Nortech Systems Incorporated (NSYS) Q2 2015 Earnings Report, Transcript and Summary

Greetings. And welcome to the Nortech Systems Second Quarter 2015 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Paula Graff. Thank you. You may begin.

Thank you and good morning. And welcome to Nortech Systems' second quarter fiscal 2015 conference call. I’m Paula Graff, Vice President and CFO. With me today is Rich Wasielewski, Nortech’s President and CEO. Following my brief introduction, Rich will offer comments on our second quarter results, industry trends and our initiative. Then we’ll open up the call for questions. As we begin, please be advised that statements made during this call maybe forward-looking and are subject to risk factors and uncertainties. Please see the Safe Harbor statement in our press release and SEC filings. Now I will turn the call over to Rich Wasielewski. Rich?

Thanks, Paula, and good morning, everyone. Sorry for the delay. I’ll begin this morning by addressing some of the factors that influenced our results. Sales in the quarter were $26.8 million, slightly higher than the first quarter and down 2% to prior year, as several of our top 10 customers continued to have a negative trend year-over-year, with some of greater than 25% compared to 2014 levels, due to global economic instability and weakness in the oil and gas industry. We have been able to counter much of this softness with growth from new industrial customers and programs. However, the product and customer mix again for the second consecutive quarter has produced less margin accounting for all of the pretax loss of $595,000 in the second quarter and the $892,000 for the six months. Half of the 3 points loss in gross margin as a percentage of sales is attributed to this mix of lower gross margin industrial business in face of medical sales. Normally good profitable business is incremental but not dollar for dollar substitution. And the other half is primarily due to the new business being heavier material content and less value added Nortech labor affecting our ability to utilize our plant capacity. Cost of ramping up new product and programs, and our new Mexico PCB operations startup costs. Actions are being taken to reduce our costs for order and improve the gross margin. Increased focus has been place on customer order, purchase orders and shop work orders. The Mexico PCB ramp up will be completed here in the third quarter and we are now producing qualified parts and orders. The Mexico ramp up cost are estimated to be $250,000 through the first six months of 2015. We have a high level of confidence in the launch of this effort, as we have been operating in Mexico since 2002, making complex cable assemblies for medical and industrial customers, and many of our current employees already have previous EMS PCB experience. The business development activity is picking up nicely with several new customers being part of the qualification process. Additionally, a more favorable mix in the second half is expected from increase sales and medical device customers, and increased engineering services from both Nortech engineering teams and new acquired Devicix Engineering Services. I will expand on the Devicix acquisition later in the call. Selling expenses of $1.3 million in the quarter are down $53,000 from the first quarter, due to the reduction in travel and other expenses, and up 165,000 to prior year, mostly related to our expansion into China. As we mentioned on our last call, we are establishing our presence there in 2015 with business development and engineering support at the request of several major customers for sourcing and producing regionally for in country. We also want to take advantage of the Asia supply base that has grown more sophisticated in the past 10 years, along with beginning production in 2016. We also plan to develop local sources for components and materials. This will help our competitiveness in North America. We currently have 15 Asian suppliers qualified for the potential savings of $250,000 annually identified. Our G&A expenses of $1.6 million for the quarter, are down $100,000 debt from the first quarter and down $187,000 from the prior year. Cost controls and reductions have been put in place since February to help offset the shortfalls in gross margins and profitability. Taking a look at our liquidity, we satisfy our liquidity needs with cash generated by operations and an operating line of credit with Wells Fargo Bank. On May 7, 2015, we entered into amendment to our credit line for the purpose of funding future working capital needs and our growth initiatives in Mexico and China, along with the acquisition of Devicix design engineering. An outside appraisal on our account receivable inventory and equipment resulted in an increase due to line of credit of $1.5 million and an increase to our equipment alone of $1 million. The last appraisal was done in the 2010 -- 2009, 2010 timeframe. We had positive operating cash flow of $102,000 in the quarter and we used $137,000 through six months. Free cash flow used for the first six months of 2015 was $1.3 million, of which 90% were used for capital equipment, for maintenance of business and automation. Major projects included a 3D printer, a