NORTECH SYSTEMS INC 10-K

Item 5. Market for Registrant ’ s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   As of March 6, 2023, there were 611 shareholders of record. Our stock is listed on the NASDAQ Capital Market under the symbol “NSYS”. We intend to invest our profits into the growth of our operations and, therefore, do not plan to pay out dividends to shareholders in the foreseeable future. We did not declare or pay a cash dividend in 2022 or 2021. Future dividend policy and payments, if any, will depend upon earnings and our financial condition, our need for funds, limitations on payments of dividends present in our current or future debt agreements, and other factors.   Stock price comparisons (NASDAQ):   During the Three Months Ended   Low     High                     March 31, 2022   $ 9.50     $ 12.38   June 30, 2022   $ 9.94     $ 14.37   September 30, 2022   $ 10.07     $ 19.56   December 31, 2022   $ 9.31     $ 16.01                     March 31, 2021   $ 6.00     $ 9.00   June 30, 2021   $ 5.45     $ 10.67   September 30, 2021   $ 7.38     $ 14.20   December 31, 2021   $ 9.02     $ 12.59     Equity Compensation Plan Information Certain information with respect to our equity compensation plans are contained in Part III, Item 12 of this Annual Report on Form 10-K.   Item 6. Selected Financial Data [Reserved]   17     Item 7. Management ’ s Discussion and Analysis of Financial Condition and Results of Operations   Overview We are a Minnesota, United States based full-service global EMS contract manufacturer in the Medical, Aerospace & Defense and Industrial markets offering a full range of value-added engineering, technical and manufacturing services and support including project management, design, testing, prototyping, manufacturing, supply chain management and post-market services. Our products are complex electromedical and electromechanical products including medical devices, wire and cable assemblies, printed circuit board assemblies, higher-level assemblies, and other box builds for a wide range of industries. We serve three major markets within the EMS industry: Aerospace and Defense, Medical, and the Industrial market which includes industrial capital equipment, transportation, vision, agriculture, oil and gas. As of December 31, 2022, we have facilities in Minnesota: Bemidji, Blue Earth, Mankato, Milaca and Maple Grove. We also have facilities in Monterrey, Mexico and Suzhou, China.   Our revenue is derived from complex designed products built to the customers’ specifications. The products we manufacture are engineered and designed products that require sophisticated manufacturing support. Quality, on time delivery, and reliability are of upmost importance. Our goal is to expand and diversify our customer base by focusing on sales and marketing efforts that fit our value-added service, early engagement design, and development strategy. We continue to focus on lean manufacturing initiatives, quality and on-time delivery improvements to increase asset utilization, reduce lead times and provide competitive pricing.   Our strategic investments have positioned us to capitalize on growth opportunities in the medical markets and improve our competitiveness by expanding our global footprint. Our industrial and defense markets are focused on improving our asset utilization and profitability while transforming to a value added, solution-sell business model that supports early engagement, design for manufacturability and rapid prototyping.   Critical Accounting Policies and Estimates   The discussion and analysis of our financial condition and results of operations are based upon our audited consolidated financial statements, which have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”). The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of our consolidated financial statements, the reported amounts of revenues and expenses during the reporting periods presented, as well as our disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and assumptions, including, but not limited to, valuation allowance for inventories, allowance for doubtful accounts, realizability of deferred tax assets and long-lived asset impairment testing.   We base our estimates and assumptions on our historical experience and on various other information available to us at the time that these estimates and assumptions are made. We believe that these estimates and assumptions are reasonable under the circumstances and form the basis for our making judgments about the carrying values of our assets and liabilities that are not readily apparent from other sources.  Actual results and outcomes could differ from our estimates primarily due to incorrect sales forecasting. We utilize a pipeline generated by our sales team and speak directly with all departments regarding estimates and assumptions. If, for any reason, those estimates, and assumptions vary substantially it would also impact our financial results.   Our accounting policies are described in “Note 1 – Summary of Significant Accounting Policies,” in Notes to Consolidated Financial Statements of this Annual Report on Form 10-K. We believe that the following discussion addresses our critical accounting policies and reflects those areas that require more significant judgments and use of estimates and assumptions in the preparation of our consolidated financial statements.   