NSYS - Nortech Systems Incorporated (NSYS) Q4 2022 Earnings Call Transcript

2023-03-17 12:22:09 ET

Nortech Systems Incorporated (NSYS)

Q4 2022 Earnings Conference Call

March 17, 2023 09:00 ET

Company Participants

Chris Jones - Chief Financial Officer

Jay Miller - President and Chief Executive Officer

Conference Call Participants

Paul Luther - Private Investor

Presentation

Operator

Greetings and welcome to Nortech’s Fourth Quarter 2022 Earnings Call. [Operator Instructions] I will now turn the conference over to your host, Mr. Chris Jones. Please go ahead.

Chris Jones

Good morning and thanks operator and Happy St. Patrick’s Day to everybody. I want to welcome everyone to our conference call today. First, Jay will begin with a review of our industry, our value proposition for customers and operational performance. And then I will review Nortech’s Q4 and full year financial results and then turn it back over to Jay for his closing comments. And then we will open up the call for your questions.

Before we continue though, please note that statements made during this call and the Q&A session maybe forward-looking regarding expected revenue, earnings, future plans, opportunities and other company expectations. These estimates, plans and other forward-looking statements involve unknown and known risks and uncertainties that may cause actual results to differ materially from those expressed or implied on this call. These risks, including those that are detailed in our most recent Form 10-K, maybe amended or supplemented. The statements made during this conference call are based upon information known by Nortech as of the date and time of this call and 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.

And with that, I will turn it over to Jay for his opening comments.

Jay Miller

Thank you, Chris and happy St. Patrick’s Day everyone. We are excited to discuss our 2022 results and we will do so shortly. But today, I want to take a little bit of time to take a step back and answer a simple question. What is Nortech’s value proposition? Though what we do here at Nortech is complex, the answer to this question is relatively simple. We engineer and manufacture complex, low-volume, high-mix electromechanical systems, assemblies and components for medical, industrial and defense customers and we do so on a global basis, with plants in Minnesota, Monterrey, Mexico and Suzhou, China.

Notably, we do not compete in the high volume, low mix space, which is dominated by larger companies like Benchmark and Plexus, admirable companies in their own right, whose factories churn off thousands of identical products everyday running multiple shifts. In contrast to those huge firms, Nortech will setup production lines that might run for a week or two or maybe a month. We constantly take down lines and setup different lines. It’s a fundamentally different business. And while we leverage some very sophisticated capital equipment in the production and testing, we primarily rely on our experienced high-skilled, high-enzyme workforce to produce these very complex technical solutions.

A $2 million to $5 million order is significant for us. And while larger contract manufacturers won’t take that business, it’s perfect for Nortech. Our largest customer accounts for roughly 25% of our revenue. But after that, our next largest customer is about 7%. We can effectively serve customers of any size that fit our global low volume, high mix, mission-critical business model. While Wall Street analysts may group all large and small EMS firms together, we do things that those larger firms cannot do or will not do. And candidly, they do things that we will not do.

Occasionally, customers learn this fundamental difference in business philosophy in the hard way. We are currently negotiating with a medical customer that had first awarded their business to a large EMS firm. It was a relatively small contract for the relatively large EMS firm and the customer was neglected. Consequently, quality and communication both suffered. The complicated, complex manufacturing process and supply chain was a poor fit for that large company’s high-volume, low-mix model. Frustrated, that customer then pulls its manufacturing back in-house.

But quickly recognizing and then managing all the suppliers they have taken on, the cash implications of managing a lot of new inventory and the complexity of their manufacturing process that customer is now talking to us and this situation fits Nortech perfectly. This simple story reflects what happens somewhat frequently.

The Nortech team is very proud of what we do daily for our customers and we feel we do it very well. It starts with taking great care of each other as Nortech employees and taking great care of our families. It’s also very important to us that we take very good care of our supplier partners by communicating with them openly and honestly and paying them on time 100% of the time. It also means that we strive to be good corporate citizens locally, nationally and globally. We know that if we take great care of all these critical stakeholders, employees and our families, customers, supplier partners and our communities, we will also take great care of our shareholders. If there is a secret to our strong results in 2022, this is it.

Now to explain our financials in more depth, we will turn it over to Chris. Chris?

Chris Jones

Alright. Thanks, Jay. So I will begin with the top line. And in Q4 2022, revenue totaled $35.6 million. This represents a 6.4% increase from revenue of $32.5 million in the fourth quarter of 2021 and it’s up slightly from the prior quarter, increases year-over-year coming from both higher volume and previous pricing actions. For the full year 2022, revenue totaled $134 million, a nearly 17% increase from revenue of $115 million in the full year of 2021. Nortech’s revenue performance was driven by growth in net sales across all the markets that we serve.