molding and wire cut machine and the majority of the equipment to setup Mexico’s SMT, surface smart technology and PCB operations. I’d like to move on to our business development and operation. Our 90-day backlog on June 30th of this year was $19.4 million, up 6% from the beginning of the quarter. Backlog for our industrial and aerospace customers has increased both over the prior year and sequential. Backlog numbers for our medical customers were down year-over-year but basically flat sequentially. Looking at revenue trends by market, industrial was up 9% for the second quarter, aerospace and defense was flat and the medical was down 16%. We are not alone in seeing a cause in medical spending, but we believe its temporary from intelligence and forecast we are getting from our customers. Our six-month revenue trends saw industrial 14% up, with aerospace and defense up by 17% and 12%, respectively. Diving a little deeper into the market and submarkets, for industrial it was a good quarter for many of our submarkets. We are seeing many of the same positive trends I mentioned in our last call. For semiconductor customers we are seeing the strong trends from Q1 continue, we have been wining projects on our customers newest platform, so the momentum is positive and additionally, we won a supplier excellence award from one of our top semiconductor customers. In process management and control, we have seen a continued downward effect from the oil and gas slowdown, and the strong U.S. dollar. Transportation is a bright spot, in Q2 we saw greater than 20% growth year-over-year. We are seeing increased demand for transportation-related projects and we are winning as new product development level. Environmental controls are slightly down in Q2 and year-over-year, while power systems for Q2 were up 16%. We are seeing some new projects here, which take advantage of our ability to improve quality box build products as well as complex cable assemblies. Our industrial sales team is hearing a lot of positive around the PCBA investment in Mexico, which I mentioned earlier. We already earned two major wins from this new location and expected to help power relative to once fully up and running production. Turning to our defense side, although, we have seen increase in revenue -- although, we have not seen the increase in revenue at this time, we continue our momentum from Q1 through three metrics, backlog, bookings and pipeline. We are pursuing a two-fold approach, first, we are making in-roads and with important programs and niche applications that other competitors may not be qualified for, a great example of the U.S. Navy vertical launching system bookings of almost $1 million in future revenue. In addition, we are also working on expanding our business to involve other parts of Nortech, including printed circuit board assemblies and box build. It’s one of our major customers for example, we have bought PCBAs for their oxygen sensor program and we see that as a springboard to other opportunity. Finally, medical markets, I’m going to give this segment more attention today to put our recent Devicix acquisition in context and explain its importance. For more than 20 years, Nortech has served the medical technology industry, including a great relationship with a major global major OEM for Advanced Medical Imaging. We’ve excelled through our unique capabilities to help design manufacture the complex wire, harnesses and assemblies for them. We are great at this, winning awards along the way. And recently, GE Healthcare presented us the 2015 Mechanical Excellence Award out of 1,500 suppliers worldwide. However, we knew there was more opportunities to expand our capabilities in the fast-growing medical markets. Five years ago, we started this journey towards being a full scale medical device service provider when we acquired Trivirix in Milaca, Minnesota. This facility formerly a Medtronic site was a natural fit for medical device manufacturing. It’s a facility that can support all levels of medical devices: Class I, Class II and III, that’s manufacturing and post-market service. It was an important move for us in our quest of expanding our medical capabilities. From 2010 through 2014, we saw sales grow four-fold, from a combined production and supporting engineering services. I might add we are talking in terms of $2.5 million when we acquired it and now it’s in the $10 million range. In 2011, our Mankato acquisition added a dedicated printed circuit board assembly operation as a key component and value software expert. This enabled us to offer a quick turn vertical supply option with our Milaca, our production and the FDA capabilities. However, we were still missing one key piece that our clients repeatedly ask for: concept and design engineering services. This was becoming more critical to help us differentiate Nortech. Medical device OEMs increasingly want to consolidate with a single turnkey vendor that supports all their needs. We looked at developing this ability in-house or through acquisitions. We found our ideal partner in Devicix. They offer exactly the strength and competency -- complement our capabilities. They’ve worked on our behalf of great companies, from local startups to Fortune 100 