Nortech Systems Incorporated (NSYS) Q4 2015 Earnings Report, Transcript and Summary

Greetings and welcome to the Nortech’s Fourth Quarter 2015 Conference Call. And 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, Ms. Graff. You may begin.

Thank you, and good morning. And welcome to Nortech Systems’ fourth quarter 2015 conference call. I’m Paula Graff, Vice President and CFO, and with me is, Rich Wasielewski, Nortech’s President and CEO. Following my introduction, Rich will offer comments on our fourth quarter results and current development in both our markets and industry. Then he’ll open up the call for your questions. Before we begin, please be advised that the statements made during this call maybe forward-looking and are subject to risk factors and uncertainties. Please see the complete Safe Harbor statements in our press release and SEC filings. I will now turn the call over to Rich Wasielewski. Rich?

Thank you, Paula, and good morning everyone. After a challenging and eventful year, our fourth quarter results were encouraging with revenue of $31.4 million up 3% over prior year and prior quarter. And income from operations of $329,000 was also up 3% over the prior year and over $300,000 to the prior quarter. There are several factors that led to the quarter-over-quarter improvement. The gross margin improved 280 basis points and was aided by the volume and customer mix. Q4 was the only quarter that sells to our largest medical customers who were at prior year levels. Otherwise we saw double-digit decreases throughout 2015. And our new medical design engineering business accounted for $1.4 million in revenue and an estimated $174,000 in contributions to our income in the quarter. For the year, revenue ended up at $115.2 million, up 3%. Gross margins finished at 10.5% down 140 basis points and our reported loss of $571,000 or $0.21 compares to net income of $880,000 and $0.32 for 2014. The design engineering acquisition at mid-year contributed $2.4 million in revenue for the majority of the increase as our core contract manufacturing business had mixed performances. And we’ll get into that here in a little bit. At the start of 2015, the strong dollar and the weakness in the oil and gas industry began to take the air out of the economy and momentum built in the latter part of 2014. Our largest global customers got hit the hardest, and it took a toll on them as well as us financially throughout most of the year. They continue to adjust their business models and cost structure as a result of the sudden changing in the environment. And the changes were major; large business segments have been sold off and/or consolidated along with staff reductions and redeployments. Our response was a mix of the same but with an eye on the future. We made several cost structure adjustments and expense cuts to adjust to our drop in revenue in the first half of the year. It wasn’t enough to offset ramp-up and investment cost of our strategic initiatives underway in Mexico PCB operations and our move to China in addition to the mid-year timing of the acquisition opportunities. So, it was good to see a strong performance in the fourth with our cost improvements taken hold in both the Mexico and the acquisition contributing. China continues to ramp up and current schedules has it up in producing by mid-year of 2016. Taking a closer look into the year-end backlog numbers, and the markets we serve. Our overall year-end 90-day backlog was up 20%. The acquisition related revenue for our medical device design services alone accounts for half of the increase, and the other half is for our defense customers. We expect some quarterly volatility to continue this year but we’re also encouraged by the increases in our pipeline, business development and early engagement activities. The $20.7 million year-end backlog was up 13% from September 30, this sequential decrease is largely attributed to the year-end push from our customers in our strong fourth quarter. Our medical market sales in the quarter rose 18% sequentially to $12.9 million and our year-over-year medical backlog climbed 27%. The medical device engineering acquisition again accounted for over 50% of the growth in sales and backlog. Our expanded medical device capabilities have boosted our business development efforts especially for customers waiting for support throughout this entire product lifecycle from concept and engineering through manufacturing and post market services. We’re encouraged by the significant increase in total dollar value on our delivered proposals. We have more than a dozen combined projects currently in the pipeline. Those are projects that combine our new engineering services with our legacy manufacturing capabilities. For our legacy medical business and complex wire and cable as I mentioned earlier, we’re seeing some stability after some negative trending during 2015. Nortech is an active valued partner in the regionalization efforts by our major medical customers. They are tailoring their products for specific regions of the globe and looking for in-country partners and sources of supply. We’re seeing regionalization trends across all industries. Customers are looking closely at the total cost of ownership and value, transportation, engineering support. Many customers value North America support with early engagement engineering and production in low-cost regions. And our expansion activity fit perfectly with their strategy and requirements. In the defense segment, our sales declined 7% sequentially from the third quarter. However, our quarterly bookings continued strong in our 90-day backlog ended the quarter at $5.7 million and up 4%. Part of that increase was caused by past due orders from program and production delays. Our defense success is continued to be driven through long-term relationships with major defense OEMs. A good example of the vehicle market which we’re seeing to start a return in earnest, most notably the Multipoint [ph] Year Awards for the joint light tactical vehicle, the JLTV. This program is beginning to drive requirements for support markets such as radios, vehicle intercom systems, tracking systems, surveillance systems and weapon systems. We expect to be well represented when these contracts are awarded over the next couple of years. Looking at the defense department budget for 2016 which was released last month, it shows increased spending for communications, electronics and intelligence after two flat years. So, that bodes well for us, specialty complex molded cable assemblies. Looking at the industrial sales customers, we were off slightly on a sequential basis down 2%. Year-over-year, our sales were up 7%. This is our largest sector and it also best exemplifies the mixed results we’re seeing here in 2015. 