Nortech Systems Incorporated (NSYS) Q3 2018 Earnings Report, Transcript and Summary

Greetings and welcome to Nortech Third Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the conference over to, Connie Beck, Vice President and CFO. Please go ahead, Ms. Beck.

Thank you, Rob. Good morning and welcome to Nortech Systems’ third quarter 2018 conference call. I am Connie Beck, Vice President and CFO, and with me is our President and CEO, Rich Wasielewski. I’m going to start today’s call by going over our financial results, which we released yesterday afternoon. Then, I will turn it over to Rich for additional comments on the third quarter, our markets and industry, and company development. Then, we’ll open it up for questions. Before we continue, please note that the statements made during this call and Q&A session maybe forward-looking regarding expected revenue, earnings, future opportunities and other Company expectations. These estimates, plans and other forward-looking statements involve known and unknown risks and uncertainties that may cause actual results to differ materially from those expressed or implied on this call. These risks include those that are detailed in our most recent Annual Report in Form 10-K and maybe amended or supplemented. The statements made during this call are based upon information known to Nortech as of the date and time of this call. We assume no obligation to update the information in today’s call. You can find Nortech’s complete Safe Harbor statements in our SEC filings. Looking at our third quarter results. Our net sales of $29.6 million reflects $1.9 million of additional revenue recognized due to our adoption of new FASB accounting standards this fiscal year. On a pro forma basis, to remove the impact of this accounting change, third quarter sales were $27.7 million. Sequentially, this is up $700,000 or 3% from the second quarter of 2018. Our net sales in the third quarter of 2017 were $28.3 million. Looking at our three core markets year-over-year and sequentially. Our industrial sales decreased 4% from the prior year period and were down 5% sequentially. Year-over-year, medical sales increased by $1.5 million or 12% with the majority of the increase attributed to our OEM medical customers. Sequentially, medical sales increased 14% from the second quarter of 2018. Aerospace and defense sales increased by 4% year-over-year and decreased 2% sequentially. Defense shipments have been especially impacted by component shortages over the past several quarters. Onto our backlog. At September 30, 2018, our 90-day shipment backlog was $27.7 million. This is a 16% increase sequentially and a 37% increase over the prior year period. Here’s the backlog picture by market. The industrial backlog increased 18% year-over-year and 23% sequentially; medical backlog increased 63% year-over-year and 20% sequentially; aerospace and defense backlog was up 22% year-over-year and was flat sequentially. There was some backlog growth due to shipment delays caused by component shortages with those orders being pushed out. We’d estimate about one-third of the backlog growth is attributed to these shortages. But, even without those shortages, we’d be experiencing double-digit increases heading into the fourth quarter. Our gross margin percentage for Q3 was 11.5%, compared to 12.4% in the prior year third quarter. Due to new revenue recognition policies cited earlier, we recognize $1.4 million of revenue related to the non-cash consideration, which was recorded at no margin. The year-over-year gross margin decline resulted from customer and product mix, as well as production start-and-stop inefficiencies from the component shortages. We continue watching our costs and spending, and we’re making those necessary adjustment to demand levels. Our selling expenses for the third quarter was $700,000 or 2.4% of sales compared to $1.1 million or 4% of sales for the prior year period. The decrease is due to timing of events and volume-related expenses. G&A expenses for the third quarter was $2 million or 6.8% of sales versus $2.1 million or 7.4% of sales for the third quarter of 2017. Operating income for the third quarter of 2018 was $600,000 compared to $300,000 for the third quarter of 2017. We reported net income of $400,000 or $0.14 per share for the third quarter of 2018, and this compares to net income of $43,000 or $0.02 per share for the same period last year. Moving onto our balance sheet and liquidity. Cash provided by operations was $2.6 million for the first nine months of 2018 compared to $600,000 for the first nine months of 2017. Our year-to-date free cash flow was $1.6 million, compared to less than $100,000 for the prior nine-month period. Major changes to our working capital were from an increase in inventory offset by an increase in accounts payables. Higher inventory levels can be attributed to three primary factors: The component shortages; the buildup of inventory in our Mexico facility in preparation to our move to a new facility; and the increase in backlog heading into the fourth quarter. We ended the third quarter with $4.8 million available on our line of credit compared to $6.3 million at the end of the second quarter. Total debt was $12.7 million at the end of the third quarter, excluding capital leases of $1.4 million, which compares to debt of $13.9 million at the end of 2017 without capital leases. That concludes my financial overview. Now, I’ll turn it over to Rich for his comments.