multinationals. They’ve frequently won design awards and are highly skilled in helping a medical device company move their idea from concept to commercialization through smart engineering and project management. The two prior acquisitions I mentioned earlier were distressed operations, resulting in bargain purchases. Devicix by contrast is a vibrant business with a strong reputation. Only three or four other design firms in our competitive arena have their unique combination of capabilities. Accordingly, the medical device expertise and trackers commend higher profit margins than other markets and customers we served. This partnership also opens additional opportunities for both traditional Devicix and Nortech pipelines. We are now qualified for projects that require both services in one single vendor. We see expanding our businesses in Devicix for engineering services in both our Bemidji and Mankato operations for our unique component manufacturing and in the lack up for integration, final assembly and post-market services. Overall, we are now lined up with that cradled grey partnership than medical device OEMs are moving towards, that they value highly and are increasing their spend with. It’s rare to see an acquisition lining up this way but we’ve created that one here. The medical market has the strongest growth and profitability potential of the three markets we serve. We are now better positioned to capitalize on that growth. Talking briefly about our overall medical market, we recently won several device builds, which we expect to significantly improve our revenue forecast in the coming months. Medical industrial trends continued towards low class products, smaller minimal invasive therapies and home used healthcare products. We are gaining a solid reputation in radio frequency, RF designed -- device designs in manufacturing. And we continue to be a leader in electronics stimulation products. The purchase price for Devicix was $5.3 million and funded by $2 million in cash from our operating line of credit. We assumed $0.5 million of customer deposits and assumed another $0.5 million in working capital debt. And two notes of $2.3 million, having our offset related to of minimum revenue. The agreement also includes an earnout tied to performance. Looking ahead through the second half of 2015, we expect this acquisition to be accretive at the sales and EBITDA levels, generating, estimate $2.5 million to $3 million in new revenue in 2015. The third-party valuation of this acquisition will be completed during the third quarter and we will be able to disclose additional information with our next reporting cycle. The full purchase details are outlined in our 10-Q. Just to note that this transaction is transforming Nortech and its businesses and I will talk a little bit later about that, corporate strategy. But the engineering and these dollars that we are talking about, we will now put us in around engineering service revenue of about 10%. The other issue with this acquisition is something that we typically haven’t had on the books is goodwill. When you buy a service organization, you can expect high levels of goodwill and that will be part of the conversation in the next call. So, Nortech will be worth -- will be dealing with the goodwill and impairment accounting probably for the next several years. With our new medical device capabilities now in place, our overall perfect strategy will have two complementary owners. First, our focus in the medical device markets will be on supporting growth opportunities. As I just explained, we are now well positioned to attract medical businesses for new customers, ranging from startups to established OEMs along with the increase in our penetration of existing customers. Second: for our core contract manufacturing business, serving primarily the industrial, medical systems cables and aerospace defense customers. Our focus will be cost management and profitability growth. These markets aren’t expected to see quite the same growth rates as medical. So, we have many well-known blue chip customers in established products and programs. Looking ahead to enhance our profitability, we are fully examining all areas of our company for potential cost savings and efficiency improvements. Everything is on the table including adjusting capacity, changing our product service offerings and divestitures in capacity, services, customers and markets. As I told all our employees in our mid-year communications last month, we must be responsible students for our shareholders, customers and employees. That means adjusting our cost to meet good demand levels and types of businesses and working capital requirements to meet changing customer and market demand. We also review our corporate structure in striving to create a more efficient organization. Concluding, execution and focus are key. Our second half results will come down to timing and execution, execution in our cost savings efforts and successful implementation of our growth initiatives. There are short-term challenges but we believe in long-term upside for growth, profitability and a stronger Nortech. Now, we look forward to answering any questions you might have this morning. Operator, would you please open the lines?

