NORTECH SYSTEMS INC 10-Q

ITEM 2. Management’s Discussion and Analysis of Financial Conditions 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, complex higher-level assemblies and other box builds for a wide range of industries. We serve three major markets within the EMS industry: Medical, Aerospace and Defense, and the Industrial market which includes industrial capital equipment, transportation, vision, agriculture, oil and gas. As of September 30, 2024, we have facilities in Minnesota: Bemidji, Blue Earth, Mankato, Milaca and Maple Grove (corporate office). We also have facilities in Monterrey, Mexico and Suzhou, China. In May, 2024, we announced the closure of our Blue Earth facility by the end of 2024 and moving its operations to our Bemidji facility. All dollar amounts are stated in thousands of U.S. dollars. Results of Operations Net Sales. Net sales for the three months ended September 30, 2024 and 2023 were $31,407 and $33,369, respectively, a decrease of $1,962 or 5.9%. Net sales for the nine months ended September 30, 2024 and 2023 were $99,513 and $103,278, respectively, a decrease of $3,765 or 3.6%. The following is a summary of net sales by our major industry markets: Three Months Ended September 30, 2024 2023 Increase (Decrease) Medical $ 18,047 $ 17,835 $ 212 1.2 % Industrial 8,434 10,435 (2,001 ) (19.2 )% Aerospace and defense 4,926 5,099 (173 ) (3.4 )% Total net sales $ 31,407 $ 33,369 $ (1,962 ) (5.9 )% Nine Months Ended September 30, 2024 2023 Increase (Decrease) Medical $ 53,991 $ 59,814 $ (5,823 ) (9.7 )% Industrial 27,643 28,966 (1,323 ) (4.6 )% Aerospace and defense 17,879 14,498 3,381 23.3 % Total net sales $ 99,513 $ 103,278 $ (3,765 ) (3.6 )% ● Medical: Net sales to our medical customers increased $212, or 1.2%, in the three months ended September 30, 2024 as compared with the same period in 2023, and decreased $5,823, or 9.7%, in the nine months ended September 30, 2024 as compared with the same period in 2023. The decrease in the nine-month comparison was primarily due to inventory re-balancing with existing customers, timing of customer product launches and lower average sales prices in anticipation of moving several programs for one customer to our Monterrey, Mexico facility which will be completed in the fourth quarter of 2024. ● Industrial: Net sales to our industrial customers decreased $2,001, or 19.2%, in the three months ended September 30, 2024 as compared with the same period in 2023, and $1,323, or 4.6%, in the nine months ended September 30, 2024 as compared with the same period in 2023. The decrease in net sales was primarily due to industrial customer’s efforts to reduce their inventory investments, delayed program launches with several customers as well as sales headwinds in several markets for which we provide products for these customers. ● Aerospace and defense: Net sales to our aerospace and defense customers decreased $173, or 3.4%, in the three months ended September 30, 2024, as compared with the same period in 2023, and increased $3,381, or 23.3% in the nine months ended September 30, 2024, as compared with the same period in 2023. The increase in net sales in the nine-month comparison relates to increasing demand in the aerospace and defense market, and improved supply chain availability of component materials. Backlog. Our 90-day shipment backlog as of September 30, 2024 was $29,631, down 1.5% from June 30, 2024, and 12.3% from the prior-year comparable quarter end. Our 90-day backlog consists of firm purchase orders we expect to ship in the next 90 days, with any remaining amounts to be shipped within 180 days. Our total order backlog as of September 30, 2024 was $69,770, a 4.8% decrease from the prior quarter end and a 31.8% decrease from the prior-year comparable quarter end. As the supply chain lead times have normalized, customers are returning to their pre-pandemic ordering practices, which has resulted in a decrease in our backlog. We continue to experience reduced visibility to revenues in the next several quarters as customers are rebalancing their inventories and, therefore, deferring the placement of some orders. 90-day and total shipment backlog by our major industry markets are as follows: September 30, 2024 June 30, 2024 September 30, 2023 90 Day Total 90 Day Total 90 Day Total Medical $ 15,684 $ 35,354 $ 15,906 $ 34,450 $ 16,775 $ 51,394 Industrial 7,200 9,445 6,398 11,423 9,656 19,680 Aerospace and defense 6,747 24,971 7,791 27,423 7,337 31,260 Total backlog $ 29,631 $ 69,770 $ 30,095 $ 73,296 $ 33,768 $ 102,334 The 90-day and total backlog as of September 30, 2024 includes orders already recognized in net sales and included in the contract asset value of $15,058. 