Nortech Systems Incorporated: FY2017 Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2017; filed March 27, 2018. The filing reports annual results, with certain material items concentrated in the fourth quarter. Nortech is a single-segment electronic manufacturing services provider serving Aerospace and Defense, Medical, and Industrial customers through operations in the United States, Mexico, and China.
Financial Performance and Position
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Net sales | $112.3 million | $116.6 million | Down 3.7% |
| Gross profit | $12.1 million | $13.8 million | Down 12.4% |
| Gross margin | 10.8% | 11.9% | Down 110 bps |
| Operating income (loss) | $(1.3) million | $0.6 million | Declined $1.9 million |
| Net income (loss) | $(2.4) million | $43,774 | Turned to loss |
| Diluted EPS | $(0.89) | $0.02 | Declined |
| Cash flow from operations | $0.8 million | $3.5 million | Down $2.7 million |
| Capital expenditures | $0.8 million | $2.0 million | Lower spending |
Revenue by market: Aerospace and Defense revenue was $15.7 million, down 2.7%; Medical revenue was $51.4 million, down 4.4%; and Industrial revenue was $45.2 million, down 3.1%.
Balance sheet and liquidity: Cash was $0.5 million and restricted cash was $0.3 million at year-end. Accounts receivable were $17.4 million and inventory was $18.5 million. Total assets were $52.1 million, total liabilities were $32.3 million, and shareholders’ equity was $19.8 million.
Debt: The company replaced its Wells Fargo facility with a Bank of America agreement in June 2017. The new facility includes a $16.0 million revolving line and a $5.0 million real estate term note, both generally maturing in 2022. Borrowings under the line were $8.5 million at year-end, with $4.2 million of borrowing-base-supported availability. The weighted-average interest rate was 3.74%. Long-term debt, net of current maturities, was $4.4 million, excluding the $8.5 million long-term line of credit and capital lease obligations.
Working capital: The cash conversion cycle increased to 86 days from 81 days, driven primarily by higher accounts receivable days. The company reported operating lease commitments of approximately $2.2 million and capital lease obligations with a present value of approximately $1.6 million.
Material Changes Versus 2016
- Sales declined 3.7%, with lower demand in all three principal markets. Medical demand was affected by customer project delays, funding constraints, inventory reductions, and lower forecasts.
- Gross margin contracted to 10.8% from 11.9% because lower revenue reduced absorption of semi-variable and fixed production and engineering costs.
- Operating results included a $908,000 goodwill impairment charge related to the Devicix acquisition. No goodwill impairment was recorded in 2016.
- The company recorded a $355,000 net gain on the sale of the Augusta, Wisconsin facility after closing the operation in January 2017. Net proceeds were applied to debt.
- A $175,000 loss on extinguishment of debt resulted primarily from legal and termination costs related to refinancing.
- Operating cash flow fell to $0.8 million from $3.5 million, substantially reflecting changes in accounts payable and other working-capital items.
- The 90-day backlog decreased to $19.4 million from $20.5 million. Medical backlog declined 41.6%, partly offset by increases of 36.6% in Aerospace and Defense and 35.1% in Industrial.
- The Suzhou, China operation moved from startup in 2016 to full production in 2017; 2016 included approximately $0.5 million of startup costs in cost of goods sold.
- The company adopted new goodwill impairment and restricted-cash guidance in 2017 and planned to adopt the new revenue-recognition standard beginning January 1, 2018.
Guidance, Outlook, Risks, and Unusual Items
The filing does not provide quantitative revenue or earnings guidance. Management states that existing financing arrangements and anticipated operating cash flows are expected to satisfy working-capital needs, capital expenditures, and debt repayments for the foreseeable future. However, the Bank of America agreement requires a fixed-charge coverage ratio of at least 1.0 to 1.0 beginning with the four quarters ending December 31, 2018, as well as minimum cumulative EBITDA of $1.97 million for the twelve months ending December 31, 2018.
Management’s strategy focuses on lean manufacturing, quality and delivery improvements, higher-value engineering and supply-chain services, expansion of the global footprint, and potential acquisitions, mergers, or joint ventures. A new ten-year lease for a 77,000-square-foot Mexico facility was signed in February 2018 and is expected to replace the existing Monterrey facility.
- Customer concentration is significant: one customer’s two divisions represented 24.9% of 2017 sales, and one division alone represented 23.5%.
- The company faces risks from customer order cancellations and rescheduling, inventory obsolescence, component shortages, commodity and energy costs, foreign exchange, and economic weakness.
- Medical and defense operations require FDA, ISO, AS9100, and ITAR compliance. Regulatory noncompliance could disrupt operations or customer relationships.
- Goodwill impairment testing involved significant assumptions regarding revenue, margins, operating performance, discounted cash flows, and comparable-company valuations. Further impairment may be required if results deteriorate.
- The 2017 tax provision included approximately $280,000 of expense from the Tax Cuts and Jobs Act, including a provisional $57,000 transition-tax amount. The company also recorded a significant valuation allowance against U.S. deferred tax assets.
- The company reported no material litigation exposure and stated that it had no material off-balance-sheet arrangements other than operating leases.
- Management concluded that disclosure controls and internal control over financial reporting were effective as of December 31, 2017. The auditors expressed an unqualified opinion on the financial statements but did not opine on internal control effectiveness.
Most Important Facts for Investors to Verify
- Whether revenue and margins recover sufficiently to satisfy the 2018 EBITDA and fixed-charge coverage covenants.
- The sustainability of the $4.2 million borrowing-base-supported credit availability and the company’s low cash balance.
- Medical customer demand, backlog trends, and the impact of customer inventory reductions and project delays.
- Exposure to the largest customer and the potential effect of any program loss, cancellation, or forecast reduction.
- Progress and costs associated with the new Mexico facility and the operating performance of the China operation.
- Potential additional goodwill impairment, particularly related to the Devicix reporting unit.
- The final impact of adopting revenue-recognition guidance in 2018, including revenue recognized over time and customer-supplied materials.
- The realizability of U.S. deferred tax assets and the finalization of provisional Tax Act accounting.