[Operator Instructions] Our first question comes from the line of Kyle Packer. Please proceed with your question.

Good morning, Rich. How you doing?

Good morning, Kyle.

Hey. Thanks for the update. Can you give us a little bit of feel for what you have set from a profitability and the revenue perspective for the back half of 2015 and if you can’t go that far, can you at least give us some expectations of revenue and profitability for Q3?

Well, we generally don’t give guidance, our expectations in terms of revenue. It bodes well with the backlog. We are up 6%. The intelligence that we are getting from some of the larger global customers are that they are working through their inventories and we should see more business than the first half. But we are not counting on it. So our focus now is on cost improvements, cost reduction and when I use that, potentially it’s upside. So I can’t -- we've stopped giving guidance because of the uncertainty in the business. But we’re feeling optimistic that if we execute and the timing of these investments come true, then we will return to profitability.

But you didn’t generate any loss in Q3?

Again, Kyle, it’s -- if the timing isn’t right for some of those investments and I can’t institute these cost improvements fast enough. That is always our potential. The expectation now is we will return profitability in the second half.

Okay. What -- how aggressive are we getting on the cost side because I’m becoming concerned about this kind of continued deterioration of profitability, this increase in debt level and the overall capital allocation and what’s that doing from a shareholder value perspective?

On the cost side, we’ve been -- Rick.

Yeah, very aggressive.

We’ve been aggressive on the SG&A. We’re cautious on the business development side and are very experienced because of the initiatives. If you take out, it’s -- if you look at our number one customer, which we say is GE in the 10Q, their percentage of our business has fallen from 25% to 17%. That’s approximately $3.5 million to $4 million. That has been substituted but it has been substituted with the Industrial business. And that’s where some of the investment in the business development area is. It’s also where the investments coming from new products in engineering. So we’re hesitant to mess with that for a long term. However, on the G&A side, we have been aggressive. We’ve taken a three-year plan of consolidating strategies at the -- what we call the corporate level in finance and sourcing and in engineering. So from the cost we can control right now, we’re very aggressive. We are now taking the next steps into the capacity. Even though we are growing, we’re going to be more selective in what kind of new product is going. We are not going to count on the medical sector to come back fast or grow fast. We’re going to count on being selective on our industrial and aerospace business that’s profitable and then adjust the cost accordingly. So those are the actions that are being taken. Now, they have been in place for the last six to eight weeks. And we expect improvement in the second half at the gross margin level because of it.

Okay. Let me -- let's go to the acquisition for a second and I appreciate the continued explanation. I think if I picked up and that’s right what you talked about is, we’re expecting revenue out of the acquisition of about $2.5 million in he back half of the year. So that is for six months. And we paid any where from 5.3 to 7.8. So we basically gave our 45% to 65% of the market capital utilization from the $2.5 million dollar revenue for the last six months of the year. Is that analysis correct?

Well, the $2.5 million is correct. The $2.5 million to $3 million would put it more into their line of their forecast to us. The 5.3 to 7.8, the 5.3 is probably more realistic. Let me look at the details of the purchase agreements. They do not start the turnout until it hit $6 million.

Annually or quarterly?

Annually.

Okay.

So that is well protective on that backend.

So what’s the forecast -- sorry. Go ahead.

Your question.

So what’s the forecast of profitability from that business if we’re given up 45% to 65% of the market capital? What is the forecast of the profitability?

The EBITDA is very promising but the profitability on reporting for that specific piece of business will be predicated on how that valuation comes in, whether it’s goodwill or intangibles. You can do some of the analysis if you make some assumptions. We’ve got some help during the acquisition to get a feel for how much goodwill and how much intangible. And also if you take the investment dollars against that with the interest and stuff, it pays off very well into that multiple. 10% plus EBITDA one time sale. So we’ve been very fortunate that we found a partner that was willing to work within our capital structure, in other words, almost a third in cash upfront, a third investing in us as well with the note and also a third potential upside. We normally wouldn’t get that upside and that’s our acquisition strategy. So we’re fortunate that the two strategies came into play. The key to this acquisition is and we’ve already seen and we’ve been working with these folks on and off over last several years but really strongly since October of 2014. We’ve won three production projects in the $3 million to $5 million range. And that’s the other part of the earnout. Anything generated by their customers or their new customers get a piece of their earnout and the piece of the manufacturing benefit. That business traditionally has been 25% to 30% gross margin. So it’s a combination of those two that we sold the internal rate of return and the profitability on.

So it sounds to me like we bought a business that has a promise of doing $5 million to 46 million next year, EBITDA of $500,000. If I’m putting all the math together and we gave up effectively 45% to 65% of the business for that?