18     Revenue Recognition Our revenue is comprised of product, engineering services and repair services. All revenue is recognized when the Company satisfies its performance obligation(s) under the contract by transferring the promised product or service to our customer either when (or as) our customer obtains control of the product or service, with the majority of our revenue being recognized over time including goods produced under contract manufacturing agreements and services revenue. A performance obligation is a promise in a contract to transfer a distinct product or service to a customer. A contract’s transaction price is allocated to each distinct performance obligation. The majority of our contracts have a single performance obligation. Revenue is recorded net of returns, allowances and customer discounts. Our net sales for services were less than 10% of our total sales for all periods presented, and accordingly, are included in net sales in the Condensed Consolidated Statements of Operations and Comprehensive Income. Sales, value add, and other taxes collected from customers and remitted to governmental authorities are accounted for on a net (excluded from revenues) basis. Shipping and handling costs charged to our customers are included in net sales, while the corresponding shipping expenses are included in cost of goods sold.   Long-Lived Assets Impairment We evaluate long-lived assets, primarily property and equipment, whenever current events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Recoverability for assets to be held and used is based on our projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge might be required to reduce the carrying amount to equal estimated fair value.   Allowance for Doubtful Accounts When evaluating the adequacy of the allowance for doubtful accounts, we analyze accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms. We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on outstanding accounts receivable. An amount of judgment is required when assessing the ability to realize accounts receivable, including assessing the probability of collection and the current credit-worthiness of each customer. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for uncollectible accounts may be required.   Inventory Reserves Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or quantities in excess of future production needs. We have an evaluation process to assess the value of the inventory that is slow moving, excess or obsolete on a quarterly basis. We evaluate our inventory based on current usage and the latest forecasts of product demand and production requirements from our customers.   19     Operating Results The following table presents our statements of operations data as percentages of total net sales for the years indicated:       2022     2021   Net Sales     100.0 %     100.0 % Cost of Goods Sold     84.7       86.2   Gross Profit     15.3       13.8                     Selling Expenses     2.8       2.0   General and Administrative Expenses     8.5       8.7   Restructuring Expenses     0.0       0.3   R&D Expenses     1.1       0.4   Loss on Abandonment of Intangible Asset     0.0       0.5   Gain on Sale of Property and Equipment     0.0       (0.1 ) Income from Operations     2.9       2.0                     Interest Expense     (0.3 )     (0.4 ) PPP Loan Forgiveness     0.0       5.4   Income Before Income Taxes     2.6       7.0                     Income Tax Expense     1.1       0.8   Net Income     1.5 %     6.2 %   Net Sales Our net sales in 2022 were $134.1 million, compared to $115.2 million in 2021, an increase of $18.9 million or 16.4% that was driven by increases in all of our markets. The industrial market increased by $3.2 million or 9.0% in 2022 as compared to 2021. The medical market increased by $12.8 million or 20.3% with medical devices accounting for 6% of the increase and medical component products 94% of the increase. Net sales from the aerospace and defense markets increased by $2.9 million or 17.5% in 2022 as compared to 2021. These increases were driven by increased demand as well as price increases to counteract higher material and labor cost. We have also taken actions to scale the direct labor workforce and strengthen the supply chain for parts.   20       Net sales by our major EMS industry markets for the years ended December 31, 2022 and 2021 were as follows (in millions):                       %       2022     2021     Change   Medical   $ 75.9     $ 63.1       20.3   Aerospace and Defense     19.5       16.6       17.5   Industrial     38.7       35.5       9.0   Total Net Sales   $ 134.1     $ 115.2       16.4     Net sales by timing of transfer of goods and services for years ended December 31, 2022 and 2021 are as follows (in millions):   Year Ended December 31, 2022       Product/ Service Transferred Over Time     Product Transferred at Point in Time     Noncash Consideration     Total Net Sales by Market   Medical   $ 51.5     $ 22.3     $ 2.1     $ 75.9   Aerospace and Defense     16.7       1.9       0.9       19.5   Industrial     28.7       8.5       1.5       38.7   Total net sales   $ 96.9     $ 32.7     $ 4.5     $ 134.1     Year Ended December 31, 2021       Product/ Service Transferred Over Time     Product Transferred at Point in Time     Noncash Consideration     Total Net Sales by Market   Medical   $ 47.3     $ 13.3     $ 2.5     $ 63.1   Aerospace and Defense     14.8       0.9       0.9       16.6   Industrial     27.2       6.9       1.4       35.5   Total net sales   $ 89.3     $ 21.1     $ 4.8     $ 115.2     21     Backlog Our 90-day order backlog as of December 31, 2022 was $35.9 million as compared to $36.9 million at the end of 2021.Our 90-day 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.   Our 90-day order backlog by market has remained relatively constant when compared to the prior year. 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.   90-day shipment backlog by our major industry markets are as follows (in millions):       90 Day Backlog as of the               Year Ended December 31,     %       2022     2021     Change   Medical   $ 21.7     $ 20.4       6.4   Aerospace and Defense     5.1       7.6       (32.9 ) Industrial     9.1       8.9       2.2   Total Backlog   $ 35.9     $ 36.9       (2.7 )   Our total order backlog as of December 31, 2022 was $104.1 million, a 9.6% increase from $95.0 million at December 31, 2021. Our total backlog remains strong as our biggest customers are placing orders into the future to secure supply of critical components, in particular for those with long lead times.   