23 of our main customers out of 40 in this category were down year-over-year. We’re starting off the year with a 90-day backlog of 8% from prior year. There doesn’t appear to be any major issues just the same mixed results we’ve been seeing over the past several quarters. And if you look into the details of the individual categories, it’s more of the same. The semiconductor equipment customers were strong again with sequential year-over-year growth both up approximately 40%. Increases were driven by our high-level box build assembly expansion and our capabilities with specialized cable harness assemblies. Power systems were flat for the quarter but up 14% annually. We’re successfully seeing early engagements that capture integrated businesses combining our PCB, wire cables into a high level of assembly utilizing our engineering capabilities. Transportation sales were also flat for the quarter but up 25% for the fiscal year. Some of this increase is driven by more regulatory requirements for tracking vehicles by fleet managers due to DOD regulations. Our locomotive business had a strong year with revenues up 46%, but it began to weaken in the fourth quarter as the end of the year backlog was flat. Process, management and control equipment was heavily impacted by the decline in the oil and gas industry down 20% for the year. And we see the softness continuing. In this tight environment, customers are asking us to collaborate in driving their cost down and improving their competitiveness. Looking at water controls and environmental controls, both finished the year up, water controls up 23%, environmental controls up 6%. We completed new product introductions for the customers and help bring products to markets sooner than the competition. Next couple of points on our liquidity, we generated positive operating cash flow in the year of $3.4 million from the non-cash add-backs of depreciation and amortization and the timing of working capital changes. We continue to work on our payment terms and conditions with our suppliers to better match-up with our customers. Free cash flow provided for the year was $1.7 million compared to $600,000 used in 2014. In February, we amended our bank agreement with Wells Fargo, the agreement provides for a line of credit of $15 million with an expiration date of May 31, 2018. We ended 2015 with $6.1 million available on our line compared to prior year of $5.1 million, a real strong effort performance in banking and cash management given the challenging business environment, the strategic investments and the acquisition. Our total debt to equity at the end of the year was high at 68% compared to 56% at the end of last year. This is an area of focus and we expect to continue to make progress throughout 2016. There is more opportunity to lower inventory levels along with increasing profits. Our capital spending was $1.7 million, the major capital investments were the Mexico PCB operations at $550,000 with the remainder being used for maintenance of business we spent monies on 3D printers, new automation and handling equipment and replacement of SMT and PCB equipment. Some comments on the current trends we’re seeing in the economy and the EMS here in the first quarter. For the North America EMS industry overall, new venture research last updated is forecasted in August. Now they expect the North America EMS market to grow about 6.1%, very similar to the performance of 2015. Our customer is continuing to look for more outsourcing options and on-shoring back to North America. We are seeing more activity and opportunity from these strategies. On the overall economy, last month I had a chance to attend the presentation by Wells Fargo’s Chief Investment Strategist in Minneapolis, James Paulsen. He gave an outlook on the U.S. and global economies for 2016 and beyond. According to Mr. Paulsen, labor shortage and a decline in productivity is hampering this economic recovery. For the first time in recent history, the demand is exceeding and outpacing supply and causing the slow recovery. We’re seeing this labor shortage firsthand at some of our U.S. locations along with a drop in productivity from the volatility and order mix. We’ve continued to increase our investments in automation and technology, and the human resource management to help out with this issue. Recent forecasts for U.S. GDP growth for 2016 are varied from 2.3% to 2.6% according to the international monetary fund’s forecast and the Wall Street Journal, not robust but steady improvement. On the plus side, U.S. industrial production pumped up 0.9% in January from December, the biggest monthly increase since 2010. From my perspective, volatility will continue quarter-to-quarter with weak global growth, the strong U.S. dollar and reduced oil and gas activity represents continued challenges. For our fiscal year we’re optimistic for an improvement over 2015 with our investments in the growth medical markets and growth projected for the overall EMS industry. And even the slight increase in GDP is welcome. These all will help our cost. Before I close, I’d like to highlight several aspects of our long-range vision. Internally we call it Vision 2020, with guiding principles that we use in our day-to-day decision making. As I mentioned, we’ve strengthened our capabilities for early engagement with customers to deliver value through total product lifecycle. We’re refining our key support functions, including business development, project management, prototype operations and engineering support. We’ll focus more sales attention, cultivating customers that appreciate our full service solutions as strategic partners. To support a leaner cost structure, we’re developing our low-cost operations regionally to meet customer requirements and for profitability in North America and Asia. We’re integrating our global supply sourcing group with regional support in matching and adjusting facilities, capacity and resources with demand. Globalization is, key for Nortech’s long-term competitiveness both for supporting our multinational customers, in establishing a competitive cost structure. Our major focus is on cost and profitability in four areas; pricing effectively through our value driven sales process; leveraging our global supply chain efforts and consolidating supply base to low cost, through the lowest cost of transactions; increase operations’ productivity through automation, capacity and asset utilization; and finally CapEx and investment strategies that accelerate and prioritized by strength of ROI. In closing, although 2015 financial performance didn’t meet any of our stakeholders’ expectations, the investment and work completed thus far will provide the foundation for 2016 improvement and in the future. We have momentum heading into 2016 with a strong finish in the fourth quarter. The acquisition integration to deploy or its being accretive and promising economic and industrial transporting in the right direct. Also, we have two major investments made in 2015, now in execution stage and another, the expansion in China implementing a project today on plan and on budget. So, it’s time to execute. Thanks. And now we’ll open up the call for any questions this morning. Operator, please open the lines.