The medical market was up by about $13 million or 20% compared to 2021, with the majority of the increase coming from medical component products. In 2022, revenue from the industrial market was up $3 million or 9% from the prior year. And last, our aerospace and defense markets were also up from prior year levels by 17.5% or $3 million. So as I mentioned earlier, the overall year-over-year revenue improvement across all our markets was primarily due to a combination of higher production volume and pricing adjustments.

Q4 gross profit totaled $5.1 million or 14.3% compared to a gross profit of $2.7 million or 8% from the prior year quarter. The fourth quarter margin was down on a sequential basis, but we believe that over the long run, we are in a more stable gross margin position. For the full year 2022, gross profit of $20.5 million or 15.3% gross margin was up from adjusted gross profit of $11.2 million or 9.7% in the prior year. Notable in 2021 is that GAAP gross profit included the $4.7 million employee retention credit and so our adjusted gross profit excludes that non-recurring item. The 83% year-over-year gross profit improvement and resulting 560 basis point improvement in year-over-year gross margin relates primarily to pricing actions to overcome inflationary cost pressures.

Fourth quarter operating expenses totaled $4.4 million, which is a 23% increase from the fourth quarter 2021 operating expenses of $3.6 million and it was flat on a sequential quarter basis. The $800,000 increase in year-over-year operating expenses was driven primarily by a $347,000 increase in selling expenses related to engineering and marketing to drive new business bookings for future quarters. Next, the majority of the $382,000 increase in year-over-year G&A costs was due to necessary investments in IT, HR and analytical capabilities. And finally, a $174,000 increase in year-over-year research and development cost reflects continued investment in new technologies such as the Active Optical Xtreme cable platform.

For full year 2022, income tax expense was $1.5 million compared to $900,000 in 2021. The effective tax rate in fiscal 2022 was 42%, up from 12% in 2021. So, that’s a large change in the tax rate. In 2022, the tax rate was driven by a valuation allowance from the Tax Cuts and Jobs Act requirement to capitalize and amortize research and experimental expenditures in 2022. And in 2021, our tax rate was driven by the non-taxable PPP loan forgiveness.

Fourth quarter EBITDA totaled $1.2 million, which is a significant increase over an EBITDA loss of $400,000 in the fourth quarter of 2021. For the full year, EBITDA totaled $5.8 million, which is a $6 million improvement on an EBITDA loss of $200,000 in 2021. Both the fourth quarter and full year increases resulted primarily from previously discussed revenue and gross profit increases offset by investments in operating capabilities.

Moving on to the balance sheet and cash flow statement. First, in 2022, cash provided by operating activities was $5.4 million compared to cash used by operations of $4.5 million in 2021. Also notable in 2022, operating cash flow included the first of two $2.6 million payments from the IRS for the employee retention credit. The IRS is still processing Nortech’s second ERC application and we hope to receive that payment at any time, but we have no visibility to when we receive that payment. We also have a $1.2 million of deferred social security tax payments that will offset the final $2.6 million ERC payment.

During the fourth quarter, net working capital improved by about $1 million as inventory levels of $22.4 million declined slightly from the prior quarter. Throughout 2022, we saw a gradual improvement in supply chain bottlenecks and component lead times. Nortech’s supply chain team is working very closely with our customers and suppliers to ensure that the entire end-to-end supply chain is optimized for on-time delivery and working capital efficiency. We ended 2022 with $6.9 million of borrowings on our $16 million line of credit with Bank of America and we had unused borrowing availability of $8.4 million. We believe that our…

[Technical Difficulty]

Operator

Apologies, ladies and gentlemen, we seem to have lost volume from our speakers. Please wait one moment while we try to reconnect, and please bear with us. Thank you.

Ladies and gentlemen, please bear with us one moment while we fix this slight technical issue. In the meantime, I will reactivate the hold music until we have our speakers. Thank you.

Thank you for your patience ladies and gentlemen. We are still trying to fix this issue. Thank you for your patience. We are still trying to fix this issue.

Ladies and gentlemen, to apologize, we appear to be having a issue to reconnect to our speakers. So you can please bear with us. We will try and recheck, and see if we can get them back on the line. Thank you for your patience and please bear with us. Once again, ladies and gentlemen, thank you for your patience, we are still trying to reconnect to our speakers for today’s call. Thank you for your patience. And I will update you again, shortly.

