288 of property and equipment purchases. Cash used in financing activities was $284, including $222 of long-term debt payments, $82 of capital lease payments, and $126 of share repurchases.
- Cash increased by $12 during the quarter. Cash and restricted cash totaled $791 at March 31, 2018, consisting of $466 of cash and $325 of restricted cash.
- Working capital was $20.7 million at March 31, 2018, compared with $19.7 million at December 31, 2017.
- Total assets were $53,330 and total liabilities were $32,548 at quarter-end. Total shareholders’ equity was $20,782.
- Debt included $8,649 outstanding under the revolving line of credit, $5,157 of net long-term debt including current maturities, and $1,485 of capital lease obligations.
- The company had $3,920 of unused borrowing availability under its $16,000 line of credit, subject to borrowing-base requirements and lender discretion.
Material Changes Versus the Prior Comparable Period
- Sales declined $1,871, or approximately 6.6%. Medical sales fell 25.5% to $10,321, while aerospace and defense sales increased 45.2% to $4,866 and industrial sales increased 1.4% to $11,260.
- Gross margin improved to 11.5% from 10.9%, attributed to product mix and cost improvements, but gross profit decreased slightly because of lower sales.
- Operating results shifted from $121 of operating income to a $120 operating loss. The prior-year period benefited from a $354 gain on the sale of the Augusta facility.
- Net loss increased substantially from $15 to $391, primarily reflecting the operating loss, higher interest expense, income tax expense, and absence of the prior-year property-sale gain.
- Operating cash flow improved from an outflow of $255 to an inflow of $542, supported by lower inventory and increases in accrued liabilities, partly offset by higher accounts receivable.
- The 90-day shipment backlog was $21,942, up 12.9% from December 31, 2017 but down 6.5% from March 31, 2017. Aerospace and defense backlog increased year over year, while medical and industrial backlog declined.
Accounting Change, Outlook, Risks and Unusual Items
- Effective January 1, 2018, Nortech adopted ASC 606, Revenue from Contracts with Customers, using the modified retrospective method. The company now recognizes most contract-manufacturing revenue over time rather than primarily upon shipment.
- ASC 606 resulted in a $1,381 adjustment to retained earnings at January 1, 2018, created $6,151 of contract assets at March 31, 2018, and increased reported Q1 sales by approximately $717 compared with the prior accounting guidance. Approximately 91% of Q1 revenue was recognized over time.
- Management expects substantially all contract assets outstanding at March 31, 2018 to transfer to receivables within 90 days, with remaining amounts transferring within 180 days. Payment terms can extend to 120 days.
- The company stated that its financing arrangements and expected operating cash flows should be sufficient for future working-capital needs. However, the credit agreement includes financial covenants, including a minimum fixed-charge coverage ratio of 1.0 to 1.0 beginning with the four-quarter period ending December 31, 2018 and a fiscal-2018 cumulative EBITDA requirement of approximately $2.0 million for the twelve months ending December 31, 2018.
- Management expects a 56% effective tax rate for full-year 2018, compared with negative 18% for 2017, primarily because of U.S. tax reform effects and a higher expected tax rate in China. The filing does not provide full-year revenue or earnings guidance.
- Key risks include customer concentration, competition and outsourcing decisions by OEMs, labor availability, raw-material and energy-cost volatility, foreign-currency exposure, FDA compliance, facility or supply-chain disruptions, cybersecurity incidents, and the potential loss of a major customer. One customer’s divisions represented approximately 20% of Q1 sales.
- The company repurchased 34,427 common shares for approximately $129 during the quarter, with approximately $90 remaining under the authorization.
- Related-party expenses included $12 under a consulting arrangement with a company co-owned by the chief operating officer and $36 under a consulting agreement with an independent director’s company.
- No impairment expense, defaults on senior securities, or material off-balance-sheet arrangements were reported. Management concluded that disclosure controls and procedures were effective.
Important Facts for Investors to Verify
- Whether aerospace and defense growth and the reported backlog can offset continued weakness in medical sales.
- Compliance with the 2018 EBITDA and future fixed-charge coverage covenants, given the Q1 operating loss.
- The collectability and timing of conversion of the $6,151 contract-asset balance into receivables and cash.
- The effects of ASC 606 on revenue timing, inventory levels, margins, working capital, and comparability with prior periods.
- Liquidity after considering restricted cash, variable-rate borrowings, capital lease payments, and the $3,920 of borrowing availability subject to the borrowing base.
- The sustainability of the 11.5% gross margin and the impact of customer concentration, raw-material costs, labor constraints, and currency movements.
- The reasonableness of management’s projected 56% full-year effective tax rate and its impact on future earnings and cash taxes.