[Operator Instructions]. Our first question comes from the line of Sheldon Grosky, a private investor. Please proceed with your question.

Good morning, everyone.

Good morning Sheldon.

If you had to guess sort of forecast, what part of your business do you think will show the best growth in 2016?

If I had to guess, definitely the medical market, our largest customer there seems to have stabilized. And our investments should start showing growth in the second half of the year. The acquisition as I mentioned throughout the conference call today is accretive and it’s very good activity. If you talk to their management team, the combination of Devicix in Nortech is making a big impact not only with the opportunities but the size of the opportunities. Both sides are seeing that synergy of early engagement engineering fees with a combination of transfer engineering fees along with the production side. So, the opportunities are larger and I see growth in that area. The defense business has a chance. But it’s getting very competitive. And with that competitive means, that we got to be careful that we don’t take opportunities that will hurt us because if you grow - they’re growing pretty fast if you looked at some of the numbers, they’re actually 75% up I think year-over-year in the backlog. It’s probably too heated too fast for that environment in the complexity of our cables. So we got to be cautious there. But we should see some improvements in defense. The industrial business, our largest segment probably, 50% of our business, 55% of our business has, we’re encouraged by this year. Even though we’re down a little bit on the backlog year-over-year, the latest trends look good. And we have a lot of activity in that area with our One Nortech cell of PC Board’s custom cables and putting things together. The new website is generating that as we’re trying to show a One Nortech look as opposed to cable and wire PC board separately. We’re in our fourth year of that and we’re starting to see good momentum. And people are discovering that we’re more than a one-trip pony. So, I think that those are all the momentums in the main areas. Again, it’s a mixed bag out there. It’s a mixed bag when we get into the sub-markets. We’re very - I think the comment about 23 out of 40 of our top industrial customers were up and down. We see that same thing in their backlog. The good news is, we’re not losing customers and we’re penetrating more on higher level assemblies.

