NORTECH SYSTEMS INC 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview We are a Maple Grove, Minnesota based full-service electronics manufacturing services (“EMS”) contract manufacturer of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industries. We provide value added engineering services and technical support including design, testing, prototyping and supply chain management to customers mainly in the aerospace and defense, medical, and industrial equipment markets. We maintain facilities in Bemidji, Blue Earth, Mankato, Maple Grove, Merrifield, and Milaca, Minnesota; Monterrey, Mexico; and Suzhou, China. All of our facilities are certified to one or more of the ISO/AS standards, including 9001, AS9100 and 13485, with most having additional certifications based on the needs of the customers they serve. Recent Developments Global Pandemic In March 2020, the World Health Organization recognized the outbreak of a novel coronavirus (“COVID-19”) as a pandemic. While the COVID-19 pandemic has had an impact on our operations, we have been able to continue to operate our manufacturing facilities and provide essential services to our customers. Additionally, in an effort to protect the health and safety of our employees and in compliance with state regulations, we have instituted a work-from-home policy for employees who can perform their job functions offsite, implemented social distancing requirements and other measures to allow manufacturing and other personnel essential to production to continue work within our manufacturing facilities, and suspended all non-essential employee travel. The full extent to which COVID-19 will directly or indirectly impact our business, financial condition, and results of operations will depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning COVID-19, the actions taken to contain it or treat its impact and the economic impact on local, regional, national and international markets. We will continue to assess the potential impact of the COVID-19 pandemic on our business, financial condition, and results of operations. We continue to actively manage our cash and working capital to preserve adequate liquidity and ensure that our business can continue to operate during these uncertain times. Facility Consolidation To further improve operational efficiencies and lower overhead costs, the Company approved on August 7, 2020, the closure of our Merrifield, Minnesota, production facility, shifting wire and cable assembly, system-level assembly and printed circuit board (PCB) manufacturing to Nortech’s other Minnesota locations. The Merrifield production facility consolidation is expected to be complete on or before December 31, 2020, and will impact approximately 60 employees, who will be offered positions at other Nortech facilities in Minnesota. As of September 30, 2020, this closure did not qualify for held for sale nor discontinued operations accounting. 18 Results of Operations The following table presents statements of operations data as percentages of total net sales for the periods indicated: Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 Net Sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of Goods Sold 93.8 87.9 91.2 89.6 Gross Profit 6.2 12.1 8.8 10.4 Selling Expenses 2.3 2.0 2.4 2.5 General and Administrative Expenses 8.2 7.7 7.2 8.6 Gain on Sale of Property and Equipment (14.5 ) 0.0 (4.8 ) 0.0 Income (Loss) from Operations 10.2 2.4 4.0 (0.7 ) Other Expenses (0.5 ) (0.9 ) (0.7 ) (0.9 ) Income (Loss) Before Income Taxes 9.7 1.5 3.3 (1.6 ) Income Tax Expense 2.3 0.1 0.8 0.2 Net Income (Loss) 7.4 % 1.4 % 2.5 % (1.8 )% Net Sales Net sales were $26.4 million in the third quarter of 2020, as compared to $30.1 million in the third quarter of the prior year, a decrease of $3.7 million or 12.3% that was driven in part by the COVID-19 pandemic. Net sales results were varied by markets; the medical market decreased by $2.8 million or 16.6% with medical devices accounting for the largest portion of the decrease. The industrial market decreased by $2.7 million or 31.1% of sales in the third quarter of 2020 as compared to the same quarter of 2019. Net sales from the aerospace and defense markets increased by $1.8 million or 41.3% of sales in the third quarter of 2020 as compared to the third quarter of 2019. Net sales were $80.3 million in the nine months ended 2020, as compared to $85.5 million in the prior year, a decrease of $5.3 million or 6.1% that was driven in part by the COVID-19 pandemic. Net sales results were varied by markets; the medical market decreased by $3.3 million, or 7.1% with medical device accounting for 45.6% of the decrease and medical component products the remaining 54.4%. The industrial market decreased by $4.3 million of sales or 16.3% for the nine months ended September 30, 2020 as compared to the same period of 2019. Net sales from aerospace and defense markets increased by $2.3 million of sales or 17.3% for the nine months ended September 30, 2020 as compared to the same period of 2019. 