Thanks, Connie, and good morning, everyone. Last year, during our third quarter 2017 conference call, we discussed how several key medical customers had built up their on-hand inventory from an overaggressive forecast and how it would impact our year-end and the beginning of 2018. Now, fast-forward, this year, we’re in a more advantageous position. Our overall medical background -- backlog ending the third quarter of 2018 is up 63% year-over-year compared to last year when it was down 36%. The prior year inventory situation is behind us and we’ve recovered nicely here in the back half of 2018. We entered our fourth quarter with $27.7 million in total 90-day backlog, which is double-digit percentagewise, up both year-over-year and sequentially, led by the improvement in the medical orders. We’re encouraged by the quarterly performance and continued profit improvements. For the last seven quarters, our results have lagged, but the last two quarters were outpacing our industry and the economy. Our customers remain optimistic and confident due to the current industry trends and the strong economy. Our capital equipment industrial customers can detract with the U.S. economy, which both posted a 3.5% GDP growth in the third quarter. The country is on pace for the strongest annual GDP in 13 years. Another helpful trend is the medtech companies are expected to attract $9.1 billion in venture funding, according to Silicon Valley Bank, which would match last year’s record high. Large medical OEMs are leading the way this year, while private capital investing is slightly down. And the defense industry, it’s having one of its best years in recent memory, as reported by Washington Post and other news outlets. The defense budget has grown significantly with all of the top five defense contractors posting healthy Q3 results. With all these favorable indicators, there are a couple of challenges that continue to impact the EMS industry and our results. And that’s electronic component shortages and the China tariffs. The component shortages are expected to continue into next year due to its current supply and demand dynamics. On the demand side, the electronics industry is seeing stronger demand from the mobile, industrial and automotive markets. New vehicles, for example, have more sensors for technology, like driver assistance and warning indicators. There’s smart cars, there is smart homes, there is smart factories, all elements of exploding Internet of Things. All these connecting and sharing data requires electronics. The most common components in short supply include capacitors, especially multi-layered ceramic capacitors or what they call MLCCs, along with resistors and memory. Many of these are relatively low cost components that have been around for decades. Because they are legacy parts, the components manufacturers are not expanding capacity. Instead, the manufacturers are investing in next-generation products. And of course, these take time with technology transitions. For Nortech, we estimate these shortage had a negative revenue impact of approximately 5% in the third quarter. Our gross margins were also impacted, not only from the loss volume, but related inefficiencies and production starts and stops. It’s also leading to higher inventory levels. We’re constantly changing production schedules to match increasing lead times and shortages. This results and costly setups and replanning. We’ve made several process changes and will continue to work with our customers and supply chain partners to minimize the impact. Tariffs are another challenge, but at least for now with minimal impact on our Company. Our China production is in country, for country, and here in North America, we’re buying most of our components and materials domestically. Next, onto major projects and business investments of interest, planned for completion by year-end in the first quarter of 2019. In Mexico, we’re our schedule and on budget to move into a newly built 78,000 square-foot production facility before year-end. It’s roughly 5 miles from our previous location in Monterey, conveniently located right across the street from the airport in the industrial park. This new facility will double our footprint, improving our production workflow, expanding our engineering capabilities and providing an enhanced customer and supplier experience. Another strategic investment is the consolidation of our two Minneapolis offices. We are relocating our Devicix by Nortech medical device products development group to an expanded corporate headquarters building here in Maple Grove, Minnesota. The remodeled space will provide new engineering labs, prototype production facilities and an improved customer collaborative space, and because -- and it carries a nice annual savings and reduced lease costs and other expenses. Our increased focused on the combined Devicix by Nortech product development and production branding efforts have built a strong pipeline. Our third quarter 90-day backlog ended at $5 million which is double the prior year. Also, we’re upgrading our ERP system with implementation planned for the first quarter of 2019. A quick update on my succession planning. We announced in August I am planning on retiring with nationwide search and interview process that’s underway. The Board has been vetting candidates and is pleased with the search firm and progress made so far. I'll continue in my current role and assist in making a smooth transition. In closing, this morning, our management team remains optimistic for all the reasons we've outlined today. We’ve worked through our major medical customer inventory issues in the first half of the year and are in significantly better position than a year ago. Customer confidence and demand trends are positive in the core markets and strong across all major revenue and profit generating groups. Growth trends are favorable in the U.S. economy and our EMS industry here in North America. Our industry is projected to grow 5% in 2018 and continue that annual pace through 2022. The tariff and shortage issues are challenges but they are industry issues, not just Nortech issues, and we are working to minimize that impact. That concludes my remarks this morning. We will now open it up for questions. Operator, please open the line.

Thank you. We’ll now be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of Sheldon Grodsky with Grodsky Associates. Please proceed with your question.

It’s nice to see a quarter where you don’t have to make excuses about why the results didn’t come in. This is the best quarter we’ve had in the long time. I just wanted to ask a quick question. It appears that you’ve done some buying back of your shares. How many shares did you buy back in the quarter?

Just -- Connie, it’s 20…

It’s couple of thousand -- give me a moment.

Just a second -- Connie, I’ll look it up. She’s got it.

Just over 8,600 shares in the quarter.

8,600 in the quarter? And do you have the number for the first nine months?

I don’t have that at my fingertips. But, we did exhaust, the first plan was -- it expired in July 31st, and we did exhaust the whole $250,000 available for that plan. So…

So, roughly 55,000 to 60,000 shares at about $4 a share.

[Operator Instructions]. Thank you. At this time, there are no additional questions. I will turn the floor back to Rich Wasielewski for closing comments.

If there are no other further questions, we’ll conclude this call. Thanks for joining us today and your interest in Nortech. We look forward to updating you in the future. To you all and all Nortech’s stakeholders, have a great day and best wishes for an awesome holiday season.

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