While the EBITDA that you calculated was from that standalone. It did not include the manufacturing synergies that we would not have gotten without that concept and design upfront. And the potential of that certainly going on. The other piece we talked about in the conference call here was a -- you're not going to have any problem with this acquisition because it’s so different than any of the past. It will have a good -- in the accounting and the disclosure that’s going to take place. So I mentioned that from the goodwill. That would be very promoted based on what you said with the debt and the execution of this -- execution of this project. So goodwill and impairment would be there for you. That would be disclosed on quarterly basis.

But our historical track record from a -- and I know you like to talk about the acquisitions individually but our historical track record going back the acquisition from 10 and 11 as we now outlined in a letter has really done nothing more but increased the debt level in the company over the years and decreased profitability? Well, what I’m struggling with is if you look at our letter that we sent to you guys back on 24th of June, we had operating income of about $1.23 million in 2010 and we had total debt of $8.2 million. On a trailing 12 month basis at 331, we have operating income of $890 million and we have debt of $13.9 million. So really -- if it causes those two acquisitions to incur the debt or other capital expenditures, we really decrease value of the business over time. And now we’re going to clock forward three four months from 331 and we’ve just lost on another $4.3 million of debt, bringing our total debt position of $18.5 million. And we’ve produced another losing quarter. And we just paid -- we basically gave upper anywhere from 35% to 65% of the market cap with the $4.5 million that we put on the book to acquire a business that maybe will be $500,000 of EBITDA?

Kyle, I need to correct a little bit of it. It’s mostly the core business is the issue. We have broken out the acquisition from Devicix. Devicix transaction is recorded. If you back, we paid $400,000 out of a foreclosure for that business. Trivirix, I am sorry. Trivirix in May of 2010 I believe. That board was about $2 million or $3 million worth of business. And it’s cash flow positive. We’ve not invested much at all other than the clean room and upgrading our people and processes. So that has been a success on a standalone project.

Same situation with Win Win.

The Win Win, if you look at the Win Win operation, they had a proprietary product. I can’t speak. I wasn’t in their boardrooms and I can’t speak to what Win Win did or didn’t do, but my observation was that when we looked at it, we walked away five times. And it kept coming back to the point where they pretty much gave it to us. I think that transaction if I remember correctly, it’s about a $1.5 million. It was all clean inventories, clean receivables. We didn’t buy anything else, and equipment that was more valued than that. The Win Win operation, they were a public company at that time, was losing $500,000 a quarter. For us, since we own them, they have been positive, accretive to our financials, and have cash flow themselves positively. And now because of their mix between the medical and the industrial growth, and they’ve had a couple of nice wins with some box assemblies. So those two transactions, even though they were distressed, I think that was my point in the call script was to make sure you guys understood that there wasn’t much to those investments. What’s happened is since the recession is our core business has been flat and the industrial and the price pressures. And I think we just started seeing and our Asia really took off in the early 2000, in the electronics that’s really -- in the industrial side that has been a great issue for us. And that’s kind of now we are trying to get the onshoring. But the aerospace business in 2008 was 44% of our business and it carried during the wars anywhere between 25% to 30% gross margins. Now that is 13% of our business, roughly $14 million, $15 million. And we are competing as strong for the dollars that are funded and sequestration as anywhere else. So our core model has changed drastically on that side of the business. Again a point of reference is we cannot subject to medical business, profitable medical business with industrial margins. And that’s what happened to us here in this first quarter. We will take the steps. As I said, we will divest anything in terms of capacity or markets or services or customers that are not profitable in that core business. And we will take this investment very seriously. And what you have been saying as far as the debt load and stuff that’s related to it, but if the market to do this stuff into.

It just feels like we are really slow to reactive changes in the market and take the appropriate expense corrections accordingly. And I think that’s largely evidenced by the increasing debt load that we continue to take on at the organization. I mean, we are sitting at a debt load that is nearly -- it’s more than doubled what it was in 2010 and we are looking at a profitability number that was more than half -- less than half than it was in 2010 and continues to decline year-over-year.