19 Net sales by our major EMS industry markets for the three and nine months ended September 30, 2020 and 2019 were as follows (in thousands): Three months Ended September 30, Nine Months Ended September 30, 2020 2019 % 2020 2019 % $ $ Change $ $ Change Medical 14,218 17,043 (16.6 ) 42,753 46,006 (7.1 ) Industrial 5,938 8,623 (31.1 ) 22,001 26,290 (16.3 ) Aerospace and Defense 6,206 4,392 41.3 15,509 13,219 17.3 Total Net Sales 26,362 30,058 (12.3 ) 80,263 85,515 (6.1 ) Net sales by timing of transfer of goods and services for the three and nine months ended September 30, 2020 is as follows (in thousands): Three Months Ended September 30, 2020 Product/ Service Transferred Over Time Product Transferred at Point in Time Noncash Consideration Total Net Sales by Market Medical $ 10,960 $ 1,853 $ 1,405 $ 14,218 Industrial 4,527 791 620 5,938 Aerospace and Defense 5,525 16 665 6,206 Total net sales $ 21,012 $ 2,660 $ 2,690 $ 26,362 Nine Months Ended September 30, 2020 Product/ Service Transferred Over Time Product Transferred at Point in Time Noncash Consideration Total Net Sales by Market Medical $ 35,835 $ 4,454 $ 2,464 $ 42,753 Industrial 17,434 3,354 1,213 22,001 Aerospace and Defense 14,160 396 953 15,509 Total net sales $ 67,429 $ 8,204 $ 4,630 $ 80,263 20 Net sales by timing of transfer of goods and services for the three and nine months ended September 30, 2019 is as follows (in thousands): Three Months Ended September 30, 2019 Product/ Service Transferred Over Time Product Transferred at Point in Time Noncash Consideration Total Net Sales by Market Medical $ 14,399 $ 1,661 $ 983 $ 17,043 Industrial 7,279 822 522 8,623 Aerospace and Defense 3,978 133 281 4,392 Total net sales $ 25,656 $ 2,616 $ 1,786 $ 30,058 Nine Months Ended September 30, 2019 Product/ Service Transferred Over Time Product Transferred at Point in Time Noncash Consideration Total Net Sales by Market Medical $ 42,039 $ 1,914 $ 2,053 $ 46,006 Industrial 22,847 2,297 1,146 26,290 Aerospace and Defense 12,236 375 608 13,219 Total net sales $ 77,122 $ 4,586 $ 3,807 $ 85,515 Backlog Our 90-day shipment backlog as of September 30, 2020 was $23 million, a 0.8% decrease from the beginning of the quarter and a 27.8% decrease from the prior year. Backlog for our medical customers has decreased 4.2% from the beginning of the quarter and decreased 35.4% from the prior year. Our industrial customers’ backlog increased 10.4% from the beginning of the quarter and decreased 41.7% from the prior year. The aerospace and defense backlog decreased 2.0% from the beginning of the quarter and increased 14.5% from the prior year. Our backlog consists of firm purchase orders we expect to ship in the next 90 days, with any remaining amounts to be transferred within 180 days. 90-day shipment backlog by our major EMS industry markets are as follows (in thousands): Shipment Backlog as of the Period Ended September 30, June 30, September 30, 2020 2020 2019 Medical $ 11,484 $ 11,987 $ 17,778 Industrial 4,860 4,401 8,334 Aerospace and Defense 6,764 6,900 5,909 Total 90-Day Backlog $ 23,108 $ 23,288 $ 32,021 21 Our 90-day backlog varies due to order size, manufacturing delays, contract terms and conditions and timing from customer delivery schedules and releases. These variables cause inconsistencies in comparing the backlog from one period to the next. Our total shipment backlog was $45.7 million at September 30, 2020 compared to $58.1 million at the end of September 30, 2019. This decrease was driven in part to the impact of COVID-19. Gross Profit Gross profit as a percent of net sales for the three months ended September 30, 2020 and 2019 was 6.2% and 12.1%, respectively. Gross profit as a percentage of sales for the nine months ended September 30, 2020 and 2019 was 8.8% and 10.4%, respectively. The decrease in both comparisons was driven by lower sales on a fixed cost base in part due to the impact of COVID-19 and increased inventory reserves. Selling Expense Selling expenses for the three months ended