Total order backlog by our major industry markets are as follows (in millions):       Total Backlog as of the               Year Ended December 31,     %       2022     2021     Change   Medical   $ 57.1     $ 54.9       4.0   Aerospace and Defense     24.5       22.0       11.4   Industrial     22.5       18.1       24.3   Total Backlog   $ 104.1     $ 95.0       9.6     The 90-day and total backlog at December 31, 2022 contain the contract asset value of $10.0 million which has been recognized as revenue.   Gross Profit Our gross profit as a percentage of net sales was 15.3% and 13.8% for the years ended December 31, 2022 and 2021, respectively. The gross profit improvement relates primarily to price increases in response to material and labor cost inflation and higher production volume which increased plant utilization. The prior year gross profit as a percentage of net sales benefited from the $4.7 million reduction in payroll and medical expenses related to the Employee Retention Credit (“ERC”).   22     Selling Selling expenses were $3.7 million, or 2.8% of net sales, for the year ended December 31, 2022 and $2.4 million, or 2.0% of net sales, for the year ended December 31, 2021. The increase in selling expense is driven by an increase in sales engineering expenses to support the increased sales.   General and Administrative General and administrative expenses were $11.4 million, or 8.5% of net sales, for the year ended December 31, 2022 and $10.0 million, or 8.7% of net sales, for the year ended 2021. General and administrative expenses for the twelve months ended December 31, 2022 were up $1.4 million mainly due to higher professional fees and higher cost of labor; the twelve months ended December 31, 2021 includes a $0.4 million reduction in payroll and medical expenses related to the ERC.   Restructuring Charges There were no restructuring charges for the year ended December 31, 2022. Restructuring charges related to the closure of the Merrifield facility were $0.3 million or 0.3% of net sales for year ended December 31, 2021.   Research and Development Expense Research and development expenses were $1.5 million or 1.1% of sales for the year ended December 31, 2022 and $0.5 million or 0.4% of sales for the year ended 2021. We have several projects in process with estimated completion dates within the next two to five years.    Loss on Abandonment of Intangible Asset There were no abandonment charges for the year ended December 31, 2022. Abandonment charges were approximately $0.6 million or 0.5% of net sales for the year ended December 31, 2021. The charges relate to the abandonment of the Devicix tradename.   Income from Operations Our income from operations for the 2022 fiscal year was $3.9 million, an increase of $1.6 million from the 2021 fiscal year income of $2.3 million. The increase in income from operations was driven by the increase in gross profit. Income from operations in the 2021 fiscal year was positively affected by the 2021 employee retention credits of $5.2 million.   Interest Expense Interest expense for the year ended December 31, 2022 and December 31, 2021 was $0.4 million in each period.   Paycheck Protection Program (PPP) Loan Forgiveness In the fourth quarter of 2021, we received forgiveness from the Small Business Association (SBA) for the $6.1 million Promissory Note under the PPP. We recorded a PPP loan forgiveness gain of $6.2 million, including interest forgiven, which is included in other income (expense) on the consolidated statement of operations and other comprehensive income (loss) for the year ended December 31, 2021.   23     Income Taxes Income tax expense was $1.5 million and $0.9 million for the years ended December 31, 2022 and 2021, respectively. The effective tax rate for fiscal 2022 and 2021 was 42% and 12%, respectively. Our 2022 tax rate was driven by the increase in the valuation allowance from the Tax Cuts and Jobs Act requirement to capitalize and amortize research and experimental expenditures in 2022. Our 2021 tax rate was driven by the nontaxable PPP loan forgiveness.   The statutory reconciliation for the years ended December 31, 2022 and 2021 is as follows (in thousands):       2022     2021   Statutory Rate   $ 572     $ 1,606   State Income Tax     41       14   Effect of foreign operations     71       110   Withholding Tax     122       -   Change in State Deferred Rate     29       (39 ) Valuation Allowance     587       472   PPP Loan Forgiveness     -       (1,276 ) US Permanent differences     (28 )     3   Federal Tax Credits     (272 )     (37 ) Global Intangible Low-Taxed Income Effect     301       391   Return to provision - credits, perm diffs     9       (481 ) IRS Payable     17       121   Other     18       (25 )     $ 1,467     $ 859     Net Income Our net income in 2022 was $2.0 million or $0.70 per diluted common share and $0.75 per basic common share. Our net income in 2021 was $7.2 million or $2.54 per diluted and $2.68 per basic common share.   Liquidity and Capital Resources We believe that our existing financing arrangements, anticipated cash flows from operations, funds expected to be received for the ERC and cash on hand will be sufficient to satisfy our working capital needs, capital expenditures and debt repayments for the next twelve months.   24     Credit Facility We have a credit agreement with Bank of America which was entered into on June 15, 2017 and provides for a line of credit arrangement of $16 million that was to expire on June 15, 2022. On December 31, 2021, we renewed the credit agreement through June 15, 2026.   