Okay. To ask you another question, you had to guess or would you think that 2016 would be a profitable year?

Well, I go into every year thinking it’s a profitable year. And I can tell you all our stakeholders, our shareholders expect it, our board expects it, we plan for it and our employees do as well and I sure do. So, we’re planning for it. We’re encouraged by the fourth quarter results. Sometimes after three quarters of losses, you get a little anxious. But we stuck to it. We stuck to the investments that are going to help us with the future. So, Sheldon, we expect to make money every quarter, every month, sometimes we have better luck than others.

Okay.

[Operator Instructions]. Our next question comes from the line of Mitch Omi of Wedbush Securities. Please proceed with your question.

Good morning.

Good morning.

I’m one of the people that make some market in your stock we’ve been following you for about a year now or so and kind of familiarizing ourselves with your business. We were originally attracted to your company because some of the valuation metrics suggested you might be undervalued. But I think this is the first time I’ve asked a question. It’s sort of a high-level question. Your return on capital for the last five years has been somewhere between 3% and 3.5%. And we’re looking at your stock trading at about $0.50 and saying well, that’s, if I can buy that there that’s a 6% return on my capital, which is kind of nice. And if the company grows its profitability which at your level, if you were to become as marginal or as profitable as most of your competitors, your profits would be about double what they are now at the very least. And so, my question has to do with allocation of capital. You made the Devicix acquisition, it looked like you spent somewhere $5 million plus for what now looks like if I can attribute the increase in operating income of $10,000 for the quarter to that acquisition, that it will maybe cover the interest expense but not really be accretive to your company. So, it always makes me worry when you have the opportunity to take firm capital and repurchase your own stock at 50% a $1 which is an immediate 100% return on equity for those dollars spent and dollars get spent on an alternative that has virtually no chance of matching that level of profitability. So, if you could address that first? I have a question about your allocation of capital on that acquisition and why that?

Let me address that if I wasn’t clear on some of the opening numbers on the results. For the quarter, the acquisition generated $1.4 million in revenue and $175,000 in profit contribution. And that was after another $45,000 or so in amortization and interest. So, the $175,000 contributions about 12% it gets close to 15% return ROS if you take it without the goodwill depreciation on it.

Okay.

So, it’s accretive in delivering, so I’m sorry if I wasn’t clear there.

So, my assumption would be that everything else since you didn’t break out that specifically, everything else declined to the tune of about $165,000?

Yes, I would agree, it’s something like that. The other piece on the acquisition, the reason for the acquisition maybe you didn’t pick it up on the other calls, is what’s it’s leading towards. We don’t have good numbers but it’s approximately 40% to 50% of the engineering projects that they get and they get about 20% a year could turn it into manufacturing which compliments what we’ve done before, we didn’t have the design shop upfront. That number is easy to track okay, because it comes out of that and we’ll probably provide some of that information as we go forward. We had one customer combined in the first six months and in the last three months we’ve had three more opportunities that led out of that into production. With the medical device, it’s a long-selling, long-production process, probably a year or so, and design, another six months through development prototypes and then possibly another six months generally 18 to 24 months before it gets through FDA and clinical, before we start seeing some full production on it. So, the cycle is going to take a little while through. But we should be able to at least address the number of opportunities that’s coming out of that acquisition. We understand your question and we understand the sensitivity from our shareholders. We’re all over it. It’s a major investment. And from our seat right now, it’s accretive it’s a better project, a better investment than we even thought when we first got started, so.

Okay. You can understand, when you trade at one tenth in revenues and you buy a company for one times revenues, we will have a very high expectation for the ROI coming out of that and you’re telling me that point, it’s somewhere around $800,000 this year?