September 30, 2020 and 2019 was $0.6 million or 2.3% of sales and $0.6 million or 2.0% of sales, respectively. Selling expense for the nine months ended September 30, 2020 and 2019 was $1.9 million or 2.4% of sales and $2.1 million or 2.5% of sales, respectively. General and Administrative Expense General and administrative expenses for the three months ended September 30, 2020 and 2019 were $2.2 million or 8.2% of sales and $2.3 million or 7.7% of sales, respectively. General and administrative expenses for the nine months ended September 30, 2020 and 2019 were $5.8 million or 7.2% of sales and $7.4 million or 8.6% of sales, respectively. The decrease in the year to date comparison was due to higher spend in the prior year related one-time expenditures to improve operations in 2019 and the benefits of those cost reduction measures in 2020. Gain on Sale of Property and Equipment The gain on sale of property and equipment was $3.8 million in the three and nine months ended September 30, 2020. This gain was due to the sale leaseback transaction we completed in the period relating to the manufacturing facilities in Bemidji and Mankato, Minnesota. Income (Loss) from Operations Third quarter 2020 income from operations was $2.7 million compared to $0.7 million for the third quarter in 2019. Income from operations for the first nine months in 2020 was $3.1 million as compared to a loss of $0.6 million for the same comparable period in 2019. The increase in the income from operations in both comparisons was due to the gain on sale of property and equipment of $3.8 million partially offset by lower gross profit. Income Taxes On a quarterly basis, we estimate what our effective tax rate will be for the full fiscal year and record a quarterly income tax provision based on the anticipated rate. As the year progresses, we refine our estimate based on the facts and circumstances, including discrete events, by each tax jurisdiction. Our effective tax rate for the three and nine months ended September 30, 2020 was 24% and our effective tax rate for the three and nine months ended September 30, 2019 was 10% and (9%), respectively. 22 Net Income (Loss) Net income for the three months ended September 30, 2020 and September 30, 2019 was $2.0 and $0.4 million, respectively. Net income for the nine months ended September 30, 2020 was $2.0 million and net loss for the nine months ended September 30, 2019 was $1.5 million. Liquidity and Capital Resources Our third quarter sales and shipment backlog were impacted by the COVID-19 pandemic. However, our focus on reducing costs, minimizing capital expenditures, and managing working capital mitigated the impact on liquidity. Due to the inherent uncertainty of this evolving situation, we are unable at this time to predict the likely impact of the COVID-19 pandemic on our future operations. However, we believe that cash provided by operations, funds available under the credit agreement with Bank of America, N.A. (BofA), funds available under a Promissory Note with BofA (“Promissory Note”) pursuant to the Paycheck Protection Program under the Coronavirus Aid, funds received from our sales leaseback transaction and cash on hand will be adequate to meet our liquidity needs, including working capital, capital expenditures, and debt payment obligations. Net cash used in operating activities for the nine months ended September 30, 2020 and September 30, 2019 was $0.1 million and $0.2 million, respectively. We have satisfied our liquidity needs over the past several years with cash flows generated from operations and a bank operating line of credit. We have a credit agreement with Bank of America (BofA) which was entered into on June 15, 2017 and amended on December 29, 2017 and provides for a line of credit arrangement of $16.0 million that expires on June 15, 2022. The credit arrangement also has a $5.0 million real estate term note outstanding with a maturity date of June 15, 2022. Both the line of credit and real estate term notes are subject to fluctuations in the LIBOR rates. The line of credit and real estate term notes with BofA contain certain covenants which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial performance, and limit the amount of annual capital expenditures. The availability under our line is subject to borrowing base requirements, and advances are at the discretion of the lender. The line of credit is secured by substantially all of our assets. On September 30, 2020, we had outstanding advances of $2.5 million