The management team and the Board have worked very closely on three areas growth, cost, and capital structure. And the capital structure currently for acquisition strategies is to work out of the line of credit and the business. You are correct this transaction by far other than the Gartner when we did in 2007 to add a second PCBs to have disaster recovery and customer service are the two biggest we’ve done. It’s not acquisition. It’s what you were saying. We have too much capacity. The growth, the industry growth hasn’t taken place and we are still too heavy on the industrial side. We had industrial in 2008. The mix of markets was 44% aerospace, I believe it was about 13%, 14% medical, and 21% medical, and I think the remainder 46% industrial. So in 2008, aerospace and defense was 38% of our makeup, medical was 18%, and industrial was 44%. In 2014, aerospace went from 38% to 13%, medical went from 18% to 38% as a high in the 2014 year. So that was a good growth, but industrial now has gone over 50%, and the perfect mix for us of business would be a third of third of third. So the market, depending on how that market swayed, okay, from 2008 to 2010, we went from 38% defense to 16% and medical went from 18% to 29%, industrial got the blunt of aerospace and went from 44% to 55%. We are currently quarter two now has 13% aerospace, 34% medical, and 53% industrial, still little bit too high on industrial mix, and that’s where we are focusing our attention. So I believe you have the same questions, the Board management are addressing. As I said, we need time and we need execution to correct that and time is not on our side.

What is the time say will look like?

As soon as possible. I mean, it’s in place now. I think the stuff that we did, we moved up the timeframe on the cost and the capacity cost from over a three year, a nice glide path that would not hurt the customer service or our businesses to probably escalating that in the next 12 to 18 months. The consolidations of finance, engineering has already taken place. The engineers and the techno expertise comes at the locations comes through attrition and probably more growth in engineering area at the locations for expertise as we become more complex, more medical focused, more box builds high level solutions selling and early engagement. So we are really careful with our engineering technical expertise.

Okay. I appreciate that. One other thing you look at and I do I struggle with the cost equation. Sales costs continue to increase. Revenues are flat. Profitability is down. You guys are paying two CEOs effectively from what I can tell. It doesn’t all add upto me so and I am really struggling with what has been chosen to pay and the amount of dilution we as shareholders are taking on this acquisition of what doesn’t. And I know it sounds like a lot of promise, since a lot of promise and not a lot of substance.

Well, I think the substance is the substance is definitely not in the gross margin area and that’s something that we have instituted about six weeks ago. And watching every customer order that comes in making sure that that order confirmation and promise is correct and that we tried to minimize the noise in the schedule. The next one is to move from the customer order to the purchase order and making sure that we are getting the best prices for the materials we are buying and making sure that if the quantities because of smaller orders or changes to the orders or changes the engineers, that’s all properly taking care of. And the last piece of those orders are on the work orders on the shop floor. I assure you is that location, every business development, customer service person is in no street and the supply chain is being taking care off. It will be executed as quick as possible.

Is management and the directors bullish about the business?

Absolutely. The medical areas, the Trivirix folks that we acquired that on contract team more than Nortech folks and the device experts are their hearts and minds are in the game and are both very excited. Ahead of this as I went through, the commentary that I use when I go through the individual segment comes right out of the directors and the business on those segments. And each one of them are robust right now. The aerospace and defense has increased its backlog for the last four quarters. They see we ended in site. However, we are very cautious on that one because that recovery may not take place until 2017, 2018. That one is under thorough investigation. The industrial side of it is growing. It’s come back. I think since 2009 it’s gone down sequentially almost every month until probably last three or four quarters. So industrial -- and why the industrial, they changed their program to solution selling early engagement higher level assembly. So people -- our messages are getting out there, not selling cable assemblies and PC boards, but we’re selling solutions at the box build level. And we won significant orders in that area for them and that’s where you’re seeing the growth. The medical one, we feel very good about the future new product introductions coming out of our medical area, both on the device side and the systems cables and coil cables as well. So, all businesses feel robust. We just have to deal with this situation that we got into which you see very clearly in the 10-Q with the major customer down this month last. The first quarter was down like 26%, 27%, this quarter they are down 32%. That scheduled, that intelligence that we have now shows that that’s improving down to 25% and then 18%, which is their first forecast that has come up in the last four quarters. So that -- your question on how does the management feel and how do we feel, we feel very good about it. We don’t feel -- we feel good about it, dropping 3 points on that margin in such a short period of time.