Yes, cash flow wise I think we did $260,000 to $270,000. And if you added goodwill, another $100,000 that’s $350,000 roughly for the first six months. Cash flow wise its better. So, it depends on what basis you want to get that, on equity, definitely what you mentioned is right. But cash flow might be a little better. The cash flow is pretty strong. So, that’s kind of where we’re at. The other question that you talked about which is buyback stock, that’s always on the table. But given our debt to equity are aligned, operations need that right now, they need it for growth on the working capital. However, even if we wanted to, the bank isn’t going to do that until they get a little more comfortable room. They have a covenant in there that we cannot that without their approval. So, we’re a little strapped there.

I guess, I was looking at that question from a vantage point prior to the acquisition when the [indiscernible] sort of looking at the acquisition and going what’s going on here. Okay, moving on. Given your different lines of business, is there one number that would represent sort of your backlog now versus 12/31 versus 12/31/14 and are you comfortable telling me how much of that backlog is in your new higher return business?

Sure. Let me look through that. It would be in the 10-K, but I’ll see if I can find it for you. So, the medical area, we started last year at $6.3 million and today we’re at $8 million. So, it’s up substantially. From the third quarter, however it’s down $1 million and the reason it’s down $1 million is seasonality for our largest customer.

Okay. So that’s in the medical device, and so, and what’s the rest of the backlog?

The rest of the backlog is in the $12 million area versus last year was $10 million, so it’s up 20% compared to the, it’s down $2 million on ‘14 compared to the start of the quarter.

Okay. On the cost containment and your Vision 2020, and I’m only saying this, I’m saying this from the vantage point, we make markets in about 1,000 stocks and we watch companies that change and everything. And going back to sort of finance one-on-one, when you’re publicly held, there is a couple of things that go with that. You have stock on the market so you can raise capital when you need to you have stock on the market so you can provide shares to attract qualified employees. And you’re sort of dependent upon your stock being valued at a fair level owing to analytical coverage, research coverage and institutional ownership. And I look at a company of your size and you know, there has been a migration towards largeness in the area of publicly held securities. You have no research coverage, you have no institutional ownership to speak of and your stock at this price to book is not at a level where you would ever use it to sell shares in the market to fund an acquisition, they’re not at a level where you would give them. We would hope you would not give shares away at 50% of book value to somebody else for their paper. And I would even go so far as to say to give shares to employees or management at this level when it’s 50% of book doesn’t make much sense. So there are material savings to be achieved by essentially moving yourself to the OTC markets, essentially the pink sheets, because the cost associated with Serving is actually compliance. And the accounting cost going with that means you can get probably as much in savings as you’re going to earn this year by listing on the pink sheets. And so, I don’t know if you’ve examined that or if there is any reason why the company feels compelled to trade on the NASDAQ market when any of the basic reasons we’re doing that seem do not exist here?

I would say that everything you mentioned very eloquently that we look at several times a year. If you go back to ‘04 through ‘08, it’s a different world completely with the growth in GDP and everything bubbling until the recession hit in ‘09. So things have changed. It paid-off pretty well through that period of time to be in the stock market and then move forward even with our low-flow and high concentration of one shareholder. Today, I believe the board, we have those questions, I don’t, I think the board has as much to say about is my recommendations, even more so I would believe as well as the shareholders that we’re in that same period of ‘04 in the $6 - it was $6 range in ‘04 and got up to about $14 in the hay days of middle of 2008. So that’s an area over the last five years since 2009 has now played out as we’ve adjusted our company and our business to instead of a group of customers that we just consolidated to one Nortech. And the type of customer base that we have can take us to higher levels. If we do some of the strategic investments that we’ve made over the last two years, I think you go back to 2010 when we started, that was really the start of our manufacturing for medical devices buying that production facility. It was an acquisition that grew in 10 years from pretty much nothing to $25 million and then came on hard times and pretty much went to $1 million or $2 million.

Can I redirect a little bit, because I think you may be missed what I just said.

No, I’m just saying that the opportunity for Nortech to grow and meet those requirements of ‘04 to ‘08, are now getting in position. But right now that going over the counter is not an option for us at this time until we play out this strategy session that we’re in. And we feel pretty good about that strategy.