under the line of credit and unused availability of $8.6 million supported by our borrowing base. We believe our financing arrangements and cash flows to be provided by operations will be sufficient to satisfy our future working capital needs. Our working capital was $22.6 million and $21.1 million as of September 30, 2020 and December 31, 2019, respectively. The Bank of America Credit Agreement provides for, among other things, a Fixed Charge Coverage Ratio of not less than (i) 1.0 to 1.0 for the three months ending December 31, 2019, six months ending March 31, 2020, nine months ending June 30, 2020 and twelve months ending September 30, 2020 and each fiscal quarter end thereafter. The Company met the covenants for the nine months ended September 30, 2020. On April 15, 2020, we entered into a Promissory Note, which provides for an unsecured loan of $6.1 million pursuant to the Paycheck Protection Program under the Coronavirus Aid, Relief, and Economic Security Act and applicable regulations (the “CARES Act”) of which funds were received on April 22, 2020. The Promissory Note has a term of 2 years with a 1% per annum interest rate. Payments are deferred for 10 months after the end of the Promissory Note covered period (which is defined as 24 weeks after the date of the loan) and we can apply for forgiveness of the Promissory Note after 60 days. Forgiveness of the Promissory Note will be determined in accordance with the provisions of the Cares Act and applicable regulations. Any principal and interest amount outstanding after the determination of amounts forgiven will be repaid on a monthly basis. We expect that all or a significant portion of the Promissory Note will be forgiven. 23 Off-Balance Sheet Arrangements We have not engaged in any off-balance sheet activities as defined in Item 303(a)(4) of Regulation S-K. Critical Accounting Policies and Estimates Our significant accounting policies and estimates are summarized in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2019. Some of our accounting policies require us to exercise significant judgment in selecting the appropriate assumptions for calculating financial estimates. Such judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. Actual results could differ from these estimates. Forward-Looking Statements Those statements in the foregoing report that are not historical facts are forward-looking statements made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. ● Volatility in the marketplace which may affect market supply, demand of our products or currency exchange rates; ● Increased competition from within the EMS industry or the decision of OEMs to cease or limit outsourcing; ● Changes in the reliability and efficiency of our operating facilities or those of third parties; ● Risks related to availability of labor; ● Increases in certain raw material costs such as copper and oil; ● Commodity and energy cost instability; ● Risks related to FDA noncompliance; ● The loss of a major customer; ● General economic, financial and business conditions that could affect our financial condition and results of operations; ● Increased or unanticipated costs related to compliance with securities and environmental regulation; ● Disruption of global or local information management systems due to natural disaster or cyber-security incident; ● Outbreaks of epidemic, pandemic, or contagious diseases, such as the recent novel coronavirus that affect our operations, our customers' operations or our suppliers' operations. The factors identified above are believed to be important factors (but not necessarily all of the important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by us. Discussion of these factors is also incorporated in Part I, Item 1A, “Risk Factors,” and should be considered an integral part of Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Unpredictable or unknown factors not discussed herein could also have material adverse effects on forward-looking statements. All forward-looking statements included in this Form 10-Q are expressly qualified in their entirety by the forgoing cautionary statements. We undertake no obligations to update publicly any forward-looking statement (or its associated cautionary language) whether as a result of new information or future events. 24 Please refer to forward-looking statements and risks as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, and the risks set forth in PART II, ITEM 1A below. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.