Thank you for your patience, ladies and gentlemen. We are still trying to contract our speakers. Hopefully, their will be with us shortly. And we can resume the conference. Thank you again for your patience.

Hello, is that, Chris?

Chris Jones

Yes, this is Chris.

Operator

Hi, Chris, thank you so much. Ladies and gentlemen, we have Mr. Jones back on the line, and I will turn it back over to him. Thank you.

Chris Jones

Right. So this is Chris Jones and Jay Miller, and we apologize for the technical problem. The telephone line in our conference room went dead. So now we’re operating off my cell phone. And we will – I understand that we lost the signal about – at the time that I was finishing up my comments on the financials. So I think the best place to restart our prepared comments is with Jay. And then we will have questions after Jay’s comments are complete.

Jay Miller

Thanks, Chris. Again, we sincerely apologize for this. We’re trying to figure out what the root cause was exactly. But before we open the call up for questions, I want to touch on three topics: our strategic planning process, our investments in new technologies and our ESG journey.

Strategic planning is an ongoing process at Nortech rather than just a once-a-year exercise. Our management team and Board are always thinking ahead beyond the next quarter or even fiscal year. For example, our current Nortech strategic plan covers 2023 to 2028, effectively 6 years ahead. Effective strategic planning for the future requires comprehensive, reliable information. And this effort were aided by our enterprise-wide ERP system that connects our entire organization and enable us to quickly adjust to demand fluctuations in this past year and will do so in the future while providing other vital insights. We implemented a new ERP a few years ago and today it’s a vital tool for the whole leadership team as we run the business.

Our strategic planning process also recognizes Nortech’s growth history as a company. It’s encouraging to look back 4 years, the span of my tenure as President and CEO, to see that we’re a much healthier business today. We are much more financially stable, including our balance sheet and cash flows. Our internal team is significantly stronger at headquarters here in the Twin Cities and in all of our plants around Minnesota and Mexico and China. We have better customer relationships, more true partnerships today. Our supplier partnerships have also improved dramatically. And we are also better corporate citizens. We take better care of each other’s employees, including our families. In each of the locations where we operate, Nortech is working to become a better community partner and a better place to work. This helps us attract and retain employees. And today, our staffing levels are sufficient and stable.

To stay on top of technologies that can help further distinguish us in the marketplace, we will continue leveraging our engineering expertise in new areas. Last year, we announced two exciting developments, launching our Active Optical Xtreme cable platform for machine vision and factory automation and receiving a U.S. patent for the Flex Faraday Xtreme flexible printed circuit for high-frequency signals. Both are future-oriented technologies with exciting potential. They are also critical stepping stones to even better innovations that will help our customers in many ways, making their products more competitive, higher-performance, lighter, more cybersecure, all while lowering overall costs. These innovations will make our products and therefore our customers’ products cleaner environmentally and more sustainable.

While we work to develop future technologies for our customers, we also must help them prepare for other challenges in the horizon. These include issues of sustainability within the context of ESG, environmental, social and governance priorities. ESG may not be in the front – may not be front and center on everyone’s radar now, but it’s only a matter of time. And Nortech will be a proactive leader, not a follower. Note this, our R&D efforts are intimately tied to our ESG priorities. Tied directly to creating shareholder value, Nortech’s Board and management team are also committed to helping our customers and suppliers achieve critically important – these critically important ESG goals. We are in the initial stages of this journey, establishing baselines and developing plans. But relatively soon, we will begin to publicly report and track Nortech’s ongoing ESG performance and progress in key areas. No business operates in a vacuum, and this effort demonstrates another way Nortech is committed to our employees, our families, customers, supplier partners and shareholders, along with a greater world around us.

And with that, we will open things up – the call up for questions. Ali, please open the line and poll for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We have a question from Paul Luther, who is a private investor. Please go ahead.

Paul Luther

Good morning folks and I guess congratulations first off on a strong 2022. And I guess with that and kind of looking at the Q4 high tax rate, I am curious what you anticipate the 2023 tax rate to run at and also kind of what you think normalized gross margins might be into the New Year?