Yeah. Well and I’ll jump off and let other questions come forward, if maybe. But I will just express again. Deeply concerned about the choice of allocation of capital, $5.3 million for the company that got a market cap today of $12 million or probably less now is a substantial decision? And I feel the shareholders, you guys have diluted up like crazy, with really no forethought and not a lot of explanation what it’s going to drive, lot of promise, but thought like we -- feels like we bought a lot of hair there?

Well, you’re welcome to your opinion on it. I think we feel differently about that situation and we’re confident that we’ll execute on it and I hope you see the results.

Okay. Thank you.

You bet. Have a good day, Kyle.

See you.

Our next question comes from the line of Sheldon Grosky from Grosky Associates. Please proceed with the question.

I probably won't be tough as last guy.

Good morning, Sheldon. How are you doing?

Okay. One quick question from the balance sheet on the 10-Q. To me a surprising increase in raw materials in your inventory, is that planned or unplanned?

Well, if you look at it year-over-year, its due to accounting change that we did as we picked up. I think this is a first quarter we picked up in transit material of about $1.2 million. So, actually, there would be a slight decrease if it wasn’t for that adjustment, so good catch on your part. It -- the reason for no change for disclosure and I -- we probably should have commented on it is -- that it just wasn’t balance sheet in and out. It went into accounts payable and inventory.

Okay. Second question has to do with China, how much of an investment do you think you’re going to have in China and do you have the people to handle it?

Okay. Do you -- how much -- let us talk about the people first and I’ll come back to it. China was a schedule to be done earlier, but I believe this acquisition got in its way. And it’s about a $750,000 to $1 million investment in facility and modifications once we get there. We are looking at alternative financing and we're also looking at several opportunities by governments and the government agencies that have provided a lot of incentives to get there but we’re being very cautious with that. So the China investment will be very -- it has been slowed down and we're being very cautious as we go through that project. We have a two phase strategy, which includes the people. We’ve had three individuals that are newly hired and that’s part of some of the business development area. Gentlemen, that is very -- is a Chinese individual that has been in the country for 17 years and has handled this. He is working with us here at the corporate offices and he has been going back and forth on a regular basis. He also is very experienced in supply chain management, which is where we’ve been using his expertise and that’s how some of those 15 suppliers have gotten qualified. The second person -- actually the first person hired was a business development customer service program manager that’s in the country, supporting the customer from a business development standpoint. We are in the process of hiring a third individual, a EE engineer, that has the capabilities of managing the facility when we get up and running and supporting the application engineers that we needed right now by the customers in Asia. I could say that the gentleman that we have here in the states that has the Chinese responsibility for sourcing and operations, he is a EE as well. So, we do have three individuals associated with that. If things go right and the timing is right, the savings from sourcing and the supply chain and the new business that comes out of the engineering application efforts will pay for this project.

So again, you said that the Chinese facility is going to be primarily to supply Asian customers.

That’s correct. The large global customers that we serve are going to a regional manufacturing and they expect their global suppliers to be with them and it’s produced for regional. So, we’re seeing that almost across the board with the big global customers, multinational customers.

One more quickie, the strong dollar, do you think is having effect on you and other manufacturers in the U.S.?

Absolutely. We’ve got word both from two of our biggies, GE and Emerson. Those are the -- there is others along with them that they stop travel. They have been concentrating on North America. The opposite is true for them. They’re having -- everyone’s having great year in the United States because of that dollar strength. So it depends on what region you’re in that you have that as mix. Our particular medical situation is the markets only 25% in North America and they ship out 75% of that equipment worldwide. So that’s where the crust happened when dollars started to strengthen. And they said, they’ve worked down their inventory, so that should be a good news item. The oil and gas has a lot to do with it too, even when that oil per barrel is down, the whole world stops buying new equipment. So that has also had a impact on the couple of our sectors.

Thank you.

You’re welcome.

And it appears that there is no further question at this time. Management, do you have any closing remarks?