17 Operating Costs and Expenses. Net sales, cost of goods sold, gross profit, and operating costs were as follows: Three Months Ended September 30, 2024 2023 Increase/(Decrease) Net sales $ 31,407 $ 33,369 $ (1,962 ) (5.9 )% Cost of goods sold 27,572 28,050 (478 ) (1.7 )% Gross profit 3,835 5,319 (1,484 ) (27.9 )% Gross margin percentage (1) 12.2 % 15.9 % (370 )bpc(2) Selling 891 923 (32 ) (3.5 )% % of Net sales 2.7 % 2.8 % General and administrative 2,950 2,958 (8 ) 2.6 % % of Net sales 9.4 % 8.9 % Restructuring charges 176 - 176 - % % of Net sales 0.6 % - % Research and development 284 314 (30 ) (9.6 )% % of Net sales 0.9 % 0.9 % Operating income (467 ) 1,124 (1,591 ) (141.5 )% % of Net sales (1.5 )% 3.4 % (1) Gross margin percentage is defined as gross profit as a percentage of net sales. (2) Basis points change in gross margin percentage. Nine Months Ended September 30, 2024 2023 Increase/(Decrease) Net sales $ 99,513 $ 103,278 $ (3,765 ) (3.6 )% Cost of goods sold 85,613 87,001 (1,388 ) (1.6 )% Gross profit 13,900 16,277 (2,377 ) (14.6 )% Gross margin percentage (1) 14.0 % 15.8 % (180 )bpc(2) Selling 2,605 2,766 (161 ) (5.8 )% % of Net sales 2.6 % 2.7 % General and administrative 9,103 9,328 (225 ) (2.4 )% % of Net sales 9.1 % 9.0 % Restructuring charges 267 - 267 - % % of Net sales 0.3 % - % Research and development 893 907 (14 ) (1.5 )% % of Net sales 0.9 % 0.9 % Operating income 1,032 3,276 (2,244 ) (68.5 )% % of Net sales 1.0 % 3.2 % (1) Gross margin percentage is defined as gross profit as a percentage of net sales. (2) Basis points change in gross margin percentage. Gross profit and gross margins. Gross profit as a percent of net sales was 12.2% and 15.9% for the three months ended September 30, 2024 and 2023, respectively. Gross profit as a percent of net sales was 14.0% and 15.8% for the nine months ended September 30, 2024 and 2023, respectively. The decrease in gross profit as a percentage of net sales in 2024 as compared with the same prior-year periods was the result of lower net sales, as discussed above, and corresponding lower operating leverage from reduced production at a number of our manufacturing facilities. 18 Selling expenses. Selling expenses were decreased slightly in the three and nine months ended September 30, 2024 and 2023 as the result of lower incentive compensation accruals in the current-year periods. General and administrative expenses. General and administrative expenses decreased slightly in the 2024 periods as compared with the 2023 periods as the result of lower incentive compensation accruals in the current-year periods. Restructuring charges . Restructuring charges were $176 and $267 in the three and nine months ended September 30, 2024, respectively, for accrued employee retention bonuses for our facility consolidation and closure of our Blue Earth facility. We expect to incur approximately $800 of cash restructuring costs, including employee retention and facility moving cost in 2024, of which substantially all are expected to be incurred and paid by December 2024. Operating income. Operating (loss) income for the three months ended September 30, 2024 and 2023 were $(467) or (1.5)% of net sales, and $1,124 or 3.4% of net sales, respectively. Operating income for the nine months ended September 30, 2024 and 2023 were $1,032 or 1.0% of net sales and $3,276 or 3.2% of net sales, respectively. Decreases in both periods were driven by the decrease in net sales and resulting gross margin. Other expense Interest expense. Interest expense was $216 and $130 for the three months ended September 30, 2024 and 2023, respectively. Interest expense was $548 and $365 for the nine months ended September 30, 2024 and 2023, respectively. This increase was driven by higher borrowings under our line of credit arrangement. Refer to “Liquidity and Capital Resources” for further discussion of financing arrangements. Income taxes. Our effective tax rate for the three and nine months ended September 30, 2024 was 8% and 62%, respectively. Our effective tax rate for the three and nine months ended September 30, 2023 was (21%) and 13%, respectively. The primary drivers of the change in rate relate to changes in pretax book income and the 2023 U.S. federal provision to return adjustments recorded in the third quarter of 2024, partially offset by realization of deferred tax assets in the 2024 periods as the Company removed its valuation allowance in the fourth quarter of 2023. Cash Flow Operating Results The following is a summary of cash flow results: Nine Months Ended September 30, 2024 2023 Cash provided by (used in): Operating activities $ (3,043 ) $ 2,181 Investing activities (971 ) (1,121 ) Financing activities 3,561 (2,388 ) Effect of exchange rates on changes in cash and cash equivalents 17 (32 ) Net change in cash and cash equivalents $ (436 ) $ (1,360 ) Operating Activities. Cash used in operating activities was $3,043 in the first nine months of 2024, compared with cash provided of $2,181 in the same prior-year period. Significant changes in operating assets and liabilities affecting cash flows during these periods included: ● Cash provided by accounts receivable and contract assets was $2,150 in the nine months ended September 30, 2024 as compared with cash usage of $1,942 in the same prior-year period. The improved cash flow in the current year was due to the timing of customer payments in the fourth quarter of 2023 as compared with the fourth quarter of 2022, both of which impacted cash collections in the subsequent year. ● Cash used in inventory was $922 in the nine months ended September 30, 2024 as compared with cash provided of $899 in the prior-year period. The increase in the current-year period cash usage was the result of normal timing variances of inventory purchases and timing