Chris Jones

Yes. This is Chris. And I will take both of those on the tax rate and normalized gross profit margin. So, on the tax rate, I think that Nortech had a unique occurrence in 2021 that made our effective tax rate low because of the PPP loan forgiveness. And then in 2022, we had a disproportionately high effective tax rate. And I think that was due to implementation of IRS rules around research and experimentation capitalization. So, in 2023, we – neither one of those two unusual occurrences will occur. So, I would expect a normal statutory income tax rate through 2023. And of course, we are working closely with our tax advisors to work on any kind of cash tax credit opportunities, especially around things like research and development. That’s our 2023 certainly ongoing planning on taxes. On gross margin, our normalized full year gross margin last year was about 15%, which was obviously up significantly from 2021. And I think as we look at the kind of a stable gross margin pattern in 2022, I would expect that to continue into 2023. I think we have a measured degree of headwinds on the margins side and tailwinds on the margins side. So, I think that’s something that obviously, in 2023, we are going to continue to focus on. And I think ultimately, as we think beyond 2023 and Nortech’s broader planning on improving margin, it’s adding more value to our customers, it’s doing more-higher level assemblies, more complex products. And I think if you heard Jay’s prepared remarks about the – ultimately, the strategic direction of the company is towards higher-margin products. But it’s going to be methodical. And I think it’s going to be stepwise quarter-on-quarter.

Jay Miller

Paul, this is Jay. First of all, thanks for your question. We appreciate it. We do feel very good about the year. As Chris noted, we all know what the headwinds are out there, and we are dealing with those and staying very close to our suppliers and our customers as we are working through these things. These pendulums tend to go back and forth. And our – part of our job is to work with our customers and try to even those things out as best we can. But long-term, over time, clearly we expect to grow our top line reasonably aggressively and grow our profitability even faster. Over time, we expect our gross profit and our gross margins to continue to build. We are not going to give specific numbers, but we expect improvement in all those areas. And again, thanks for the question.

Paul Luther

Thank you, Chris and Jay. And just kind of – can you add a pinch of color you got – to the comment of headwinds and tailwinds, more importantly on the headwinds. I know there is labor, inflationary pressures, there is material pressures. But is that the driver, or is it competitive market conditions at the customer level or the need to be extra competitive to win new business, or can you put a little flavor on that kindly?

Jay Miller

Yes. I would say one of the significant headwinds is as this, we were not as the global supply chain starts to ease, and really, if we look back 12 months to 18 months, it is quite a bit better now than it was before. As we have seen that ease, our customers are more comfortable with their inventory and, in some cases, they have pushed orders out because they are not as concerned about the inventory, because we are performing better, which makes for an interesting dynamic in the market. There is also concerns, of course, as the Fed has pretty – been pretty aggressive about taking interest rates up about whether we are going to really see a hard landing or a softer landing. As we see this, by the way, we kind of anticipate that that pendulum as it goes back, and we have seen business push out, we expect that, that will come back, of course. And we will get back to normal run rates in terms of business. Our customers, for the most part, tend to be a little more independent, if you will, of a lot of the regular market or economic fluctuations because they are in the defense space or because in they are in the medical space. So, we expect things to normalize out a little bit here this year. And look, we are all anticipating and, well, we will say, we are planning for a harder landing and hoping for a softer landing, if you will.

Paul Luther

Got it. Thank you. And one final question. Here we sit two weeks before the end of Q1. Would you guys give us a little sense of how Q1 is tracking at year-end? And maybe relative to Q4 top line run rate margin and the like?

Jay Miller

Yes. We won’t comment specifically on Q1 at this point, partly because we are – obviously, we are right in the middle of it. And like most businesses, the last month of each quarter is pretty busy. So, we won’t comment necessarily on Q1. But we do expect that we will have a solid year this year overall, and we really like our strategic plan going forward over the next 6 years.

Paul Luther

Got it. Thank you, gentlemen.

Chris Jones

Thank you, Paul. Appreciate it.

Operator

[Operator Instructions] There appear to be no further questions in queue at this time, so I will hand it back to management for any closing remarks they may have.

Jay Miller

Good. Ali, thank you very much and thanks everyone for joining us today. We look forward to talking to you next in May at our first quarter – for our first quarter 2023 results. Thank you and happy St. Patrick’s Day.

Chris Jones

And this is Chris, and I will go through our Safe Harbor statement again. So, as a reminder, statements made during this call and the Q&A session were forward-looking regarding expected revenue, earnings, future plans, opportunities, expectations. These estimates, plans and other forward-looking statements involve unknown and known risks and uncertainties that may cause the actual results to differ materially from those expressed or implied on this call. These risks, including those that are detailed in our most recent Form 10-K, may be amended or supplemented. The statements made during this conference call are based on information known by Nortech as of the date and time of this call, and 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.

And with that, I will end the call. Thank you and we will talk again in May.

Operator

Thank you, ladies and gentlemen. This does conclude today’s conference call. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation.

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