Under the Bank of America credit agreement, the line of credit is subject to variations in the Bloomberg Short-Term Bank Yield (BSBY) index rate. Our line of credit bears interest at a weighted-average interest rate of 5.2% and 3.5% as of December 31, 2022 and 2021, respectively. We had borrowings on our line of credit of $6.9 million and $9.0 million outstanding as of December 31, 2022 and December 31, 2021, respectively. There are no subjective acceleration clauses under the credit agreement that would accelerate the maturity of our outstanding borrowings. In addition, the credit agreement does not expire within one year, the Company is not in violation of the covenants and the Company expects Bank of America to be capable of honoring the financing arrangement.   The line of credit with Bank of America contains certain covenants which, among other things, require us to adhere to regular reporting requirements, abide by shareholder dividend limitations, maintain certain financial performance, and limit the amount of annual capital expenditures.   The Bank of America Credit Agreement provides for, among other things, a Fixed Charge Coverage Ratio of not less than 1.0 to 1.0, for the twelve months ending December 31, 2022 and each Fiscal Quarter end thereafter subject only during a trigger period commencing when our availability under our line is less than $2.0 million until availability is above that amount for 30 days. The Company met the covenants for the period ended December 31, 2022.   At December 31, 2022 and 2021, we had unused availability under our line of credit of $8.4 million and $3.5 million, respectively, supported by our borrowing base. The line is secured by substantially all of our assets. During 2022, we amended our credit agreement to include the Employee Retention Credit Receivable as security in our line of credit which improves our unused availability which expired on January 15, 2023.   On April 15, 2020, we entered into a Promissory Note with Bank of America, N.A., which provides for an unsecured loan of $6.1 million pursuant to the Paycheck Protection Program (“PPP”) 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 loan was accounted for as debt until November 3, 2021 when the $6.1 million loan and $0.1 million accrued interest was fully forgiven by the SBA. As a result, we recorded a PPP loan forgiveness gain of $6.2 which is included in other income (expense) on the consolidated statements of operations and other comprehensive income for the year ended December 31, 2021.   Our China operation has a financing agreement with China Construction Bank which provides for a line of credit arrangement of 10,000,000 Renminbi (RMB) (approximately 1.5 million USD) that will expire on August 18, 2023. We had no amounts outstanding as of December 31, 2022 and 2021.   25     Cash flows for the years ended December 31, 2022 and 2021 are summarized as follows:   (in thousands)   2022     2021   Cash flows provided by (used in):                 Operating activities   $ 5,402     $ (4,540 ) Investing activities     (2,426 )     (730 ) Financing activities     (2,667 )     3,931   Effect of exchange rate changes on cash     (53 )     0   Net change in cash   $ 256     $ (1,339 )   Cash provided by operating activities for the year ended December 31, 2022 was $5.4 million compared to cash used in operations of $4.6 million for the year ended December 31, 2021. In 2022, the cash provided by operating activities was driven by results from operations. In 2021, increases in working capital due to higher sales backlog as well as actions taken to address the global supply chain shortages drove the use of cash from operating activities, primarily increased inventories of $4.6 million.   Net cash used in investing activities was $2.4 million for the year ended December 31, 2022 and net cash used in investing activities was $0.7 million for the year ended December 31, 2021. Cash used in investing activities in 2022 relates primarily to the purchase of $2.4 million of property and equipment. Cash used in investing activities in 2021 relates primarily to the purchase of $1.3 million of property and equipment offset by the proceeds from the sale of $0.6 million of property and equipment related to the Merrifield plant closure.   Net cash used in financing activities in 2022 of $2.7 million consisted primarily of net payments on the line of credit of $2.1 million and capital lease payments of $0.6 million. The cash provided by financing activities in 2021 of $3.9 million consisted primarily of increased borrowing on the line of credit of $5.7 million offset by payments on long-term debt and capital leases of $1.7 million.   26       Forward-Looking Statements This Annual Report on Form 10-K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We may also make forward-looking statements in other reports filed with the SEC, in materials delivered to stockholders and in press releases. Such statements generally will be accompanied by words such as “anticipate,” “believe,” “estimate,” “expect,” “forecast,” “intend,” “possible,” “potential,” “predict,” “project,” or other similar words that convey the uncertainty of future events or outcomes. Although we believe these forward-looking statements are reasonable, they are based upon a number of assumptions concerning future conditions, any or all of which may ultimately prove to be inaccurate. Forward-looking statements involve a number of risks and uncertainties. Important factors that could cause actual results to differ materially from the forward-looking statements include, without limitation:   ♦ 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-K 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.   Item 7A. Quantitative and Qualitative Disclosures About Market Risk Not applicable.   27       NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES TABLE OF CONTENTS FOR THE YEARS ENDED DECEMBER 31, 2022 AND 2021