of product shipments and increased inventory levels to support the transition of manufacturing from our Blue Earth facility to our Bemidji plant. ● Cash used by changes in accounts payable was $3,609 in the current-year period as compared with cash use of $1,636 in the same prior-year period, primarily related to the timing of cash payments. ● Cash provided by customer deposits was $1,195 in the nine months ended September 30, 2024 as compared with cash provided of $345 in the same prior-year period which is driven by timing of customer deposits received before the quarter end. 19 Investing Activities. Cash used in investing activities was $971 in the first nine months of 2024, compared with cash used of $1,121 in the same prior-year period, both primarily for capital expenditures. Financing Activities. Cash provided by financing activities was $3,561in the first nine months of 2024, compared with cash used of $2,388 in the same prior-year period. The increase in cash provided by financing activities resulted from the cash used for working capital in the nine months ended September 30, 2024. Liquidity and Capital Resources We believe that our existing financing arrangements, anticipated cash flows from operations and cash on hand will be sufficient to satisfy our working capital needs for the next twelve months, capital expenditures and debt repayments. Credit Facility. We had a credit agreement with Bank of America, which was entered into on June 15, 2017 and provided for a line of credit arrangement of $16,000, that was to expire on June 15, 2026. On February 29, 2024, we replaced the asset backed line of credit agreement with a $15,000 Senior Secured Revolving Line of Credit with Bank of America (the “Revolver”). The Revolver allows for borrowings at a defined base rate, or at the one, three or six month Secured Overnight Finance Rate, also known as “SOFR,” plus a defined margin. If the Company prepays SOFR borrowings before their contractual maturity, the Company has agreed to compensate the bank for lost margin, as defined in the Revolver agreement. The Company is required to quarterly pay a 20-basis point fee on the unused portion of the Revolver. The Revolver requires the Company to maintain no more than 2.5 times leverage ratio and at least a 1.25 times minimum fixed charges coverage ratio, both of which are defined in the Revolver agreement. The Company met the covenants for the period ended September 30, 2024. There are no subjective acceleration clauses under the Revolver that would accelerate the maturity of outstanding borrowings. The Revolver contains certain covenants which, among other things, require the Company to adhere to regular reporting requirements, abide by shareholder dividend limitations, maintain certain financial performance, and limit the amount of annual capital expenditures. The Revolver is secured by substantially all the Company’s assets and expires on February 28, 2027. We were in compliance with all the financial covenants related to this agreement as of and for the period ended September 30, 2024, except for the covenant related to operating expense contributions to our Mexican operations in the first and second quarters of 2024 in excess of the amounts allowed under the Revolver. We received a waiver of this event of default from the bank in August 2024. Under the amended Bank of America credit agreement signed February 29, 2024, the line of credit is subject to variations in the SOFR index rate. Under the prior credit agreement with Bank of America, the line of credit borrowing availability was restricted by a defined asset borrowing base, and interest was based on variations in the Bloomberg Short-Term Bank Yield (BSBY) index rate. Our line of credit bears interest at a weighted-average interest rate of 7.9% and 8.3% as of September 30, 2024 and December 31, 2023, respectively. We had borrowings on our line of credit of $9,550 and $5,846 outstanding as of September 30, 2024 and December 31, 2023, respectively. As of September 30, 2024 we had unused availability on the line of credit of $5,450. The Company has an interim funding agreement as of September 30, 2024 with a bank related to $317 of deposits made on equipment purchases that will be funded through a finance lease when the equipment is received and operational. As of September 30, we have $317 outstanding on the interim funding agreement for equipment we expect to receive in the fourth quarter of 2024. The line of credit is shown net of debt issuance costs of $42 and $31 on the condensed consolidated balance sheet as of September 30, 2024 and December 31, 2023, respectively. 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. 20 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; ♦ Supply chain disruption and unreliability; ♦ Lack of supply of sufficient human resources to produce our products; ♦ 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; ♦ 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 obligation to update publicly any forward-looking statement (or its associated cautionary language) whether as a result of new information or future events. 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, 2023. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.