To operate unsolicited opinion in a decision that’s wholly yours, as a market maker in your stock, you’re going to lose nothing in terms of an audience for your shares by moving from the NASDAQ market to OTC markets, you’re going to lose nothing in my opinion.

I respect it and we’ll continue to take a look at it. The stronger we look at it, maybe than even we did yesterday. And thank you.

One more question, we’ll just go and then I’ll get off and let somebody else ask.

No problem, no problem.

China, you’re going into China and I guess it’s one of those things that I’ve seen a lot of companies do this and it’s sort of like building a house. If you come anywhere near the time of completion that was originally scheduled in your budget that’s a total win but you usually don’t. And so, how experienced has this company, given its size and how much study have you done and how much certainty do you have in expanding into China that you know all of the things that can come up and that will come up going in there. Because the usual result as people are going to go to China, it sounds great, it’s all cool right until they get there. And then a lot of things go off-track. And so, I just, if you can quantify that for me at all?

Yes, I’ll try to do that for you. I think we started, we’ve been, I wouldn’t say pushed real hard for the last, since 2002, 2002 that’s when it was heated and, say, you had to get there and now that has slowed for at least 10 years. But the last three years when China has grown from a high-volume and all cost and not a lot of complexity, not a very good supply chain and stuff. It’s almost a necessity for our global customers to have that presence there and their supply base. It’s a different world today, 10 to 12 years difference than when we first looked at it. We are fortunate at the timing to do it, there was a couple of questions, you said quantify, well, I can quantify the project cost and what the expectations are a little bit for you in the project. But the research that we did before we made the decision that helps that we’re getting from both our supplier base and our customer base has been very helpful. Our banking relationships have helped out. Our accounting firms have helped out. We are walking not slow because our customers expect us to get there quick. We’re not opening up the business in Asia outside of global customers that we currently have and for expertise that we know. And taking everyone’s advice, working with proven suppliers, making sure that everything is transferred, same systems, same - so it’s not, we didn’t rush into it and we put a good plan together, started in October of ‘14. And the implementation was supposed to be to October, we moved it out slightly for a lot of reasons. And now we feel we’re on track. We have experienced people that are on our employment with us, managers that have done it. We have experience in the company from people that have been there, not a lot. But we have people and now with year and half into it, we’re almost experienced in it. So, we’ve always worked with the China operations for our customers, so that’s not going to be new. We don’t have to learn the customer because we’re only going to customers we know that we’ve already worked with through their global supply chain. We work with folks in Europe, we worked with a lot of folks in Asia, Singapore, Taiwan, with our customers and who we ship it to. A lot of them come back and forth with sometimes in the United States and sometimes in here. The dollar amount magnitude of the cost, we’re probably in a $250,000 range to $300,000 so far invested. We track it religiously. In 2015, the cost of ramp up here has increased a little bit, probably being in the $500,000 or $600,000 for the first half. The sales, because you have to qualify, we need to qualify both ISO and then for our customer certification. So that’s in play. So, we’re comfortable with it. They are helping us out immensely. So we’re not doing it alone. Then we should start being done with the ramp-up cost. We have business that they’re anxious for us to get there with and transfer. And they are lining us up. So, we’re hoping that the ramp up cost stops, that’s the plan in the third quarter. There may be some residual but it’s there, everything has been on plan so far. So, hope that answers your question.

It does. Thank you very much.

You bet. Have a good day. Thank you. Thanks for your questions.

At this time we have no further questions in audio portion of the conference. I would now like to turn the conference back over to management for closing remarks.

If there are no further questions, we’ll conclude this call. Thank you for your interest in Nortech. And we look forward for updating you in the future. A reminder, our Annual Meeting is scheduled for Wednesday, May 04, 2016 at 3 o’clock Central Standard Time. And this year remember, this is a change we’ll be doing it here at our Maple Grove corporate offices in Minneapolis. So, we’ll probably get that out on the wire someplace so you can see it in our internet. So, thank you for your interest. And have a great day.

This concludes today’s teleconference. Thank you for your participation. You may disconnect your lines at this time.